The Effect of Discontinued Internal Control Audit on Small Companies’ Financial Reporting Quality

• In Event: Internal Controls

Abstract

Section 404 (b) of the Sarbanes Oxley Act requires auditors of public companies to attest to the effectiveness of clients’ internal control. SOX 404 (b) became effective in 2004 for accelerated filers and was to become effective for non-accelerated filers (after several delays) in June 2010. However, the Dodd Frank Act permanently exempted SOX 404 (b) audits for non-accelerated filers. Using a sample of non-accelerated filers that voluntarily complied with the requirements of SOX 404 (b) (probably in anticipation of mandatory internal control audits which was to become effective soon) we examine whether financial reporting quality declined for those that discontinued ICFR audits following the multiple extension dates for 404 (b) compliance, and after they were exempted from the requirements of Section 404 (b) by the Dodd-Frank Act. If the internal control audits of these non-accelerated filers resulted in deployment of new resources to maintain good internal control, we argue that dropping ICFR audits will not result in deterioration of financial reporting quality. By contrast, if the ICFR audit provided a monitoring role, then the financial accounting quality of non-accelerated filers will decrease after ICFR audit is dropped. Our results are consistent with the resource deployment conjecture. We find no evidence of deterioration of financial reporting quality after ICFR audits are discontinued.

Authors

• Jagan Krishnan, Temple University

• Jayanthi Krishnan, Temple University

• Sophie Li Liang, Temple University