Did the Permanent Exemption from Internal Control Audits Affect Small Firms’ Management Reporting on Internal Control?

• In Event: Effects of Audit Regulation

Abstract

The Dodd-Frank Act of 2010 permanently exempted small companies (non-accelerated filers, NAFs) from compliance with Section 404(b) of the Sarbanes-Oxley Act, which requires auditors’ attestation on their clients’ internal control over financial reporting. NAFs are required to comply only with Section 404(a), which requires management reports on internal controls and consequently, these reports are the only available information about the NAFs’ internal control quality. We examine the trends in ineffective internal controls reported by managements over the period surrounding the Dodd-Frank Act, and document a phenomenon hitherto unnoted in the literature: There was a discontinuity in the trend in the proportion of ineffective internal control management reports in 2010, with an increase in the post-Dodd-Frank years. The exemption was granted after several postponements of the effective date for compliance with Section 404(b). Consequently, throughout the period 2007-2010, NAFs were expecting to be required to comply with Section 404(b). After the permanent exemption in 2010, the auditors’ attestation was no longer a forthcoming “threat”. We investigate whether the removal of this threat of a Section 404(b) audit resulted in a change in management Section 404(a) reporting in the post-exemption period. Our multivariate tests indicate that in the post-exemption period, non-accelerated filers are more likely to report ineffective internal control over financial reporting than they did in the pre-exemption period. In addition, non-accelerated filers are less likely to remediate previously disclosed internal control weaknesses in the post-exemption period.

Authors

• Jayanthi Krishnan, Temple University

• Lu Lu, Temple University