Do Control Effectiveness Disclosures Require SOX 404(b) Internal Control Audits? A Natural Experiment with Small U.S. Public Companies

Abstract

We use incremental and joint implementation of multiple SOX‐based control effectiveness disclosure and audit mandates to assess relative performance of alternatives for small U.S. public companies. Using data from several low‐ and high‐effort management disclosure and audit regimes implemented from 2003 to 2008, we find substantial and statistically significant increases in material weakness disclosure rates for small firms undergoing initial SOX 404(b) internal control audits, but find quantitatively and statistically similar increases for initial management reports of small firms exempt from such audits. As to audit cost, fees more than double for initial 404(b) audits in 2004 and remain high, while 404(b)‐exempt firms’ fees grow about 10% annually. Our results support the view that, for small firms, management internal control reports and traditional financial audits may be a cost effective disclosure alternative to full application of SOX 404(b). Also, our results suggest that, even without management reports on internal control, analysis of the cause of known accounting mistakes may yield substantial material weakness disclosures.

Public Equity and Audit Pricing in the United States

“…Consistent with research documenting higher audit fees due to internal control audits (e.g., Iliev []), the estimated coefficient on SOX404 is statistically significant and positive at 0.470 (or 60% higher audit fees) for the full sample and 0.403 (or 50% higher audit fees) for the propensity score–matched sample. These coefficients are roughly consistent with other evidence that audit fees typically doubled when public companies first apply SOX 404(b) (Kinney and Shepardson []) . The effect of SOX404 on audit pricing is particularly relevant as private equity firms are exempt from internal control audits…”

“…Specifically, SOX 404(b) requires independent audits of internal controls over financial reporting for larger public equity firms (firms with greater than $75 million in public float) while smaller public and private firms may choose to have such audits. Given the costs of section 404(b) audits (Iliev [], Kinney and Shepardson []) and to ensure that internal control audits are not driving our fee results, we include an indicator variable ( SOX404 ) if the audit firm had an internal control audit . Prior research also suggests that firms with material weaknesses in internal control have complex operations, higher accounting risk, financial stress, and poorer accounting quality (Ashbaugh‐Skaife, Collins, and Kinney [], Doyle, Ge, and McVay []) so we identify firms with ineffective internal controls ( M_WEAK ).…”

Direct and Indirect Effects of Internal Control Weaknesses on Accrual Quality: Evidence from a Unique Canadian Regulatory Setting*

“…Issues related to costs have been at the heart of the U.S. debate since the passage of SOX in 2002, especially regarding the alleged disproportionate costs on smaller public companies that are above the minimum market capitalization requiring full SOX disclosure, that is, accelerated filers (see Hoitash, Hoitash, and Bedard 2008, 2009; Kinney and Shepardson 2010). Since 2007, even nonaccelerated filers have had to report under SOX 404 Part (a) which requires separate management certification of the results of an assessment of internal control design and implementation effectiveness.…”

“…We found generally consistent results with our two main Dechow and Dichev measures. Extant research (e.g., Kinney and Shepardson 2010;Dhaliwal, Naiker, and Navissi 2010) uses the Dechow and Dichev accruals model. recursive path analysis embedded in a structural equation model and the results.…”

The impact of the Sarbanes–Oxley Section 404(b) exemption on earnings informativeness

“…Krishnan and Yu (2012) provided evidence of less aggressive discretionary revenue reporting with 404(b) compliance. Kinney and Shepardson (2011) provided evidence of increased control weakness disclosures with initial implementation of SOX 404(b) but noted "management internal control reports and traditional financial audits may be a cost effective disclosure alternative to full application of SOX 404(b). Kinney and Shepardson (2011) provided evidence of increased control weakness disclosures with initial implementation of SOX 404(b) but noted "management internal control reports and traditional financial audits may be a cost effective disclosure alternative to full application of SOX 404(b).…”