offers or sales of securities by or for the issuer that are of the
same or a similar class as those offered or sold under Regulation D,
other than those offers or sales of securities under an employee
benefit plan as defined in Rule 405 under the Act, 17 CFR 230.405.''
---------------------------------------------------------------------------

    Inasmuch as the alternative to the safe harbor is the inherent
uncertainty of the five-factor test, the practical effect of the
waiting period between Regulation D offerings is to undermine issuers'
flexibility and impede them from obtaining financing at a time that
business goals, and good judgment, would otherwise dictate.
    In short, we believe that the dual six-month safe harbor period
represents an unnecessary restriction on companies that may very well
be subject to changing financial circumstances, and weighs too heavily
in favor of investor protection, at the expense of facilitating capital
formation. We believe that a shorter safe harbor period between
offerings of 30 days strikes a more appropriate balance between the
financing needs of smaller companies and investor protection, while
preserving both investor protection and the integrity of the existing
registration/exemption framework.
Recommendation IV.S.10
    Clarify the Sarbanes-Oxley Act Section 402 loan prohibition.
    Section 402, of the Sarbanes-Oxley Act, which added Section 13(k)
\187\ to the Exchange Act, prohibits public companies from extending
personal loans to directors or executive officers.\188\ The prohibition
was enacted following abuses associated with company loans in several
well-publicized corporate scandals. To date, the SEC's Division of
Corporation Finance has not provided interpretive guidance with respect
to Section 13(k). We believe that confusion exists among public
companies and their attorneys concerning the applicability of the loan
prohibition to a number of transactions that could be construed as
loans.
---------------------------------------------------------------------------

    \187\ 15 U.S.C. 78m(k).
    \187\ 17 CFR 230.405.
    \188\ Pub. L. 107-04, Sec.  402, 166 Stat. 745 (2002).
---------------------------------------------------------------------------

    We strongly support the loan prohibition contained in Section 13(k)
of the Exchange Act. We recommend that the SEC staff seek to provide
clarifying guidance as to the types of transactions that fall outside
the prohibition.
    In particular, we recommend that the SEC's Division of Corporation
Finance clarify whether Section 13(k) prohibits the cashless exercise
of stock options, indemnity advances, relocation accommodations to new
hires and split dollar life insurance polices. We believe that these
transactions, if approved by independent directors, are unlikely to
lead to the abuses envisioned under Section 402 of the Sarbanes-Oxley
Act.
Recommendation IV.S.11
    Increase uniformity and cooperation between federal and state
regulatory systems by defining the term ``qualified investor'' in the
Securities Act and making the NASDAQ Capital Market and OTCBB stocks
``covered securities'' under NSMIA.
    In fulfillment of our basic mandate--to identify methods of
minimizing costs and maximizing benefits--we believe it is important to
increase uniformity and cooperation between federal and state
securities regulatory systems by eliminating unnecessary and
duplicative regulations.
    In our view, this can be accomplished by both (1) defining
``qualified purchaser'' as permitted by the National Securities Markets
Improvement Act of 1996,\189\ or NSMIA, allowing transactions to
involve ``covered securities'' and (2) making NASDAQ Capital Market and
OTCBB stocks ``covered securities,'' thereby preempting most state
securities registration provisions.
---------------------------------------------------------------------------

    \189\ Pub. L. No. 104-290, 110 Stat. 3416 (1996).
---------------------------------------------------------------------------

    In connection with its passage of NSMIA, Congress authorized the
SEC to define the term ``qualified purchaser'' under Securities Act
Section 18 to include, among others, ``sophisticated investors, capable
of protecting themselves in a manner that renders regulation by state
authorities unnecessary.'' Section 18 also provides that sales to
``qualified purchasers'' are by definition ``covered securities.'' The
effect of defining ``qualified purchasers,'' therefore, would be to
exempt offers and sales to persons included in the definition from
unnecessary state registration requirements.
    The Commission in 2001 issued a release in which it proposed to
define ``qualified purchaser'' to have the same meaning as the term
``accredited investor'' under Rule 501(a) of Regulation D.\190\
Although the Commission solicited comment from interested parties, it
took no further action on the proposal, in part because of the
opposition of state securities regulators.\191\
---------------------------------------------------------------------------

    \190\ Defining the Term ``Qualified Purchaser'' Under the
Securities Act, SEC Release No. 33-8041 (Dec. 19, 2001) [66 FR
66839].
    \191\ See, e.g., Letter from Joseph P. Borg, NASAA President and
Director, Alabama Securities Commission, on behalf of the North
American Securities Administrators Association to Committee (Mar. 4,
2002), available at http://www.sec.gov/rules/proposed/s72301.shtml.

---------------------------------------------------------------------------

    The Committee applauds the SEC's initiative in issuing the
qualified purchaser release, and recommends that the ideas expressed in
the release, principally, that all ``accredited investors'' be deemed
``qualified purchasers,'' be adopted substantially as proposed. The
release states, and we agree, that defining ``qualified purchaser'' to
mean ``accredited investor'' would strike the appropriate balance
between the need for investor protection and meaningful regulatory
relief from duplicative state regulation for issuers offering
securities, in particular small businesses.\192\ Investor protection
would be maintained, as accredited investors have long been deemed not
to require the full protection of Securities Act registration and have
sufficient bargaining power to gain access to information with which to
make informed investment decisions.
---------------------------------------------------------------------------

    \192\ Supra note 190, at 4.
---------------------------------------------------------------------------

    As the Commission is aware, in 1996 NSMIA realigned the
relationship between federal and state regulation of the nation's
securities markets in order to eliminate duplicative costs and improve
market efficiency, while maintaining necessary investor protections.
Although NSMIA greatly benefited large businesses, it had a more
limited effect on small businesses, the securities of many of which
trade on the NASDAQ Capital Market and the OTCBB and consequently do
not qualify for the favorable exemptive treatment accorded ``covered
securities.'' For these smaller public companies, the added

burden, complexity and transaction costs that result from a need to
comply with numerous sets of laws and regulations, rather than just
one, places them at a distinct disadvantage in comparison with their
larger counterparts.
    In our view, the two-tiered regulatory structure to which the
NASDAQ Capital Market and OTCBB-traded securities are subject
represents an unnecessary and duplicative level of regulation that
impedes the free flow of capital, while adding little in terms of
investor protection. All companies traded in both markets are required
to be Exchange Act reporting companies. Therefore, we recommend that
the Securities Act Section 18(b) definition of ``covered securities''
be expanded to include the shares of all NASDAQ Capital Market and
OTCBB issuers, provided that such companies (1) are current in their
Exchange Act filings and (2) adhere to the corporate governance
standards, detailed in Part III of this Committee report, that
companies would be required to observe in order to get relief from
certain requirements of Sarbanes-Oxley Act Section 404. We believe that
this action would be consistent with the sentiment expressed in
Securities Act Section 19(d), which mandates greater federal and state
cooperation in securities matters in order to provide both maximum
uniformity in federal and state regulatory standards and to minimize
interference with capital formation. Further, investor protection would
be preserved, as states would retain their anti-fraud authority and the
SEC would maintain its supervisory role through review of issuer
registration statements and Exchange Act filings.
    A final word should be said concerning the manner in which this
recommendation is implemented. Although not entirely clear, it appears
that the express language of Section 18 may not provide the Commission
with the authority to expand the definition of ``covered securities''
to encompass NASDAQ Capital Market and OTCBB securities without further
Congressional action. In such event, we recommend that the Commission
petition Congress to enact legislative changes to Section 18 in order
to effect such changes.
Recommendation IV.S.12
    Clarify the interpretation of or amend the language of the Rule 152
integration safe harbor to permit a registered initial public offering
to commence immediately after the completion of an otherwise valid
private offering the stated purpose of which was to raise capital with
which to fund the IPO process.
    Rule 152 provides an integration safe harbor that protects against
integration of a private offering followed closely by a registered
public offering. By its terms, the language of Rule 152 appears to
require that an issuer ``decide'' to file for the public offering after
the private offering.\193\ In other words, the safe harbor protection
from integration would not appear to be available to an issuer that
contemporaneously plans a private placement (for among other reasons,
to raise funds necessary to sustain it through the IPO process) and a
subsequent registered offering. Moreover, Rule 152 does not apply to
private offerings undertaken pursuant to Rules 504 or 505, which are
exempt pursuant to Securities Act Section 3(b), not Section 4(2) as set
forth in the rule. Although the staff of the Division of Corporation
Finance has indicated that it does not interpret Rule 152 literally,
and will extend safe harbor treatment even in cases where an issuer
concurrently plans a private placement and registered offering,\194\ we
believe that it is time to clarify or amend the language of the rule
appropriately.
---------------------------------------------------------------------------

    \193\ Rule 152 provides as follows: ``The phrase `transactions
by an issuer not involving any public offering' in Section 4(2)
shall be deemed to apply to transactions not involving any public
offering at the time of said transaction although subsequently
thereto the issuer decides to make a public offering and/or files a
registration statement.'' 17 CFR 230.152.
    \194\ See, e.g., SEC No Action Letter, Verticom, Inc. (Feb. 12,
1986).
---------------------------------------------------------------------------

Part V. Accounting Standards

    We devoted a considerable amount of time and effort surveying the
current state of U.S. GAAP that apply to smaller public companies and
certain of the processes related to the audits of their financial
statements. In general, we believe that current regulations and
processes in these areas serve smaller public companies and their
investors very well. We did, however, identify several concerns in this
area which, we acknowledge, are not all unique to smaller public
companies. In decreasing order of concern, these areas are:
     Complexity of current accounting standards;
     Diminished use and acceptance of professional judgment
because of fears of being second-guessed by regulators and the
plaintiffs bar;
     Perception of lack of choice in selection of an audit
firm;
     Lack of judgment concerning application of auditor
independence rules; and
     Lack of professional education requirements covering SEC
reporting matters for auditors of public companies.

