SEC adopts definition of "significant deficiency"

By Cydney Posner

The SEC has adopted a definition of the term "significant deficiency" for purposes of its rules implementing SOX 302 and SOX 404. The rule becomes effective on September 10, 2007.

In June, the SEC issued interpretive guidance and rule amendments intended to help public companies strengthen their evaluations and assessments of internal control over financial reporting ("ICFR") while reducing unnecessary costs. (See my emails dated 6/22/07 and 6/29/07, pasted at the end of this email.) In addition to adopting a definition of "material weakness," the SEC determined, as part of that release, to propose a definition of "significant deficiency."

In its proposal, the SEC focused its definition of the term "significant deficiency" on the communications required to take place among management, audit committees and independent auditors. As a result, the framework of the definition, unlike the framework of "material weakness," did not include a likelihood component (that is, "reasonable possibility"), but instead focused on matters that were important enough to merit attention, with the intention of encouraging the use of judgment by management to determine those deficiencies that needed to be reported to the independent auditor and the audit committee. Although the SEC received comments advocating the inclusion of a likelihood component, the SEC determined not to add one, reasoning that the exclusion of a likelihood component from the definition "reduces the chance that management or independent auditors will design and implement evaluations or audits for the purpose of identifying deficiencies that are less severe than material weaknesses." (Note that the PCAOB, working with the SEC staff, took a similar stance by modifying its proposed definition of "significant deficiency" to eliminate the "reasonable possibility" element, instead focusing the auditor on the communication requirement and clarifying that auditors should not scope their audit procedures to search for deficiencies that are less severe than a material weakness.)

Accordingly, the SEC adopted the definition substantially as proposed. The final rules amend Exchange Act Rule 12b-21 and Rule 1-023 of Reg S-X to define a significant deficiency as ""a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant’s financial reporting."

This content is provided for general informational purposes only, and your access or use of the content does not create an attorney-client relationship between you or your organization and Cooley LLP, Cooley (UK) LLP, or any other affiliated practice or entity (collectively referred to as “Cooley”). By accessing this content, you agree that the information provided does not constitute legal or other professional advice. This content is not a substitute for obtaining legal advice from a qualified attorney licensed in your jurisdiction and you should not act or refrain from acting based on this content. This content may be changed without notice. It is not guaranteed to be complete, correct or up to date, and it may not reflect the most current legal developments. Prior results do not guarantee a similar outcome. Do not send any confidential information to Cooley, as we do not have any duty to keep any information you provide to us confidential. This content may be considered Attorney Advertising and is subject to our legal notices.