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American Accounting Association

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Exempting small firms from audit mandates may be mistake, 2 studies suggest

Key FDIC and SEC audit regulations no longer apply to smaller publicly owned companies

When the Dodd-Frank bill was enacted this year, much was made of the vast increase in financial regulations companies would face. Little noted was that the legislation permanently  exempts most publicly owned firms from a much-criticized piece of financial regulation.

The mandate in question, Section 404 of the Sarbanes-Oxley Act of 2002 (SOX), requires firms annually to evaluate the internal control systems governing their operations and financial reports and to have an outside auditor attest to that evaluation. Dodd-Frank exempts all companies with less than $75-million capitalization (that is, most public companies) from the auditor-attestation requirement, which many accounting scholars consider key to 404's effectiveness.

Ironically, this exemption becomes law just as a new study in the American Accounting Association's journal Accounting Horizons, the first to specifically assess the mandate's effect on the frequency of financial restatements, "provides evidence that the S404 compliance effort reduces the likelihood of issuing materially misstated financial statements, and suggests that the S404 regulation is meeting its objective of improving the quality of financial reports."

Meanwhile, a report in a second AAA journal, The Accounting Review, focuses specifically on the banking industry (excluded from the first study) and finds a concentration of suspect auditing in publicly  owned companies that are exempted by virtue of their relatively small size from a mandate similar to S404

The study concludes that "to the extent that our results for banks are generalizable to other industries, our findings of increased earnings management by small banks that are less closely regulated are relevant to the debate on reducing the requirements of SOX for small firms."

Profs. Gerald J. Lobo of the University of Houston, Gopal V. Krishnan of Lehigh University, and Kiridaran Kanagaretnam of McMaster University analyze data from some 300 publicly owned banks over the seven years 2000-2006, and find a suspect association between abnormal fees for auditors and abnormal loan-loss provisions of the banks they audit. This association occurs disproportionately in relatively small banks, which are exempted from an FDIC regulation that served as a model for SOX 404.  

Abnormalities in loan-loss provisions (LLP) are of great significance in bank auditing, because, as the Accounting Review study puts it, "bank managers have considerable discretion in estimating LLP. This discretion allows them flexibility in using LLP for income-increasing or income-decreasing earnings management, or for smoothing earnings. LLP is also by far the largest and most important accrual for banks, thus affording bank managers wide latitude in its use."

The professors find that "unexpected auditor fees are unrelated to earnings management in large banks"  but that they are significantly related to earnings management in "small banks that are not subject to the same level of regulatory scrutiny as larger banks." Banks of under $500 million (raised to $1 billion in 2005) were exempted from the FDIC internal-control -assessment mandate during the period of the study.

The Accounting Horizons report, by Albert L. Nagy, an accounting professor at John Carroll University in Cleveland, Ohio, takes advantage of the fact that S404 was phased in over time, with companies below $75 million capitalization initially exempt from the rule even while subject to other provisions of SOX. This temporary exemption created a population of complying companies, with capitalizations above the threshold, and a second population of non-complying companies, with capitalizations below that line. The study's sample included about 1,000 firms capitalized within $50 million of the threshold -- one group capitalized at $25 million to $75 million and the second at $75 million to $125 million. Firms were observed over the two years 2005-2006, when they issued a total of 1,951 financial statements, of which 375 had to be restated.

Prof. Nagy found that 20% of the financial reports from non-complying companies had to be reissued because of material misstatements compared to only 14.5% of the reports from compliers. In other words, non-complying  companies proved almost 40% more likely than compliers to restate.

Comments Nagy: "The study's findings may raise doubts about whether  Dodd-Frank should have permanently exempted small companies from having an independent auditor attest to their internal-control assessments. The audit report arguably gives S404 its teeth. Evaluation of internal control is rather subjective, and it is questionable whether companies will perform quality assessments without the auditor-attestation requirement."

He adds: "Section 404 eliminates lack of awareness of flawed management as a handy excuse for financial misstatements. Now that small firms are exempt from the rule's auditor-attestation requirement, it will behoove regulators to keep a sharp eye on their financial reporting. Although these companies do not dominate the market in terms of capitalization, they represent by far the largest number of public corporations, and there is considerable potential for harm to investors if the financial information they disseminate is inaccurate or misleading."

The Accounting Horizons study, entitled "Section 404 Compliance and Financial Reporting Quality," is in the Sept-Nov. issue of the journal, a peer-reviewed quarterly publication of the 8,000-member AAA, a worldwide organization devoted to excellence in accounting education, research, and practice. The Accounting Review study, entitled "An Empirical Analysis of Auditor Independence in the Banking Industry," appears in the Nov.-Dec. issue of that publication. Other journals published by the AAA or its specialty sections include Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.


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