Study of the Sarbanes-Oxley Act of 2002 Section 404 Internal Control over Financial Reporting Requirements

Purpose Central to the Sarbanes–Oxley Act was a requirement that every company have an audit of its internal control over financial reporting. However, there were concerns that this requirement was overly burdensome, from a financial perspective, for small businesses. This concern promoted several delays in enforcing the law for small companies and ultimately caused congress to permanently exempt small businesses. Yet, there are some small companies that voluntarily elect to comply with the law. The purpose of this paper is to explore why these companies elect to incur these costly audits. Design/methodology/approach Using a sample of 5,834 non-accelerator US firms, this paper uses a robust logistic regression model to examine why some firms comply voluntary with SOX Section 404(b). Findings This study shows that small companies getting audits of internal controls may be doing so to restore investor confidence after reporting failures, to appear credible prior to raising funds, as a response to organizational changes, or in anticipation of being required to comply. Practical implications This study provides regulators with an improved understanding of when it is necessary to implement mandatory rather than voluntary guidance. Originality/value This study is the first to document why a client would voluntarily comply with SOX Section 404 (b).

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Auditor Attestation under SOX Section 404 and Earnings Informativeness

Auditing A Journal of Practice & Theory ◽

10.2308/ajpt-50334 ◽

2012 ◽

Vol 32 (1) ◽

pp. 61-84 ◽

Cited By ~ 18

Author(s):

Lucy Huajing Chen ◽

Jayanthi Krishnan ◽

Heibatollah Sami ◽

Haiyan Zhou

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Control Sample ◽

Audit Fees ◽

Test Sample ◽

Section 404 ◽

Earnings Informativeness ◽

Sarbanes Oxley ◽

Audit Reports ◽

Section 302

SUMMARY Section 404 of the Sarbanes-Oxley Act requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). Policymakers expect the ICFR audits to enhance the credibility of firms' financial statements. Prior research argues that audit characteristics that enhance the credibility of financial reporting are associated with stronger earnings-return associations. We examine whether earnings accompanied by the first-time Section 404 ICFR reports were associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. We conduct our analysis for a test sample of accelerated filers with clean ICFR reports and clean previous Section 302 disclosures. Using a difference-in-differences approach, we compare the change in earnings informativeness for the test sample with that for a control sample of non-accelerated filers. We find that earnings informativeness for companies with clean internal control reports was greater in the Section 404 adoption year than in the previous year, while there was no change in earnings informativeness for the non-accelerated filers. Also, there is no difference in the increase in earnings informativeness across firms with small and large compliance costs (measured by change in audit fees), suggesting that both groups benefited from the Section 404 ICFR audits.

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The Impact of SOX Section 404 Internal Control Quality Assessment on Audit Delay in the SOX Era

Auditing A Journal of Practice & Theory ◽

10.2308/aud.2006.25.2.1 ◽

2006 ◽

Vol 25 (2) ◽

pp. 1-23 ◽

Cited By ~ 180

Author(s):

Michael L. Ettredge ◽

Chan Li ◽

Lili Sun

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Small Sample ◽

Impact Factors ◽

Section 404 ◽

Material Weakness ◽

Control Quality ◽

Sarbanes Oxley ◽

Specific Material ◽

The Impact

This study analyzes the impact of internal control quality on audit delay following the implementation of the Sarbanes-Oxley Act (2002) (SOX). Unlike prior studies of audit delay that obtain information about internal control strength via surveys, or use fairly crude proxies for internal control quality, our study employs external auditor assessments of internal control over financial reporting (ICOFR) that are publicly disclosed in SEC 10-K filings under SOX Section 404. Thus, the empirical evidence provided in this study is both timely and reliable (i.e., not subject to small sample bias or weak proxies). Consistent with our expectation, we find that the presence of material weakness in ICOFR is associated with longer delays. The types of material weakness also matter. Compared to specific material weakness, general material weakness is associated with longer delays. Additional analyses indicate that companies with control problems in personnel, process and procedure, segregation of duties, and closing process experience longer delays. After controlling for other impact factors, this study also documents a significant increase in audit delay associated with the fulfillment of the SOX Section 404 ICOFR assessment requirement. This suggests that Section 404 assessments have made it more difficult for firms to comply with the SEC's desire to shorten 10-K filing deadlines. Our finding thus supports and helps explain the SEC's decisions in 2004 and 2005 to defer scheduled reductions in 10-K filing deadlines (from 75 days to 60 days) for large, accelerated filers.

