SEC Report Recommends No New SOX 404(b) Exemptions

An SEC study of Section 404(b) of the Sarbanes-Oxley Act recommends no new exemptions to the requirements.


The study by the SEC’s Office of the Chief Accountant was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Its scope was restricted to companies with a market capitalization between $75 million and $250 million.


The findings, released Friday, recommend maintaining existing requirements of Section 404(b) for accelerated filers in general. It also calls for actions “that have potential to further improve both effectiveness and efficiency of Section 404(b) implementation.”


The 404(b) requirements, which focus on the auditor’s report on internal control over financial reporting, have been in place since 2004 for domestic issuers and 2007 for foreign private issuers. In June 2007, the PCAOB issued Auditing Standard no. 5, An Audit of Internal Control Over Financial Reporting That is Integrated With An Audit Of Financial Statements, to address the costs in conducting an effective audit of internal controls and feedback on 404(b).


Dodd-Frank tasked the SEC with determining how the Commission could reduce the burden of complying with Section 404(b) for smaller accelerated filers, while maintaining investor protections for such companies. It also required a review of whether a complete exemption for such companies from Section 404(b) compliance would encourage companies to list on U.S. exchanges in their initial public offerings (IPOs).


“The Staff’s analysis shows that the United States has not lost U.S.-based companies filing IPOs to foreign markets for the range of issuers that would likely be in the $75-$250 million public float range after the IPO,” according to the study. “While U.S. markets’ share of world-wide IPOs raising $75-$250 million has declined over the past five years, there is no conclusive evidence from the study linking the requirements of Section 404(b) to IPO activity,” the SEC staff concluded.


The study addresses the auditor attestation requirement with respect to an issuer’s internal control over financial reporting (ICFR) pursuant to Section 404(b). It does not address management’s responsibility for reporting on the effectiveness of ICFR pursuant to Section 404(a) of the Sarbanes-Oxley Act.


Based on its review of prior academic and other research on Section 404, the SEC study drew four conclusions:


  • The cost of compliance with Section 404(b), including both total costs and audit fees, has declined since the 2007 reforms under AS 5;
  • Research has found no conclusive evidence linking the enactment of Section 404(b) to decisions by issuers to exit the reporting requirements of the SEC, including ICFR reporting;
  • Auditor involvement in ICFR is positively correlated with more accurate and reliable disclosure of all ICFR deficiencies, and restatement rates for issuers with the auditor attestation is lower than that for issuers without this attestation; and
  • Disclosure of internal control weaknesses conveys relevant information to investors.


In its recommendations section the report states that at the request of SEC Chairman Mary Schapiro, the SEC staff “is taking a fresh look at several of the Commission’s rules, beyond those related to Section 404(b), to develop ideas for the Commission about ways to reduce regulatory burdens on small business capital formation in a manner consistent with investor protection. However, the Dodd-Frank Act already exempted approximately 60% of reporting issuers from Section 404(b), and the Staff does not recommend further extending this exemption.”


The report suggests that the PCAOB consider publishing observations, beyond those previously published in September 2009, on the performance of audits conducted in accordance with AS 5. These observations could help auditors in performing top-down, risk-based audits of ICFR, the report states, and could highlight lessons that can be learned from internal control deficiencies identified through PCAOB inspections.


The SEC staff is also monitoring COSO’s work to review and update its internal control framework, which “is the most common framework used by management and the auditor alike in performing assessments of ICFR,” the report states.


The study’s analysis of prior research found, among other things, that:


  • More internal control weaknesses were discovered by the auditor (or auditor and client jointly) and by control tests rather than substantive tests.
  • Disclosures of material weaknesses under Section 302 were more likely in the fourth quarter when auditors were on-site at the client’s office most frequently and when the audit firm or office had experience with Section 404 audits
  • The majority of internal control deficiencies that were classified by the auditor as a significant deficiency or a material weakness were initially classified by the issuer as less severe.


The following statement was released Monday by Cindy Fornelli, executive director of the Center for Audit Quality, an autonomous public policy organization affiliated with the AICPA dedicated to enhancing investor confidence and public trust in the global capital markets:


“I am pleased that the SEC’s Office of the Chief Accountant’s thoughtful study recommends retention of Section 404(b) of the Sarbanes Oxley Act for companies whose market capitalization is between $75 and $250 million. Section 404(b) requires independent auditors to attest to management’s assessment of the effectiveness of its internal controls over financial reporting (ICFR). The study concluded that costs of Section 404(b) compliance have declined and financial reporting is more reliable when the auditor is involved with ICFR assessments. Importantly, the study found that investors generally view the auditor‘s attestation on ICFR as beneficial. Finally, we are happy to see that there is no conclusive evidence linking the requirements of Section 404(b) to listing decisions of the studied range of issuers.”


“The CAQ, joined by the Council of Institutional Investors, filed a comment last September with the SEC fully supporting retention of 404(b). We hope this study will effectively discourage further discussions around ways to dilute the investor protections contained in Sarbanes-Oxley,” Fornelli said in the statement.


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