Investor advocate stresses importance of financial reporting controls

SEC Investor Advocate Rick Fleming said Congress should not weaken the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act of 2002 in a report he submitted to Congress on Dec. 21, 2016.

“Effective internal control over financial reporting—and attestation by an independent accountant as to the effectiveness of such controls—promotes reliable financial reporting, strengthens public confidence, and encourages investment in our capital markets,” Fleming wrote in the annual report describing his activities for fiscal 2016, which ended on Sept. 30. The report was due by the end of the calendar year.

Fleming said he opposed H.R. 4139, Fostering Innovation Act of 2015, which would broaden the exemption for small public companies from the auditor attestation requirements of Section 404(b). The bipartisan bill passed the House of Representatives in May 2016 and was referred to the Senate Banking Committee.

The bill applies the exemption to emerging growth companies (EGCs), which the JOBS Act of 2012 defined as companies with less than $1 billion in revenue and within five years of their initial public offerings. Sec. 1 of PL112-106

Of the exemptions granted to EGCs by the JOBS Act, one of the most significant is the five-year exemption from Section 404(b). But H.R. 4139 extends the exemption to 10 years as long as an EGC does not have revenues of $50 million or more.

“In our view, ICFR and auditor attestation provide investors with a critical window into the competence of a company’s management, the integrity of its financial reporting, and the quality and sustainability of its earnings,” Fleming wrote. “Moreover, the importance of ICFR will only grow as a result of new accounting standards.”

FASB’s revenue recognition standard goes into effect in 2018 for public companies, the lease accounting amendments become effective in 2019, and publicly traded companies will have to begin applying the credit loss standard in 2020.

SEC Chief Accountant Wesley Bricker encouraged companies to update and maintain their internal controls in a Dec. 5, 2016 speech, at the AICPA Conference on Current SEC and PCAOB Developments.

“It is hard to think of an area more important than ICFR to our mission of providing high-quality financial information that investors can rely on,” Bricker said. “If left unidentified or unaddressed, ICFR deficiencies can lead to lower-quality financial reporting and ultimately higher financial reporting restatement rates and higher cost of capital.”

In his report to Congress, Fleming described the agency’s Disclosure Effectiveness initiative, which departing SEC Chair Mary Jo White started about three years ago in response to companies’ complaint that disclosure requirements have grown lengthy and costly without providing commensurate value to investors. Investors were initially worried that the agency will only seek to cut requirements, but SEC officials have reassured them that they would also work to add information that investors may find useful.

Under the initiative, the SEC has issued several rulemaking documents that sought comments, among other things, about Regulation S-K, the set of rules that cover information outside the financial statements that companies must provide in their annual and quarterly reports, and about Regulation S-X, which sets the form and content of financial reports.

“These are important and substantive proposals that could significantly revise the disclosure requirements of public companies and, in turn, impact investors and the markets,” Fleming noted. However, because the large volume of the proposals—totaling 1,084 pages and 577 questions—has made it difficult for investors to provide comments, he said his office has encouraged the SEC to be more proactive in determining what investors want. Businesses often dominate the public debate on regulations, and investors tend to be underrepresented.

Moreover, Fleming said his office has begun conducting investor outreach to determine how a variety of investors make decisions in buying and selling securities and voting during annual meetings.

“These discussions will help to inform our thinking, and ultimately our advocacy, regarding the proposed changes to the disclosure requirements,” Fleming wrote. “In addition, we have laid the groundwork for the commission to conduct more investor testing in this area, utilizing focus groups and other methods to determine what is actually in the best interests of investors.”

Fleming said his office, working with the SEC’s Office of Acquisitions, has designed a program to facilitate greater use of investor testing by the commission, which will include surveys and focus groups.

“In my view, investor testing provides an opportunity to alleviate a significant shortcoming of the rulemaking process,” Fleming said. “In that process, proposed rules are published for public comment, but members of the general public who stand to benefit from the rules are underrepresented in the comment letters that are submitted.”

Until Jay Clayton, President-elect Donald Trump’s nominee to chair the SEC, is confirmed by the Senate and sworn-in, the next stage of the Disclosure Effectiveness project will remain unclear to the public.

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