SARBANES OXLEY ACT

2002: SECTION 404-

BENEFITS AND COSTS Md Moniruzzaman

MAY 1, 2014 COURSE NO: BUPA 503, SPRING 2014

KELLEY SCHOOL OF BUSINESS INDIANAPOLIS

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One of the most controversial aspects of Sarbanes Oxley Act (SOX Act) is Section 404,

which requires company management to provide assertions of effective internal control

over financial reporting and for the company's independent audit firm to attest to those

assertions. Section 404 is today the focal point in the debate over the costs and benefits of

the changes in corporate practice mandated by Sarbanes-Oxley.

What is Section 404?

Section 404 aims to rebuild public trust by bolstering the internal controls that under-pin

the accuracy and reliability of published financial information. It seems obvious that

control effectiveness is closely correlated with the reliability of reported financial data and

that public confidence in a company’s controls is therefore closely correlated to public

confidence in its reporting. Section 404 of the Sarbanes-Oxley Act seeks to build on this

correlation by requiring that every public company annually issue and file with the

Securities and Exchange Commission a management report concerning the effectiveness

of the company’s internal control over financial reporting. Section 404 also requires that

these management reports be accompanied by a public report from the company’s financial

statement auditor attesting to the accuracy of management’s internal control report.

The Implementation of Section 404

SOX dramatically enhanced the penalties for false financial reporting, and both prosecutors

and plaintiffs’ lawyers have become extremely aggressive in pursuing false financial

reporting cases. Directors and senior executives therefore rush to embrace anything that

minimizes the risk that the financial statements that they must sign-off on are materially

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inaccurate or that their company’s controls do not meet the statutory requirements. In fact,

there is evidence that many executives do view Section 404 in that light and that it is

serving its purpose. For example, 79 percent of 222 financial executives surveyed by

Oversight Systems reported that their company has stronger internal controls after

complying with Section 404. Seventy-four percent said that their company benefited from

compliance with Sarbanes-Oxley and, of those, 33 percent said that compliance lessened

the risk of financial fraud.1 Further, according to Compliance Week, 27 companies with

revenue of more than $75 million disclosed material weaknesses or significant deficiencies

in internal controls during the month of January 2005, compared to only seven that made

such disclosures during the same month in 2004.2

This data seems to show that Section 404 is having a real, positive impact on controls.

There is, however, also considerable concern about adverse and counter-productive

impacts of Section 404. It has been suggested that Section 404 reporting is diverting large

amounts of executive time and company resources away from the fundamental profit-

making objectives of the business. Specific criticisms seem to fall into two categories --

that the way the requirement is being implemented has resulted in unintended

consequences, and that the costs of Section 404 exceed the benefits. One of the most

common charges is that, as a result of internal control reporting, companies can no longer

look to their auditors for advice on difficult accounting issues.

1 “Financial Executives Call Sarbanes-Oxley Compliance a ‘Good Investment,’ According to Oversight Survey,” Press Release of Oversight Systems, Inc. (December 14, 2004). 2 ”Adverse Opinions Emerge in Internal Control Disclosure,” Compliance Week (March 2005), p. 16.

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The Costs and Benefits

There are arguments that section 404 is imposing costs that are out of proportion. Based on

the survey of its members, Financial Executives International says that the expected

average first-year cost is 27,000 hours of internal time for companies with an average of

$5 billion in sales. As to anticipated total costs of compliance, FEI found that the average

first year expenditure was $4.36 million, including $1.34 million in internal costs; $1.30

million in audit fees and $1.72 million in external costs (consulting and software).3

While the costs of compliance are visible, estimating the benefits of SOX is a more

challenging proposition.

A study of a population of nearly 2,500 companies indicated that those with no material

weaknesses in their internal controls, or companies that corrected them in a timely manner,

experienced much greater increases in share prices than companies that did not.4 The report

also indicated that the benefits to a compliant company in share price were greater than

their SOX Section 404 costs. On the other hand, Iliev (2009) indicated that SOX 404 led

to conservative reported earnings and lower earnings often cause the share price to

decrease.5

3 ”FEI Survey on SOX Section 404 Implementation” (March 2005). http://www.sec.gov/news/studies/2009/sox-404_study.pdf 4 The Lord & Benoit Report: Do the Benefits of 404 Exceed the Cost? http://www.section404.org/pdf/Lord%20&%20Benoit%20Report%20Do%20the%20Benefits%20of%20404%20Exceed%20the%20Cost.pdf 5 "The Effect of SOX Section 404: Costs, Earnings Quality and Stock Prices” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=983772

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However, it is suggested that the future cost associated with section 404 will decrease

substantially in future.6 With time, no doubt, the law's balance of costs and benefits will

improve significantly: some of the costs have been once-and-for-all. Right now, though,

the balance looks unfavorable.

Conclusion

The objective of the Sarbanes-Oxley Act is to restore confidence in financial reporting.

The costs are tangible, quantifiable and immediate, while many of the benefits are

intangible, harder to quantify and longer term. The ultimate test of Section 404, and of

those charged with implementing, is whether we succeed in maintaining the public’s

confidence in the integrity and transparency of stock markets.

6 “Sarbanes-Oxley Section 404 Work Looking at the Benefits” The IIA Research Foundation (2005) http://www.theiia.org/bookstore/media/pdf/2009.dl_ExecSumm.pdf