The Securities and Exchange Commission yesterday approved a new standard requiring outside accountants to test internal safeguards for detecting fraud at the companies they audit.
Weaknesses in corporate systems of checks and balances have been cited as contributing factors in several recent financial scandals, including those at Rite Aid Corp. and WorldCom Inc. Supporters argue the new scrutiny could cut down on abuses and mistakes by ensuring that companies have strong controls in place for periodically reviewing their own financial records and checking account balances.
Business groups have protested the move, arguing it could cost millions of dollars at firms with large or multinational operations. A study by Financial Executives International this year found that the biggest public U.S. companies expected to pay more than $4 million each to comply.
The SEC's chief accountant, Donald T. Nicolaisen, yesterday said the standard "strikes an appropriate balance" by allowing room for auditors to make "reasonable" judgments about the amount of work they must perform.
The standard requires auditors to track sample deals and payments through a company's financial system. It also requires outside accounting firms, which are hired by companies' audit committees, to assess how effective the audit committees at their client companies have been, among other steps.
The standard is among the first major projects of the Public Company Accounting Oversight Board, which was created under a 2002 corporate reform law to impose independent discipline on the accounting industry. Its proposed standards must be endorsed by the SEC before they become final.
William J. McDonough, chairman of the accounting board, yesterday called the standard "one of the most important and far-reaching auditing standards the board will ever adopt."
He added that testing a company's checks and balances is "the first line of defense against misconduct and one of the most effective deterrents to fraud."
Officials at the SEC and the accounting board said they will issue additional guidance for companies and auditors with specific questions about the control standard within the next several days.
For large public companies, the internal control standards take effect for audits of financial statements for fiscal years ending on or after Nov. 15. Smaller publicly traded firms and foreign issuers have until July 15, 2005, to comply.