SEC proposal to exempt companies from internal control audits sparks pushback

• Key Insight: See why federal regulators and stock exchanges are pushing to reduce corporate audit mandates.
• What’s at Stake: Investors and newly public companies face a dramatic shift in financial oversight protections.

Audit and accounting firms are concerned about recent proposals from the Securities and Exchange Commission and the New York Stock Exchange that would reduce the need for both external and internal auditors.

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The SEC proposal, which was unveiled in May, aims to divide the filer statuses for public companies into two main categories — large accelerated filers and non-accelerated filers — while raising the threshold requirements for large accelerated filers, and extending to all non-accelerated filers the existing accommodations and scaled down disclosures for smaller reporting companies and emerging growth companies. The Commission is also proposing to extend periodic reporting deadlines for the smallest non-accelerated filers, as measured by their total assets. 

Among the effects would be exempting about 81% public companies from the requirements under Section 404(b) of the Sarbanes-Oxley Act of 2002 for audits of internal controls. 

“There’s this crazy quilt of all sorts of different things that have built up over time — emerging growth companies, accelerated filers, large accelerated filers, whatever, some from statutes, some from SEC rules over the years, overlapping things,” said SEC chairman Paul Atkins during Financial Executives International’s Corporate Financial Reporting Insights online conference. “You really need maybe not a Ouija board, but a very good staff of lawyers to help you figure out what might be best for your company and so forth.”

Atkins wants to encourage more companies to go public and “make IPOs great again,” as he has often said.

“Our goal is to recalibrate these disclosure requirements based on the company size, how long it’s been public,” he said during the FEI CFRI conference. “The various changes that we have are still going to mean that companies that, for example, are required to get auditor attestation will still be about 94 to 95% of total public float. We’re looking at the smaller companies, and then trying to recalibrate things that inhibit people from the private markets to go public. A lot of these things are the complexity, the cost, the brain damage that it takes for management to distract them from building a company and working for investors to increase the return on investors to do the paper chase that too often is demanded by the SEC. Companies have said that these requirements are the most costly aspect, including the auditor attestation. We’re looking at all of that, and that’s part of our goal.”

Pushing back

The Center for Audit Quality pushed back against the proposals in a July comment letter. “By expanding the population of companies exempt from internal control over financial reporting (ICFR) auditor attestation to approximately 81% of public companies, the proposal may extend accommodations too broadly, including to companies where independent assurance over internal controls remains important to investors and the capital markets,” wrote Dennis McGowan, vice president of professional practice at the CAQ.

The SEC is also proposing to provide a five-year accommodation for newly public companies, regardless of their size, which seems inappropriate given the kinds of mammoth companies now going public, such as Anthropic and SpaceX.

“A five-year accommodation for newly public companies regardless of size is not appropriately tailored,” said the CAQ. “The concern is particularly acute for highly capitalized, newly public companies, where a five-year accommodation regardless of size may be inconsistent with the company’s resources, complexity, investor following, and potential impact on the capital markets. The CAQ believes any accommodation for newly public companies should be calibrated to preserve investor protections for companies that already have the scale and market significance of a larger public company.”

Lou Pizzileo, a partner at Grassi, a Top 75 Firm based in New York, who has guided newly public companies through SEC reporting and audit requirements, has seen drastic changes in the regulatory environment over the years. He was working at the former Big Five firm Arthur Andersen in the early 2000s at a time when accounting scandals at Andersen clients such as Enron and WorldCom erupted that led to the passage of Sarbanes-Oxley, the creation of the Public Company Accounting Oversight Board, and the closure of Andersen. He later worked at KPMG and the PCAOB. 

“Over the past 12 to 18 months, we’ve seen the pendulum go from extreme regulation closer to the middle,” he said. “Those proposals out there are political pandering. When I look at something like repealing Sarbanes-Oxley for only the largest issuers, you think about the benefit of that to the proposer or the political party that put it forth, and the overall risk of, let’s say, getting egg on your face, and you wonder how likely it is that it will actually go there. I think it’s a long shot. I do think that the SEC’s come a long way recently in creating an environment in which the smaller public companies can take advantage of capital markets and raise capital and grow capital and promote technology and innovation at that level. I’ve always looked at the micro cap sector of the market as a public venture. There’s a place for it. Institutional capital and retail investors will be there, and to date the SEC’s done a good job of regulating it, certainly since the days of the blowups in the early 2000 period.”

There is a risk of losing ground by rolling back the SOX requirements. “We’ve come a long way from ‘Sarbanes Oxley 1.0’, where it was one size fits all,” said Pizzileo. “I think there has been a rightsizing of the regulation to the particular issuers and filers and who has to apply 404(a) and (b). It wasn’t that way in the beginning. We’ve already moderated t what’s working. I do think it’s a long shot that we would further scale back those rules, but anything’s possible.”

Semiannual reporting option

He also believes the SEC’s proposal for a semiannual reporting option is a long shot. “I don’t think it meaningfully changes the economic model either internally for these companies or externally with their securities attorneys and accountants,” said Pizzileo. “At the end of the day, it’s an annual arrangement with quarterly periods. Whether they’re semiannual periods or quarterly periods, it doesn’t meaningfully impact the economic model. I do think, though, many of the companies like to speak quarterly both to the investor public and their shareholder base. So, regardless of whether they have a regulatory requirement to produce a 1934 [Securities Exchange] Act 10-Q or something like it, foreign private issuers have something different. I think they will speak on a quarterly basis anyway. It’s interesting, but I think it’s mostly fodder at this point.”

