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    Auditor Attestation under SOX Section 404 and Earnings...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
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    Title:
    Auditor Attestation under SOX Section 404 and Earnings Informativeness
    Practical Implications:

    Section 404 is one of the most controversial provisions of the Sarbanes-Oxley Act. Many studies have examined the negative consequences of adverse reports on internal control issued by the auditor. Other studies have looked at the cost of compliance of Section 404 and find that it is burdensome, disproportionately so for small companies. This study focuses on the benefits of internal control audits. Regulators have argued that the benefits of Section 404 are hard to measure because of the difficulty in quantifying the benefits. This study contributes to the debate on the benefits of Section 404 by documenting evidence that although compliance with Section 404’s requirements has been reported to be associated with high costs, the first-time internal control reports seem to have increased earnings informativeness. 

    Citation:

    Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).

    Keywords:
    earnings informativeness; internal control; Sarbanes-Oxley; Section 302; Section 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act (SOX) requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). This policy is intended to enhance the credibility of firms’ financial statements. Prior research suggests that audit characteristics that enhance the credibility of financial reporting are associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. This study examines the SEC’s and PCAOB’s expectation about the increased quality and reliability of financial reporting resulting from Section 404. By using a difference-in-differences approach, the authors compare the change in earnings informativeness for the test sample used with that for a control sample of non-accelerated filers. 

    Design/Method/ Approach:

    The authors used previous research and policy makers’ expectations to develop the following hypothesis for testing:

     

    H1: Earnings accompanied by the first-time clean SOX404 ICFR reports are more informative that the previous annual earnings that were not accompanied by ICFR.

     

    This hypothesis was tested by comparing earnings informativeness for the annual filings containing the first-time ICFR reports and the annual filings of the previous year. The sample consisted of two types of firms (1) accelerated filers with clean Section 404 reports for the current year and clean Section 302 management reports for the seven preceding quarters, and (2) non-accelerated filers with clean Section 302 management reports throughout the sample period. The sample period included firm year-ends between November 15, 2003 and November 15, 2005. The final sample consisted of 381 firms. 

    Findings:
    • Firms with first-time clean ICFR reports have higher earnings informativeness in SOX years than in the pre-SOX years when they received only financial statement audit reports.
    • The firms that benefited the most are those with higher likelihood of material weaknesses.
    • Firms with both low and high costs of compliance experience an increase in earnings informativeness. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
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