Accounting Standards--Primary Recommendations

    We recommend that the Commission and other bodies, as applicable,
effectuate the following:
Recommendation V.P.1
    Develop a ``safe-harbor'' protocol for accounting for transactions
that would protect well-intentioned preparers from regulatory or legal
action when the process is appropriately followed.
    This recommendation represents an attempt by us to address the
diminished use of professional judgment caused in part by fears of
second-guessing by regulators and the plaintiff's bar. This is a very
serious issue for smaller public companies. Testimony taken by us, as
well as written communications we received, strongly supported this
view.
    Accounting standards for public companies vary in nature, ranging
from standards containing principles and implementation guidance on
broad accounting topics to those containing guidance pertaining to
specific business transactions or industry events. Even with the broad
spectrum of existing accounting standards, transactions or other
business events frequently arise in practice for which there is no
explicit guidance. In these situations, public companies and their
auditors consider other relevant accounting standards and evaluate
whether it would be appropriate to apply the guidance in those
standards by analogy. Preparers often find it difficult to make these
determinations, particularly in new or emerging areas. Even when
accounting guidance is applied by analogy, questions frequently arise
as to whether the analogy is appropriate based on a company's
particular facts and circumstances. The result is that companies
frequently end up adopting an approach dictated by their auditors,
which the companies believe is caused by their auditors' concerns about
regulators questioning their judgments, or for other reasons.
    In view of this situation, we are recommending that a ``safe-
harbor'' protocol be developed that would protect well-intentioned
preparers from regulatory or legal action when a prescribed process is
appropriately followed and results in an accounting conclusion that has
a reasonable basis. A possible outline for the protocol for the
preparer to follow would be as follows:
     Identify all relevant facts.
     Determine if there is appropriate ``on-point'' accounting
guidance.

     If no on-point guidance exists, develop and timely
document the preparer's conceptual basis for their conclusion as to the
appropriate accounting treatment.
     Determine and timely document how the proposed accounting
treatment reflects the economic realities of the transaction.
     Disclose in the financial statements and in Management's
Discussion & Analysis the nature of the transaction, the possible
alternative accounting treatments, and the rationale for the approach
adopted.
    We believe that a ``safe harbor'' approach is suitable for dealing
with this problem. In general, a safe harbor provision in a law serves
to excuse liability if an attempt to comply in good faith can be
demonstrated. Safe harbor provisions are used in many areas of the
federal securities laws. One well-known safe-harbor that may serve as a
model for crafting a safe-harbor for accounting transactions is the
safe-harbor for forward-looking statements under the Private Securities
Litigation Reform Act of 1995. The PSRLA provides a safe harbor from
liability in private claims under the Securities Act and Exchange Act
to a reporting company, its officers, directors and employees, as well
as underwriters, for projections and other forward-looking information
that later prove to be inaccurate, if certain conditions are met. The
PSLRA's safe-harbor was based on aspects of SEC Rule 175 under the
Securities Act and Rule 3b-6 under the Exchange Act.\195\ Both of these
rules, adopted in 1979, provide a safe-harbor for certain forward-
looking statements published in documents filed with the SEC, provided
the filer had a reasonable basis to make the statement and was acting
in good faith. By combining aspects of, but not eliminating, Rules 175
and 3b-6 with the judicially created ``bespeaks caution'' doctrine,
Congress created a statutory safe-harbor based on the belief that the
existing SEC rule-based and judicial safe-harbor protections did not
provide adequate protections to reporting companies from abusive
private securities litigation.\196\
---------------------------------------------------------------------------

    \195\ 17 CFR 230.175, 240.3b-6.
    \196\ The PSLRA provides a safe-harbor from liability under the
Securities Act and Exchange Act to the reporting company, its
officers, directors, employees and underwriters, if the forward-
looking statements later prove to be inaccurate, if:
    1. The forward-looking statement is identified as such and is
accompanied with meaningful cautionary statements identifying
important factors that could cause actual results to differ
materially; or
    2. The forward-looking statement is immaterial; or
    3. The plaintiff fails to prove the statement was made with
actual knowledge that it was materially false or misleading.
    See Jay B. Kasner, The Safe Harbor for Forward-Looking
Statements Under the Private Securities Litigation Reform Act of
1995, Practising Law Institute (Sept. 2000); See also Stephen J.
Schulte and Alan R. Glickman, Safe Harbors for Forward-Looking
Statements: An Overview for the Practitioner, Practising Law
Institute (Nov. 1997).
---------------------------------------------------------------------------

    We believe that implementation of this recommendation has the
potential to assist smaller public companies when working with their
audit firms and other parties involved in the financial reporting
system. This, in turn, should reduce excessive and unnecessary
regulatory burdens on smaller public companies.
    We do not believe that implementation of our recommendation would
fully address the diminished use of professional judgment due to fears
of being second-guessed. This is a deep seated problem related to the
excessive litigiousness of our society.\197\ Accordingly, we urge the
Commission, other regulators and federal and state legislators to
continue to search for appropriate and effective ways to lessen this
problem and reduce unnecessary regulatory burdens on smaller companies.
---------------------------------------------------------------------------

    \197\ See Record of Proceedings 95-100 (June 16, 2006)
(statements of George Batavick, Adv. Comm. Observer, and Mark
Jensen, Adv. Comm. Member, on the importance of tort reform to
reduce litigation costs and facilitate a return to principles-based
accounting).
---------------------------------------------------------------------------

Recommendation V.P.2
    In implementing new accounting standards, the FASB should permit
microcap companies to apply the same extended effective dates that it
provides for private companies.
    New accounting standards typically introduce new accounting
requirements or change existing requirements. In order to allow
sufficient time for companies to gather information required by the new
accounting standards, the FASB does not require new standards to be
effective immediately upon issuance. Instead, the FASB establishes a
date in the future when the accounting standards should be adopted, or
become effective. The amount of time allowed by the FASB between the
issuance of a new standard and its effective date varies and depends on
the nature of the accounting requirements and the number of companies
impacted. In addition, the FASB may establish different effective dates
for private companies and public companies.\198\
---------------------------------------------------------------------------

    \198\ FASB standards that distinguish between private and public
companies usually define those terms. For examples where the FASB
has deferred the effective dates for non-public entities, as defined
therein, see FASB Statement of Financial Accounting Standards No.
150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity ] 29 (May 2003) and
FASB Staff Position 150-3 (Nov. 2003).
---------------------------------------------------------------------------

    In some cases, a company will need to gather and analyze a
significant amount of information in order to adopt an accounting
standard. Smaller public companies oftentimes may not have the
resources of larger companies to assist with this effort.\199\ For
example, companies may not have sufficient information technology or
valuation specialists on staff and would need to consider hiring
external parties. In addition, as business transactions have become
more complex in recent years, accounting standards also have become
more complex, requiring greater study and expertise by the preparers
and auditors' of financial statements.\200\
---------------------------------------------------------------------------

    \199\ See Letter from Ernst & Young LLP to Committee (May 31,
2005); Letter from American Bankers Association to Committee (Aug.
31, 2005).
    \200\ See Letter from BDO Seidman, LLP to Committee (May 31,
2005).
---------------------------------------------------------------------------

    We note that some of the more complicated accounting standards
recently issued by the FASB permit private companies an extended period
of time in which to adopt the new standard.\201\ We believe that
allowing microcap companies more time to implement new accounting
standards is appropriate. We are recommending that microcap companies
be allowed to apply the same effective dates that the FASB provides for
private companies in implementing new accounting standards. The
Committee considered and rejected the notion that smallcap companies,
in addition to microcap companies, also should be allowed extended
effective dates. We believe that, in general, smallcap companies have
more resources than microcap companies and should be able to adopt new
accounting standards on the same time line as larger public companies.
---------------------------------------------------------------------------

    \201\ See Statement 150, paragraph 29. See also FASB Statement
of Financial Accounting Standards No. 123, Share-Based Payment Sec.
69, B248 (revised 2004) (permitting small business issuers, as
defined, to defer adoption of the standard on the basis that those
companies may have fewer resources to devote to implementing new
accounting standards and thus may need additional time to do so).
---------------------------------------------------------------------------

    While making this recommendation, we do not propose to establish
different accounting standards for smaller and larger public companies.
Primarily through our Accounting Standards Subcommittee, we considered
the so-called Big GAAP versus Little GAAP debate. This debate involves
the advisability of adopting two different accounting standards for
smaller and larger public companies, and whether U.S. GAAP should be
made scalable for smaller public companies. The

Committee considered whether the needs of users of smaller public
company financial statements are different from the needs of users of
larger public company financial statements, whether smaller public
companies incur disproportionate costs to provide certain financial
information, and whether such information is actually used. The
Committee discussed whether smaller public companies should have
accounting standards with recognition, measurement and/or disclosure
requirements that are different from those of larger public companies,
and whether unintended adverse consequences would result from having
two sets of GAAP.
    We have determined that different accounting standards should not
be created for smaller and larger public companies. We believe such an
approach would confuse investors and that, in many cases, the financial
community would require smaller public companies to follow the more
stringent accounting standards applicable to larger companies. We
believe that if a two-tiered system of accounting standards existed,
many smaller public companies would voluntarily follow the more
stringent standards, so as not to be perceived as less sophisticated.
We also believe that two different accounting standards for public
companies would add significant costs to the financial reporting system
and could potentially increase the cost of capital to smaller public
companies, as risk premiums could attach to what might be perceived as
less stringent accounting standards.\202\ Finally, we did not see
evidence of any overwhelming support for a two-tiered system of
accounting standards in the written and oral submissions we
received.\203\
---------------------------------------------------------------------------

    \202\ See, e.g., Letter from Council of Institutional Investors
to Committee (Aug. 26, 2005).
    \203\ See Record of Proceedings 24-26, 42 (Oct. 14, 2005)
(testimony of Jane Adams, Maverick Capital Ltd., New York, New York,
stating that companies by virtue of size should not be able to
choose among multiple GAAP's to structure transactions and keep
relevant information from investors, and if different standards are
permitted, whether GAAP or internal controls, any financial
statements and filings prepared under this light version should warn
investors that this information did not come with the full package
of protections and controls). See also Letter from
PricewaterhouseCoopers LLP to Committee (Sept. 2, 2005); Letter from
Grace & White, Inc. to Committee (Oct. 6, 2005); Letter from Glass
Lewis & Co. to Committee (Sept. 14, 2005). See also responses to
Questions 16 and 21 of Request for Public Input by Advisory
Committee on Smaller Public Companies, SEC Release No. 33-8599 (Aug.
5, 2005) available at http://www.sec.gov/rules/other/265-23survey.shtml
.

