Sarbanes-Oxley Act: Consideration of Key Principles Needed in
Addressing Implementation for Smaller Public Companies
(13-APR-06, GAO-06-361).
Congress passed the Sarbanes-Oxley Act to help protect investors
and restore investor confidence. While the act has generally been
recognized as important and necessary, some concerns have been
expressed about the cost for small businesses. In this report,
GAO (1) analyzes the impact of the Sarbanes-Oxley Act on smaller
public companies, particularly in terms of compliance costs; (2)
describes responses of the Securities and Exchange Commission
(SEC) and Public Company Accounting Oversight Board (PCAOB) to
concerns raised by smaller public companies; and (3) analyzes
smaller public companies' access to auditing services and the
extent to which the share of public companies audited by
mid-sized and small accounting firms has changed since the act
was passed.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-361
ACCNO: A51638
TITLE: Sarbanes-Oxley Act: Consideration of Key Principles
Needed in Addressing Implementation for Smaller Public Companies
DATE: 04/13/2006
SUBJECT: Auditing procedures
Auditing standards
Audits
Fees
Internal controls
Reporting requirements
Small business
Voluntary compliance
Federal law
Financial reporting
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GAO-06-361
* SARBANES-OXLEY ACT
* Consideration of Key Principles Needed in Addressing Implementation
for Smaller Public Companies
* Contents
* Results in Brief
* Background
* Smaller Public Companies Have Incurred Disproportionately
Higher Audit Costs in Implementing the Act, but Impact on
Access to Capital Remains Unclear
* Smaller Public Companies Incurred Disproportionately
Higher Audit Costs
* Smaller Public Companies Incurred Other Costs in
Complying with the Act
* Smaller Companies Have Different Characteristics Than
Larger Companies, Some of Which Contributed to Higher
Implementation Costs
* Complexity, Scope, and Timing of PCAOB Guidance also
Appeared to Influence Cost of Section 404
Implementation
* Costs Associated with the Sarbanes-Oxley Act May Have
Impacted the Decision of Some Smaller Public Companies
to Go Private, but Other Factors also Influenced
Decision to Go Private
* It Is Too Soon to Determine How Sarbanes-Oxley Affected
Access to Capital for Smaller Public Companies
* SEC and PCAOB Have Been Addressing Smaller Company Concerns
Associated with the Implementation of Section 404
* Sarbanes-Oxley Act Requirements Minimally Affected Smaller
Private Companies, Except for Those Seeking to Enter the
Public Market
* Sarbanes-Oxley May Have Affected IPO Activity; however,
Other Important Factors also Influence Entry into the
Public Market and Access to Capital
* Potential Spillover Effects of the Sarbanes-Oxley Act
on Private Companies Have Been Minimal
* Smaller Companies Appear to Have Been Able to Obtain Needed
Auditor Services, Although the Overall Audit Market Remained
Highly Concentrated
* Smaller Companies Found It Harder to Keep or Obtain the
Services of a Large Accounting Firm, but Overall Access
to Audit Services Appeared Unaffected
* Recent Auditor Changes Resulted in Small Accounting
Firms Gaining Clients
* Reasons for Auditor Changes May Have Included Costs
Related to the Act and Risk Assessments
* Mid-sized and Small Accounting Firms Continued to
Operate in a Highly Concentrated Market
* Sarbanes-Oxley Act May Impact the Continuing
Competitive Challenges Faced by Mid-Sized and Small
Accounting Firms
* Conclusions
* Recommendations
* Agency Comments and Our Evaluation
* Appendix I: Objectives, Scope, and Methodology
* Impact of Sarbanes-Oxley Act on Smaller Public Companies
* Audit Fees and Auditor Changes
* Deregistrations
* Survey of Public Company Views on Implementing the
Sarbanes-Oxley Act
* SEC and PCAOB Efforts to Address Smaller Company
Concerns
* Impact of Act on Smaller Privately Held Companies
* Company Access to Auditing Services and Changes in
Share of Public Companies That Small Firms Audit
* Appendix II: Additional Details about GAO's Analysis of Companies
Going Private
* Our Database Included Firms That "Went Dark" as Well as
Firms That Completely Exited the Public Market
* Consistent with Outside Studies, We Found That the
Number of Companies That Went Private Increased
Significantly from 2001 through 2004
* We Grouped Reasons for Company Decisions to Go Private
into Seven Categories
* More Companies Have Cited Costs as Reasons for Going
Private Since 2002
* Companies Going Private Typically Were among the
Smallest of Publicly Traded Companies
* Appendix III: Comments from the Securities and Exchange
Commission
* Appendix IV: Comments from the Public Company Accounting
Oversight Board
* GAO Contacts
* Appendix V: GAO Contacts and Staff Acknowledgments
* GAO Contacts
* Acknowledgments
* Order by Mail or Phone
Report to the Committee on Small Business and Entrepreneurship, U.S.
