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10 Years After Enron, Time to Throw Out Sarbanes–Oxley's Section 404

Posted By David C. John On December 2, 2011 @ 1:36 pm In Featured | Comments Disabled

Exactly 10 years ago today, the Enron Corporation filed for bankruptcy after it was revealed that it had blatantly falsified its earnings statements for many years. Although most of the accounting irregularities that caused its collapse were already illegal, Congress overreacted and passed Sarbanes–Oxley, a massive and deeply flawed accounting reform law. A decade later, it is time for cooler heads to prevail, and to consider repealing Section 404.

This onerous provision is supposed to ensure that the financial reports of publicly traded corporations meet certain standards, but in reality its major role is to greatly increase compliance costs. It continued presence discourages growing companies from going public to raise capital by imposing on them very high compliance costs in the name of protecting their shareholders.

The result is lower job growth by these companies and fewer workers hired by new businesses [1]. Congress partially recognized this in 2010 by granting an exemption to publicly traded companies whose stock is worth a total of $75 million or less, but this threshold is far too low, and questions remain if Section 404 is needed at all.

Section 404 duplicates part of Section 302 and requires the management of any publicly traded company to produce an internal control report describing the scope and adequacy of its financial reporting procedures and internal financial control structures. The company is required to include this information in its annual report, send it to investors, and file it with the SEC.

In addition, the company must produce “an assessment…of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.” In the same report, an outside auditor must both attest to and report on the management’s assessment of the effectiveness of the company’s internal controls and procedures.

In short, Section 404 requires both an internal audit and external audit of financial accounting controls, which has turned out to be costly and time-consuming in practice.

As The Heritage Foundations’ David Addington stated in a recent paper [2]:

Congress should reconsider carefully the requirements in Section 404 for company management to assess the effectiveness of its internal control structure and procedures and then for the company’s registered public accounting firm to attest to that management assessment. Given the traditional role of each state in regulating the corporate governance of corporations incorporated in that state, Congress should first examine anew whether federal law should address those subjects, or whether they should be left to state law. In a society based on limited government and free enterprise, and in light of the traditional role of the states in our federal system, Congress should start its examination with a presumption in favor of repealing Section 404 and leaving the subjects addressed by Section 404 to the states.

An immediate repeal would be the best option, but if that is not possible, Congress should seriously consider increasing the current $75 million market cap exemption to at least $1 billion. The current exemption is so tiny that all but the very smallest newly publicly traded firms could exceed it almost immediately. Medium-sized companies that fall outside of the current exemption are still discouraged from seeking the lower-cost capital available to publicly traded companies. A smaller exemption would not have the same effect on new registrations or job creation.

Sarbanes–Oxley is an object lesson that congressional overreaction to a crisis or scandal can have serious negative consequences. Although Sarbanes–Oxley initially calmed investors’ fears and strengthened the internal controls of U.S. companies, it has also had a number of damaging unintended consequences. These are mainly, but not exclusively, due to Section 404 and how it has been implemented. Congress can partially address this problem by increasing the existing Section 404 exemption to firms with market capital of $1 billion or less.


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URL to article: http://blog.heritage.org/2011/12/02/ten-years-after-enron-it-is-time-to-throw-out-sarbanes%e2%80%93oxley%e2%80%99s-section-404/

URLs in this post:

[1] fewer workers hired by new businesses: http://www.heritage.org/research/reports/2011/11/high-unemployment-reduced-job-creation-not-layoffs

[2] a recent paper: http://www.heritage.org/research/reports/2011/09/congress-should-repeal-or-fix-section-404-of-the-sarbanes-oxley-act-to-help-create-jobs?query=Congress+Should+Repeal+or+Fix+Section+404+of+the+Sarbanes%E2%80%93Oxley+Act+to+Help+Create+Jobs

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