---------------------------------------------------------------------------

Recommendation V.P.3
    Consider additional guidance for all public companies with respect
to materiality related to previously issued financial statements.
    We heard testimony related to a recent increase in financial
statement restatements for previously undetected accounting
errors.\204\ The Committee is concerned that these restatements are
occurring where the impact of the error is not likely to be meaningful
to a reasonable investor. The determination as to whether an event or
transaction is material to the financial statements can be highly
subjective and judgmental. One source of information for public
companies to consider when making this determination is SEC Staff
Accounting Bulletin No. 99, Materiality (SAB 99). SAB 99 expresses the
staff's views regarding reliance on certain quantitative benchmarks to
assess materiality in preparing financial statements and performing
audits of those financial statements. One issue that is not addressed
in SAB 99 relates to the assessment of materiality in quarterly
reporting periods, including quarterly reporting periods of previously
reported annual periods. We discussed whether one reason for these
restatements might be the lack of guidance pertaining to assessing
materiality in quarterly periods.
---------------------------------------------------------------------------

    \204\ Record of Proceedings 30-31 (Sept. 19, 2005) (testimony of
Lynn E. Turner, Managing Director of Research, Glass Lewis & Co.,
noting that Huron Consulting Group reported that 75% of the
restatements over the last five years have come from small
companies); Record of Proceedings 105 (Sept. 19, 2005) (testimony of
Michael McConnell, Managing Director, Shamrock Capital Advisors,
Burbank, Calif., citing several studies that show half to three
quarters of the restatements of public companies in the last several
years have been by companies with either revenues under a half
billion or market cap under $100 million). But see Record of
Proceedings 108 (Sept. 19, 2005) (statement of Robert E. Robotti,
Adv. Comm. Member, noting that the amount of restatements by smaller
companies is proportionate to that of larger companies, since
microcap companies represent 50% of all public companies).
Institutional investor advisory firm Glass, Lewis & Co. estimates
that a record 1,200 of the total 15,000 public companies will have
announced accounting restatements by the time annual reports are
filed for 2005. This compares with 619 restatements in 2004, 514 in
2003, 330 in 2002 and 270 in 2001, the year before the Sarbanes-
Oxley Act was passed. The threat of criminal penalties for
executives and the focus on internal controls by the Sarbanes-Oxley
Act has created an environment of second-guessing by auditors, where
minor accounting errors can now result in a full investigation of a
company's accounting procedures. Excavations in Accounting: To
Monitor Internal Controls, Firms Dig Ever Deeper Into Their Books,
Wash. Post, Jan. 30, 2006, at D1.
---------------------------------------------------------------------------

    We recommend that the SEC consider providing additional guidance
for all public companies with respect to materiality related to
previously issued financial statements, to ensure that investor
confidence in the U.S. capital markets is not being adversely impacted
by restatements that may be unwarranted. Two specific fact patterns
should be considered in developing additional guidance:
     The effect of the previously undetected error is not
material to any prior annual or quarterly financial statements, the
effect of correcting the cumulative error is not expected to be
material to the current annual period, but the impact of correcting the
cumulative error is material to the current quarter's financial
statements. In this circumstance, we recommend the SEC consider whether
the appropriate treatment would be to correct the cumulative error in
the current period financial statements, with full and clear disclosure
of the item and its impact on the current quarter, with no restatement
of prior year or quarterly financial statements. We believe this
treatment is consistent with the guidance in paragraph 29 of Accounting
Principles Board Opinion No. 28, Interim Financial Reporting.\205\
---------------------------------------------------------------------------

    \205\ The Accounting Principles Board (APB) was the predecessor
entity to the FASB.
---------------------------------------------------------------------------

     The effect of a previously undetected error is not
material to the financial statements for a prior annual period, but is
material to one or more of the quarters within that year. In addition,
the impact of correcting the cumulative error in the current quarter's
financial statement would be material to the current quarter, but is
not expected to be material to the current annual period. In this
circumstance, we recommend the SEC consider whether the appropriate
treatment would be the same as described above since the impact on the
previously issued annual financial statements is not material. In this
event, full disclosure in the current quarter financial statements
should be required.
Recommendation V.P.4
    Implement a de minimis exception in the application of the SEC's
auditor independence rules.
    The Commission's rules on the independence of public company
auditors include a general standard of auditor independence.\206\ In
determining whether a relationship or provision of a service not
specifically prohibited by the rules impairs the auditor's
independence, four principles must be considered.\207\ The

Commission's rules also set forth specific prohibitions on financial,
employment, and business relationships between an auditor and an audit
client, as well as prohibitions on an auditor providing certain non-
audit services to an audit client, and augment the general standard and
related principles.\208\ One of the principles is that an auditor
cannot audit his or her own work. The Committee considered whether the
current auditor independence rules should be modified for smaller
public companies to make it clear that an auditor may provide some
assistance.
---------------------------------------------------------------------------

    \206\ The most recent revision to the auditor independence rules
occurred in Jan. 2003. See Strengthening the Commission's
Requirements Regarding Auditor Independence, SEC Release No. 33-8183
(Jan. 28, 2003) (68 FR 6006).
    \207\ See Remarks by Edmund W. Bailey, Senior Associate Chief
Accountant, U.S. Securities and Exchange Commission, Before the 2005
AICPA National Conference on Current SEC and PCAOB Developments
(``Bailey 2005 AICPA Remarks'') (discussing principles regarding
auditor independence).
    \208\ See Preliminary Note to Rule 2-01 of Regulation S-X and
Item 201(c)(4) of Regulation S-X, 17 CFR 210.2-01(c)(4); Exchange
Act Section 10A(g).
---------------------------------------------------------------------------

    In May 2005, the Commission issued a statement related to internal
control reporting requirements that also discussed this issue.\209\ The
Commission stated that as long as management makes the final
determination regarding the accounting to be used for a transaction and
does not rely on the auditor to design or implement internal controls
related to that accounting, it did not believe that the auditor's
providing advice or assistance, in itself, constitutes a violation of
the independence rules. The Committee considered whether this guidance
would enable an auditor to provide assistance to smaller public company
related to new and/or complicated accounting standards or with unusual/
complicated transactions.
---------------------------------------------------------------------------

    \209\ See Commission Statement on Implementation of Internal
Control Reporting Requirements, May 16, 2005.
---------------------------------------------------------------------------

    Ultimately, we concluded that no modification to the Commission's
independence rules is warranted with respect to auditors providing
assistance to smaller public companies. In making this recommendation,
we noted the principle that auditors should not audit their own work
and believe this basic premise is critical to ensuring auditor
independence and the resulting confidence of investors in the financial
statements of all companies, including smaller public companies. The
Committee concluded that a separate set of auditor independence rules
for larger and smaller publicly-held companies would be inappropriate.
We believe that our recommendation to apply the same extended effective
dates for microcap companies that the FASB provides for private
companies will help serve to alleviate the pressure and costs to
microcap companies in implementing new accounting standards and reduce
their need for significant assistance from their auditors.
    As a separate matter, we acknowledged that the current auditor
independence rules do not provide relief for violations of the rules
based on materiality considerations. As a result, we believe that a
seemingly insignificant violation of the auditor independence rules
could have significant consequences.\210\ These consequences could
require a company to immediately change audit firms, to declare its
previous filings invalid and to engage an audit firm to re-audit its
prior financial statements, creating significant cost and disruption to
the company and its stockholders. The Committee therefore recommends
that the SEC examine its independence rules and consider establishing a
rule provision that provides relief for certain types of violations
that are de minimis in nature as long as these are discussed with and
approved by the company's audit committee.\211\
---------------------------------------------------------------------------

    \210\ One witness testified that audit firms are somewhat
paranoid about violating these independent rules and rightfully so.
The SEC and PCAOB need to go further to provide very clear
guidelines for audit firms as to what they can do and cannot do. In
order to facilitate audit firms assist smaller public companies with
their SEC reporting, some degree of proportionality in limiting the
amount of the penalty for an inadvertent violation of the auditor
independence rules should be used. Record of Proceedings 14 (Aug. 9,
2005) (testimony of Mark Schroeder, Chief Executive Officer, German
American Bancorp).
    \211\ See Bailey 2005 AICPA Remarks (discussing some of the
information considered by the SEC Office of the Chief Accountant
when making assessments regarding the impact of an independence
rules violation).
---------------------------------------------------------------------------

Accounting Standards--Secondary Recommendations

    In addition to the foregoing primary accounting standards
recommendations, we also submit for the Commission's consideration the
following secondary recommendations:
Recommendation V.S.1
    Together with the PCAOB and the FASB, promote competition and
reduce the perception of the lack of choice in selecting audit firms by
using their influence to include non-Big Four firms in committees,
public forums, and other venues that would increase the awareness of
these firms in the marketplace.
    This recommendation represents our best attempt to deal with the
very serious problem of the lack of competition in the auditing
industry, stemming in large part from market concentration. Smaller
companies are seriously harmed by this state of affairs.\212\ A large
concentration of both large and small public companies is audited by
the Big Four audit firms.\213\ Notwithstanding that the Big Four audit
firms have earned a well-deserved reputation of expertise in auditing
public companies, we heard testimony from several non-Big Four audit
firms that indicated that they too are capable of serving smaller
public companies.\214\

The PCAOB has registered and oversees over 900 U.S. public audit firms.
The experience of some of our members, as well as submissions made to
us, confirms a trend for smaller public companies to consider options
other than the Big Four audit firms.\215\ More encouragement should be
given to audit committees and underwriters to seriously consider
engaging a non-Big Four audit firm. We believe that market forces
ultimately will determine which firms will audit public companies. We
recognize the Commission's, the PCAOB's and the FASB's limited
authority to affect concentration in the auditing industry. We also
recognize that some of our recommendations concerning internal control
may increase the concentration of smaller public companies with
revenues over $250 million who are audited by the Big Four.\216\
---------------------------------------------------------------------------