Senate
United States Government Accountability Office
GAO
April 2006
SARBANES-OXLEY ACT
Consideration of Key Principles Needed in Addressing Implementation for
Smaller Public Companies
GAO-06-361
Contents
Letter 1
Results in Brief 4
Background 9
Smaller Public Companies Have Incurred Disproportionately Higher Audit
Costs in Implementing the Act, but Impact on Access to Capital Remains
Unclear 14
SEC and PCAOB Have Been Addressing Smaller Company Concerns Associated
with the Implementation of Section 404 26
Sarbanes-Oxley Act Requirements Minimally Affected Smaller Private
Companies, Except for Those Seeking to Enter the Public Market 36
Smaller Companies Appear to Have Been Able to Obtain Needed Auditor
Services, Although the Overall Audit Market Remained Highly Concentrated
42
Conclusions 52
Recommendations 58
Agency Comments and Our Evaluation 58
Appendix I Objectives, Scope, and Methodology 61
Appendix II Additional Details about GAO's Analysis of Companies Going
Private 73
Appendix III Comments from the Securities and Exchange Commission 84
Appendix IV Comments from the Public Company Accounting Oversight Board 86
Appendix V GAO Contacts and Staff Acknowledgments 87
Tables
Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting
Public Companies and Registered Accounting Firms 11
Table 2: Primary Reasons Cited by Companies for Going Private, 1998-2005,
by Percent 23
Table 3: SEC Extensions of Section 404 Compliance Dates 27
Table 4: IPO Direct Expenses as a Percentage of Company's Revenues, by
Size 38
Table 5: Companies Changing Accounting Firms, 2003-2004 44
Table 6: Cross-sectional Comparison of Request Letter Questions, Our
Report Objectives, and Selected Findings 61
Table 7: Reason for Going Private, by Category Descriptions 80
Figures
Figure 1: Median Audit Fees as a Percentage of 2003 and 2004 Revenues
Reported by Public Companies as of August 11, 2005 16
Figure 2: Total Number of Companies Identified as Going Private, 1998-2005
22
Figure 3: Where Companies Traded Prior to Deregistration, July 2003-March
2005 25
Figure 4: IPO and Stock Market Performance, 1998-2005 39
Figure 5: Average Size of Companies Changing Auditors, 2003-2004, by Type
of Accounting Firm Change 46
Figure 6: Percentage of Clients Audited by Revenue Category, 4 Largest
Accounting Firms versus Mid-sized and Small Accounting Firms, 2004 49
Figure 7: Total Number of IPOs, by Size of Accounting Firm, 1999-2004 51
Figure 8: Total Number of Companies Identified as Going Private from 1998
to 2005 77
Abbreviations
AMEX American Stock Exchange CEO chief executive officer CFO chief
financial officer COSO Committee of Sponsoring Organizations of the
Treadway Commission EDGAR Electronic Data Gathering, Analysis, and
Retrieval system FCPA Foreign Corrupt Practices Act of 1977 HHI
Hirschman-Herfindahl Index IPO initial public offering NASD National
Association of Securities Dealers, Inc. NASDAQ The Nasdaq Stock Market,
Inc NYSE New York Stock Exchange PCAOB Public Company Accounting Oversight
Board QPL Questionnaire Programming Language OTCBB Over the Counter
Bulletin Board SAS statistical analysis software SBA Small Business
Administration SEC Securities and Exchange Commission SPO secondary public
offering
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
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separately.
United States Government Accountability Office
Washington, DC 20548
April 13, 2006
The Honorable Olympia J. Snowe Chair Committee on Small Business and
Entrepreneurship United States Senate
The Honorable Michael B. Enzi United States Senate
In response to numerous corporate failures arising from corporate
mismanagement and fraud, Congress passed the Sarbanes-Oxley Act of 2002. 1
Generally recognized as one of the most significant market reforms since
the passage of the securities legislation of the 1930s, the act is
intended to help protect investors and restore investor confidence by
improving the accuracy, reliability, and transparency of corporate
financial reporting and disclosures, and reinforce the importance of
corporate ethical standards. Public and investor confidence in the
fairness of financial reporting and corporate ethics is critical to the
effective functioning of our capital markets. The act's requirements apply
to all public companies regardless of size and the public accounting firms
that audit them.
The act established the Public Company Accounting Oversight Board (PCAOB)
as a private-sector non-profit organization to oversee the audits of
public companies that are subject to securities laws. PCAOB, which is
subject to oversight by the Securities and Exchange Commission (SEC), is
responsible for establishing related auditing, quality control, ethics,
and auditor independence standards. The act also addresses auditor
independence and the relationship between auditors and the public
companies they audit. The act requires public companies to assess the
effectiveness of their internal control over financial reporting and for
their external auditors to report on management's assessment and the
effectiveness of internal controls. 2 The act also contains provisions
intended to make chief executive officers (CEO) and chief financial
officers (CFO) more accountable, improve the oversight role of boards of
directors and audit committees, and provide whistleblower protection.
Finally, the act expanded the SEC's oversight powers and mandated new and
expanded criminal penalties for securities fraud and other corporate
violations.
1Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).
2Internal control is defined as a process effected by an entity's board of
directors, management, and other personnel, designed to provide reasonable
assurance regarding the achievement of the following objectives: (1)
effectiveness and efficiency of operations; (2) reliability of financial
reporting; and (3) compliance with laws and regulations. Internal control
over financial reporting is a process that a company puts in place to
provide reasonable assurance regarding the reliability of financial
reporting and the integrity of the financial statement preparation
process.
3For the purposes of this report, we use the term smaller public company
to refer to a company with a market capitalization of $700 million or less
unless otherwise noted. We use the term large accounting firms to refer to
the top four U.S. accounting firms in terms of total revenue in fiscal
year 2004-Deloitte & Touche LLP, Ernst & Young LLP, PricewaterhouseCoopers
LLP, and KPMG LLP; mid-sized firms to refer to the four next largest U.S.
firms-Grant Thornton LLP, BDO Seidman LLP, Crowe Chizek & Company LLC, and
McGladrey & Pullen LLP; and small firms to refer to all other accounting
firms in the United States., which consist of regional and local firms.
4Audit Analytics is an online market intelligence service that provides
information on U.S. public companies registered with SEC and accounting
firms.
5We conducted an analysis to determine whether the respondents to our
survey differed from the population of 591 companies in company assets,
revenue, market capitalization, or type of company (based on the North
American Industrial Classification System code) and found no evidence of
substantial non-response bias on these characteristics. However, because
of the low response rate, we do not consider these data to be a
probability sample of all smaller public companies.
6COSO was originally formed in 1985 to sponsor the National Commission on
Fraudulent Financial Reporting, an independent private-sector initiative
that studied the causal factors that can lead to fraudulent financial
reporting and developed recommendations for public companies and their
independent auditors, SEC and other regulators, and educational
institutions.
