Sarbanes-Oxley Section 404’s Effect on Financial Reporting Quality

One of the most significant costs of the Sarbanes-Oxley Act of 2002 (“SOX”) compliance is the cost for independent external auditors to report on the effectiveness of a company’s internal controls over financial reporting, which is included in SOX Section 404(b). The prevailing concern is that the financial cost of compliance with Section 404(b) is too significant for smaller companies who will then decide to de-list or be deterred from going public in the first place. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) partially addressed this concern by exempting companies with a market capitalization below $75 million from the requirement of Section 404(b) to have external auditors report on the effectiveness of their internal controls over financial reporting. However, per Albert Nagy, a professor of accounting at John Carroll University, companies subject to SOX Section 404 (“SOX404”) met the regulations primary objective by improving the quality of financial reports. Accordingly, this exemption may lead to the inaccurate and misleading financial information and cause considerable harm to investors if these “smaller companies” do not focus on maintaining strong controls.

Per Mr. Nagy’s study, J.C. Bedard, a professor of accounting at Bentley University, has published the only known study to explore whether SOX404 compliance has improved earnings quality. Bedard explores whether SOX404 resulted in lower unexpected accruals and therefore higher earnings quality. Bedard’s study found that earnings quality improves in the same period that an internal control weakness is disclosed. Furthermore, this study found that earnings quality improves in the first year that a company is required to report on its internal controls.

Mr. Nagy extends Bedard’s study in two areas. First, Bedard uses unexpected accruals as a determination of earnings quality and argues that effective internal controls will reduce unexpected accruals. Mr. Nagy’s study uses materially misstated financial statements as a measure of financial reporting quality. Second, Bedard found that in the first year companies complied with SOX404, those who reported effective internal controls had lower unexpected accruals. Bedard’s finding suggests that the SOX404 assessment process may have resulted in improved internal control and/or increased audit effort.

Mr. Nagy’s study consists of a sample of companies surrounding the SOX404 compliance cutoff ($75 million float) for the years 2005 and 2006. The sample period begins with 2005 observations, the year following the SOX404 effective date for accelerated filers. The sample period ends with 2006 observations, which allows some time for the accounting misstatements to be identified and restated. The initial screening was arbitrarily determined as companies with a market capitalization within $50 million of the compliance threshold (i.e., between $25 million and $125 million). The companies included in the sample consist of the smaller accelerated filers that have complied with SOX404 requirements and the larger nonaccelerated filers that have yet to comply with the requirements of Section 404(b).

The results of Mr. Nagy’s study found that compliance with SOX404 reduced the likelihood of a company issuing materially misstated financial statements, which suggests that SOX404 regulation has led to improved quality of financial reports. Mr. Nagy points out that his study has certain limitations. First, the sample consists of companies that surround the SOX404 compliance threshold (i.e. $75 million float), which means that the study may not extend to larger companies. Second, the study only extends to the first two years of compliance, which may not be reflective of future periods, as companies and auditors may have conducted more documentation during the early years of SOX404 compliance. Third, the characteristics of compliant companies could be different than those of noncompliant companies. If any of these characteristics are correlated with accounting misstatements, then the results may lead to incorrect conclusions. Lastly the quality of earnings is based on accounting restatements. However, this may not be the most optimal measurement as companies may never identify or restate misstatements.

The Dodd-Frank Act mandates that additional studies be performed to assess the cost/benefit of the exemption for smaller companies of Section 404(b). One of these studies is to be conducted by the Government Accountability Office (GAO), which will assess whether exempt companies have fewer or more restatements. Additionally, this GAO study will include an analysis of the cost of capital of exempt versus nonexempt issuers and whether there are any differences in the confidence of investors resulting from this exemption. The GAO study is not due to Congress until 2013. The analysis by Mr. Nagy suggests that the study will likely show that SOX404 compliance does provide higher quality financial reporting and fewer restatements.