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Reviled though it has been, Sarbanes-Oxley's Section 404 substantially reduces corporate financial misstatements, study finds

But Dodd-Frank has now exempted small companies from a key provision

In the barrage of criticism directed by business against the Sarbanes-Oxley act of 2002, probably no part of the law has been bombarded more than Section 404, which requires firms and auditors to formally assess annually the systems of internal control governing company operations and financial reports. The intensity of the complaints can be gleaned from the view expressed in one law journal that 404's implementation was "one of the greatest failures of cost-benefit analysis in the history of the Securities and Exchange Commission."

Thus, it comes as no great shock that this year's Dodd-Frank financial-reform bill permanently exempts companies with less than $75-million capitalization from a key provision of 404 that requires an outside auditor to attest annually to firms' internal-control evaluations.

Ironically, this small-company exemption becomes law just as a new study reveals that, whatever mistakes were made in its initial implementation, S404 substantially lowers the incidence of financial misstatements among small firms.

The report, published in the current issue of the American Accounting Association's journal Accounting Horizons, "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."

The study, 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 1951 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.

Much of this difference is attributable to factors other than compliance. Particularly prone to misreporting were companies that achieved four successive quarters or more of earnings growth as well as firms that had recently sustained losses and companies that acknowledged material weaknesses in their internal-control systems. Controlling for these factors, Prof. Nagy estimates that compliance reduced the probability of misstatements by the companies in his sample by 6.3%.

"Whether a reduction of this magnitude justifies the expense companies incur as a result of S404 is something that this study can't answer," he says. "But it strikes me as a sizeable effect, and, given the progress that regulators have made over time in enforcing the rule efficiently, this finding may serve to moderate the controversy and criticism that S404 set off.

"It may also raise doubts," he continues,"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."

Reminded that Dodd-Frank directs the US Comptroller General to investigate whether companies exempted from the requirement issue more restatements, Prof. Nagy says that his research has done essentially that. "While the findings do not provide an answer to precisely that question, they certainly come close," he comments.

"Section 404 eliminates lack of awareness of flawed management as a handy excuse for financial misstatements," the professor adds. "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 study, entitled "Section 404 Compliance and Financial Reporting Quality," is in the Sept-Nov. issue of Accounting Horizons, published quarterly by the American Accounting Association, an 8,000-member worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include The Accounting Review, 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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