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The PCAOB's Niemeier: Defending Sarbanes-Oxley
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Posted by: Jack Ciesielski 11/16/2006 5:04 AM
Public Company Accounting Oversight Board member Charles Niemeier delivered a speech on October 30 at the National Association of State Boards of Accountancy, in which he provided more reasons why Sarbanes-Oxley is best left alone.

Niemeier points out that while it's true that the Foreign Corrupt Practices Act of 1977 first mandated public companies to adopt effective internal controls, many companies hadn't done so by the early 1990's. Prima facie evidence: the banking sector and its early 1990's implosion. Niemeier cites the GAO findings that:

“...internal control weaknesses [were] a significant cause of bank failures” and that “[h]ad these problems been corrected, [certain] banks might not have failed or their failure could have been less expensive to the” bank insurance fund. The GAO also noted in particular that internal control weaknesses might not be detected because, under then-existing standards, auditors “need not thoroughly evaluate nor test internal accounting controls.”

In response, the FDIC Improvement Act of 1991 (FDICIA) required that certain financial institutions report to federal banking regulators on the condition of their internal accounting controls - including auditor attestation upon them. The problem was that the Act was not very specific in its requirements and the evaluation and reporting was rather lax even within the banking sector. Outside the banking sector, controls became notoriously lax. (See: Enron, WorldCom, Xerox, tech bubble, etc.)

In all the rhetoric about "unwarranted costs" of Sarbanes-Oxley compliance, an important fact is lost: the law has been effective in restoring virility to corporate internal controls. Niemeier cites a study by Audit Analytics showing that, in the first year of internal control reporting, close to 16 percent of accelerated filers reported material weaknesses. (Want evidence that the FDICIA controls weren't implemented rigorously? The proportion of FDICIA banks with material weaknesses wasn't much better than firms in other industries).

In the second year of reporting, however, over half the companies reporting weaknesses in Year 1 reported repairs of the weaknesses in Year 2. That's encouraging in its own right - but there's more. Reported weaknesses linked to restatements of past financial statements has gone from 50% in Year 1 to 37% in Year 2. And while restatements will probably hit a new record level in 2006, there's an encouraging trend within the gross numbers: restatements by companies audited by the largest accounting firms last year and are declining in 2006. In 2005, 65% of restatements were tied to the eight largest accounting firms; this year, less than half of the restatements are linked to them. The bad news, of course, is that the small firm share of restatements has more than taken up the slack. In the first half of 2006, they're tied to 497 restatements; in the first half of last year, “only” 185.

Think quick: small firms typically audit small publicly-traded companies. Small publicly-traded companies keep begging for SOX 404 relief. (And get it.) What does the restatement rate at the small end of the auditor/company spectrum suggest about internal control reporting and evaluation? Exactly the opposite of relief: more effective internal controls, and assurance from auditors that the controls are working. (For clarity: those are not Niemeier's comments. They're mine.)

Also on the less encouraging side: 69% of Year 2 weaknesses were tied to material year end adjustments - up from 53% in Year 1. There's still work to be done by companies in getting their reporting right: is cutting back on SOX 404 really the right idea? No.
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