Highlights

The PCAOB proposed a standard, An Audit of Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial Statements, to replace PCAOB Audit Standard no. 2 (AS2). The proposal is designed to focus audits on the matters most significant to internal control, eliminate unnecessary procedures, simplify the standard itself by reducing detail (the text is roughly one-third the length of AS2) and make audits more scalable for smaller companies. The proposed standard would

Direct the auditor to the most important controls and emphasize the importance of risk assessment.

Revise the definitions of significant deficiency and material weakness, as well as the “strong indicators” of a material weakness.

Clarify the role of materiality, including interim materiality, in the audit.

Remove the requirement to evaluate management’s process.

Permit consideration of knowledge obtained during previous audits.

Direct the auditor to tailor the audit to reflect the attributes of smaller and less-complex companies.

Refocus the multilocation testing requirements on risk rather than coverage.

Although the effective date is not yet determined, PCAOB Chair Mark Olson said, “We’re trying to have the whole thing done so that it can be fully absorbed for the 2007 audit.”

The PCAOB also proposed to revise and redistribute certain topics covered in AS2 to other existing standards; these include easing restrictions on using the work of others and new guidance on audit committee preapproval of services related to internal control.

Comments are due by February 26. To view the EDs, visit www.pcaobus.org/Rules/Docket_021/index.aspx .

The SEC proposed interpretive guidance for management on its obligations under section 404 of the Sarbanes-Oxley Act of 2002. The guidance is organized around two principles:

Management should evaluate the design of the controls it has implemented to determine whether there is a reasonable possibility that a material misstatement in the financial statements would not be prevented or detected in a timely manner.

Management should gather and analyze evidence about the operation of the controls being evaluated based on its assessment of the risk associated with those controls.

The SEC also proposed changes to SEC rules 13a-15 and 15d-15 to clarify that a company choosing to evaluate internal control in accordance with the new guidance would satisfy the annual evaluation requirement. However, the commission says it would allow management to use methods other than those in the proposed guidance to achieve the same objectives. This would give larger companies that have already complied with section 404 the option to continue to use their current processes rather than starting over under the new guidance.

The SEC also plans to amend Regulation S-X to clarify the auditor’s reporting requirement under section 404. To view the new guidance, visit www.sec.gov/rules/proposed.shtml .

The effective date has not been determined. In an interview with the JofA, SEC Chairman Christopher Cox said, “I expect that 404 relief will be in effect for U.S. companies—or for companies both in the United States and abroad—no later than the second quarter of 2007.” Comments are due by February 26.

The commission also adopted revised compliance deadlines for smaller companies. Previously, nonaccelerated filers were to begin including both management’s assessment of internal control and an auditor’s attestation to management’s assessment for fiscal years ending on or after July 15, 2007. The new deadline gives nonaccelerated filers until fiscal years ending on or after December 15, 2007, to provide management’s assessment of internal control over financial reporting. But nonaccelerated

filers now will have another year to meet the auditor’s attestation requirement.

FASB issued an exposure draft to address concerns that existing disclosure requirements do not provide adequate information to investors and others about the effects of derivative and hedging activities on a company’s financial statements. The ED, Disclosures About Derivative Instruments and Hedging Activities, would, among other things, require entities to discuss their objectives and strategies for using derivative instruments in terms of the underlying risk and accounting designation.

The ED would amend and expand the disclosure requirements of the similarly titled FASB Statement no. 133.

“The proposed disclosure requirements are intended to enhance understanding of how and why entities use derivatives, how they are accounted for in an entity’s financial statements, and how they affect an entity’s financial position, results of operations and cash flows,” FASB Project Manager Kevin Stoklosa said in a news release.

The requirements would take effect for periods ending after December 15, 2007. Comments are due by March 2. The draft is available at www.fasb.org/draft/ed_derivatives_disclosure.pdf.