7Until recently, SEC distinguished between two types of public companies
for financial reporting purposes-accelerated filers and non-accelerated
filers. SEC defined a public company as an accelerated filer if it met
certain conditions, namely that the company had a public float of $75
million or more as of the last business day of its most recently completed
second fiscal quarter and the company filed at least one annual report
with SEC. A non-accelerated filer is generally a public company that had a
public float of less than $75 million as of the last business day of its
most recently completed second fiscal quarter. In December 2005, SEC
created a new category, the large accelerated filer. A large accelerated
filer is generally a public company that had a public float of $700
million or more as of the last business day of its most recently completed
second fiscal quarter. SEC also redefined an accelerated filer as a
company that had at least $75 million but less than $700 million in public
float. Accelerated filers and large accelerated filers are subject to
shorter financial reporting deadlines than non-accelerated filers. SEC
defines public float as the aggregate market value of voting and
non-voting common equity held by non-affiliates of the issuer.
8This report focuses on smaller public companies, but some of the
identified challenges and costs may also be present in larger public
companies.
9While there is no standard definition of corporate governance, it can
broadly be taken to refer to the system by which companies are directed
and controlled, including the role of the board of directors, management,
shareholders, and other stakeholders. According to the Organisation for
Economic Co-operation and Development, corporate governance provides the
structure through which the objectives of the company are set and the
means of attaining those objectives and monitoring performance are
determined.
10In addition to those companies required to file reports with SEC under
the Securities Exchange Act of 1934, the Sarbanes-Oxley Act also applies
to companies considered to be issuers that have filed a Securities Act of
1933 registration statement that is not yet effective.
11SEC also has a specific category of smaller companies called "small
business issuers" that may use separate reporting requirements designed to
be less onerous than those applicable to larger filers. Generally, "small
business issuers" have less than $25 million in revenues and public float.
See 17 C.F.R. S: 228.10(a)(1).
12COSO, Internal Control - Integrated Framework, 1992 and 1994.
13Pub. L. No. 95-213, 91 Stat. 1494 (Dec. 19, 1977).
14We also looked at audit fees as a percentage of market capitalization.
While there is less of a disparity when this measure is used, a
significant difference is still observable between smaller and larger
public companies.
15As noted in figure 1, public companies with market capitalization
between $75 million and $250 million paid roughly 4.1 times what public
companies with market capitalization greater than $1 billion paid in 2003.
For those public companies that reported implementing section 404, this
ratio increased only slightly to 4.3.
16See "Management's Report on Internal Control over Financial Reporting
and Certification of Disclosure in Exchange Act Periodic Reports," 68
Federal Register 36636 (June 18, 2003) (final rule).
17See COSO's exposure draft, "Guidance for Smaller Public Companies
Reporting on Internal Control over Financial Reporting" (Oct. 26, 2005),
for a discussion of the challenges that smaller companies face in
implementing effective internal control over financial reporting.
18SEC, 24th Annual SEC Government-Business Forum on Small Business Capital
Formation, Final Report (Washington, D.C.: November 2005).
19PCAOB Release No. 2005-023 Report on the Initial Implementation of
Auditing Standard No. 2, An Audit of Internal Control over Financial
Reporting Performed in Conjunction with An Audit of Financial Statements
(Washington, D.C.: Nov. 30, 2005).
20According to the "Fast Answers" section of SEC's website, "a company
goes private when it reduces the number of its shareholders to fewer than
300 and is no longer required to file reports with SEC." See
www.sec.gov/answers/gopriv.htm . Stock of these companies no longer trades
on the major markets; however, companies can and do continue trading on
the less regulated Pink Sheets, which have no minimum listing standards.
When a company suspends its duty to report to SEC but continues to trade
on the Pink Sheets, it is commonly referred to as having "gone dark,"
since investors no longer have access to information in the form of 8-Ks
or quarterly and annual financial statements filed with SEC. Or, after
deregistering, some companies elect to become "fully private" and are no
longer traded or listed on any market. For purposes of this report, we
consider both types of companies-"gone dark" and "fully private"-as
private. As such, the terms deregistering and "going private" are used
interchangeably in this report. See appendix II for more details on the
definition of "going private" used in this report.
21We eliminated companies that deregistered common stock as a result of
acquisitions and mergers that were not "going private" transactions,
liquidations, reorganizations, bankruptcy filings, or re-emergences. We
also eliminated duplicate filings and filings by foreign registrants.
These trends are consistent with a number of studies we identified,
although data collection methodologies differ across samples. See appendix
II for a full discussion of GAO's analysis.
22See appendix II for full description of each reason.
23Consistent with our findings, a number of research reports also find
that companies most often cited cost savings from not having to comply
with SEC regulations as a benefit of going private. For example, see C.
Luez, et al., "Why Do Firms Go Dark? Causes and Economic Consequences of
Voluntary SEC Deregistrations," Wharton School Working Paper, University
of Pennsylvania, September 2004, and S. Block, "The Latest Movement to
Going Private: An Empirical Study," Journal of Applied Finance, 14 (1):
2004.
24In general, public companies will differ in the costs incurred and
benefits obtained as a result of their public company status because of
differences in size, industry, or other factors.
25Well before the passage of the Sarbanes-Oxley Act, analysts noted that a
decline in analyst and research coverage of smaller companies and other
challenges had resulted in a large number of smaller companies with
extremely low valuations and limited trading volume and investor interest.
For example, research in 2003 suggested that, while 95 percent of all
companies with market capitalization greater than $1 billion were covered
by an analyst, 21 percent of companies with market capitalization between
$25-50 million were covered by an analyst, and just 3 percent of companies
below $25 million market capitalization were covered.
26The OTCBB is an electronic quotation system for equity securities not
traded or listed on any of the national exchanges or NASDAQ. Generally,
issuers of securities quoted on the OTCBB are smaller companies.
27Although National Association of Securities Dealers, Inc. (NASD)
oversees the OTCBB, the OTCBB is not part of the NASDAQ Stock Market. SEC
has found that fraudsters often claim that an OTCBB company is a
NASDAQ-listed company to mislead investors into thinking that the company
is bigger than it actually is (see Microcap Stock: A Guide for Investors:
http://www.sec.gov/investor/pubs/microcapstock.htm). Pink Sheets LLC has
no affiliation with NASD and its activities are not regulated by SEC.
28On January 20, 2006, we submitted a comment letter to COSO on its draft
guidance that contained specific recommendations on areas where we felt
the guidance could be improved.
29See 71 Federal Register 11090 (Mar. 3, 2006).
