The Impact of the Sarbanes-Oxley Section 404(b) Exemption on Earnings Informativeness

• In Event: Continental Breakfast and Research & Education Forum
  In Paper Session: Table 11: Internal Controls

Abstract

Section 404(b) of the Sarbanes-Oxley mandated annual external examinations of internal controls. Subsequently, the Dodd-Frank Act of 2010 eliminated, for smaller publicly traded companies, the requirement to comply with Sarbanes-Oxley Section 404(b). We investigate how this exemption affected earnings informativeness of companies that had initially engaged their auditors to provide 404(b) opinions and then ceased to do so. In essence we consider companies that have used 404(b) examinations to establish reporting credibility, and then we ask whether that credibility persists after the decision to eliminate the external 404(b) engagement. Prior research has shown that smaller publicly traded companies are almost four times as likely to have ineffective controls as their larger counterparts, and it is these smaller companies that Dodd-Frank exempted from obtaining an auditor’s report on internal control. Using an association study approach, we show that stopping compliance with Section 404(b) led to a drop in market’s perception of earnings informativeness of almost 24%, which is significant both statistically and economically. This argues for the value of 404(b) examinations and calls into question the decision to exempt smaller registrants from the requirement.

Authors

• Alexey Lyubimov, Concordia University

• Larry R Davis, University of St Thomas - Minneapolis

• Gregory M Trompeter, University of Central Florida