    \212\ One witness testified that smaller public companies are
having trouble timely filing their annual and quarterly reports with
the SEC, because the Big Four audit firms are dropping them as
clients, generally because they fall outside the Big Four's profiles
for acceptable risk. Record of Proceedings 12 (June 17, 2006)
(testimony of Edward S. Knight, Executive Vice President and General
Counsel, NASDAQ Stock Market, Inc.). Another witness testified that,
due to changes in the accounting industry resulting from the
Sarbanes-Oxley Act and consequent pressure from institutional and
retail investors, increasing importance has been placed on using a
Big Four firm. As a result, smaller public companies, who are the
least prepared to negotiate, are increasingly facing oligopolies,
resulting in a disruption in the normally balanced relationship
between a company and its accounting firm. Young smaller public
companies are now in constant fear that their auditors will either
increase their audit fees or abandon them because of the pressure on
the auditing firm to obtain more profitable business from larger
companies. He recommended that emphasis be placed on the
acceptability of more regional accounting firms for use by smaller
public companies, as well as the establishment or encouragement of a
fifth or sixth Big Four audit firm to restore a more appropriate
balance between accounting firms and their client companies in order
to contain costs and at the same time provide an alternative audit
firm that is generally accepted by the investment community. Record
of Proceedings 32-33, 37-38 (June 17, 2005) (testimony of Alan
Patricof, Co-Founder, Apax Partners). See also Remarks by
Christopher Cox, Chairman, U.S. Securities and Exchange Commission,
Before the 2005 AICPA National Conference on Current SEC and PCAOB
Developments (Dec. 5, 2005) (stating that competition is essential
for the proper functioning of any market, and a broader and more
competitive market for audit services should be encouraged).
    \213\ See United States General Accounting Office, Report to the
Senate Committee on Banking, Housing, and Urban Affairs and the
House Committee on Financial Services, Public Accounting Firms,
Mandated Study on Consolidation and Competition (GAO-03-864) (July
2003).
    \214\ Record of Proceedings 19 (Sept. 19, 2005) (testimony of
Richard Ueltschy, Executive, Crowe Chizek and Company, LLC)
(``[S]maller public companies, virtually all of them could be served
adequately by more than the Big Four, certainly the eight largest
firms that are subject to annual review by the PCAOB. And, in fact,
many of those smaller public companies could also be effectively
served by the dozens of qualified regional C.P.A. firms.''); Record
of Proceedings 129, 130-133 (Aug. 9, 2005) (testimony of Bill
Travis, Managing Partner, McGladrey & Pullen LLP, commenting that
his firm, as well as many other second-tier non-Big Four audit
firms, have a level of expertise and resource capabilities that can
certainly serve the needs of very large mid-market companies with
global facilities around the world, as well as a much greater
percentage of small and mid-size publicly-traded companies). See
also Record of Proceedings 92 (Oct. 14, 2005) (testimony of Gerald
I. White, Grace & White, Inc., New York, New York) (``I don't see
any evidence that the large firms do any better job than the small
ones.'').
    \215\ One witness testified that, although the bottom line is
whether audit committees and investment banks are willing to advise
choosing a non-Big Four firm, current market conditions are
fortunately driving some changes in the industry out of necessity.
Big Four firms have limited resources and are allocating their
resources to wherever the best use of those resources may be used by
their major clients. Non-Big Four firms are benefiting from this
market development in that very high quality public companies have
to go find other non-Big Four firms to do their audits. Accordingly,
he indicated that firms like his are receiving many inquiries as to
whether they are capable of doing the work, and are in fact winning
the work, including such firms as Grant Thornton, LLP and BDO
Seidman, LLP. Accordingly, he believes that market conditions are
doing a lot more to win work for the non-Big Four audit firms than
any marketing communications could have done. See Record of
Proceedings 130-131 (Aug. 9, 2005) (testimony of Bill Travis,
Managing Partner, McGladrey & Pullen LLP). See also Record of
Proceedings 19 (Sept. 19, 2005) (testimony of Richard Ueltschy,
Executive, Crowe Chizek and Company, LLC) (``We are seeing today
many companies at * * * the smaller end of the large company
classification, as this group's defined it, that are now choosing to
look outside the Big Four for their audit services. And they're
doing so largely because of an attempt to introduce a bit of market
competition into the pricing for the service. * * * [T]here's a fair
amount of activity in terms of auditor change, there's real price
competition being introduced into that process.''); Record of
Proceedings 92 (Oct. 14, 2005) (testimony of Gerald I. White, Grace
& White, Inc., New York, New York) (``[S]maller firms seem to be
clearly gravitating away from the largest auditors to smaller
auditors. And I suspect that not just audit costs, but 404 costs are
driving that process.'').
    \216\ See Letter from Crowe Chizek and Company LLC to Committee
(Feb. 20, 2006), available at http://www.sec.gov/rules/other/265-23/mhildebrand022006.pdf
 (``Removing the auditor involvement

requirement for Smallcap companies will cause firms other than the
Big Four to have very few internal control audit clients * * * This
will create a large, unintended competitive advantage to the Big
Four and foster further consolidation in the audit profession.'')
and Letter from McGladrey and Pullen LLP to Committee (Feb. 21,
2006), available at http://www.sec.gov/rules/other/265-23/btravis022106.pdf
 (supporting the efforts of the Advisory Committee

but expressing concern that the Committee's Section 404
recommendations will further concentrate audit services of public
companies with the Big 4 audit firms and suggesting that the SEC
take further measures to ensure that there is no further audit
concentration of audit services in the United States).
---------------------------------------------------------------------------

    We nevertheless believe that efforts to promote competition in the
auditing industry and educate registrants in the choice of selecting
audit firms is essential to maintain pricing discipline and to address
the perceived lack of competition in the auditing industry. We are
therefore recommending that the SEC, the PCAOB promote competition
among audit firms and that the FASB further this effort by ensuring
that non-Big Four firms are included in committees, public forums, and
other venues that would increase the awareness of these firms in the
marketplace.\217\
---------------------------------------------------------------------------

    \217\ See, e.g., Record of Proceedings 84 (June 17, 2005)
(testimony of Wayne A. Kolins, National Director of Assurance and
Chairman of the Board, BDO Seidman, LLP, encouraging the use of
symposiums, whereby the CEO's and CFO's of smaller public companies
meet to discuss their experiences using non-Big Four audit firms);
Record of Proceedings 130 (Aug. 9, 2005) (testimony of Bill Travis,
Managing Partner, McGladrey & Pullen LLP, encouraging non-Big Four
audit firms to become more active with regulatory organizations like
the PCAOB and SEC and others to build awareness of the capabilities
of the non-Big Four audit firms); Record of Proceedings 63-64, 82-83
(June 17, 2005) (testimony of Alan Patricof, Co-Founder, Apax
Partners, recommending that regulatory bodies use the bully pulpit
and moral suasion to increase awareness and acceptance of the good
quality of regional non-Big Four auditing firms, including
encouraging investment banking firms to rely upon these non-Big Four
firms).
---------------------------------------------------------------------------

Recommendation V.S.2
    Formally encourage the FASB to continue to pursue objectives-based
accounting standards.\218\ In addition, simplicity and the ease of
application should be important considerations when new accounting
standards are established.
---------------------------------------------------------------------------

    \218\ See SEC Staff's Study Pursuant to Section 108(d) of the
Sarbanes-Oxley Act of 2002 on the Adoption by the United States
Financial Reporting System of a Principles-Based Accounting System,
released in July 2003 (``Principles-Based Accounting System Staff
Study'') (``objectives-oriented'' standards are distinguished from
``principles-based'' or ``rules-based'' standards).
---------------------------------------------------------------------------

    This recommendation is an attempt to deal with the issue of
excessive complexity in accounting standards.\219\ This complexity
disproportionately impacts smaller public companies due to their lack
of resources. Complexity is created because of:
---------------------------------------------------------------------------

    \219\ See Remarks by Robert H. Herz, Chairman, Financial
Accounting Standards Board, Before the 2005 AICPA National
Conference on Current SEC and PCAOB Developments (Dec. 6,
2005)(discussing the complexity in financial reporting). See also
Remarks by Christopher Cox, Chairman, U.S. Securities and Exchange
Commission, Before the 2005 AICPA National Conference on Current SEC
and PCAOB Developments (Dec. 5, 2005); Remarks by Scott A. Taub,
Acting Chief Accountant, U.S. Securities and Exchange Commission,
Before the 2005 AICPA National Conference on Current SEC and PCAOB
Developments (Dec. 5, 2005).
---------------------------------------------------------------------------

     An unfriendly legal and enforcement environment that
diminishes the use and acceptance of professional judgment in today's
financial reporting system because of fears of second-guessing by
regulators and the plaintiff's bar.\220\
---------------------------------------------------------------------------

    \220\ One witness encouraged a move towards more of a
principles-based and a judgment-based approach to accounting so that
competent people on the audit committees, in management and in the
audit firms can work together to use their respective intellect,
judgment and knowledge of the business to determine where best to
spend their time each year, in such areas, for example, as internal
control compliance with Section 404 of the Sarbanes-Oxley Act. He
commented that all the guidance provided so far by the SEC and the
PCAOB on the use of professional judgment is tempered, however, by
the current uncertainty as to what will be the expectations of
company management, the audit committee and the auditor once there
is a major failure due to an unintended mistake reported in the
system. Until we see the results of such a mistake, he believes
there will continue to be conservatism in the practice of audit
firms, management teams and audit committees. Record of Proceedings
117-118 (Aug. 9, 2005) (testimony of Bill Travis, Managing Partner,
McGladrey & Pullen LLP).
---------------------------------------------------------------------------

     Development of complex business arrangements and
accounting-motivated transactions.\221\
---------------------------------------------------------------------------

    \221\ The SEC Staff's report entitled Report and Recommendations
Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 On
Arrangements with Off-Balance Sheet Implications, Special Purpose
Entities, and Transparency of Filings by Issuers (``Off-Balance
Sheet Staff Study''), released in June 2005, refers to an
accounting-motivated structured transaction as a transaction
structured in an attempt to achieve reporting results that are not
consistent with the economics of the transaction. As an example, the
report cites to the restructuring of lease arrangements to avoid the
recognition of liabilities on the balance sheet following the
issuance of the FASB's Statement No. 13, Accounting for Leases,
released in 1976.
---------------------------------------------------------------------------

     Constituent concerns about earnings volatility and desire
for industry-specific guidance and exceptions.\222\
---------------------------------------------------------------------------

    \222\ See Principles-Based Accounting System Staff Study
(listing three of the more commonly-accepted shortcomings of rules-
based standards, such as numerous bright-line tests, exceptions to
principles underlying the accounting standards, and complexity in
and uncertainty about the application of a standard reflected in the
demand for detailed implementation guidance).
---------------------------------------------------------------------------

     Frequent requests by preparers and auditors for detailed
accounting guidance to limit potential inconsistencies in the
application of accounting standards and second-guessing by the legal
community and enforcement authorities.\223\
---------------------------------------------------------------------------

    \223\ Id. See also FASB Staff Position No. 123(R)-2, Practical
Accommodation to the Application of Grant Date as Defined in FASB
Statement No. 123(R) (Oct. 18, 2005).
---------------------------------------------------------------------------

    Certain accounting standards create complexity because:

     The lack of a fully developed conceptual framework leads
to inconsistent concepts and principles being applied across accounting
standards.\224\
---------------------------------------------------------------------------

    \224\ For example, related to the accounting for revenue
transactions, FASB Statement of Concepts No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises, states
that revenues are not recognized until earned. FASB Statement of
Concepts No. 6, Elements of Financial Statements, defines revenues
as inflows or other enhancements of assets or liabilities. The FASB
currently has a revenue recognition project on its agenda designed
in part to eliminate this inconsistency. The FASB also has on its
agenda a joint project with the International Accounting Standards
Board to develop a common conceptual framework that is complete and
internally consistent.
---------------------------------------------------------------------------

     Scopes in standards are at times unclear and may contain
exceptions.\225\
---------------------------------------------------------------------------

