Did Sarbox Make Companies Cleaner?

Even as the SEC prepares to ease Sarbox 404 requirements, a new report credits 404 with lowering the number of errors finding their way into financ...
Sarah JohnsonDecember 13, 2006

On the eve of a highly anticipated Securities and Exchange Commission meeting that could bring about looser regulations for small businesses that have yet to comply with the Sarbanes-Oxley Act, a new study credits the 2002 law with cleaning up larger companies’ internal controls and reducing the number of errors in financial statements.

In fact, the Glass Lewis & Co. report — released on Tuesday — says the number of restatements by larger companies fell 26 percent during the first nine months of 2006. The report’s authors attribute this decline to the most contentious provision of Sarbox, Section 404, which requires management to attest that their company has adequate internal controls.

Accelerated filers with market capitalization of at least $750 million uncovered thousands of weaknesses during their first year of compliance, the corporate-governance research firm says, and thus restated and tidied up their controls. As a result, Glass Lewis reports, the number of larger companies’ restatements have decreased this year. “We believe this is because the majority of companies that have undergone internal-control testing and at least one independent internal-control audit have corrected any weaknesses they, or their auditors, discovered,” the report’s author wrote. “And now that they have effective controls in place, fewer errors are making their way into the companies’ financial statements.”

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To be sure, the total number of restatements is still high. Up until September 30, U.S. companies filed 1,063 restatements this year, which is a 12 percent increase over 2005, itself a record year when the number of restatements had doubled. Glass Lewis predicts that by the end of 2006, one in 10 companies will have filed at least one restatement.

But Glass Lewis attributes the current elevated level of restatements to micro-cap companies. These companies — whose market cap is less than $75 million — do not yet have to comply with Sarbox, but are preparing to do so. Micro-cap firms filed 655 restatements at the beginning of 2006, an increase of 45 percent compared to the same period last year. “Their lax internal controls, which remain untested by independent auditors, continue to produce materially erroneous financial reports for investors and other users of financial statements,” the Glass Lewis writers claim.

Lynn Turner, managing director of research for Glass Lewis, laments that large companies haven’t shown real progress in their internal controls until now, five years after Enron’s downfall and four years after Sarbox’s enactment. “It’s been a painful process,” he told “I wish we hadn’t had to go through all these restatements, but in a way, this indicates things are working. The way Sox was expected to work was to find the problems and get them fixed.”

Turner, a former SEC chief accountant, says that the timing of the report’s release has nothing to do with the SEC meeting and more to do with when his firm finished its report in time for two presentations in the next week.

Still, the timing is interesting. The SEC plans to address the question of easing Section 404 requirements at its meeting on Wednesday. Meanwhile, changes to the Public Company Accounting Oversight Board’s AS2 auditing standard, itself spawned by section 404, is on that board’s agenda for another meeting next week. The SEC reportedly will push back the deadline for small companies having to assess their internal controls. Citing unnamed SEC officials, The New York Times reported earlier this week that the commission will introduce a relaxed standard for small companies that will address their cost concerns.