3071 Federal Register 11090, 11098.
31SEC staff told us that they had not conducted a legal analysis of the
preliminary recommendations to determine if SEC has authority to issue
exemptions from section 404.
32The exposure draft of the Advisory Committee on Smaller Public Companies
uses the term "product revenue" as one of the criteria for categorizing
smallcap companies for the purposes of its recommendations. However, the
exposure draft did not contain an explanation of the term "product"
revenue. As a result, it was not possible to analyze how a $10 million
"product" revenue filter might affect the number of smallcap companies
that would become eligible for the full exemption from section 404
otherwise limited to microcap companies under the Advisory Committee's
preliminary recommendations. See 71 Federal Register 11093, 11104, and
11105.
33The 9,428 public companies identified by SEC included U.S. companies
listed on the New York and American Stock Exchanges (NYSE and AMEX,
respectively), the NASDAQ Stock Market, and the OTC Bulletin Board.
However, data prepared for the Advisory Committee by SEC's Office of
Economic Analysis noted that the 9,428 public companies do not include
approximately 3,650 U.S. public companies whose stock trades on the Pink
Sheets. The omission of Pink Sheet companies results in an understatement
of the number and percentage of public companies that would be affected by
the committee's recommendations calling for section 404 regulatory relief
for smaller public companies.
34Under the committee's recommendations, "smallcap" companies with annual
product revenues below $10 million would receive the same treatment as
microcap companies and be exempted from having to comply with both
sections 404(a) and (b).
35The specified corporate governance provisions included (1) adherence to
standards relating to audit committees in conformity with Rule 10A-3 under
the Securities Exchange Act and (2) adoption of a code of ethics with the
meaning of Item 406 of Regulation S-K applicable to all directors,
officers, and employees and compliance with further obligations under Item
406(c) relating to the disclosure of the code of ethics. Additionally, the
committee recommended that management continue to be required to report on
any known material weaknesses, including those uncovered by the external
auditor and reported to the audit committee.
36PCAOB Release No. 2005-023, Report on the Initial Implementation of
Auditing Standard No. 2, An Audit of Internal Control over Financial
Reporting Performed in Conjunction with An Audit of Financial Statements
(Washington, D.C.: Nov. 30, 2005).
37See Glass Lewis & Co., "Restatements - Traversing Shaky Ground," Trend
Alert, June 2, 2005. The restatement rate calculation only included
companies with available financial data. The lack of financial data and,
therefore, exclusion of these companies, may lead to a slight bias in the
restatement rate for all companies (with a slightly larger impact on the
rate for smaller companies).
38Section 404's requirements only apply to annual reports required by
section 13(a) or section 15(d) of the Securities Exchange Act of 1934.
39Illinois, Texas, and California.
40For more information on small business equity capital formation, see
GAO, Small Business: Efforts to Facilitate Equity Capital Formation,
GAO/GGD-00-190 (Washington, D.C.: Sept. 29, 2000).
41Pink Sheets LLC, a privately held company, does not require companies to
be registered with SEC; therefore, many of these companies do not make
available the kind of detailed financial disclosures that SEC-registered
companies must provide.
42Cost increases associated with concentration in the accounting industry
are one of these potential factors. Some companies and their investment
banks would consider only a large accounting firm when preparing for an
IPO. In 2003 and 2004, over 80 percent of the companies completing the IPO
process used a large accounting firm.
43In addition to the four largest and four mid-sized firms, there were
roughly 800 small and mid-sized accounting firms that issued audit
opinions for U.S. companies in 2002 and approximately 600 that issued
audit opinions in 2004.
44The term "revenue" is used interchangeably with the term "sales" used in
the Who Audits America database. See appendix I for more detail.
45We analyzed auditor change data using the Audit Analytics database,
excluding foreign filers, funds and trusts without market data, and
benefit plans. We grouped public companies into five size categories based
on their respective market capitalization: (1) up to $75 million, (2)
greater than $75 million to $250 million, (3) greater than $250 million to
$700 million, (4) greater than $700 million to $1 billion, and (5) greater
than $1 billion. If market capitalization data were not available, revenue
data were used as relevant proxies for company size. Companies without
market capitalization or revenue data were not included in the analysis
(643 companies).
46Forty-four companies (less than 1 percent) reported not finding a new
auditor as of December 2004. Some of these companies may have
deregistered, gone bankrupt, merged with or been acquired by another
company, or otherwise ceased business activity.
47These figures do not include foreign companies or companies that did not
trade on NYSE, NASDAQ, AMEX, OTCBB, or the Pink Sheets. See appendix I for
data reliability.
48In a previous report, Public Accounting Firms: Mandated Study on
Consolidation and Competition, GAO-03-864 (Washington, D.C.: July 2003),
we noted that public companies wishing to demonstrate their worthiness for
debt and equity investments might continue to employ a large accounting
firm to increase their credibility among potential lenders and investors
and that some companies and boards of directors have been reluctant to
consider small firms.
49Many of the public accounting firms with whom we talked had a
significant number of accelerated filers for 2004 and noted that the
additional work challenged the firm's capacity. While the firms expanded
and supplemented their capacity to handle the additional work, these firms
also acknowledged that they took the workload and capacity issues into
account in conducting their ongoing client acceptance and retention
reviews. Many of the firms-particularly the large accounting
firms-acknowledged that since 2002, their review and retention processes
have resulted in a reduction of their public company audit client base to
better match workload capacity.
50Ninety-four percent of the companies changing auditors that had going
concern opinions had market capitalization of $75 million or less (or, if
no market capitalization data were available, $75 million or less in
revenues). A going concern opinion is issued by an auditor if the auditor
has doubts about the company's ability to generate or raise enough
resources to stay operational (to continue as a "going concern").
51See GAO-03-864 .
52These concentration statistics suggest a Hirschman-Herfindahl Index
(HHI) of 2,505, which is equivalent to the index calculated for 2002
(2,566). The HHI is calculated by summing the squares of the individual
market shares of all the participants. An HHI above 1,800 indicates a
highly concentrated market in which firms have the potential for
significant market power. While concentration ratios and the HHI are good
indicators of market structure, these measures only indicate the potential
for oligopolistic collusion or the exercise of market power and can
overstate the significance of a tight oligopoly on competition. See
GAO-03-864 for further discussion of the HHI.