    \225\ For example, FASB Interpretation No. 45, Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, clarifies the scope
of FASB Statement No. 5, Accounting for Contingencies. This
interpretation excludes certain guarantees from its scope and also
excludes other guarantees from the initial recognition and
measurement provisions of the interpretation.
---------------------------------------------------------------------------

     The standards have different measurement attributes (such
as historical cost versus fair value) and treatment alternatives.\226\
---------------------------------------------------------------------------

    \226\ See, e.g., FASB Statement No. 115, Accounting for Certain
Investments in Debt and Equity Securities (providing classification
alternatives for investments in debt and equity securities,
resulting in different measurement alternatives).
---------------------------------------------------------------------------

     Rules and bright-line standards provide opportunities for
accounting-motivated transactions that are not necessarily driven by
economics.\227\
---------------------------------------------------------------------------

    \227\ See Off-Balance Sheet Staff Study.
---------------------------------------------------------------------------

     The standards themselves have become extremely lengthy and
difficult to read.\228\
---------------------------------------------------------------------------

    \228\ See, e.g., FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities (June 1998) (exceeding
800 pages of authoritative guidance and over 180 implementation and
interpretive issues).
---------------------------------------------------------------------------

    Additional complexity in accounting standards also comes about
because:
     In prior years, multiple parties set standards, such as
the SEC, the FASB, the AICPA, the Accounting Principles Board (APB),
and the Emerging Issues Task Force (EITF).
     Differing views exist on the application of fair value
measurement techniques and models.\229\
---------------------------------------------------------------------------

    \229\ The FASB currently has a project on its agenda to provide
guidance regarding the application of the fair value measurement
objective in generally accepted accounting principles.
---------------------------------------------------------------------------

     Phased projects produce only interim changes.\230\
---------------------------------------------------------------------------

    \230\ For example, FASB Statement No. 150 is part of the FASB's
broad project on financial instruments that was added to the FASB's
agenda in 1986.
---------------------------------------------------------------------------

    We believe that the current financial reporting environment could
be modified to reduce the reporting burden on smaller public companies,
as well as larger public companies, while improving the quality of
financial reporting.
    We commend the efforts of the SEC and FASB to pursue ``objectives-
based accounting standards,'' as this should help to reduce
complexity.\231\ The Committee recognizes that success will require
preparers, financial advisors and auditors to apply the intent of the
rules to specific transactions rather than using ``bright-line''
interpretations to achieve a more desirable accounting treatment. The
Committee also believes that simplicity and the ease of application of
accounting standards should be important considerations when new,
conceptually-sound accounting standards are established. Success will
also require regulators and the courts to accept good faith judgments
in the application of objectives-based accounting standards. We believe
these goals will only be accomplished by long-term changes in culture
versus short-term changes in regulations. This will allow for greater
consistency and comparability between financial statements.
---------------------------------------------------------------------------

    \231\ See, e.g., SEC Staff Study, The Principles-Based
Accounting System. See also FASB Response to SEC Study on the
Adoption of a Principles-Based Accounting System (June 2004).
---------------------------------------------------------------------------

    Accordingly, we offer the following suggestions aimed at
simplifying future accounting standards:
     There should be fewer (or no) exceptions for special
interests.
     Industry and other considerations that do not necessarily
apply to a broad array of companies should be addressed by FASB staff
positions rather than in FASB statements.
     FASB statements should attempt to reduce or eliminate
``bright-line tests'' in accounting standards, and in cases where the
standard-setter intends that a ``bright-line'' test be applied make
that clear in the guidance.
    The Committee is making this recommendation in lieu of recommending
modifications to certain existing accounting standards for smaller
public companies. Primarily through our Accounting Standards
Subcommittee, we identified certain accounting standards where
modifications might be considered in the future for smaller public
companies. The Committee recognized that smaller public companies, as
well as larger public companies, struggle with the application of
certain accounting standards, such as FASB Interpretation No. 46
(revised December 2003), Consolidation of Variable Interest Entities.
The Committee also looked for certain common themes in those standards
that could be used to develop recommendations regarding accounting
pronouncements.
    In reviewing existing accounting standards, we considered the
effect of their measurement and disclosure requirements on smaller
public companies. The Committee also considered possible screening
criteria that could be used to determine whether an accounting standard
should be modified for smaller public companies. The objective of our
efforts was to determine whether for certain accounting standards, the
information is very costly for a small business to prepare and yet the
information is not being utilized by its investors or other users of
its financial statements.
    After deliberating these questions, we unanimously concluded that,
since we believe it is inappropriate to create different standards of
accounting for smaller public companies (i.e., Big GAAP versus Little
GAAP), we should not propose recommendations to modify existing
accounting standards for smaller public companies.
    In sum, we agreed that the current financial reporting environment
could be improved to reduce the reporting burden on both smaller public
companies, as well as for larger public companies, while improving the
quality of financial reporting. In this light, we formulated the above
recommendation to have the SEC formally encourage the FASB to continue
to pursue objectives-based accounting standards. The Committee also
recommended that simplicity and the ease of application should be key
considerations when establishing new conceptually-sound accounting
standards.
Recommendation V.S.3
    Require the PCAOB to consider minimum annual continuing
professional education requirements covering topics specific to SEC
matters for firms that wish to practice before the SEC.
    Of the 939 U.S. audit firms registered with the PCAOB, we noted
that approximately 82% of them audit five or fewer public companies. We
believe that continuing professional education pertaining to SEC-
related topics would be useful to the professional personnel of
registered firms, especially for those firms that do not audit many
public companies and for which this training would improve their
ability to serve public companies. While several different groups and
governmental bodies, such as the individual state licensing boards,
establish continuing professional education requirements for

accountants, the PCAOB does not currently have any minimum annual
training standards for registered firms' partners and employees who
serve public companies. The Committee suggests, therefore, that minimum
annual SEC training requirements be established for applicable partners
and employees of audit firms registered with the PCAOB.
Recommendation V.S.4
    Monitor the state of interactions between auditors and their
clients in evaluating internal controls over financial reporting and
take further action to improve the situation if warranted.
    The recent implementation of Sarbanes-Oxley Act Section 404 by
certain public companies has raised many questions and issues. One
issue that has been identified pertains to the adverse impact Section
404 has had on the relationship between audit firms and the management
of smaller public companies and the nature and extent of their
communications on accounting and financial reporting matters.\232\ We
noted the substantial amount of testimony on this issue.\233\ We also
noted that the PCAOB and the SEC had issued guidance in May 2005
regarding the implementation of Section 404 and the interaction between
an auditor and its client.\234\
---------------------------------------------------------------------------

    \232\ The SEC Staff's Statement on Management's Report on
Internal Control Over Financial Reporting, released in May 2005,
stated that feedback from both auditors and registrants revealed
that one potential unintended consequence of implementing Section
404 and Auditing Standard No. 2, An Audit of Internal Control Over
Financial Reporting Performed in Conjunction with An Audit of
Financial Statements, has been a chilling effect in the level and
extent of communications between auditors and management regarding
accounting and financial reporting issues.
    \233\ One witness commented that audit firms are too fearful to
provide guidance and advice to any inquiry by a public client, as
such inquiry could be interpreted as an admission of an internal
control weakness by the company in that area. Although he recognizes
that auditing firms cannot provide non-audit services to their
clients, he believes that they should be able to point their clients
in the right direction so that the client can do the work. He
indicated that audit firms are unclear as to where the line of
auditor independence is drawn. As a result, when in doubt, audit
firms take the safe route and do nothing out of fear that if they
cross the line, they will put the entire audit firm at risk. Record
of Proceedings 24 (Aug. 9, 2005) (testimony of Mark Schroeder, Chief
Executive Officer, German American Bancorp.). Similarly, another
witness testified that auditors and audit committees are too fearful
of lawsuits to rely upon their judgment in implementing Section 404
internal controls. He believes explicit common sense standards
applied universally to all companies of a given size need to be
developed by the regulators to indicate clearly what the auditors
need to cover, and what the materiality levels are. Record of
Proceedings 189 (Aug. 9, 2005) (testimony of James P. Hickey,
Principal, Co-Head of Technology Group, William Blair & Co.). See
also Record of Proceedings 126-127, 139 (August 9, 2005) (testimony
of Bill Travis, Managing Partner, McGladrey & Pullen LLP, commenting
that once there is greater consistency and clarification on what is
expected by the PCAOB and its inspectors with regard to Auditing
Standard No. 2, the time, effort and costs incurred by the auditors
will be reduced and the willingness of auditors to use their
professional judgment will increase); Record of Proceedings 9-18, 56
(Oct. 14, 2005) (testimony of Thomas A. Russo, Russo & Gardner,
Lancaster, Penn., describing a very stark tension growing between
companies and their auditors, due to the lack of PCAOB Section 404
guidelines which has resulted in a zero percent sort of materiality
test as auditors are unwilling to exercise judgment, but rather go
to the end of the earth to confirm the integrity of control
systems); Record of Proceedings 57, 61 (Sept. 19, 2005) (testimony
of Kenneth Hahn, Senior Vice President, Chief Financial Officer,
Borland Software Corp., Cupertino, Calif., commenting that the
dynamics of risk make it virtually impossible for the control
portion of Section 404 to be cost effective for small and mid-size
companies, as both auditors and boards will make the decision to
over-engineer the testing of a company's internal control systems);
Record of Proceedings 100 (June 17, 2005) (testimony of Prof.
William J. Carney, Emory University School of Law, referring to a
study indicating that auditing fees have increased by as much as
58%, due to the increased costs associated with the new requirements
of the Sarbanes-Oxley Act). But see Record of Proceedings 33-34 and
41 (Sept. 19, 2005) (testimony of Lynn E. Turner, Managing Director
of Research, Glass Lewis & Co., predicting the costs of Section 404
internal controls to come down after the first year of
implementation, and commenting that both in-house accountants and
external auditors are working together to make the implementation of
Section 404 internal controls for smaller companies much more
difficult than warranted); Record of Proceedings 18-19 (Sept. 19,
2005) (testimony of Richard Ueltschy, Executive, Crowe Chizek and
Company, LLC, anticipating costs to implement Section 404 internal
controls for the second year to fall, and noting that auditors are
now willing to provide fixed fee quotes both for smaller public
companies in their second year of 404 implementation, as well as for
new accelerated filers undertaking their fist year of 404
implementation); Record of Proceedings 106 (Sept. 19, 2005)
(testimony of Michael McConnell, Managing Director, Shamrock Capital
Advisors, Burbank, Calif., indicating that most investors, including
both direct investors and institutional capital, do not have a
problem with the costs of Section 404, as opposed to the capital
raising agency community, such as the lawyers, bankers and managers,
that are uncomfortable in general with any heightened standards of
accountability). One witness testified that several public equity
offerings in which he was involved experienced unprecedented delays
due to the inability or unwillingness of the auditors to provide
timely responses during the registration process with the SEC. He
believes that auditors can no longer be looked to for advice on how
to handle various issues, as it seems that almost every issue now
needs to be ``run through the national office'' of the auditor. He
notes that as auditor responses may now take weeks longer to be
produced than was the case a couple of years ago, he believes such
delays leave potential issuers subject to additional market risk
that did not exist in the past. Record of Proceedings 176 (Aug. 9,
2005) (testimony of James P. Hickey, Principal, Co-Head of
Technology Group, William Blair & Company). See also Record of
Proceedings 33 (June 17, 2005) (testimony of Alan Patricof, Co-
Founder, Apax Partners, explaining that an unnatural relationship
has developed between companies and their auditors as accountants
have become more gun shy about taking a risk-focused approach to
their audit and express concerns about the pressure to comply with
PCAOB requirements which has caused the relationship between
auditors and companies to go from one of cooperation and
consultation to that of an adversarial nature).
    \234\ See SEC Statement on Implementation of Internal Control
Reporting Requirements, May 16, 2005.
---------------------------------------------------------------------------

