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1、The Effect of Voluntary Internal Control Audits on the Cost of CapitalCory A. CassellAssistant Professor of AccountingUniversity of ArkansasSam M. Walton College of BusinessFayetteville, ARemail: ccassellwalton.uark.eduLinda A. MyersProfessor of AccountingUniversity of ArkansasSam M. Walton College
2、of BusinessFayetteville, ARemail: lmyerswalton.uark.eduJian ZhouAssociate Professor of AccountingState University of New York at BinghamtonSchool of ManagementBinghamton, NYemail: jzhoubinghamton.eduMay 2011Keywords: Sarbanes-Oxley ActSection 404; internal control; cost of capital; voluntary audit;
3、voluntary disclosure; non-accelerated filersData Availability: The data used are publicly available from the sources cited in the text._We thank James Myers, Tim Seidel, and workshop participants at SUNY at Binghamton, University of Arkansas and University of Hawaii at Manoa for helpful comments and
4、 suggestions. Linda Myers gratefully acknowledges financial support from the Garrison/Wilson Chair at the University of Arkansas.The Effect of Voluntary Internal Control Audits on the Cost of CapitalAbstract: In this paper, we investigate whether companies that voluntarily comply with Section 404(b)
5、 of the Sarbanes-Oxley Act of 2002 enjoy a lower cost of capital. Section 404(b) requires an external audit firms attestation report on managements assessment of the companys internal controls over financial reporting. While accelerated filers have been required to comply with the provisions under S
6、ection 404(b) since November 15, 2004, non-accelerated filer compliance has been (and, as of July 21, 2010, will continue to be) voluntary. Using a sample of companies that voluntarily have their internal controls audited by an external auditor and a control group of companies that report on the str
7、ength of internal controls but do not have managements internal control assertions audited, we first model the determinants of voluntary compliance. We find that companies issuing equity or debt and those with stronger monitoring mechanisms (i.e., Big 4 auditors and higher institutional ownership) a
8、re more likely to voluntarily comply with Section 404(b). Next, we test whether voluntary compliance companies enjoy a lower cost of capital relative to companies that do not comply with Section 404(b) and whether voluntary compliance companies enjoy a decline in the cost of capital in the first yea
9、r of compliance. We find that the cost of equity and the cost of debt capital are significantly lower for those companies choosing to have their internal controls audited and that voluntary compliance companies enjoy a reduction in the cost of equity and the cost of debt in the year of voluntary com
10、pliance. Our findings are important because they demonstrate an important benefit that small companies can derive from purchasing internal control audits.The Effect of Voluntary Internal Control Audits on the Cost of Capital1. IntroductionSections 302 and 404(a) of the Sarbanes-Oxley Act of 2002 (SO
11、X) require managers to take responsibility for establishing and maintaining effective internal controls and to periodically evaluate and report on the effectiveness of their companys internal controls. All corporations in the United States (U. S.), regardless of size, are required to comply with the
12、se provisions. Non-accelerated filers, Exchange Act Rule 12b-2 defines an accelerated filer as a company which meets the following conditions as of the end of its fiscal year: 1) the company has a public float of at least $75 million (computed on the last day of the companys most recent second fisca
13、l quarter), 2) the company has been subject to Exchange Act reporting requirements for at least 12 calendar months, 3) the company has filed (with the Securities and Exchange Commission) at least one annual report, and 4) the company is not eligible to use forms 10-KSB and 10-QSB for its annual and
14、quarterly reports. Thus, non-accelerated filers are those companies that do not meet these conditions. however, have been exempt from the requirements outlined in Section 404(b) of SOX that an external audit firm provides an attestation report on managements assessment of the companys internal contr
15、ols over financial reporting. Relevant excerpts from SOX Sections 302 and 404 are provided in the Appendix. Although Section 404(b) has never been mandatory for non-accelerated filers, a number of companies have chosen to voluntarily comply with its provisions. In this paper, we investigate the char
16、acteristics of companies that voluntarily comply with Section 404(b) and whether there is any capital related benefits associated with such voluntary compliance. The U. S. Securities and Exchange Commission (SEC) establishes and enforces rules associated with requirements under SOX. The SECs initial
17、 rules stated that non-accelerated filers would be required to comply with Section 404 (in its entirety) for fiscal years ending on or after April 15, 2005. After several extensions, non-accelerated filer compliance with Section 404(a) was required beginning only for fiscal years ending on or after
18、December 15, 2007. Note that SEC guidance required that non-accelerated filers “furnish” rather than “file” reports pursuant to Section 404(a). Furnished Section 404(a) reports would not be subject to liability under Section 18 of the Exchange Act (see SEC Release Nos. 33-8760 and 33-8934). Section
