Restatements Rise for Companies Bypassing SOX's 404 Provision

In what may be a cautionary notice to auditors of small public companies, recent research shows that financial report restatements are increasing at small businesses that have been exempt from the onerous 404 provision of the Sarbanes-Oxley (SOX) accounting reform act, but dropping for companies that do follow 404.

The number of restatements filed by public companies to correct accounting errors during the first nine months of this year versus the same period in 2005, rose 45 percent for small “micro-cap” companies, that have been exempt from 404, according to a recent report. The 404 provision requires companies to establish and maintain internal controls for financial reporting and prepare annual reports of the control processes.

Public companies that have been following the 404 rule have seen steep declines in their restatements. For the very largest companies, with stock market values of more than $750 million, the number of restatements dropped 25 percent and for mid-cap companies of between $75 million and $750 million in market capitalization, restatements dropped 13 percent.

The report was done by Glass Lewis & Co., a financial research firm whose research managing director is Lynn E. Turner, former chief accountant for the Securities and Exchange Commission (SEC). The report found that restatements for public companies overall increased 12 percent during the first nine months, which compares to the 2004-to-2005 time frame when they doubled to 1,250.

While that report may be evidence that SOX 404 is improving the reporting process, the SEC last week took a big step toward making the provision less difficult for small companies. As previously reported by AccountingWeb, the commission unanimously voted to approve changes to SOX that would allow company officials to identify potential risks in their bookkeeping and focus efforts only in those areas.

Under the current rules, company managers and outside auditors must evaluate, document, and publicly disclose all financial controls. The SEC was prompted to move toward changing the rule by complaints from the small business sector that complying with 404 is overly time-consuming and costly and costs as much for them as much as it does for multi-billion-dollar companies, even though small companies have much smaller, less complex systems.

The proposed changes will allow smaller companies to "scale and tailor their evaluation methods and procedures," Securities and Exchange Commission Chairman Christopher Cox said. Small company auditors, both internal and external, may now be wondering that if the SEC recommendation becomes enacted, will their reporting suffer when management opts for a less strenuous review of their reporting systems.

The Glass Lewis study found that more than half of the errors that led to restatements during this year’s first nine months were related to basic accounting mistakes, including such things as errors in categorizing cash flows and improper accounting for convertible securities.

To be sure, the SEC was well aware of the study’s findings long before they voted last week to recommend the 404 changes. In fact, the study findings were mentioned in, among other places, a Dec. 11 New York Times story that previewed last week’s SEC vote.

Written by John Covaleski.

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