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SOX Section 404 Material Weakness Disclosures and Audit Fees

Auditing A Journal of Practice & Theory ◽

10.2308/aud.2006.25.1.99 ◽

2006 ◽

Vol 25 (1) ◽

pp. 99-114 ◽

Cited By ~ 258

Author(s):

K. Raghunandan ◽

Dasaratha V. Rama

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Audit Fees ◽

Internal Controls ◽

Fiscal Year ◽

Section 404 ◽

Control Material ◽

Material Weakness ◽

Sarbanes Oxley ◽

The Mean

Section 404 of the Sarbanes-Oxley Act and Auditing Standard No. 2 (PCAOB 2004) require management and the auditor to report on internal controls over financial reporting. Section 404 is arguably the most controversial element of SOX, and much of the debate around the costs of implementing section 404 has focused on auditors' fees (Ernst & Young 2005). In this paper, we examine the association between audit fees and internal control disclosures made pursuant to section 404. Our sample includes 660 manufacturing firms that have a December 31, 2004 fiscal year-end and filed the section 404 report by May 15, 2005. We find that the mean (median) audit fees for the firms in our sample for fiscal 2004 is 86 (128) percent higher than the corresponding fees for fiscal 2003. Audit fees for fiscal 2004 are 43 percent higher for clients with a material weakness disclosure compared to clients without such disclosure; however, audit fees for fiscal 2003 are not associated with an internal control material weakness disclosure (in the 10-K filed following fiscal 2004). We also find that the association between audit fees and the presence of a material weakness disclosure does not vary depending on the type of material weakness (systemic or non-systemic).

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Borrowers' Accounting Information and the Quality of Banks' Loan Portfolios

The Accounting Review ◽

10.2308/tar-2016-0298 ◽

2020 ◽

Author(s):

Carlo Maria Gallimberti

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Public Funding ◽

Section 404 ◽

Loan Portfolio ◽

Loan Contracts ◽

Loan Portfolios ◽

Sarbanes Oxley ◽

Positive Effect

I examine the relation between borrowers' financial reporting (FR) and the quality of banks' loan portfolios. This relation is theoretically ambiguous as better FR improves banks' monitoring of loans but also grants more creditworthy borrowers cheaper access to alternative public funding, increasing competition and creating adverse selection problems for banks. Using the adoption of Section 404 of the Sarbanes-Oxley Act to identify improvements in borrowers' FR, I find an overall positive effect of FR on banks' lending: the quality of loans extended to borrowers subject to Section 404 improves relative to the quality of loans extended by the same bank to other borrowers exempted from Section 404. Additional tests examining borrowers' internal control over FR and loan contracts' characteristics confirm that improved monitoring and screening are both responsible for the higher loan portfolio quality. Overall, my study highlights unexplored consequences of companies' FR on the quality of banks' assets.

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Control Self-Assessment and Costs of Compliance with Sarbanes-Oxley Section 404

Journal of Management Accounting Research ◽

10.2308/jmar-52399 ◽

2019 ◽

Vol 31 (3) ◽

pp. 5-24 ◽

Cited By ~ 1

Author(s):

Lawrence J. Abbott ◽

Susan Parker ◽

Gary F. Peters ◽

Theresa J. Presley

Keyword(s):

Control Systems ◽

Financial Reporting ◽

Internal Control ◽

Audit Fees ◽

Negative Association ◽

Management Control ◽

Section 404 ◽

Self Assessment ◽

Internal Auditor ◽

Sarbanes Oxley

ABSTRACT Control self-assessment (CSA) represents the practice of making operational-level managers responsible for internal control monitoring. We investigate the association between the use of CSA and certain costs incurred in maintaining internal control systems and complying with regulatory requirements. We find a negative association between CSA and external audit fees paid for the audit of internal control over financial reporting. Moreover, we find an incremental fee reduction resulting from the interaction between CSA and Section 404 assistance provided to the external auditor by the internal auditor. Additionally, we find a negative association between the use of CSA and some costs of the internal audit's own evaluation of operational and financial controls for managerial purposes. In sum, our study suggests that CSA can lessen at least some internal control costs while reducing control risk as proxied by external costs of internal control compliance. We discuss implications for broader management control systems.