    It appears that audit firms are starting to become more comfortable
with the idea that it is acceptable to advise their clients with
respect to new accounting standards and/or complicated transactions,
consistent with the guidance issued by the PCAOB and SEC, while
remaining fully cognizant of the need for company management to take
full responsibility for its financial statements and the underlying
decisions on the application of accounting principles. We recommend
that the SEC and the PCAOB remain vigilant in monitoring the impact of
its guidance through the Spring of 2006 reporting season. If the
guidance is being appropriately applied, no further action with respect
to the interaction of the auditor and its clients would be required,
except for implementation of our recommendation on implementing a de
minimis exception for certain immaterial violations of the SEC's
independence rules.

Part VI. Epilogue

[Content of Part VI To Be Included in Final Report.]

Part VII. Separate Statement of Mr. Jensen

Introduction

    I am dissenting to recommendations III.P.1, III.P.2 and III.P.3
contained in the Final Report of the Advisory Committee. Since the time
of the original vote on the recommendations, I have become aware that
certain investor groups are concerned with the removal of Section 404
of the Sarbanes-Oxley Act of 2002 requirements for a large number of
public companies. While no one knows the exact extent of investor
opposition, I believe this group is too important to the health of our
capital markets to ignore their point of view. Specifically, I believe
that providing a permanent exemption for smaller public companies from
these requirements may ultimately harm investors of those companies. In
addition, I disagree with the adoption of a weakened auditing standard
for Section 404 compliance by certain companies.
    The fact that the Advisory Committee heard so many different points
of view on these critical issues supports the fact that we do not yet
have sufficient experience with implementation of Section 404 to know
with certainty that a permanent exemption is a better

answer, or whether any change in auditing standards is warranted. In
light of these factors, my recommendation calls for additional
temporary deferrals coupled with a study of key implementation elements
and a definitive timetable for resolution.

Dissenting Views and Rationale

    I agree with the rationale in the Final Report describing the need
to scale securities regulation for smaller companies. As a member of
the Advisory Committee I heard testimony from many on the potentially
damaging impact of the costs of Section 404 on the growth potential of
smaller public companies. Additionally, many parties provided written
comment on the disproportionate burden of Section 404 related costs on
smaller public companies. The Final Report includes a number of
examples and anecdotes on the reasons for this disproportionate burden
including constraints caused by limited internal and external
resources, lack of guidance tailored to smaller companies and less
revenue with which to offset implementation and ongoing compliance
costs. I acknowledge that this cost issue necessitates a significant
and substantial effort to develop an appropriate application of
Auditing Standard No. 2 in the small public company environment.
    I am also cognizant of testimony and written comments the Committee
received on the significant benefits of Section 404. Many reminded the
Advisory Committee of the corporate failures that resulted in Congress
enacting the Sarbanes-Oxley Act of 2002. Other investors gave testimony
on the benefits of Section 404 both to themselves and to the companies
in which they invest and the increased confidence instilled in the
investor community as a result of the additional checks and balances
required by the Act. A smaller public company, as information provided
to the Advisory Committee indicates, is more likely to suffer control
deficiencies than a larger company. This fact logically means that
investors will consider their investment in smaller public companies a
higher risk. It seems, therefore, that smaller public companies could
benefit from a process that improves investor confidence in their
financial reporting thereby helping them achieve a wider and more
diverse investor base. If such benefits for both companies and
investors can be derived from Section 404, then it seems to me that
eliminating the requirement for these companies is unwarranted. Rather,
more effort should be expended to scale the approach to smaller public
companies.
    The key is to balance the needs of the users of financial
statements with the costs to companies in supplying the required
information. Balancing what preparers of financial statements can
reasonably provide and what users of financial statements can
reasonably expect to receive is a basic principle of our financial
reporting and regulatory systems. The current debate around Section 404
demonstrates clearly that this required balance does not exist at
smaller public companies today. Many smaller public companies have
indicated that the solution to this problem is to eliminate their
compliance with Section 404. However, simply eliminating the
requirement will tip the scales and investors, who will not receive the
information and assurances intended to be provided under the Act, will
likely believe that the system is out of balance to their detriment. I
believe that through additional implementation experience, guidance and
tools, Section 404 reporting can become more efficient and cost-
effective for smaller public companies.
    I disagree with the adoption of an alternative auditing standard. A
lesser standard may prove not to be in the interest of the smaller
public company as it creates a two tier system. The existence of a two
tiered system could reduce investor confidence in the smaller public
companies' financial reporting process and would thereby eliminate all
of the benefits of Section 404 which, as discussed above, may be an
important benefit that could be derived by smaller public companies. I
believe that effective Section 404 compliance in the smaller public
company will continue to improve investor confidence and I also
strongly believe that compliance can be achieved in a cost effective
manner.

Further Consideration

    Accordingly, in lieu of permanent exemptions, I recommend an
additional temporary deferral of the Section 404 reporting for non-
accelerated filers that have not yet reported under Section 404,
coupled with a definitive action plan led by the SEC as outlined below.
This plan includes participation by smaller public companies, the
auditing profession and the PCAOB. Given the cost concerns provided to
the Advisory Committee on smaller public companies, such an additional
temporary deferral could include an optional, temporary suspension of
certain of the requirements for smaller public companies that recently
implemented the Section 404 requirements and meet the market
capitalization and revenue criteria in recommendations III.P.1 and 2.
On this latter point, the SEC would have to weigh the implications of
this proposal with the likelihood that many of the companies already
complying would nonetheless choose to continue to comply.
    The steps that I would propose would be subject to a defined
timeline and a set of actions to definitively resolve the scope of
Section 404 implementation for smaller public companies prior to the
2008 year-end. For example, these actions could include:
     Reconsideration of the end product in the ongoing process
to tailor the COSO requirements for smaller businesses. This project
has been underway for some time. It is essential that the final
document succeed in being truly useful to smaller companies. It is
vitally important that the final document be replete with guidance,
examples and tools, which permit the efficient implementation and
testing of COSO requirements for smaller businesses. A definitive guide
for performing management's assessment of internal control
effectiveness for smaller public companies would be the single most
useful element of this effort.
     The conduct of an SEC-led pilot program for a prescribed
number of micro-cap and smaller public companies during 2006 that would
serve as a field test and lead to the development of guidance on
application of AS2 in that environment for auditors, as well as the
development of internal control and Section 404 compliance tools for
management of micro-cap and smaller public companies.
     An in-depth study of the companies that have two years of
experience in complying with Section 404, perhaps by focusing on the
smaller of the complying companies in order to gain an in depth
understanding of the costs and benefits. The criticality of reliable,
not anecdotal, cost-benefit information is a fundamental predicate to
finalizing the important regulatory and public policy decisions that
the SEC needs to make.
    The basic timeline for this action plan could be: Pilot program and
study in 2006, develop and field test guidance and rules in 2007, and
implement in 2008.
    Should this recommendation be adopted, my firm would be willing
dedicate resources to participate in any efforts to gather evidence,
field test new guidance, or develop tools for management and auditors
that will further support this process. We would look forward to
working with others in the accounting profession, vendors of

technology solutions, and companies in the program and other public and
private-sector organizations to achieve success in this endeavor.
    It is important to note that this timeline includes only one
additional annual deferral of the Section 404 requirements for non-
accelerated filers; however, it should also include specific, defined
steps during this period, to significantly improve guidance and tools,
and increase the cost effectiveness of implementation for smaller
public companies.
    This recommendation is made with our mutual public interest goals
in mind. It reflects my opinion that after only two years of
implementation for accelerated filers, market participants and
regulators do not have sufficient information to make final decisions
regarding the long-term application of these important internal control
requirements for smaller public companies. I recommend that a process
be developed to gather empirical, field-driven information to resolve
this important question, and that an additional deferral be granted
until this can be accomplished.

Part VIII. Separate Statement of Mr. Schacht

    This Separate Statement to the Final Report of The Advisory
Committee on Smaller Public Companies (the ``Report'') is submitted for
the purpose of dissenting on several of the primary recommendations of
the Advisory Committee. These relate to the work of the sub-committee
on Internal Controls Over Financial Reporting (the ``Sub-Committee'').
As a member of the Sub-Committee and consistent with our dissenting
opinion of December 14, 2005, a copy of which is attached, we remain
opposed to key portions of the Report.
    Observers and committee participants agree that the most
substantive recommendations in the Report relate to the application of
Section 404 of Sarbanes-Oxley (``Section 404'') to smaller public
companies. As a Committee, we reviewed several issues impacting smaller
public companies. It is clear however, that the impacts of Section 404,
particularly the resource demands and costs of implementing 404, have
proven to be the most challenging. During our deliberations, the Sub-
Committee discussed dozens of ways and options for reducing costs,
while maintaining investor protections.