19、18 of the Exchange Act identifies liable persons as follows: “Any person who shall make or cause to be made any statement in any application, report, or document filed pursuant to this title or any rule or regulation thereunder or any undertaking contained in a registration statement as provided in
20、subsection (d) of section 15, which statement was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, shall be liable to any person (not knowing that such statement was false or misleading) who, in reliance upon such statem
21、ent, shall have purchased or sold a security at a price which was affected by such statement, for damages caused by such reliance, unless the person sued shall prove that he acted in good faith and had no knowledge that such statement was false or misleading. A person seeking to enforce such liabili
22、ty may sue at law or in equity in any court of competent jurisdiction. In any such suit the court may, in its discretion, require an undertaking for the payment of the costs of such suit, and assess reasonable costs, including reasonable attorneys fees, against either party litigant.” The SEC also r
23、epeatedly extended the implementation of Section 404(b) by non-accelerated filers. The final extension was issued in October 2009 and called for non-accelerated filer adoption of Section 404(b) beginning with fiscal years ending on or after June 15, 2010 (see SEC Press Release No. 2009-213). In the
24、SEC press release announcing this final extension, SEC Chairman Mary Shapiro commented, “since there will be no further Commission extensions, it is important for all public companies and their auditors to act with deliberate speed to move toward full Section 404 compliance” (see SEC Press Release N
25、o. 2009-213). Thus, although the actual date of Section 404(b) implementation was uncertain throughout much of this time period, non-accelerated filers anticipated eventual mandatory compliance.Politicians, regulators, academics, and other stakeholders have vigorously debated the wisdom of compellin
26、g non-accelerated filers to comply with Section 404(b). This debate reached its climax in early 2010 as politicians, responding to the recent financial crisis, worked to develop financial sector regulatory reforms. In both houses of Congress, proposals which sought to permanently exempt non-accelera
27、ted filers from the provisions under Section 404(b) were put forth. These proposals proved to be among the most contentious on the legislative agenda. In a joint letter dated April 22, 2010 to the Senate Committee on Banking, Housing and Urban Affairs, directors from the Center for Audit Quality, th
28、e Chartered Financial Analyst (CFA) Institute, and the Council of Institutional Investors stated, If Congress agrees to a permanent 404(b) waiver for smaller companies, there may be little independent scrutiny of financial reporting safeguards at half of all listed companies nationwide. Reporting un
29、der Section 404 provides investors with meaningful information regarding a public companys internal control over financial reporting (ICFR). In addition, we believe that the required independent audit of managements assessment of the effectiveness of ICFR, as required by SOX Section 404(b), has been
30、 integral to the achievement of the intended objectives of ICFR reporting under SOX Section 404.The letter cites a 2009 study by Audit Analytics which finds that “companies that have not yet had auditors review their internal control reports have a restatement rate that is 46 percent higher than lar
31、ger public companies, despite claiming they have effective controls” (Fornelli, Schacht, and Mahoney 2010).Proponents of the proposals pointed to the high costs associated with the implementation of Section 404(b) by small companies. Indeed, a recent SEC study found that initial year Section 404 imp
32、lementation costs (as a percentage of total assets) were significantly higher for the smallest companies (i.e., those with a public float of $50 to 150 million, at 0.79 percent of assets) relative to the largest companies (i.e., those with a public float of greater than $700 million, at 0.14 percent
33、 of assets) (SEC 2009). The debate culminated with President Obamas signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) into law on July 21, 2010. The Dodd-Frank Act permanently exempts non-accelerated filers from the requirements under Section 404(b). The SEC s
34、ubsequently adopted amendments to its rules to conform to the requirements outlined in the Dodd-Frank Act. SEC Release Nos. 33-9142 and 34-62914 state, “The Commission is adopting amendments to its rules and forms to conform them to new Section 404(c) of the Sarbanes-Oxley Act, as added by Section 9
35、89G of the Dodd-Frank Act. Section 404(c) provides that Section 404(b) of the Sarbanes-Oxley Act shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-29 under the Exchange Act.”, The Dodd-Fra
36、nk Act did not exempt non-accelerated filers from requirements under Section 404(a). SEC Release Nos. 33-9142 and 34-62914 emphasize that Section 404(a) reports filed by “non-accelerated filers for fiscal years ending on or after June 15, 2010 will be considered to be “filed” under the Exchange Act.
