Sarbanes-Oxley Act:

Consideration of Key Principles Needed in Addressing Implementation for Smaller Public Companies

GAO-06-361: Published: Apr 13, 2006. Publicly Released: May 8, 2006.

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Congress passed the Sarbanes-Oxley Act to help protect investors and restore investor confidence. While the act has generally been recognized as important and necessary, some concerns have been expressed about the cost for small businesses. In this report, GAO (1) analyzes the impact of the Sarbanes-Oxley Act on smaller public companies, particularly in terms of compliance costs; (2) describes responses of the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) to concerns raised by smaller public companies; and (3) analyzes smaller public companies' access to auditing services and the extent to which the share of public companies audited by mid-sized and small accounting firms has changed since the act was passed.

Regulators, public companies, audit firms, and investors generally agree that the Sarbanes-Oxley Act of 2002 has had a positive and significant impact on investor protection and confidence. However, for smaller public companies (defined in this report as $700 million or less in market capitalization), the cost of compliance has been disproportionately higher (as a percentage of revenues) than for large public companies, particularly with respect to the internal control reporting provisions in section 404 and related audit fees. Smaller public companies noted that resource limitations and questions regarding the application of existing internal control over financial reporting guidance to smaller public companies contributed to challenges they face in implementing section 404. The costs associated with complying with the act, along with other market factors, may be encouraging some companies to become private. The companies going private were small by any measure and represented 2 percent of public companies in 2004. The full impact of the act on smaller public companies remains unclear because the majority of smaller public companies have not fully implemented section 404. To address concerns from smaller public companies, SEC extended the section 404 deadline for smaller companies with less than $75 million in market capitalization, with the latest extension to 2007. Additionally, SEC and PCAOB issued guidance intended to make the section 404 compliance process more economical, efficient, and effective. SEC also encouraged the Committee of Sponsoring Organizations of the Treadway Commission (COSO), to develop guidance for smaller public companies in implementing internal control over financial reporting in a cost-effective manner. COSO's guidance had not been finalized as of March 2006. SEC also formed an advisory committee to examine, among other things, the impact of the act on smaller public companies. The committee plans to issue a report in April 2006 that will recommend, in effect, a tiered approach with certain smaller public companies partially or fully exempt from section 404, "unless and until" a framework for assessing internal control over financial reporting is developed that recognizes the characteristics and needs of smaller public companies. As SEC considers these recommendations, it is essential that the overriding purpose of the Sarbanes-Oxley Act--investor protection--is preserved and that SEC assess available guidance to determine if additional supplemental or clarifying guidance for smaller public companies is needed. Smaller public companies have been able to obtain access to needed audit services and many moved from the largest accounting firms to mid-sized and small firms. The reasons for these changes range from audit cost and service concerns cited by companies to client profitability and risk concerns cited by accounting firms, including capacity constraints and assessments of client risk. Overall, mid-sized and small accounting firms conducted 30 percent of total public company audits in 2004--up from 22 percent in 2002. However, large accounting firms continue to dominate the overall market, auditing 98 percent of U.S. publicly traded company sales or revenues.

Status Legend:

More Info
  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: In light of concerns raised by the SEC Advisory Committee on Smaller Public Companies and others regarding the ability of smaller public companies to effectively implement section 404 of the Sarbanes-Oxley Act, the Chairman of SEC should assess the guidance available, with an emphasis on implementation guidance for management's assessment of internal control over financial reporting, to determine whether the current guidance is sufficient and whether additional action is needed, such as issuing supplemental or clarifying guidance to help smaller public companies meet the requirements of section 404.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: On June 27, 2007, SEC published interpretive guidance in the Federal Register to help public companies strengthen their internal control over financial reporting while reducing unnecessary costs, particularly at smaller companies. According to SEC Chairman Cox, the interpretive guidance will allow companies of all sizes to scale and tailor their evaluation procedures according to the facts and circumstances. While the guidance is intended to help public companies of all sizes, SEC has stated that smaller companies, which will begin complying with Section 404 in 2007, should specifically benefit from its scalability and flexibility.

    Recommendation: In light of concerns raised by the SEC Advisory Committee on Smaller Public Companies and others regarding the ability of smaller public companies to effectively implement section 404 of the Sarbanes-Oxley Act, the Chairman of SEC should coordinate with PCAOB to (1) help ensure that section 404-related audit standards and guidance are consistent with any additional guidance applicable to management's assessment of internal control and (2) identify additional ways in which auditors' can achieve more economical, effective, and efficient implementation of the standards and guidance related to internal control over financial reporting.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: On June 12, 2007, PCAOB issued revised auditing standards for auditors to follow in their section 404 related audit engagements. According to the Public Company Accounting Oversight Board (PCAOB) and SEC, the revised section 404-related auditing standards were closely aligned with SEC's interpretive guidance on management's review of internal controls to ensure consistency, particularly with regard to prescriptive requirements, definitions, and terms. According to PCAOB, its auditing standard were revised to allow "scaling the 404 audit to account for the particular facts and circumstances of companies, particularly smaller companies." The revised section 404 auditing standards are effective for audits of fiscal years ending on or after November 15, 2007.

    Recommendation: If, in evaluating the recommendations of its advisory committee, SEC determines that additional relief is appropriate beyond the current July 2007 compliance date for non-accelerated filers, the Chairman of SEC should analyze and consider, in addition to size, the unique characteristics of smaller public companies and the knowledge base, educational background, and sophistication of their investors in determining categories of companies for which additional relief may be appropriate to ensure that the objectives of investor protection are adequately met and any relief is targeted and limited.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Not Implemented

    Comments: SEC adopted regulations in December 2006 that permit smaller public companies--those with $75 million or less of public float--to postpone their first Section 404 audit until the first fiscal year after December 14, 2008 (for calendar year end companies, that would mean March 2009). In response to the recommendations of its advisory committee and others (including GAO), SEC issued interpretive guidance on June 27, 2007, to aid companies, particularly smaller companies, in the evaluation and assessment of internal control over financial reporting. In its press release on the interpretive guidance, SEC indicated no change to the effective compliance date for section 404 implementation for smaller public companies. Additionally, SEC worked with the Public Company Accounting Oversight Board (PCAOB) to ensure that its interpretive guidance was consistent with revision made by PCAOB to its section 404 auditing standards. At this time, it appears that SEC does not plan any additional actions related to the recommendations of its advisory committee regarding section 404 implementation by smaller public companies.

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