Since the 2002 enactment of the Sarbanes-Oxley Act, no provision of the law has provoked more animus than Section 404(b), which requires public companies to have external auditors annually assess the adequacy of their internal controls over financial reporting.

Scorned recently by a prominent economist as “one of the most costly and counterproductive regulations ever introduced,” SOX 404(b) may be trimmed, many observers believe. Whereas the provision currently applies to companies with public floats of at least $75 million, that threshold may soon be raised to $250 million or even $500 million.

Yet in the longstanding controversy over 404(b), the voice of one constituency has been conspicuous by its absence — and ironically, it’s the very group the regulation supposedly protects: namely the investment community. Whether the provision actually holds value to investors has remained unclear.

Now, the January issue of the The Accounting Review, an American Accounting Association journal, includes the first study whose primary purpose is gauging investor demand for internal controls (IC) audits.

Looking at the impact of a rule that enables companies for one year to opt out of IC audits for newly acquired firms, the paper reveals a significant drop in the acquirer’s stock on the day the opt-out becomes public with the issuance of the acquiring company’s annual report.

Depending on how this decline is calculated, one-day abnormal stock returns compared with opt-in companies can be as much as 44 basis points, according to the study authors, Robert Carnes of the University of Florida, Dane Christensen of the University of Oregon, and Phillip Lamoreaux of Arizona State University.

Until now, research into the question of investor demand for 404(b) has generally focused on companies just above and below the $75 million public-float threshold for mandatory IC audits.

To further probe the importance investors attach to IC audits, the researchers investigated how the market reacts to opt-outs in a variety of circumstances that might affect that response.

For example, they found the stock-price dip occasioned by opting out of internal controls audits becomes more pronounced the greater the size of the acquired entity relative to the size of the acquirer, as would be expected if investors value an auditor’s internal control assurance.

The professors also found a more negative effect for acquisitions in the first half of a buyer’s fiscal year, suggesting that opting out becomes more suspect to investors the more time acquirers have to integrate the two companies’ finances.

Are investors justified in taking a dim view of opt-outs? In a word, yes. Companies that choose the option, the study revealed, are more likely to misstate their finances in the post-acquisition year.

The authors also pointed to other recent research concluding opt-out companies also do worse than opt-ins with respect to future returns on assets and short- and long-term stock performance.

The new paper’s findings are based on an analysis of 1,803 acquisitions by 925 companies over a nine-year period. An acquisition was included in the sample if the purchaser was a U.S. company subject to SOX 404(b), was audited by a Big Four accounting firm, and bought 100% of the target company.

Targets had market capitalizations at least 1% of their acquirers’ and would have been large enough on their own to be subject to 404(b).

The professors saw their research as informative to policymakers. “Aside from the PCAOB’s recent focus and inspection efforts, regulators have continually reduced the scope and extent of mandated internal control audits,” they wrote. “Our results suggest that future reductions … may be viewed negatively by investors.”

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