37、”A large body of research has helped inform the debate surrounding the implementation of Section 404(b) by non-accelerated filers. For example, studies investigating Section 404 implementation suggest that costs are disproportionately higher for smaller companies (CRA 2006, GAO 2006, Zhang 2006, Pra
38、kash 2008, SEC 2009). Moreover, recent research provides evidence which suggests that some small companies avoid compliance costs and/or increased litigation exposure associated with SOX mandates by going dark (Leuz, Triantis, and Wang 2008) or private (Engel, Hayes, and Wang 2007). In addition, Gao
39、, Wu, and Zimmerman (2009), Iliev (2010), and Nondorf, Singer, and You (2011) suggest that some companies near the mandatory Section 404(b) compliance threshold of $75 million in public float engaged in behavior which enabled them to avoid the costs associated with compliance. Collectively, these st
40、udies provide evidence which suggests that the regulatory burden of Section 404 is high, particularly for smaller companies. In contrast, Hansen, Pownall, and Wang (2009) find no evidence of increased delisting activity among U.S. companies due to the passage and implementation of SOX. Instead, thei
41、r results suggest that delisting trends during this time period were driven by other firm-specific and market factors. Several recent studies investigate the implications of internal control deficiency (ICD) disclosures under Section 302 and Section 404. For example, Hammersley, Myers, and Shakespea
42、re (2007) and Beneish, Billings, and Hodder (2008) document a negative stock price reaction to Section 302 ICD disclosures. In general, studies investigating the cost of capital effects of ICD disclosures document a positive association between disclosures of internal control problems and the cost o
43、f equity capital (Beneish et al. 2008, Ashbaugh-Skaife et al. 2009) and between disclosures of internal control problems and the cost of debt capital (Kim, Song, and Zhang 2010, Costello and Wittenberg-Moerman 2011). However, Ogneva, Subramanyam, and Raghunandan (2007) find no significant associatio
44、n between ICD disclosures and the cost of equity capital after controlling for other determinants of the cost of capital. They suggest that their inability to detect a relation between internal control problems and the cost of capital may be due to their focus on ICD disclosures made by large compan
45、ies. Consistent with this, Beneish et al. (2008) find that the magnitude of the negative market reaction to disclosures of internal control problems is significantly greater for smaller public companies, for which prior information asymmetry is likely to be larger. Our study differs from this prior
46、work because we control for the strength of internal controls in order to investigate the cost of capital effects of auditor attestation about the strength of internal controls (rather than the cost of capital effects of the strength of internal controls).Researchers have also investigated benefits
47、that derive from Section 404 compliance. For example, a Glass Lewis study documents a 45 percent reduction in the number of material weaknesses reported by accelerated filers between 2005 and 2006 (Grothe 2007), and Wagner and Dittmar (2006) suggest that Section 404 compliance contributes to improve
48、ments in the strength of the control environment and the effectiveness and efficiency of control procedures (e.g., reduced human error and increased process standardization). Moreover, in a 2009 study, the SEC reported results from a survey of financial executives with Section 404 experience (thus,
49、most of the respondents were employed by accelerated filers). The results indicate that the benefits of Section 404 compliance include improvements in the companys control structure (73 percent), audit committee confidence in the companys ICFR (71 percent), quality of the companys financial reporting (49 percent), and the companys ability to prevent and detect fraud (48 percent
