The Economic Consequences of Section 404 of Sarbanes-Oxley on Small Public Companies

Following the American Psychological Associations Guidelines

Indira Hall University of Maryland, University College

Resulting from the events that brutally shook U.S. capital markets in the early 2000s was new reform in the name of the Public Company Accounting Reform and Investor Protection Act of 2002, commonly known as the Sarbanes-Oxley Act (SOX) (Spiceland, Sepe, & Nelson, 2011, 16). The overall goal of this reform was to restore credibility and investor confidence in the financial reporting process (p.16). Accounting scandals were running rampant. With the collapse of Enron in 2011, the dismantling of Arthur Andersen in 2002, and accounting scandals at WorldCom, Xerox, Merck, and Adelphia Communications, something had to be done. Investors had lost billions of dollars and investor confidence was greatly affected (16). The Sarbanes-Oxley Act was controversial, seen as dramatic measures by some and necessary measures by others (pp. 16-17). It shifted business attitudes from what-you-dont-know-canthurt-you to honesty-is-the-best-policy (Bisoux, 2005, p.25). This paper will examine the economic consequences and benefits of increased financial reporting and disclosures required by SOX, specifically Section 404, on small public companies compared to large public companies. SOX consists of 11 titles that address auditor independence, corporate responsibility, enhanced financial disclosure, analyst conflicts of interest, corporate and criminal fraud accountability, white-collar crime penalty enhancements, and so on (Wang, 2008, p.3). SOX applies to all companies that are required to file reports with the SEC under the Securities Exchange Act of 1934 (p.3). Section 404 has been the most controversial part of SOX because its costs to implement have been substantial to all businesses, with a larger impact on small businesses (Bisoux, p.25). Small businesses are those classified as non-accelerated filers, which have public float of less than $75 million (Wang, p.3). Iliev (2010) references a study conducted by Duke University which found that increased regulations were one of the top concerns of U.S. corporations (p.1163). Section 404 focuses on internal controls, requiring that

management creates a reliable internal financial control. Secondly, management must attest to the reliability of those controls and the accuracy of financial statements. Each annual report must contain a report on internal control which must state the responsibility of management for establishing and maintaining an adequate internal control structure and procedure for financial reporting (Wang, p. 4). Lastly, an independent auditor must express an opinion on whether effective internal controls have been maintained over the financial reporting. Section 404 was reformed in 2007 due to many complaints that SOX compliance was entirely too costly. Accounting Standard No. 5 replaced Accounting Standard No. 2, adding an interpretive guidance which allows management to evaluate internal controls more effectively and efficiently (Benoit, 2008, 4). Before this reform, not only was a company required to document financial results, they were required to also document every process that have been used to generate those results (Bisoux, p. 25). One of the economic consequences of Section 404 is the substantial cost to implement and maintain compliance each year. The SECs initial estimates were substantially understated. The SEC estimated that compliances with Section 404 would be approximately $1.24 billion collectively. However, annual costs estimated from several studies projected costs to total almost 30 times that number, $35 billion (Wang, p. 5). Smaller companies are disproportionately affected (p. 2). Year one implementation for small accelerated filers (market capitalization between $75 million and $700 million) averaged $1.5 million, or .46% of revenue. Large accelerated filers incurred costs of $7.3 million, or .09% of revenue. Companies that complied with Section 404 also experienced a huge increased in audit fees the first year of compliance. Average increase was 84.5%, while non 404 filers experienced an average increase of only 6.1% (6). Even after the learning curve of the first year, Section 404 filers still experienced an average

