Sarbanes-Oxley Act: Section 404

Tucker (2018) raised the concern of dwindling public sector capital investment during last couple of decades, and at the same time increase in private corporations related directly to the inception of Sarbanes-Oxley act’s enactment in 2002 after the debacle of Enron and WorldCom. Accounting audit requirements laid down in section 404 of Sarbanes-Oxley act resulted in cost expenditures, which is several times of what SEC had estimated. Similar to review of Dodd Frank act of 2009 initiated by Trump administration, Tucker (2018) suggested that Congress should simultaneously reform or repeal Sarbanes-Oxley act because auditing costs are making it difficult for the entrepreneurs to take small companies public.

In Sarbanes-Oxley’s section 404, there are two principal parts:

1. Section ‘a’ requires all public companies from their management to attest that effectiveness of internal controls over financial reporting.

2. Section ‘b’ requires independent and external auditors to attest the management’s assessment

of the effectiveness of internal auditing controls.

The Competitive and Open Markets that Protect and Enhance the Treatment of Entrepreneurs (COMPETE) act of 2006

The Competitive and Open Markets that Protect and Enhance the Treatment of Entrepreneurs (COMPETE) act of 2006 had opted out the smaller companies from Section 404’s requirements, while still requiring internal controls and transparency (John & Marano, 2007). Specifically, the COMPETE bill defined small and mid-size companies as the ones having fewer than 1500 shareholders, total capitalization under $700 million, and total purchase revenues of under $125 million. The objective of the bill was to reduce the financial burden associated with complex auditing requirement under SOX Section 404 for smaller public companies (John & Marano, 2007).

The Dodd-Frank Wall Street Reform and Consumer Protection act of 2010

The Dodd-Frank Wall Street Reform and Consumer Protection act of 2010 was enacted after the 2008 financial crisis and its focus is to enact significant financial reforms in areas of regulatory regimes, swaps trading, derivatives valuation and corporate performance pay to reduce the risk in certain areas of economy (Investopedia, 2015). 2008 financial crisis is believed to be caused in part by issues with swaps trading in credit default swaps and mortgage-backed securities, which were traded over the counter instead of centralized exchanges as stocks and commodities are. Dodd- Frank act setup centralized exchanges for swaps trading to reduce default concerns and enhances transparency to public through disclosures (Investopedia, 2015).

Dodd-Frank amended Sarbanes-Oxley’s section 404 by adding section ‘c’, which provide relief from external auditors for smaller companies (Peregrine, 2017). The permanent exemption would reduce the ongoing cost of being a public company. The intent is to target the financial expense and administrative costs associated with section 404, which are outweighing any benefit to investors. Companies can rather use that money to creating more jobs or improving their products and services (Peregrine, 2017).

Jumpstart our business startups (JOBS) act of 2012

Jumpstart our business startups (JOBS) act of 2012 was aimed to help business raise funds in public capital markets by minimizing regulatory requirements (US SEC, 2019). The act allows small businesses to raise capitals with fewer restrictions and allow them to go public with less than $1 billion in annual gross revenue (Kenton, 2019). The act also provide legitimacy to the practice of crowd-funding through platforms like Kickstarter (Kenton, 2019). The JOBS act exempts the emerging growth companies from Sarbanes-Oxley’s Section 404(B) attestation requirement from external auditors, with the hope that lesser restrictions will result in spurring the growth of new IPOs (Peregrine, 2017).

2019 Suggested Amendment to Sarbanes-Oxley Act’s Section 404

To counter the issue of higher audit fees, SEC proposed an amendment to section 404(b) of Sarbanes-Oxley act by removing the requirements of external and independent audit for smaller companies, with the hope that the change will result in more IPOs (Jackson, 2019). Idea is to roll back the requirements of external auditors to comment on company’s claim that auditing controls are in place thus resulting in accurate disclosures to investors. The intent of this requirement in Sarbanes-Oxley act was that management would be more honest about auditing control, knowing that external auditors would review their work (Jackson, 2019).

Summary

Venzuela (2016) studied the effectiveness of Sarbanes-Oxley act’s financial code of ethics and found that earnings restatements due to financial mismanagement have reduced significantly since the enactment of act in 2002. The act mandates certification of internal audits and setup civil and criminal penalties for security violations (Super Pages, 2019). Some of the highlights of the Sarbanes-Oxley act are:

1. All public companies, big or small are regulated for financial statements, accounting practices, and corporate responsibilities.

2. Act grants the external auditors more access to company data, with special provisions for compensation disclosure of upper management.

3. Act protects the whistleblowers from retribution by adding up to 10 years of prison time for the companies.

4. Act require correct financial statements to reflect company’s fiscal health and responsibility.

5. Company executives are required to sign off their financial statements for accountability under the act.

6. Act set up to 20 years of prison if corporate employees alter or hide or misfile documents to obstruct justice. Accountants can get up to 10 years in prison for intentionally throwing away documents before the five-year limit.

In summary, Sarbanes-Oxley act illustrates the significance of ethical corporate responsibilities, with stiff penalties for violations (Super Pages, 2019). However, section 404 in SOX act is the primary provision, which has triggered several efforts to either repeal or modify or exempt certain public companies from complex auditing requirements and attestation of internal auditing controls. COMPETE act of 2006 exempted companies under the capitalization of $700 million from SOX section 404 completely. Similarly, Dodd-Frank’s amendment added section 404(c) by opting out the section 404(b) only for smaller companies, which require third party audits attesting companies’ statements regarding effectiveness of internal audit controls. JOBS act of 2012 exempted emerging growth companies with less than $1billion annual gross revenue from section 404(b) in the hopes of stimulating new IPOs. More recently, SEC is suggesting another amendment to section 404(b) by removing the requirements of external and independent audit for smaller companies.

References

Venzuela, L. (2016). Study validates effectiveness of Sarbanes Oxley 406 financial code of ethics. Retrieved from https://phys.org/news/2016-10-validates-effectiveness-sarbanes-oxley-financial.html

Super Pages (2019). Sarbanes Oxley Act Summary. Retrieved from https://www.superpages.com/em/sarbanes-oxley-act-summary/

John, D. & Marano, N. (2007). The Sarbanes-Oxley Act: do we need a regulatory or legislative fix? Retrieved from https://www.heritage.org/government-regulation/report/the-sarbanes-oxley-act-do-we-need-regulatory-or-legislative-fix

Kenton, W. (2019). Jumpstart our business startups (JOBS). Retrieved from https://www.investopedia.com/terms/j/jumpstart-our-business-startups-act-jobs.asp

U.S. Securities and Exchange Commission (2019). The laws that govern the securities industry. Retrieved from https://www.sec.gov/answers/about-lawsshtml.html

Investopedia (2015). What is the difference between Sarbanes-Oxley act and the Dodd-Frank act? Retrieved from https://www.investopedia.com/ask/answers/051815/what-difference-between-sarbanesoxley-act-and-doddfrank-act.asp

Peregrine, M. (2017). Tread lightly when tweaking Sarbanes-Oxley. Retrieved from https://corpgov.law.harvard.edu/2017/04/12/tread-lightly-when-tweaking-sarbanes-oxley/

Jackson, R. (2019). Statement on proposed amendments to Sarbanes-Oxley 404(b) accelerated filer definitions. Retrieved from https://www.sec.gov/news/public-statement/jackson-statement-proposed-amendments-accelerated-filer-definition

Tucker, G (2018). Sarbanes-Oxley is suffocating our essential capital markets. Retrieved from https://www.realclearmarkets.com/articles/2018/05/11/sarbanes-oxley_is_suffocating_our_essential_capital_markets_103255.html