53As such, the four-firm and eight-firm (large accounting firms plus
second-tier firms) concentration ratios are 0.55 and 0.75 respectively for
this particular section of the market. These ratios are consistent with an
HHI below 1,000. As a general rule, an HHI below 1,000 indicates a market
predisposed to perform competitively, while an HHI above 1,800 indicates a
highly concentrated market. See GAO-03-864 .
54See GAO-03-864 .
55Based on a large sample analyzed from Audit Analytics, when we broadened
the market to include SEC reporting companies that do not publicly trade,
funds and trusts, the 600 small and mid-sized firms we identified audited
over 4,400 domestic public clients.
56As we noted in our 2003 report, mid-sized and small accounting firms
face challenges in effectively competing for large national and
multinational public company audits. The challenges include lack of staff
resources, experience, technical expertise, and global reach necessary to
audit large multinationals; establishing recognition and credibility with
larger companies and market participants to counter the perception that
only large firms can provide the required auditing services; increased
litigation risk and insurance costs associated with auditing public
companies; and difficulty in raising capital to expand infrastructure to
compete with large accounting firms. Also, at a recent conference on
auditor concentration organized by The American Assembly, experts
generally agreed that significant challenges restrict the ability of
mid-sized accounting firms to increase their market share and present a
major alternative to the large accounting firms. "The Future of the
Accounting Profession: Auditor Concentration," which was held on May 23,
2005, was a follow-on to the Assembly's November 2003 meeting where 57
business leaders, academics, journalists, and regulatory officials
discussed the challenges the accounting profession faced. For more
information, see http://www.americanassembly.org/index.php .
1SEC's definition of a non-accelerated filer is based in part on the
company's "public float," which is a subset of market capitalization.
Market capitalization is defined as the number of shares outstanding
multiplied by the price per share. Generally, a company's public float
includes shares that are available to the public. Thus, shares held by
company insiders such as the CEO or CFO would not be included in public
float.
2In general, when working with any of the financial database, breaking out
the number of companies by size will result in the loss of observations
because some companies will not have financial data available.
3Companies that were merged into, or were acquired by, another company
were only included if the transaction was initiated by an affiliate of the
company (either the company filed a form Schedule 13E-3 with SEC or GAO
analysis found evidence of a "going private" transaction in the case of
OTCBB- and Pink Sheet-listed companies).
4There may also be additional omissions due to errors on Form 15s or
because some Form 15s that were initially listed by SEC were not found or
were not available in electronic form. In a few instances, it appeared
that the Form 15 was completed incorrectly by the firm. Mistakes included
missing fields or an obvious misunderstanding of what information was
required.
5A test of a random sample of 200 of these companies found that merging,
bankrupt, and liquidating firms typically reported one or zero as the
number of holders of record. In each case, the companies were found to
have either merged with another company or had gone bankrupt or
liquidated. See also Marosi and Massoud (2004), "Why Do Firms Go Dark,"
who used a similar method to exclude mergers and acquisitions.
6Leuz et al. (2004).
1Under certain SEC rules, public companies voluntarily can deregister by
filing a Form 15 with SEC if they have fewer than 300 holders of record or
fewer than 500 holders of record if the company's total assets have not
exceeded $10 million at the end of the company's 3 most recent fiscal
years and if the company meets some additional criteria. Many of these
companies can have thousands of actual beneficial shareholders. For
example, Ced & Co., the nominee of Depository Trust Company would be
counted as one certificate holder of record for many thousands of
investors served by the brokerage firms that are members of the Depository
Trust Company.
2The Pink Sheets LLC does not require companies whose securities are
quoted upon its systems to meet any listing requirements or require the
companies to be registered with SEC.
3Because we are addressing the potential effects on the access to capital,
our database focuses on "going private" from a public disclosure
requirement perspective-not necessarily from a trading perspective. Some
companies actively trade but are not required to disclose information to
SEC via periodic filings-these are considered private; some companies do
not trade actively but report to SEC-these are considered public and when
they file a Form 15 and cease filing with SEC are considered to have gone
private.
4In a few cases, we found companies that deregistered their common stock
and had other public securities that were still subject to SEC reporting
requirements, but later deregistered those securities shortly after the
initial Form 15 filing. These types of companies are also included in our
final numbers.
5Generally, if the transaction is initiated by an affiliate (an insider)
of the company, Rule 13e-3 of the Securities Exchange Act of 1934 requires
the affiliate to file a Schedule 13E-3 with SEC. The filing of a Schedule
13E-3 may also be required when affiliated transactions result in a
company's publicly held securities no longer being traded on a national
securities exchange or an inter-dealer quotation system, such as NASDAQ.
The Schedule 13E-3 requires a discussion of the purposes of the
transaction, any alternatives that the company considered, and whether the
transaction is fair to all shareholders. The schedule also discloses
whether and why any of its directors disagreed with the transaction or
abstained from voting on the transaction and whether a majority of
directors,who are not company employees, approved the transaction.
6The companies were found to have either merged with another company or,
in some cases, had gone bankrupt or were liquidated. See also Marosi and
Massoud (2004), "Why Do Firms Go Dark," University of Alberta, March 2004,
who used a similar criterion to exclude companies.
7Ten additional companies went private between April 1, 2005, and April
24, 2005, bringing the total to 1,103.
8SEC recently targeted regulatory problems that they identified where
shell companies have been used as vehicles to commit fraud and abuse SEC's
regulatory processes.
9Blank check companies are typically development stage companies that have
no specific business plan or purpose or have indicated that their business
plan was to engage in a merger or acquisition with an unidentified company
or companies, entities, or persons. SEC defines a shell company as a
company with no or nominal operations and either no or nominal assets,
assets consisting solely of cash and cash equivalents, or assets
consisting of any amount of cash and cash equivalents and nominal other
assets. SEC noted that many investors have been victimized in shell
company schemes over the years. However, their corporate structures and
status as publicly listed entities and fully reporting issuers are
features of interest for some small companies with a desire to go public
by way of reverse merger. In a reverse merger, a private company merges
with a public company and continues as the dominant successor.
