GAO releases report on Sox 404

By:  Cydney Posner

As the Washington Post is reporting today, the GAO has just released its report, dated April 2006, on the impact of SOX 404 on smaller public companies.  The report concludes that smaller companies face disproportionately higher compliance costs as a percentage of revenue than do bigger firms and that some smaller companies may remain private to avoid having to comply with the law. The report also indicates that smaller public companies are challenged by resource limitations and questions regarding the application of existing internal control guidance. However, the report also suggests that much of the expense relates to one-time start-up costs and confusion over how to begin compliance. Although the full impact won't be known for years, the report concludes that "[r]egulators, public companies, audit firms, and investors generally agree that the Sarbanes-Oxley Act of 2002 has had a positive and significant impact on investor protection and confidence."

The GAO report noted two specific concerns regarding the recommendations of the SEC's Special Advisory Committee on Smaller Public Companies. That Committee recommended that smaller public companies be given relief from SOX 404 "unless and until a framework" for assessing internal control for smaller companies is developed that "recognizes the characteristics and needs of those companies." First, the report is critical of the Committee's failure to "address what needs to be done to establish such a framework or how such a framework should take into consideration the characteristics and needs of smaller public companies." The report suggests that the challenges of SOX 404 relate less to problems with the control framework itself and more to the absence of implementation based on risk, facts and circumstances, and professional judgment. Second, the report is critical of the ambiguity surrounding the conditional nature of the "unless and until" provisions of the recommendations, especially in light of the potential impact on a large number of companies (up to 70% of all U.S. public companies) that would likely qualify for the proposed exemptions for an extended period. The report suggests that "[u]ntil sufficient guidance is available for smaller public companies, some interim regulatory relief on a limited scale may be appropriate. However, given the number of public companies that would potentially qualify for relief under the recommendations being considered, we believe that a significant reduction in scope of the proposed relief needs to occur to preserve the overriding investor protection purpose of the Sarbanes-Oxley Act….Public and investor confidence in the fairness of financial reporting is critical to the effective functioning of our capital markets. Market reactions to financial statement misstatements illustrate the importance of accurate financial reporting, regardless of a company’s size. SEC staff and others have pointed to the increased level of restatements as an indicator that the Sarbanes-Oxley Act—section 404 in particular—has prompted companies to identify and correct weaknesses that led to financial reporting misstatements in prior fiscal years. Indicators also show that in some respects, smaller companies have a higher risk profile for investors…."

The report recommends that the Chairman of SEC:

• "assess the guidance available, with an emphasis on implementation guidance for management’s assessment of internal control over financial reporting, to determine whether the current guidance is sufficient and whether additional action is needed, such as issuing supplemental or clarifying guidance to help smaller public companies meet the requirements of section 404, and
• coordinate with PCAOB to (1) help ensure that section 404-related audit standards and guidance are consistent with any additional guidance applicable to management’s assessment of internal control and (2) identify additional ways in which auditors’ can achieve more economical, effective, and efficient implementation of the standards and guidance related to internal control over financial reporting."
• The report further recommends (taking a giant leap beyond the problematic ambiguity and lack of specificity of the Advisory Committee), if the SEC determines that additional relief is appropriate beyond the current July 2007 compliance date for non-accelerated filers, that the Chairman of the SEC "analyze and consider, in addition to size, the unique characteristics of smaller public companies and the knowledge base, educational background, and sophistication of their investors in determining categories of companies for which additional relief may be appropriate to ensure that the objectives of investor protection are adequately met and any relief is targeted and limited."

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