Risk & Compliance

Material Weakness at the Roundtable

Opening salvos at the SEC roundtable included talk of better definitions of material weaknesses.
Marie LeoneMay 10, 2006

See our special report on “The 404 Debate.”

Regulators were asked to go back to the drawing board by panelists speaking out about second-year experiences related to Section 404 of the Sarbanes-Oxley Act. Many panelists — including corporate-governance gurus Barbara Hackman Franklin and Mary K. Bush, as well as auditors — called on the Securities and Exchange Commission to provide more guidance to management and auditors via the Public Company Accounting Oversight Board in order to better define material weaknesses and control deficiencies.

The remarks were made Wednesday morning at a roundtable sponsored by the SEC and the PCAOB. Franklin commented that auditors are still “nervous” about straying from the letter of the law and companies may be suffering because of it. She believes that SEC guidance would “empower” auditors to use business judgment in assessing material weaknesses correctly.

Franklin also noted that SEC guidance on deficiencies in controls would likely benefit small companies the most. She opined that guidance, rather than a blanket exemption to 404, would help smaller companies deal with the rigors of Sarbox.

On a cautionary note, Edward Nusbaum, chief executive of auditor Grant Thornton, called for practical guidance from the SEC regarding what constitutes a material weakness. Specifically, he would like to see case studies and examples issued by the SEC. He contends that overall guidance should be principles-based, but “real-life examples” must accompany such standards.

Samuel DiPiazza, chief executive of PricewaterhouseCoopers, pointed out that without a clear definition, auditors and managers are under tremendous “stress” and therefore act overly conservative when assessing control deficiencies. As a result, a “default assumption” is made that deficiencies in internal controls automatically lead to a material weakness, and then a restatement.

But Franklin countered that standard setting using case studies may not be the most useful approach. Case studies of specific companies “will not capture the complexity” of the entire issue. She wants the SEC to come up with better definitions of material weaknesses. “It’s been a bee in my bonnet” for some time, she said.

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