Sarah McVay, professor of accounting at the University of Washington’s Foster School of Business, is also skeptical about the SEC proposal for a semiannual reporting option. “There’s clearly pervasive overwhelming opposition to this proposal, which then lends a question: Why is the SEC so determined to make this change? It’s concerning,” she said. “The SEC floated the idea of semi-annual reporting in 2018, but there was opposition at that time.”

The opposition at that time was not as extreme as it is this time around, she noted. In 2018 only 43% of the 89 comment letters submitted to the SEC opposed the semi-annual reporting proposal, 43% were conditional, and 13% supported it. Now, an overwhelming majority of comments seem to be negative, according to an unofficial tracker from an Ohio State University accounting professor.

“There’s so little support,” said McVay. 

The American Accounting Association criticized the proposal in a July comment letter. “After reviewing the proposal and the relevant academic literature, we conclude that the expected benefits of semiannual reporting are uncertain and likely modest, while the potential costs are more substantial and better supported by existing evidence,” said the AAA, a group of accounting professors.

McVay and two other professors submitted their own comment letter in July on the proposal to the SEC as well as the proposal for changes in the accelerated filer thresholds.

“We have significant concerns about extending scaled disclosures that were intended for relatively small issuers to all issuers with less than $2B public float, which is a substantial expansion of the population eligible for scaled disclosures,” they wrote. “The Smaller Reporting Company (SRC) designation replaced small business issuers in 2008, expanding the scope from issuers with under $25M in both public float and revenue to $75M in public float or less than $50M in revenue if public float was not calculable (e.g., public-debt-only issuers). Even after the 2018 expansion, eligibility remained limited to issuers with a public float of less than $250M or annual revenues of less than $100M and a public float of less than $700M. The proposal eliminates the revenue qualification and raises the public float threshold to $2B, extending scaled disclosure accommodations to much larger, more mature companies, including large subsidiaries with public debt that are currently excluded from SRC treatment. As a result, disclosure accommodations originally justified for very small or low-revenue companies, where, for example, three years of historical financial information or extensive executive compensation disclosures may provide limited incremental value, would become available to issuers for which those original rationales may be less applicable.”

Financial statement preparers may have mixed feelings about the proposal.

“It means reduced disclosures for every company under $2 billion float,” said McVay. “Preparers are happy with that. They won’t have to provide as much, but semiannual is more complicated because a lot of the preparers are still going to be doing quarterly. That’s the way their systems are built. That’s the sequencing that they have with their investors, so many preparers are going to stay the same.”

Semiannual reporting could also increase the possibility of fraudulent activity going undetected for longer. 

“We have academic evidence that frequent reporting actually acts as a disciplinary mechanism, so it constrains managerial discretion,” said McVay. “If you’re a new company, having a longer time period before you actually have to give someone your cash flow statement means that investors are at risk for longer periods of time. You’ve got a longer runway. If you’re going to be reporting quarterly but not filing, you can misrepresent that and have another three months to hope that you can cover your tracks. It’s just problematic.”

Atkins defended the semiannual reporting proposal at the FEI CFRI conference while acknowledging that most of the 240,000 were negative. “We already have companies that are traded here in the United States, foreign companies, that report semiannually,” said Atkins. “\We got a lot of negative comments, but we’ve also gotten a lot of positive comments. I think a lot of those negative comments misunderstood the proposal, because it is meant to be a flexible proposal. You can still stay with your Qs and do the same old thing. You can go semiannual or halfway. You don’t have to do a full Q. You can do earnings guidance. You can come out with things that you want to disclose that are material. There’s a lot of built-in flexibility, and it’s not necessarily a decision that lasts for the rest of eternity. It’s flexible. You can change from year to year, depending on the circumstances of your company. What we’re trying to do is be conscious of the various situations that are out there with companies.”

He cited the example of a new biotech company that has collected investor funds through its offering, and is waiting for the Food and Drug Administration to approve its product before it earns revenue. 

“There’s a burn rate,” said Atkins. “Should we be paying accountants and lawyers for three Qs during the year with MD&A and everything else. Why can’t that biotech company choose another way to husband its investor resources for better uses for research and development or whatever they may need to do, and then at any rate, if something happens with the FDA, they’re going to have to do an 8-K probably or something that will fall, chances are, outside the Qs. That’s, I think, a really great example of how flexibility is really paramount in a very diverse marketplace that we have, and to be able to try to coax people from the private markets into the public markets.” 

NYSE audit proposal

The SEC isn’t the only group that’s been proposing to loosen the requirements for companies going public. The Institute of Internal Auditors is asking the SEC to reject a New York Stock Exchange proposal that would allow newly listed companies to take up to five years to establish an internal audit function.  

“Five years is far too long for a public company to operate without the ongoing, objective assurance an internal audit function provides,” said IIA president and CEO Anthony Pugliese in a statement in September. “The Exchange has offered no evidence for this change, and the protections it points to do not apply to most of these companies. This requirement has served investors well for more than two decades, and it has been relaxed once already. Extending it fivefold would be a significant step backward for good governance.” 

One reason why the NYSE may be proposing to loosen the requirement may be as a way to compete against Nasdaq for new listings.

“There’s certainly a competition aspect to it because Nasdaq doesn’t have the requirement at all so the New York Stock Exchange probably is looking at it,” said former IIA president and CEO Richard Chambers, who is now a senior advisor on audit and AI at Optro. “I wouldn’t think that not wanting to have an internal audit function is going to make a company decide to list on the Nasdaq versus the New York Stock Exchange. But it’s probably just a desire to make the listing requirements as clean as possible.”

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