Benefits and Costs of Sarbanes-Oxley Section 404(B) Exemption : Evidence from Small Firms’ Internal Control Disclosures

Thousands of publicly traded U.S. firms are exempt from auditor oversight of internal control effectiveness disclosures (Section 404(b) of the Sarbanes-Oxley Act of 2002). We provide initial estimates of the measurable benefits and costs of this exemption. We measure the benefit of exemption with audit fee savings, which we estimate to be an aggregate $388 million from 2007 through 2014 for our sample of exempt firms. The key concern of exemption is internal control misreporting (IC misreporting; i.e., firms with ineffective internal controls erroneously disclosing effective internal controls). We estimate that 9.3 percent of exempt firms are IC misreporters, and that 404(b) compliance would lower this IC misreporting to 5.8 percent. IC misreporting imposes at least two measurable costs on current and prospective shareholders: lower operating performance due to non-remediation, and market values that fail to reflect a firm’s underlying internal control status. We calculate the cost of 404(b) exemption from 2007 through 2014 to be an aggregate $719 million in lower future earnings due to non-remediation, and a $935 million delay in aggregate market value decline due to the failure to disclose ineffective internal controls. Although the measurable costs of exemption exceed the measurable benefits, the audit fee savings benefit shareholders of all exempt firms, whereas costs are borne by shareholders of only a fraction of exempt firms (the IC misreporters). In addition to providing initial evidence on measurable benefits and costs of internal control disclosure regulation, our study provides a tool for identifying the firms most at risk of inaccurately disclosing internal control effectiveness