Implications of the Sarbanes-Oxley

Act of 2002
Product of BKMSH

Adequate Internal Control Over Financial Reporting

The provision under Section 404 of the Sarbanes-Oxley Act is considered to be the most controversial and the
most challenging part of the Act. Section 404 obliges the external auditors and their client firms to disclose the
efficacy and adequacy of the companys internal control over financial reporting.
Implementing Section 404 is not all about compliance. For the most part, realizing the regulations and policies
under the provision will provide significant benefits to the company. These include enhanced effectiveness and
competence of internal control practices, increased investor confidence, and more thorough information for
investors. However, these benefits are correlated, but with considerable costs. Some believe that the costs far
exceed the benefits that surround Section 404. Nevertheless, an effective internal control will inarguably enhance
and better the quality of financial reporting.

Challenges in Implementing Section 404

According to a top accounting firm, the enforcement of Section 404 poses considerable challenges to the
corporate boards and managements since they have to dedicate a lot of time and capital in adhering to the
provision. In addition, there will be an increased corporate responsibility in assessing and disclosing, annually, the
adequacy of internal control over financial reporting in evaluating the effects and consequences of reporting the
said matters. Furthermore, the supervision of the managements procedures, discoveries, and remediation efforts
as they carry out their strategy for Section 404 will also be enhanced.

Implementation and Maintenance Costs

The root of all negative hypes on Section 404 is its compliance costs. According to Financial Executives
International (FEI), the average expenses in complying with Section 404 are $8 million for big companies and $3
million for small entities. However, an article in the Wall Street Journal dated 2006 reported that firms are guilty of
exaggerating the compliance costs. Most of the expenses can be attributed to improvements and changes that
some companies yearn for, even before the enactment of SOX. Moreover, after the implementation of SOX, there
had been significant surges in internal costs, external costs, and fees charged by external auditors, hence high
compliance costs.
According to MarketWatch, the expenses associated with Section 404 are just a small fraction of the billions of
dollars that stockholders lost due to recent frauds. If the enactment of Section 401 can lead to the prevention of
fraudulent transactions, then the compliance costs that are involved are justified.
Since SOXs implementation, there has been a substantial decrease in Section 404 costs. CNETNEWS.COM
ascribed it on software developments that have led to efficient internal control monitoring processes and more
relaxed firms. The Financial Times reported that the trend in compliance costs will continue to decrease in the
next few years, due to the guidance released by the Securities and Exchange Commission (SEC) and the Public
Company Accounting Oversight Board (PCAOB). This guidance is focused on curtailing costs that are identified
with Section 404.

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Effect on the Aggressiveness of U.S. Securities Markets

Another concern regarding Section 404 is its effect on the U.S. market. It has been said that the enforcement of
the provision resulted in a significant decrease in the number of U.S. corporations that went public. Moreover,
SOX 404 is regarded as the main driver of U.S. companies going public on mostly-unregulated Alternative
Investment Markets. Similarly, foreign entities refusal to go public in the U.S. market is a phenomenon that is
also affected by SOX 404.

Opinion of Companies with SOX 404

FEI asked companies how the provisions, policies, and implementation of SOX 404 can be improved. Most of
them suggested curtailing the documentation, increasing the reliance on internal audit data, permitting the
roll-forward method, explicating the meaning of key controls, and authorizing the dependence on year one
testing and documentation. Other proposals included the acceptance of the systems that have been set up in the
second half of the year and elucidation of the meaning of significant deficiency and material weakness.
Nonetheless, less than one percent of the surveyed companies said that changes in SOX 404 are not needed.

15301 Dallas Parkway, Suite 960 Addison, Texas 75001 Phone: 214.545.3965 Fax: 214.545.3966 www.bkmsh.com