In Focus

Section 404 Works and Is Important for Small Companies, SEC Commissioner Aguilar Feels

Section 404 of the Sarbanes-Oxley Act is helping to provide investors with a better assurance of the accuracy of financial statements of companies, according to SEC Commissioner Luis Aguilar. During a speech before the Fraud and Forensic Accounting Education Conference at Georgia Southern University, he added that smaller companies have much to gain from Section 404 as well. In times of economic downturn, the temptation to "cook the books" is greatest, Aguilar warned, but Section 404 helps hold back the temptation.

Section 404(a) requires company management to assess the effectiveness of the company's internal controls over financial reporting, and Section 404(b) requires an auditor attestation on management's assessment. According to Aguilar, about 95% of the market capitalization in the U.S. equity securities markets is from companies covered by these provisions. He believes that Section 404 has made fraud harder to commit and easier to detect.

Overall the section, along with the entire Sarbanes-Oxley Act, has created a larger sense of responsibility among corporate executives and internal audit groups, according to Aguilar. He has noticed a greater willingness among management to call in forensic accountants in the early stages of what is suspected to be fraudulent reporting. He added that while internal controls are not new and have long been required by 1934 Act Section 13(b)(2)(B), Section's 404 focus on improved controls has increased the number of internal investigations that were started due to the possibility of improper accounting. Section 404 gives management a stronger base for relying on internal controls, according to Aguilar. He added that in many cases, these investigations have resulted in self-reporting to the SEC by companies.

Section 404 is also good for business, according to studies cited by Aguilar. One study indicates a relationship between weak internal controls and poorer earnings relative to effective internal controls. The predictability of earnings improves once internal controls improve, the research found. Another study indicated that companies reporting weaknesses in internal controls are more likely to restate earnings in the future.

The costs of Section 404 will fall once implementation is complete, Aguilar believes, and as processes are established and personnel trained. The markets are appreciating Section 404 more and more, according to Aguilar, in large part because of the work of the SEC and the PCAOB, particularly due to the PCAOB's adoption of Audit Standard No. 5.

The successes of the Sarbanes-Oxley Act lead to the question of whether Section 404(b)'s auditor attestation requirements ought to be applied to the approximately 7,300 smaller public companies. Aguilar noted that due to concerns about the costs facing smaller companies, there have been multiple extensions of the compliance date, with the current extension to expire later this year. Small companies account for about 65% of public companies. According to Aguilar, each delay of Section 404 compliance requires higher scrutiny. Since the last extension, the PCAOB staff has issued guidance on Section 404(b) as it applies to smaller companies. Other guidance has come from the SEC and the Committee of Sponsoring Organizations of the Treadway Commission.

Smaller companies gain particular benefits from Section 404(b) compliance, Aguilar believes. Managers of smaller companies may be able to dominate and override existing internal controls. The companies also have limitations on the resources needed to maintain appropriate technical controls. Having Section 404(b) apply to smaller companies will be a help, Aguilar added.

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