Cost-Benefit Analysis

    The Advisory Committee members generally agree that the costs of
Sarbanes- Oxley (``SOX'') are the real issue. While minimization of
regulatory costs is always a desirable goal, the Report confirms what
we knew coming into this Committee process, that the costs have
exceeded all estimates, and have significantly impacted small
companies. There have been numerous cost studies and other anecdotal
comments on whether these costs are, or will be, coming down in
subsequent years. The evidence will only be clear once we have actual
data in the coming months. For many companies that have yet to go
through the process, the initial costs will be high. But the analysis
must not end there. It suggests that whatever the benefits of Section
404 might be, they are surely far outweighed by these more obvious cost
figures. The Report states that the benefits are of less certain value
and moves on to other matters.
    The Advisory Committee, by and large, agrees that internal controls
over financial reporting at public companies are important. More
specifically, we assert they are an important feature for accurate
financial reporting, investor protection, and market integrity. But is
there a measurable benefit? It is impossible to measure the value of a
financial/accounting fraud avoided. In 2005, there were approximately
1300 restatements and weaknesses in financial reporting revealed and
fixed by a Section 404 inspired process, more than double the number in
2004. This dramatic increase will have an inestimable and far-reaching
impact on financial reporting reform. Some argue this is a reflection
of deferred maintenance on an internal controls process that has been
neglected and that SOX represents a renaissance for proper internal
control process and environments. Whatever the reason, these are
benefits that are significant and certain. Moreover, they are benefits
which, we believe, balance the cost of a properly scaled and verified
internal control structure.

Section 404 Exemption vs. Improved Section 404 Implementation

    The Sub-Committee set about its work with the focus of adjusting
the main cost driver of Section 404, the level to which internal
controls need to be documented, verified and tested by management and
outside auditors. The original objectives were to reduce the cost
burdens but maintain the investor protections associated with Section
404. The Sub-Committee focused on a variety of ways to meet the
objectives but narrowed its attention to two. The first is creating a
more tailored and cost-efficient internal control structure and
verification process for small companies, i.e., reducing the cost and
resource drain of Section 404 through better implementation. The second
is providing small companies with an exemption from the main
requirements of Section 404.
    The objectives of cost control and investor protection need not be
mutually exclusive. However, the Report's primary recommendations make
them so. Our strongest objection is that the Report recommends a flat-
out exemption from all auditor 404 involvement in reviewing and
confirming internal controls. This is not for just a few, but for what
will effectively be more than 70 to 80 percent of the public companies
in this country.
    One could cite any number of flaws in this approach, but several in
particular stand out:
     First, the entire premise of SOX was to bolster investor
confidence by requiring meaningful corporate governance and financial
reporting reforms. Likewise, maintaining investor protections is a
primary tenet of the Committee Charter. Properly designed and
functioning internal controls over financial reporting were and are a
cornerstone of this legislation. Proper structuring and implementation
of 404 requirements are very different from eliminating these
completely for a broad segment of U.S. companies. That approach works
against the statute's legislative intent and the directive that we
heard from both Chairman Donaldson and Chairman Cox.
     Second, it is unclear to many whether the broad exempting
recommendations of this subcommittee are even within the commission's
legal authority. Comprehensive, sweeping exemptions from Section 404
may not be possible under the current legislation, which specifically
excluded Section 404 from the Securities and Exchange Act of 1934. As
the full Commission works toward final recommendations, it would be
well served to resolve that potential legal uncertainty so as to avoid
further litigation delays in addressing Section 404 concerns.
     Third, with regard to MicroCaps as defined, the Report
recommends exemptive relief from not only auditor involvement in
reviewing internal controls but also exempts the managers of these
firms from having to do their own internal assessment of such controls.
Essentially, no one has to check the design, implementation and
effectiveness of internal controls over financial reporting at these
companies. The reason for this complete 404 exemption according to the
Report is that there is no specific directions/

guidance available to such small company managers to know how to create
an appropriate internal control structure. We wonder about two things
in this context. First, how have these firms been able to meet the on
going legal requirements for maintaining an effective system of
internal controls (actually mentioned as part of the recommendation)
and more importantly, if such guidance is missing for micro caps, how
does it suddenly become clear for managers of small companies above
$125 million in market cap? In the event any of these exemptive
recommendations are adopted by the SEC, we believe logic dictates that
managers in all public firms be required to complete an annual Section
404 assessment of internal controls.
     Fourth and maybe most important, small public companies
need checks and balances over financial reporting. This includes the
Section 404 checks and balances in our view. The Report indicates that:
Small cap firms have less need for internal controls; requiring
external verification of internal controls is a waste of corporate
resources; and, that better corporate governance is a substitute for
such verification. It further suggests that investors in these
companies don't particularly care about internal control protections
and that these companies represent an inconsequential bottom 6% of
total U.S. market capitalization, rendering even an Enron-like blowup a
minor event. At the same time, the Report characterizes such small
companies as a critical link in economic growth and competitiveness and
that Section 404 is the regulatory tipping point and barrier to
accessing public markets. Parsing through these contrasting views of
inconsequential vs. critical seems to suggest incorrectly that venture
capital exit strategies are more important to protect than public
investors providing risk capital. A number of experts we heard from
feel that properly structured and verified internal controls are
probably more important for the riskier, smaller firms and that
additional corporate governance provisions are in no way a substitute
for properly working internal controls. For example, these small firms
consistently have more misstatements and restatements of financial
information, nearly twice the rate of large firms, according to one
report. Alarmingly, these small firms also make up the bulk of
accounting fraud cases under review by regulators and the courts (one
study puts it at 75 percent of the cases from 1998-2003).
     Finally, we note that as part of each of the
recommendations for Section 404 exemption, the Report suggests these
companies be reminded of pre-SOX legal requirements to have an
effective system of internal controls in place. This legal reminder
simply points out how ineffective the rules were pre-SOX and how they
are no substitute for having some level of external verification of
controls as prescribed by Section 404.

Better Implementation of Section 404 & SOX ``LIGHT'

    A more balanced approach to fixing the cost concerns of Section 404
is to continue requiring manager assertions and auditor attestation of
internal controls, but direct the appropriate regulatory and de facto
standard-setting bodies (the Committee of Sponsoring Organizations of
the Treadway Commission (COSO), the Public Company Accounting Oversight
Board) and the SEC to develop specific guidance for small companies.
This approach has been referred to as a ``404 Light'' or ``SOX Light''
approach. However, the term has become confusing over the course of the
Committee debate.
    Much of the outline for this approach appeared in preliminary
recommendations of the Sub-Committee. We encourage the Committee to be
clear on the options for better implementation and for the Commission
to consider a broad range of approaches. These may include: (1)
Reviewing/refining the existing AS-2 standards; (2) possible
development of an alternative auditing standard (the Report references
AS-X) that provides for a meaningful, but more cost effective audit;
and (3) development of specific directives from COSO and PCAOB on how
to ``right-size'' for small issuers, the control structure, the
requirements for managers assessment and the scope of an internal
controls audit.
    This ``Better Implementation'' approach appears in the Report, but
comes only as a fall-back alternative to the exemptive recommendations.
To ensure continued investor confidence in our markets, we support the
approach that preserves the investor protection aspects of 404 while
lowering costs to implement and verify proper internal controls over
financial reporting.

Investors Support Section 404

    It is clear that we need to do something for small companies.
Investors in these companies, more than anyone, have a significant
stake in making sure we balance the regulatory burden with the need to
grow and access capital markets. Investors and the economy are ill-
served by a system that neglects either.
    We heard commentary from several professional investors and
institutional managers in support of Section 404 requirements. The
weight of such testimony has been questioned since many do not invest
directly in micro cap firms. Moreover, the lack of specific individual
testimony from micro cap and small cap investors along with the
observation that people still invest in these firms without Section 404
protections, both in U.S. and foreign markets, has been suggested as
evidence that investors do not care about section 404 protections.
    While we encourage more of these small company investors to come
forward and participate in the next comment period, we believe the
investor base involved in these firms is very fragmented. These
companies represent somewhere between 70 and 80 percent of public
companies and collectively have millions of individual retail and
private shareholders. It is unlikely this group will magically coalesce
and speak with a collective voice on this or any other regulatory or
financial reporting issue affecting the companies in which they invest.
That silence should not be misinterpreted. These are precisely the
investors that need the formal and self-regulatory ``system'' to
provide the necessary protections, transparency and honesty that
ensures a fair game. It is what continues to make U.S. markets the gold
standard.
    We appreciate the opportunity to serve on the Advisory Committee
and to serve as a representative for investor views. We encourage
investors to provide timely commentary to this Report. As with any
regulation, it is important to reach the proper balance between cost
burden on the issuer and investor protection. We firmly support
realignment and better implementation, not elimination of Section 404,
as the proper balance.

Statement of Mr. Schacht Dated December 14, 2005

    I appreciate the opportunity to address the entire committee on the
work of the 404 subcommittee and want to acknowledge all of my
colleagues' hard work. It was a pleasure working with them.
    As a committee, we have reviewed several issues affecting smaller
public companies. It is clear however, that the impacts of Section 404
of Sarbanes-Oxley, particularly the implementation costs, have proven
to be by far the most challenging. While I do not agree with several
subcommittee