10E. Engel, R. Hayes, and X. Wang, "The Sarbanes-Oxley Act and Firms'
Going Private Decisions," University of Chicago Working Paper, May 2004;
C. Luez, A. Triantis, and T. Wang, "Why Do firms Go Dark? Causes and
Economic Consequences of Voluntary SEC Deregistration," University of
Pennsylvania Working Paper, September 2004; and Marosi and Massoud (2004),
"Why Do Firms Go Dark," University of Alberta, March 2004.
11It should be noted that these reasons are self reported by the company
and are not based on any additional (and more complex) analysis of company
behavior. Furthermore, because the Schedule 13E-3 requires a discussion of
the purposes of the transaction, any alternatives that the company
considered, and whether the transaction is fair to all shareholders,
affiliates of the company that are advocating the transaction may list all
the pros and cons of going private. As a result, in cases where a company
is required to file a Schedule 13E-3 with SEC, cost savings are generally
listed as a benefit of going private and therefore captured in our
database as one of the reasons for the decision.
12Given that the financial data are based on the company's last annual
filing, these results should be viewed as estimates of company size.
The specific objectives of this report are to (1) analyze the impact of
the Sarbanes-Oxley Act on smaller public companies, including costs of
compliance and access to capital; (2) describe SEC's and PCAOB's efforts
related to the implementation of the act and their responses to concerns
raised by smaller public companies and the accounting firms that audit
them; (3) analyze the impact of the act on smaller privately held
companies, including costs, ability to access public markets, and the
extent to which states and capital markets have imposed similar
requirements on privately held companies; and (4) analyze smaller
companies' access to auditing services and the extent to which the share
of public companies audited by small accounting firms has changed since
the enactment of the act.. 3
To address these objectives, we reviewed information from a variety of
sources, including the legislative history of the act, relevant regulatory
pronouncements and public comments, research studies and papers, and other
stakeholders (such as trade groups and market participants). To analyze
the impact of the act on smaller public companies, we obtained data from
SEC filings provided through a licensing agreement with Audit Analytics,
and analyzed data elements including auditing fees and auditor changes to
determine costs of compliance. 4 Similarly, we constructed a database of
public companies that went private using SEC filings and press releases
retrieved from Lexis-Nexis, an online periodical database. To obtain
information on smaller public companies' experiences with Sarbanes-Oxley
Act compliance, we also conducted a survey of companies with market
capitalization of $700 million or less and annual revenues of $100 million
or less that, as of August 11, 2005, reported to SEC that they had
complied with the act's internal control-related requirements. One hundred
fifty-eight of 591 companies completed the survey, for an overall response
rate of 27 percent. 5 Additionally, we held discussions with
representatives of SEC, the Small Business Administration (SBA), PCAOB,
smaller public companies, the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), financial service providers, rating agencies,
institutional investors, trade groups, accounting firms, and other market
participants. 6
Because SEC has extended the date by which registered public companies
with less than $75 million in public float (known as non-accelerated
filers) had to comply with the act's internal control-related provisions
(section 404) to their first fiscal year ending on or after July 15, 2007,
we could not analyze the impact of the internal control provisions of the
act for a significant number of smaller public companies (SEC estimates
that non-accelerated filers represent about 60 percent of all registered
public companies). 7 Thus, to gain some insight into the potential impact
these provisions may have on smaller public companies, we analyzed public
data and other information related to the experiences of public companies
that have fully implemented the act's provisions. To determine the act's
impact on smaller privately held companies, we interviewed officials about
state requirements comparable to key Sarbanes-Oxley provisions and
representatives of smaller private companies and financial institutions
about capital access requirements. We also analyzed data on companies'
initial public offering (IPO) and secondary public offering (SPO) from SEC
filings. To assess changes in the domestic public company audit market, we
used public data-for 2002 and 2004-on public companies and their external
accounting firms to determine how the number and mix of domestic public
company audit clients had changed for firms other than the large
accounting firms. As requested by your staff, we addressed nine specific
questions contained in your request letter.
Appendix I contains a more complete description of our scope and
methodology, including a cross-sectional comparison between the nine
specific questions contained in the request letter and the four objectives
of this report. We conducted our work in California, Connecticut, Georgia,
Maryland, New Jersey, New York, Virginia, and Washington, D.C., from
November 2004 through March 2006 in accordance with generally accepted
government auditing standards.
Results in Brief
While regulators, public companies, auditors, and investors generally
agree that the Sarbanes-Oxley Act has had a positive impact on investor
protection, available data indicate that smaller public companies face
disproportionately higher costs (as a percentage of revenues) in complying
with the act, consistent with the findings of the Small Business
Administration on the impact of regulations generally on small businesses.
While smaller companies historically have paid disproportionately higher
audit fees than larger companies as a percent of revenues, the percentage
difference between median audit fees paid by smaller versus larger public
companies grew in 2004, particularly for companies that implemented the
act's internal control provisions (section 404). Smaller public companies
also cited other costs of compliance with section 404 and other provisions
of the act, such as the use of resources for compliance rather than for
other business activities. Moreover, the characteristics of smaller
companies, including resource and expertise limitations and lack of
familiarity with formal internal control frameworks, contributed to the
difficulties and costs they experienced in implementing the act's
requirements. This situation was also impacted by the fact that many
companies documented their internal control for the first time and needed
to make significant improvements to their internal control as part of
their first year of implementing section 404, despite the fact that most
have been required by law since 1977 to have implemented a system of
internal accounting controls. Smaller public companies and accounting
firms noted that the complexity of the internal control framework and the
scope and complexity of the audit standard and related guidance for
auditors on section 404 issued during rather than prior to the initial
year of implementation contributed to the costs and challenges experienced
in the first year of implementation. 8 It is generally expected that
compliance costs for section 404 will decrease in subsequent years, given
the first-year investment in documenting internal controls. The act, along
with other market forces, appeared to have been a factor in the increase
in public companies deregistering with SEC (going private)-from 143 in
2001 to 245 in 2004. However, these companies were small by any measure
(market capitalization, revenue, or assets) and represented 2 percent of
public companies in 2004. Based on our survey responses and discussions
with smaller public companies that implemented section 404, it appears
that the act has not adversely affected the ability of those smaller
public companies to raise capital. However, it is too soon to assess fully
the impact of the act on access to capital, particularly because of the
large number of smaller public companies-the more than 5,900 small public
companies considered by SEC to be non-accelerated filers-that have been
given an extension by SEC to implement section 404.