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Corporate Governance and Internal Control over Financial Reporting: A Comparison of Regulatory Regimes

The Accounting Review ◽

10.2308/accr.2009.84.3.839 ◽

2009 ◽

Vol 84 (3) ◽

pp. 839-867 ◽

Cited By ~ 288

Author(s):

Udi Hoitash ◽

Rani Hoitash ◽

Jean C. Bedard

Keyword(s):

Corporate Governance ◽

Financial Reporting ◽

Internal Control ◽

Audit Committee ◽

Section 404 ◽

Sarbanes Oxley ◽

Material Weaknesses ◽

Financial Expertise ◽

Financial Expert ◽

Section 302

ABSTRACT: This study examines the association between corporate governance and disclosures of material weaknesses (MW) in internal control over financial reporting. We study this association using MW reported under Sarbanes-Oxley Sections 302 and 404, deriving data on audit committee financial expertise from automated parsing of member qualifications from their biographies. We find that a lower likelihood of disclosing Section 404 MW is associated with relatively more audit committee members having accounting and supervisory experience, as well as board strength. Further, the nature of MW varies with the type of experience. However, these associations are not detectable using Section 302 reports. We also find that MW disclosure is associated with designating a financial expert without accounting experience, or designating multiple financial experts. We conclude that board and audit committee characteristics are associated with internal control quality. However, this association is only observable under the more stringent requirements of Section 404.

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The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality

Auditing A Journal of Practice & Theory ◽

10.2308/ajpt-50570 ◽

2013 ◽

Vol 33 (1) ◽

pp. 93-116 ◽

Cited By ~ 15

Author(s):

Emma-Riikka Myllymäki

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Reporting Quality ◽

Financial Reporting Quality ◽

Control Problems ◽

Section 404 ◽

Material Weakness ◽

Sarbanes Oxley ◽

Material Weaknesses ◽

History Of

SUMMARY This study examines whether Sarbanes-Oxley (SOX) Section 404 material weakness (MW404) disclosures are predictive of future financial reporting quality. I find evidence that for companies with a history of MW404s, the likelihood of misstatements in financial information continues to be significantly higher for two years after the last MW404 report compared to companies without a history of reported MW404s. The magnitude of the effect decreases non-linearly with decreasing speed. The findings further imply that the reason for the misstatement incidences is the unacknowledged pervasiveness of control problems. In particular, it appears that in many cases, the future misstatements are unrelated to the MW types disclosed in the last MW404 report, suggesting that some MW types are unacknowledged and, hence, control problems are even more pervasive than what was identified. Overall, the findings of this study highlight the importance of discovering and disclosing material weaknesses in internal control over financial reporting.

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Controls, Security, and Audit in Online Digital Accounting

Digital Accounting ◽

10.4018/978-1-59140-738-6.ch010 ◽

2011 ◽

pp. 318-383

Author(s):

Ashutosh Deshmukh

Keyword(s):

Financial Reporting ◽

Internal Control ◽

Annual Report ◽

Control Structure ◽

Internal Controls ◽

Section 404 ◽

Checks And Balances ◽

The Public ◽

Sarbanes Oxley ◽

Public Company

Internal controls have existed since the dawn of business activities. Internal controls are basically systems of checks and balances. The purpose is to keep the organization moving along desired lines as per the wishes of the owners and to protect assets of the business. Internal controls have received attention from auditors, managers, accountants, fraud examiners and legislatures. Sarbanes Oxley Act 2002 now requires the annual report of a public company to contain a statement of management’s responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and management’s assessment of the effectiveness of the company’s internal control structure and procedures for financial reporting. Section 404 of the Act also requires the auditor to attest to and report on management’s assessment of effectiveness of the internal controls in accordance with standards established by the Public Company Accounting Oversight Board (PCAOB).

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SOX Section 404 Twenty Years After: Reviewing Costs and Benefits

ACRN Journal of Finance and Risk Perspectives ◽

10.35944/jofrp.2020.9.1.008 ◽

2020 ◽

Vol 9 (1) ◽

pp. 103-112

Author(s):

Bianca Fischer ◽

Bernadette Gral ◽

Othmar Lehner

Keyword(s):

Earnings Management ◽

Financial Reporting ◽

Internal Control ◽

Earnings Quality ◽

Costs And Benefits ◽

Section 404 ◽

Positive Effects ◽

Sarbanes Oxley

Some issues of the Sarbanes Oxley Act of 2002 are still discussed controversially in literature. Thereof, Section 404 concerning internal control over financial reporting is one of the most criticized parts. This article focuses on costs and benefits of the section and impacts on earnings management. Most authors agree that compliance costs of Section 404 far outweigh its benefits. However, long-term benefits are expected. Regarding earnings management, studies show that the section has positive effects such as increased earnings quality and improved internal control systems. Although the section is heavily debated in literature, there is consensus that SOX Section 404 greatly contributed to the improvement of quality of financial reporting and of corporate governance as a whole.

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