recommendations, Section 404 is one of the key issues to focus on.
Solutions to its overly burdensome cost, particularly on small issuers,
are not simple.
    Notwithstanding that I am the lone dissenting vote on the
subcommittee, I do want to acknowledge that this group has examined
this topic closely. They fully considered my concerns and those of
others who commented on the proper ways to ``fix'' 404. We discussed
dozens of ways and options for reducing costs, while maintaining
investor protections.
    We all agree that the costs of SOX are the real issue. They have
been too high, exceeding all estimates, and they hit small companies
much more significantly. There have been numerous cost studies and
other anecdotal comments on whether these costs are or will be coming
down in subsequent years. I think the evidence will only be clear once
we have actual data in the coming months, because this is clearly not
yet at a point of equilibrium. For many companies that have yet to go
through the process, the initial costs will be high. There is no
question about this.
    Also, we all agree that internal controls at public companies are
important. They are an important feature for accurate financial
reporting, investor protection, and market integrity. Some argue that
internal controls have been somewhat neglected, and SOX has tried to
bring about some assurance that adequate controls are in place and
working as desired. How the markets get that assurance--that is, the
level to which these internal controls need to be verified and tested
by management and outside auditors--is the rub.
    The subcommittee goal was to reduce the cost burdens but maintain
the investor protections associated with Section 404. These need not be
mutually exclusive. My concern, and the basis for my dissent, is that
the panel's recommendations make them mutually exclusive. We seem to
say you can't have meaningful cost reductions unless you eliminate 404,
including the investor protections.
    Our biggest concern is that the main recommendations give a flat-
out exemption from all auditor 404 involvement in reviewing and
confirming internal controls. This is not for just a few, but for what
will effectively be more than 80 percent of the public companies in
this country.
    One could cite any number of flaws in this approach, but three in
particular stand out:
     First, the entire premise of SOX was to bolster investor
confidence by requiring meaningful corporate governance and financial
reporting reforms. Properly designed and functioning internal controls
over financial reporting were and are a cornerstone of this
legislation. Proper structuring and implementation of 404 requirements
are very different from eliminating these completely for a broad
segment of U.S. companies. That approach works against the statute's
legislative intent and the directive that we heard from both Chairman
Donaldson and Chairman Cox.
     Second, it is unclear to many whether the broad exemptive
recommendations of this subcommittee are even within the commission's
legal authority. Comprehensive, sweeping exemptions from Section 404
may not be possible under the current legislation, which specifically
excluded Section 404 from the Securities and Exchange Act of 1934. As
the full committee works toward final recommendations, it would be well
served to resolve that issue, as I expect there will be legal
challenges of this authority.
     Finally, and maybe most importantly, small public
companies need checks and balances over financial reporting. They
consistently have more misstatements and restatements of financial
information, nearly twice the rate of large firms, according to one
report. Alarmingly, they also make up the bulk of accounting fraud
cases under review by regulators and the courts (one study puts it at
75 percent of the cases from 1998-2003).
    A more balanced approach to fixing SOX 404 is to continue requiring
manager assertions and auditor attestation of internal controls, but
direct the appropriate regulatory and defacto standard-setting bodies
(the Committee of Sponsoring Organizations of the Treadway Commission
(COSO), the Public Company Accounting Oversight Board) and the SEC to
develop specific guidance for small companies. These would specifically
outline appropriate control structures and the auditing scope for small
companies under 404--a SOX `light' approach.
    Much of the outline for this approach appears in Recommendation 3
of the subcommittee's report. However, it comes only as a fall-back
alternative to the exemptive recommendations. To ensure continued
investor confidence in our markets, we deserve an approach that
preserves the investor protection aspects of 404 while lowering costs
to implement and verify proper internal controls over financial
reporting.
    It is clear that we need to do something for small companies. But
giving them a pass on any verification and oversight of internal
controls will come back to haunt us.
    The subcommittee's recommendations will now attract a fuller public
debate on some very important public policy issues. I would offer this
challenge to investors and, indeed, all participants in the financial
reporting process to get involved in commenting on these
recommendations. It is important to reach the proper balance between
cost and investor protection. Realignment not elimination of Section
404 is needed to accomplish that.

Part IX. Separate Statement of Mr. Veihmeyer

    Section 404 of Sarbanes-Oxley has contributed significantly to the
improvement of financial reporting, oversight of internal controls, and
audit quality. The public interest and the capital markets have been
well served by this legislation. At the same time, compliance with the
provisions of Section 404 has placed important responsibilities on
issuers and auditors that are both expensive and time consuming.
Clearly, the important goals of Section 404 must be achieved in the
most cost-effective and least burdensome manner, to ensure that the
costs of Section 404 do not outweigh the benefits. This is particularly
challenging with respect to smaller public companies. The Advisory
Committee on Smaller Public Companies has worked very hard to determine
where to strike the appropriate balance between the benefits to
investors and the burdens on issuers. The Final Report of the Advisory
Committee is the result of that work. While I respect the Committee's
efforts to find the best possible solutions to these difficult
problems, I differ with the majority over one fundamental principle. In
my judgment, sound public policy dictates that the protections provided
by Section 404 should be available to investors in all public
companies, regardless of size. Accordingly, our focus at this time
should not be on exempting companies from Section 404, but on
developing implementation guidance for assessing and auditing internal
control over financial reporting for smaller public companies that
recognizes the characteristics and needs of those companies. This
guidance should be jointly developed by regulators, issuers and the
accounting profession and should be field-tested for effectiveness,
including appropriate cost analysis, before implementation.
    The Final Report provides extensive root-cause analysis of the
costs of

compliance with Section 404, but fails to address the reality that
economies of scale do influence the relative cost of regulatory
compliance and professional services, including audits of financial
statements. Therefore, there is need for additional steps to be taken
to further improve the execution of Section 404 compliance relative to
smaller companies, as described below.
    I also believe that PCAOB Auditing Standard No. 2 is fundamentally
sound and scalable, and it is not prudent to consider amending the
Standard at this time. The first year of integrating the financial
statement audit with the requirements of Auditing Standard No. 2 was a
difficult process due to a number of environmental issues that have
been well-documented. Simply stated, the full integration of the
financial statement and internal control audit did not occur in year
one. However, my firm's experience is that the additional year of
experience, coupled with the May 2005 guidance from the SEC and the
PCAOB, and the efforts of issuers and auditors to improve their
respective approaches, has resulted in further integration of the
financial statement and internal control audit and is reducing the
total cost of compliance. I believe that issuers and auditors should be
allowed the opportunity to introduce incremental effectiveness and
efficiency into the compliance process--a migration that will occur
naturally as issuers and auditors move forward on the learning curve
associated with reporting on internal control over financial reporting.
    Because I believe that compliance with the provisions of Section
404 provides needed protection to investors in all public companies,
regardless of size, I do not support recommendations III.P.1, III.P.2,
and III.P.3 in the Final Report, as each would serve to dilute this
protection.
    Specifically, Recommendation III.P.3 referencing a standard
providing for an audit of the design and implementation of internal
control, but not the testing by the auditor of the operating
effectiveness, is in my view not advisable. While clear disclosure that
a company has not undergone an audit of internal control over financial
reporting is understandable to users, those same users cannot be
expected to assess the relative gradations of assurance provided by
this proposed distinction in reporting on internal control. An
alternative providing for an auditor's report only on design and
implementation of internal controls, at a time when much attention has
been directed toward reporting on the effective operation of internal
controls, will result in users' misunderstanding the level of assurance
provided by the auditor. It is important to note that a well-designed
system of internal control, while vital, does not equate to the
generation of reliable financial information in the absence of
effective operation of internal control. Accordingly, I believe that
Recommendation III.P.3 would serve to widen an already existing
expectation gap with respect to audit services at a time when emphasis
should be directed toward reducing that gap.
    I do not support Recommendations III.P.1 and III.P.2 based on my
belief that Section 404 of Sarbanes-Oxley has made and will continue to
make significant contributions to improving financial reporting,
oversight of internal controls, and audit quality. In my judgment,
sound public policy dictates that the protections derived from these
contributions should be available to investors in all public companies,
regardless of size.
    I believe that compliance with the provisions of Section 404 by
issuers, and application of the principles of Auditing Standard No. 2
by auditors, represent evolutionary skills that will become more
effective and efficient with more experience. As noted above, the
effectiveness and cost-efficiencies of Section 404 execution have
improved over the first two years. However, additional efficiencies and
experience with Auditing Standard No. 2 are not likely to fully address
the concerns of certain-sized smaller public companies. Accordingly, I
recommend that regulators, issuers and the accounting profession work
expeditiously to develop specific guidance, focused on the
characteristics of these smaller companies and their internal control
structures, which will further improve the execution of Section 404
compliance. I will commit resources of my firm to participate in and
support this effort. Additional implementation guidance specifically
tailored to the application of internal control concepts in a smaller
company environment should, at a minimum, address the following:
significance of monitoring controls, risk of management override, lack
of segregation of duties, extent and formality of company documentation
and assessment, and evaluation of the competency of a smaller company's
accounting and financial reporting function. This guidance should
address both the assessment to be made by management and the auditor's
performance requirements relevant to such assessment, as well as the
execution of auditing procedures pursuant to the provisions of Auditing
Standard No. 2. In addition, I believe that field testing the
effectiveness of this additional guidance, including appropriate cost
analyses, should be performed to facilitate well-informed decisions
regarding the reasonable application of the provisions of Section 404
in a smaller public company environment. It may become evident, as a
result of field testing and meaningful cost analyses, that an audit of
internal control over financial reporting may not be justified for
certain very small public companies that evidence certain
characteristics. For those smaller public companies, an exemption from
the provisions of Section 404 may be warranted, but such an exemption
should be considered only after careful analysis of the data derived
from the field tests. In short, we simply do not have sufficient
implementation guidance, experience, or information available at this
time to make a permanent reduction in the protections provided by
Section 404.
    It is essential that the additional implementation guidance,
specifically tailored to the application of internal control concepts
in a smaller public company environment, be developed and tested
expeditiously, given the importance of this issue to smaller public
companies and investors. While this guidance is being developed and
field tested, I recommend the continued deferral of the Section 404
requirements for all smaller public companies that have not already
been required to implement Section 404. However, I would envision that
such deferral would not extend more than a year beyond the current
implementation date for non-accelerated filers.
    It should be noted that this separate statement focuses solely on
the recommendations to which I dissent, and not to any specific
statements or opinions contained in the Final Report which are
inconsistent with my own views.
    The work of the Advisory Committee and our Final Report has raised
important issues relative to application of the provisions of Section
404. To address those issues, I propose additional guidance for smaller
public companies, and the field testing of that guidance, relative to
reporting on internal control over financial reporting as well as the
continued deferral for non-accelerated filers for an additional year if
these activities cannot be completed within one year. I believe these
proposals are consistent with our Charter to further the SEC's investor
protection mandate, and to consider whether the costs imposed by the
current regulatory system for small

companies are proportionate to the benefits, to identify methods of
minimizing costs and maximizing benefits, and to facilitate capital
formation by smaller companies.

Appendices*

Index of Appendices

A. Official Notice of Establishment of Committee
B. Committee Charter
C. Committee Agenda
D. SEC Press Release Announcing Intent to Establish Committee
E. SEC Press Release Announcing Full Membership of Committee
F. Committee By-Laws
G. Request for Public Comments on Committee Agenda
H. Request for Public Input
I. Background Statistics for All Public Companies
J. Universe of Publicly Traded Equity Securities and Their
Governance
K. List of Witnesses
L. Letter from Committee Co-Chairs to SEC Chairman Christopher Cox
dated August 18, 2005
M. SEC Statement of Policy on Accounting Provisions of Foreign
Corrupt Practices Act

    *Access to each appendix is available by clicking its name on
the copy of this page posted on the Internet at http://www.sec.gov/info/smallbus/acscp-finalreport_ed.pdf

    Authority: In accordance with Section 10(a) of the Federal
Advisory Committee Act, 5 U.S.C. App. 1, Sec.  10(a), Gerald J.
Laporte, Designated Federal Officer of the Committee, has approved
publication of this release at the request of the Committee. The
action being taken through the publication of this release is being
taken solely by the Committee and not by the Commission. The
Commission is merely providing its facilities to assist the
Committee in taking this action.

    Dated: February 28, 2006.
Nancy M. Morris,
Committee Management Officer.
[FR Doc. 06-1992 Filed 3-2-06; 8:45 am]

BILLING CODE 8010-01-U