increase of 65.7% in audit fees compared to just 9% for non-filers. This indicates that the substantial increase in audit fees were not just a onetime increase due to a learning curve, but represents what typical costs are under SOX(p. 6). Small companies incur an unfair proportion of costs due to inherent disadvantages with internal controls (Wang, p. 9). An analysis of survey data obtained by the SEC found that absolute costs were greater for larger companies, but scaled costs were greater for smaller companies (Office of Economic Analysis, p. 2). Smaller companies have steeper learning curves due to a lack of knowledge and experience with SEC regulations. Their internal control structure is more vulnerable because they typically lack internal accounting staff with the knowledge to handle the complexity of the internal control structure (pp. 9-10). More resources in the form of money and time are spent on fixing internal control issues. Additional training for staff is given, and outside consultants are sought. Wang references a survey conducted by the U.S. Government Accountability Office on the impact of SOX on smaller public companies. The results of this study found that 81% of respondents had to hire a separate accounting firm or consultant to help them with planning, documenting, and assessing the internal controls, whereas large companies could rely on their own personnel (p. 10). It was found that some executives felt that they would rather have the auditor fix certain problems and cite a material weakness in their controls because the accounting standard was too complex (p. 10). Research done by the SEC shows that SOX costs are projected to decrease as time goes by under the Reform of 2007. Companies experienced an average 19% decline in compliance costs from the year pre-reform, compared to the year after 2007. Unfortunately, the reforms goal of lowering costs only worked for medium to large companies. The average total compliance

costs for non-accelerated filers decreased only from $769,000 to $690,000. This is not a significant reduction (Office of Economic Analysis, p. 5). Even with the inherent costs associated with increased reporting and disclosure, and controversy surrounding SOX, there have been measurable results from Section 404 that have benefited companies. Before SOX was passed, investor confidence was severely shaken. Stock markets were falling, with the DOW down 25%, the S&P 500 down 40%, and the NASDAQ down 70% from the market peaks of 2000. Trading volume dropped 54% with 84% of investors believing that corporate wrongdoing was widespread rather than isolated (Prentice, 2007, 712). SOX helped revive capital markets, spurring a speedy recovery (p. 712). Companies that have strong internal controls, or fix weaknesses in internal controls based on a SOX 404 audit opinion have experienced significantly lower cost of capital and high stock price returns (Gottlieb, 2006, p.1). A study conducted by Lord & Benoit (2006) found that average share prices of companies with good internal controls pre-SOX increased 28% from the year before SOX was required (p. 1). Stock prices for companies that were reported to have bad internal controls pre-SOX decreased 9% the first year. Companies that had a report of bad internal controls the first year of reporting under SOX that were able to improve internal controls experienced a 25% increase in stock prices. Companies that already had a good system for internal controls were significantly rewarded with higher returns than companies who were able to fix their weaknesses. Companies with good internal controls also benefited from lower cost of capital. Goltlieb (2006) references a statement made in the academic paper entitled, The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital:

The magnitude of the cost of equity capital effects of the internal control deficiency are economically important ranging from 50-150 basis points depending on the analysis. Our study provides evidence that internal control risk matters to investors and that firms reporting strong internal controls or firms that correct prior internal control problems benefit from lower costs of equity capital beyond that predicted by other internal control risk factors (2). It makes perfect sense that good internal controls would have a correlation with firm risk and the cost of equity. Investors are more likely to perceive companies with good internal controls as a better investment. Good internal controls mean a reduced likelihood of corporate fraud and corruption. Unfortunately for companies with a deficiency in its internal controls, it is found that the market does not make a significant distinction in severity of an internal control deficiency. Any internal control deficiency will result in the same negative result (Ashbaugh-Shaife, Collins, Kinney and Lafond, 2008, pp. 15-16). It is argued that the costs still outweigh the benefits to smaller companies. This is supported by Wang who concludes that companies with low value of being public after Section 404, are the companies with low value of being public before Section 404 who experience higher compliance costs, and less Section 404 related benefits. As stated previously, smaller companies have inherent disadvantages over larger companies when it comes to internal controls. This means that it is more likely for a smaller company to experience the negative effects of a deficiency in its internal control, e.g., decrease stock prices and higher cost of equity. Smaller companies do not benefit as much from being a public company as larger companies. They are thinly traded, undervalued, have low share price and highly concentrated ownership structure, lack of investor interest and analyst coverage, thus having difficulty raising capital from the

