From: Robert V. Dickinson
To the Advisory Committee on Smaller Public Companies:
I would like to thank you for your thoughtful review of the impact of Section 404 of the Sarbanes-Oxley Act on small public companies and to register my support for your recommendations.
The legislation is certainly well intentioned and is aimed at preventing future accounting scandals similar to those at Enron and Worldcom with their severe consequences for shareholders and other stakeholders. However, as is often the case, there have been unintended consequences that have lead to a disproportionate negative impact on smaller public companies without corresponding benefits.
The intent of Section 404 is to ensure that a company’s internal controls provide reasonable assurance that its financial reports are reliable. Unfortunately, in practice, the consequences of Section 404 have turned out to be much more draconian. I believe this is due to several factors. First, when the PCAOB issued Accounting Standard 2 it set a much higher bar than reasonable reliability, specifically that a deficiency in internal controls that has more than a remote chance of failing to prevent a material misstatement is a material weakness in internal controls. Second, having had no experience with Section 404 compliance, both public accounting firms and companies took an extremely risk averse approach. In spite of guidance to the contrary, this led to a checklist approach rather than a top down risk based approach and a huge escalation of compliance efforts and costs compared to initial estimates. This continues to be the case to a great extent. Third, also as a result of risk averseness, auditors have imposed much stringent standards for what constitutes a material weakness.
All of this has lead to a much greater expenditure of resources and money than had been anticipated. In many cases, the focus on achieving compliance with Section 404 has actually diverted attention from ensuring reliable financial reporting in a true case of form over substance.
It is also ironic that public accounting firms, some of which were inattentive or even complicit in the scandals that led to the legislation, appear to be the only winners in this tale. Because of the dramatic increase in public accounting resources needed to perform 404 compliance audits in addition to financial audits, not only have companies had to pay for both but hourly rates have been rising in accordance with the law of supply and demand.
I believe that public companies need to take whatever measures are needed to ensure reliable financial reporting. However, the costs of 404 compliance are not commensurate with the benefits derived from them and I applaud and support your thoughtful and measured proposals for addressing the issue.
Robert V. Dickinson