Assessing the Accuracy of Small Firmss Internal Control Disclosures

Abstract

We investigate the costs and benefits of exempting firms from auditor oversight of internal control effectiveness disclosures (Section 404(b) of the Sarbanes-Oxley Act of 2002). The key benefit of exemption is audit fee savings, which we estimate as $228 million from 2007-2013 for our sample of exempt firms. The cost of exemption is misreporting (i.e., the failure to discover or disclose ineffective internal controls), which imposes at least two costs on shareholders: operational inefficiency and untimely disclosures. We identify suspected misreporters using a prediction model of ineffective internal controls. Based on our model, we estimate that 48 percent of firms in our sample with ineffective internal controls fail to disclose their ineffective controls absent 404(b), whereas we estimate the extent of misreporting would fall to 31 percent had these firms been subject to 404(b) – a 35 percent decline. We estimate the cost of 404(b) exemption to be an aggregate operational efficiency loss of $538 million, and a delay of a decline in aggregate market value of $441 million due to untimely disclosures. In addition to providing evidence on both the costs and benefits of internal control disclosure regulation, our study provides a tool for market participants to identify the firms most at risk of inaccurately disclosing effective internal controls.