In response to concerns that smaller public companies raised about
Sarbanes-Oxley Act requirements as implemented, particularly section 404,
SEC and PCAOB have undertaken efforts to help the companies meet the
requirements of the act. SEC initially provided those smaller public
companies that are non-accelerated filers with additional time to comply
with section 404 and subsequently extended the deadline several times,
with the latest extension to July 15, 2007. SEC also formed an Advisory
Committee on Smaller Public Companies to examine the impact of the act on
smaller public companies. On March 3, 2006, the committee issued an
exposure draft of its final report for public comment that contained
recommendations that, if adopted by SEC, would exempt up to 70 percent of
all public companies and 6 percent of U.S. equity market capitalization
from all or some of the provisions of section 404, "unless and until" a
framework for assessing internal control over financial reporting is
developed that recognizes the characteristics and needs for smaller public
companies. Specifically, the committee proposed that "microcap" companies
(companies with market capitalization below $128 million) with revenues
below $125 million and "smallcap" companies (companies with market
capitalization between $128 million and $787 million) with revenues below
$10 million would not have to comply with section 404(a) and section (b),
management's and the external auditor's assessment and reporting on
internal control over financial reporting, respectively. "Smallcap"
companies with revenues between $10 million and $250 million would not
have to comply with section 404(b), the external auditor's attestation on
management's internal control assessment and the effectiveness of internal
control over financial reporting. Following a public comment period, the
committee is scheduled to issue its final recommendations in April 2006,
at which time the recommendations would be considered by SEC.
Additionally, SEC asked COSO to develop guidance designed to assist
smaller public companies in using COSO's internal control framework in a
small business environment. COSO issued a draft for public comment in
October 2005, and plans to finalize the guidance in early 2006. While not
specifically focused on small business issues, SEC held a public
"roundtable" in April 2005, in which GAO participated, that gave public
companies and accounting firms an opportunity to provide feedback to SEC
and PCAOB on what went well and what did not during the first year of
section 404 implementation. In response, SEC and PCAOB issued additional
section 404 guidance in May 2005. PCAOB also issued a report on November
30, 2005, that detailed inefficiencies companies experienced in the
implementation of its auditing standard on internal control. SEC and PCAOB
plan to hold another roundtable on the second year of section 404
implementation in May 2006. However, because many efforts-particularly
SEC's response to the exemption recommendations and COSO's efforts to
provide guidance on using its internal control framework in a small
business environment-are ongoing, smaller public companies may be
deferring efforts to implement section 404 until such issues are resolved.
While the act does not impose new requirements on privately held
companies, companies choosing to go public must realistically spend time
and funds in order to demonstrate their ability to comply with the act,
section 404 in particular, to attract investors who will seek the
assurances and protections that compliance with section 404 provides. Such
requirements, along with other factors, may have been a contributing
factor in the reduced number of initial public offerings (IPO) issued by
small companies. However, the overall performance of the stock market and
changes in listing standards also likely affected the number of IPOs. From
1999 through 2004, IPOs by companies with revenues of $25 million or less
decreased substantially from 70 percent of all IPOs in 1999 to about 46
percent in 2004. For those privately held companies not intending to go
public, our research and discussions with representatives of financial
institutions suggested that financing sources were generally not imposing
requirements on private companies similar to those contained in the
Sarbanes-Oxley Act as a condition for obtaining access to capital or other
financial services. While a number of states proposed legislation with
provisions similar to the Sarbanes-Oxley Act following its passage, three
states passed legislation calling for private companies or nonprofit
organizations to adopt requirements similar to some of the act's corporate
governance provisions. In addition, our interviews and review of available
research indicate that some privately held companies have voluntarily
adopted some of the act's enhanced governance practices because they
believe these practices make pragmatic business sense. Specifically, they
have adopted practices such as CEO/CFO financial statement certification,
appointment of independent directors, corporate codes of ethics,
whistleblower procedures, and approval of nonaudit services by the board.
Smaller public companies have been able to obtain access to needed audit
services since the passage of the act; however, data show that a
substantial number of smaller public companies have moved from the large
accounting firms to mid-sized and small firms. Many of these moves
resulted from the resignation of a large accounting firm. The reasons for
these changes range from audit cost and service concerns cited by
companies to client profitability and risk concerns cited by accounting
firms, including capacity constraints and assessments of client risk. As a
result, mid-sized and small accounting firms increased their share of
smaller public company audits during 2002-2004. Our analysis of the risk
characteristics of the companies leaving the large accounting firms shows
that mid-sized and small accounting firms appear to be taking on a higher
percentage of public companies with accounting issues such as going
concern qualifications and other "risk" issues. Overall, mid-sized and
small accounting firms conducted 30 percent of the total number of public
company audits in 2004-up from 22 percent in 2002. However, the overall
market for audit services remains highly concentrated, with companies
audited by large firms representing 98 percent of total U.S. publicly
traded company sales (revenues). In the long run, the act may reduce some
of the competitive challenges faced by mid-sized and small accounting
firms. For example, mid-sized and small accounting firms could increase
opportunities to enhance their recognition and acceptance among capital
market participants as a result of operating under PCAOB's registration
and inspection process.
