The results of this study are important because they illuminate the impact of new accounting rules on standard setters and companies abiding by these rules (in this case, the specific context was the implementation process related to SOX Section 404). The study suggests that a number of steps are required in order to perfect the guidance. It is important to understand the meaning and intentions behind authoritative literature in order to follow it. The observations suggest that the process for implementing new guidance has room for change, yet has evolved over time to increase effectiveness. The findings are specific to the implementation for assessment and auditing of internal controls for public companies.

For more information on this study, please contact Zoe-Vonna Palmrose (zv.palmrose@marshall.usc.edu).

Palmrose, Z.-V. 2010. Balancing the Costs and Benefits of Auditing and Financial Reporting Regulation Post-SOX, Part I: Perspectives from the Nexus at the SEC. Accounting Horizons 24 (2):313-326.

Sarbanes-Oxley (SOX) Section 404 adds requirements for disclosures discussing management’s assessment of internal controls. Zoe-Vonna Palmrose served as the Deputy Chief Accountant for Professional Practice in the Office of the Chief Accountant. From August 2006 to July 2008, Palmrose observed the effects of SOX Section 404 on practice. The paper describes her observations related to:

• The purpose of SOX Section 404.
• Initial implementation efforts related to SOX Section 404.
• Improvements for the implementation of SOX Section 404. These improvements primarily focus on the cost-benefit for smaller companies that had to report under SOX Section 404.
• Overall cost-benefit effect on SOX Section 404 filers.

The author collected data through personal experiences from August 2006 through July 2008. She observed and recorded information related to SOX Section 404 during her time as the Deputy Chief Accountant in the Professional Practice Group.

• The author finds that SOX Section 404 does not require a company to implement adequate internal controls because previous standards released in 1977 already accomplished that objective. Instead, SOX Section 404 requires disclosure of management’s assessment of the adequacy of its internal controls. The assessment is based on whether the internal controls can provide reasonable assurance about the reliability of the financial statements. SOX Section 404 does not allow management to disclose that its internal controls are effective if it determines material misstatements exist in the financial statements. The guidance also requires that a registered PCAOB auditor opines on management’s assessment of internal controls.
• The author finds that the problems associated with the initial implementation of SOX Section 404 arose because it was issued from the top down. Few companies were reporting on internal controls before SOX required public companies to do so. The author observes that AS No. 2 was initially poorly suited for reporting on internal controls because it was difficult to determine the respective responsibilities of the auditor and management. In June 2006, the PCAOB clarified the standard in response to this confusion.
• The author finds that the PPG aided the amendment to AS No. 2, accomplished in AS No. 5. Furthermore, an open meeting between the SEC and the PCAOB was primarily held to discuss how to make management and the auditor’s responsibilities more effective with respect to the responsibilities of each party.
• The author finds that deferring implementation of SOX Section 404 for smaller public companies allowed the implementation flaws to be discovered before smaller companies were harmed.
• The author finds that audit fees rose in order to compensate for the added work for the auditors. Cost-benefit relationships were analyzed in order to determine the effectiveness of the work to be completed.

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