stock market (Wang, p. 25). Not only are smaller companies incurring more expenses relative to larger companies as a percentage of revenue, but Section 404 reduces the already low value that smaller companies were receiving from being a public company. This has caused many companies to go dark, i.e., deregister their securities (Leuz, Triantis, and Wang, 2004, 2). The high cost of reporting is generally cited as the main reason a company is going dark, with smaller companies more likely to deregister. The decision to go dark cannot be taken rashly. Going dark doesnt come without penalties to a company as well as its investors. Companies generally face a -10% reaction on the market when it announces that it is going dark (Leuz, Triantis, and Wang, 2). This reaction is the result of a decrease in investor confidence. Shareholders are left in the dark, without publicly available information (p. 1). Shareholders may view deregistration as a way for managers to hide poor performance, protect from legal liability, or benefit financially through compensation and perks (p. 5). A loss of liquidity is also likely, which drives up the cost of equity. Investors expect a higher return to compensate for the loss of liquidity. Firms can also expect a higher cost of debt. Banks would be forced to increase monitoring that is not required because of disclosures necessary for SEC reporting. Bargaining power with banks would also be lost. This may cause a company to have to pass on profitable investments because of the high cost of capital. Profitability may able be affected because of the lack of disclosure affecting relationships with suppliers and customers (p. 10). A survey conducted by the SEC has found that 70% of small firms, compared to 44% of all firms considered going private because of Section 404. Also, 30% of small firms, compared to 56% of all firms are not motivated at all to go private. More foreign firms are considering delisting from the U.S. exchange with 76% of small foreign firms very seriously considering delisting, and 51% of all foreign firms very seriously considering delisting (Office of Economic

Analysis, 67). It is not surprising that a disproportionate amount of small companies in the U.S. and abroad, compared to large companies, are considering the financial benefits of delisting even with the apparent consequences. Periodic SEC reporting requirements necessitates significant internal resources and requires not just auditors, but retaining lawyers as well. Increased regulations under SOX have compounded these costs, adding higher audit and legal fees, improvements to internal control systems, higher D&O insurance premiums, and other compliance expenses (p. 8). There are additional cost savings that a company must consider when deciding whether or not to go dark. Indirect cost savings include being able to keep information in house and not have to possibly disclose information that may be of value to competitors. Managers can also focus on the companys strategy and operations first and foremost, shifting the focus from increasing returns to shareholders (pp.8-10). This would only work if the managers truly had the best interest of the business in mind, and make ethical decisions even without having strict audit oversight. Lack of oversight when going dark leaves companies open to mismanagement, fraud, and misappropriation of company funds. The article, The Tipping Point: Collision of Relaxed Regulation, Small Business and the Economy, details an interview with an anonymous financial official from a small publicly held company (Lord & Benoit, 2009, p.3). This small publicly held company was a start-up that had much potential for success, with stock prices on the rise. Financials werent the best which is typical for start-ups; not a lot of revenue, a lot of debt and high operating costs. The CEO was even featured in magazine articles and made the list as a high paid executive because of share-based compensation. This company ended up filing for bankruptcy. Millions of investor dollars were lost. The company was spending investor dollars on expensive furniture, apartments, car leases, bonuses that are guaranteed not based on

performance, and advances and loans to employees. This company did not have the internal controls in place required by SOX Section 404 because the deadline for compliance had been pushed back. There was no balance of power for the CEO who had entirely too much power. Certain actions that occurred would not have happened under Section 404, or would have been disclosed. Lack of oversight definitely is not a good thing and may be detrimental to some companies, especially small companies that lack internal controls already (pp. 4-12). In conclusion, Section 404 has been extremely costly to all companies with smaller companies incurring more costs relative to revenues. This is still the case even with the SOX reform of 2007. These increased costs have motivated some smaller companies to go dark in an attempt at avoiding these costs. Unfortunately, going dark is not the perfect solution. Companies that deregister their shares face falling stock prices, increased cost of capital, and possible losses in revenue. Not to mention being open to the same type of corruption that SOX was created to prevent. Neither option is ideal. A company would have to weigh all opportunity costs in order to determine the best option for the firm that aligns with its business strategy and ensures future solvency. Hopefully new reform will be done to make things easier on small businesses.

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