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    Does SOX 404 Have Teeth? Consequences of the Failure to...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses.
    Practical Implications:

    The evidence showing that, all else equal, SEC sanctions following restatements are no more likely for firms that previously claimed to have effective internal controls (and, in some cases, are less likely) suggests that public enforcement of SOX 404 is unlikely to provide strong incentives to detect and disclose existing weaknesses. Also, the results showing that penalties stemming from various private mechanisms are more likely for firms that report their internal control weaknesses in advance of restatements suggests the existence of possible disincentives to detect and disclose existing weaknesses. Together, these results offer a potential explanation for why the majority of restatements occur at firms that previously claimed to have effective controls.


    Rice, S. C., Weber, D. P., & Wu, Biyu. 2015. Does SOX 404 Have Teeth? Consequences of the Failure to Report Existing Internal Control Weaknesses. Accounting Review 90 (3): 1169-1200.

    enforcement, internal controls, restatements, Sarbanes-Oxley Act, SOX 404
    Purpose of the Study:

    In this paper, the authors examine several potential consequences of failing to report existing control weaknesses as required by Section 404 of the Sarbanes-Oxley Act of 2002. The investigation is motivated largely by recent concerns about the reliability of SOX 404 reports and related evidence of firms claiming to have effective internal controls over financial reporting when they instead have material weaknesses in those controls. Understanding the consequences of such reporting failures is important because it bears on managers’ and auditors’ incentives to detect and disclose internal control weaknesses and, thus, on the effectiveness of SOX 404 in achieving its intended goal of boosting investor confidence in the reliability of financial reports. This importance is underscored by the high costs of control audits, which have made these requirements the most controversial aspect of SOX. Under SOX 404, firms and their auditors are required to provide formal opinions on the effectiveness of internal controls over financial reporting within the annual 10-K filing. However, concerns have begun to emerge about the reliability of SOX 404 reports, and the effectiveness of SOX 404 in providing advance warning of potential accounting problems remains unclear.

    Design/Method/ Approach:

    The authors use Audit Analytics to create a full sample of 659 observations of firms that are subject to SOX 404 and that also have restatements. The full sample includes 134 firms that reported the existence of material weaknesses prior to their restatements and 525 that did not. The authors extracted all restatements for U.S. incorporated firms announced by the end of 2010 that include annual reporting periods ending after the effective date of SOX 404 (November 14, 2004).

    • The likelihood of receiving an Accounting and Auditing Enforcement Release (AAER) following a restatement is similar regardless of whether firms had reported their control weaknesses or instead claimed that their controls were effective prior to the restatement. 
    • The prior acknowledgment of control weaknesses increases the likelihood of receiving an AAER by about 6 percent.
    • The authors find no evidence of vigorous public enforcement of SOX 404; instead, the evidence is suggestive of the opposite: that reported control weaknesses aid the SEC in identifying cases where potential enforcement actions are likely to succeed and make it difficult for management to claim they were unaware of the problems that led to the restatement.
    • Class action lawsuits are 5 to 10 percent more likely when firms report internal control weaknesses prior to restatements. This is true even when the authors remove lawsuits that are later dismissed.
    • The top management turnover is 15 to 26 percent more likely at firms that report control weaknesses prior to their restatements. This result holds for both CEOs and CFOs.
    Accountants' Reporting, Internal Control
    Impact of 404 on Fees and Financial Reporting Quality, Restatements