We have two concerns with certain draft recommendations from the Advisory
Committee on Smaller Public Companies related to internal control. Our
first concern relates to lack of specificity in the recommendations. While
calling for an internal control framework that recognizes the needs of
smaller public companies, the recommendations do not address what needs to
be done to establish such a framework or what such a framework might
include. In reviewing the implementation of section 404 for larger public
companies, we noted that many, if not most, of the significant problems
and challenges related to implementation issues rather than the internal
control framework itself. We think it is essential that public companies,
both large and small, have appropriate guidance on how to effectively
implement the internal control framework and assess and report on the
operating effectiveness of their internal control over financial
reporting. Our second concern relates to the ambiguity surrounding the
conditional nature of the "unless and until" provisions of the
recommendations and the potential impact that may result for a large
number of public companies that would qualify for either full or partial
exemption from the requirements of section 404. Our concerns also include
the additional time that may be needed to resolve the concerns of smaller
public companies and the impact any further regulatory relief may have in
delaying important investor protections associated with section 404.
When SEC begins its assessment of the final recommendations of its small
business advisory committee, it is essential that SEC balance the key
principle behind the Sarbanes-Oxley Act-investor protection-against the
goal of reducing unnecessary regulatory burden on smaller public
companies. This report recommends that, in considering the concerns of the
Advisory Committee on Smaller Public Companies regarding the ability of
smaller public companies to effectively implement section 404, SEC should
(1) assess whether the current guidance, particularly guidance on
management's assessment of internal control over financial reporting, is
sufficient or whether additional action is needed to help smaller public
companies meet the requirements of section 404; (2) coordinate with PCAOB
to help ensure that section 404-related audit standards and guidance are
consistent with any additional guidance applicable to management's
assessment of internal control and identify additional ways in which
auditors of public companies can achieve more economical, effective, and
efficient implementation of the standards and guidance related to internal
control over financial reporting; and (3) if further relief is deemed
appropriate, analyze and consider the unique characteristics of smaller
public companies and their investors in determining categories of
companies for which additional relief may be appropriate so that the
objectives of investor protection are adequately met and any relief is
targeted and limited.
We provided a draft of this report to the Chairman of SEC and the Acting
Chairman of PCAOB for review and comment. We received written comments
from SEC and PCAOB that are discussed in this report and reprinted in
appendixes III and IV. SEC agreed that the Sarbanes-Oxley Act has had a
positive impact on investor protection and confidence, and that smaller
public companies face particular challenges in implementing certain
provisions of the act, notably section 404. SEC stated that our
recommendations should provide a useful framework for consideration of its
advisory committee's final recommendations. PCAOB stated that it is
committed to working with SEC on our recommendations and that it is
essential to maintain the overriding purpose of the Sarbanes-Oxley Act of
investor protection while seeking to make its implementation as efficient
and effective as possible. Both SEC and PCAOB provided technical comments
that were incorporated into the report as appropriate.
Background
Responding to corporate failures and fraud that resulted in substantial
financial losses to institutional and individual investors, Congress
passed the Sarbanes-Oxley Act in 2002. As shown in table 1, the act
contains provisions affecting the corporate governance, auditing, and
financial reporting of public companies, including provisions intended to
deter and punish corporate accounting fraud and corruption. 9
The Sarbanes-Oxley Act generally applies to those companies required to
file reports with SEC under the Securities Exchange Act of 1934 and does
not differentiate between small and large businesses. 10 The definition of
small varies among agencies, but SEC generally calls companies that had
less than $75 million in public float non-accelerated filers. Accelerated
filers are required by SEC regulations to file their annual and quarterly
reports to SEC on an accelerated basis compared to non-accelerated filers.
As of 2005, SEC estimated that about 60 percent -5,971 companies-of all
registered public companies were non-accelerated filers. SEC recently
further differentiated smaller companies from what it calls "well-known
seasoned issuers"-those largest companies ($700 million or more in public
float) with the most active market following, institutional ownership, and
analyst coverage. 11
Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting
Public Companies and Registered Accounting Firms
Provision Main requirements
Section 101: Public Company Establishes the PCAOB to oversee the audit of
Accounting Oversight Board public companies that are subject to the
securities laws.
Section 201: Services Registered accounting firms cannot provide
Outside the Scope of certain nonaudit services to a public company
Practice of Auditors if the firm also serves as the auditor of the
financial statements for the public company.
Examples of prohibited nonaudit services
include bookkeeping, appraisal or valuation
services, internal audit outsourcing services,
and management functions.
Section 301: Public Company Listed company audit committees are
Audit Committees responsible for the appointment, compensation,
and oversight of the registered accounting
firm, including the resolution of
disagreements between the registered
accounting firm and company management
regarding financial reporting. Audit committee
members must be independent.
Section 302: Corporate For each annual and quarterly report filed
Responsibility for with SEC, the CEO and CFO must certify that
Financial Reports they have reviewed the report and, based on
their knowledge, the report does not contain
untrue statements or omissions of a material
fact resulting in a misleading report and
that, based on their knowledge, the financial
information in the report is fairly presented.
Section 404: Management This section consists of two parts (a and b).
Assessment of Internal First, in each annual report filed with SEC,
Controls company management must state its
responsibility for establishing and
maintaining an adequate internal control
structure and procedures for financial
reporting, and assess the effectiveness of its
internal control structure and procedures for
financial reporting. Second, the registered
accounting firm must attest to, and report on,
management's assessment of the effectiveness
of its internal control over financial
reporting.
Section 407: Disclosure of Public companies must disclose in periodic
Audit Committee Financial reports to SEC whether the audit committee
Expert includes at least one member who is a
financial expert and, if not, the reasons why.
Source: GAO.
Title I of the act establishes PCAOB as a private-sector nonprofit
organization to oversee the audits of public companies that are subject to
the securities laws. PCAOB is subject to SEC oversight. The act gives
PCAOB four primary areas of responsibility:
o registration of accounting firms that audit public companies in
the U.S. securities markets;
o inspections of registered accounting firms;
o establishment of auditing, quality control, and ethics
standards for registered accounting firms; and
o investigation and discipline of registered accounting firms for
violations of law or professional standards.
Title II of the act addresses auditor independence. It prohibits
the registered external auditor of a public company from providing
certain nonaudit services to that public company audit client.
Title II also specifies communication that is required between
auditors and the public company's audit committee (or board of
directors) and requires periodic rotation of the audit partners
managing a public company's audits.
Titles III and IV of the act focus on corporate responsibility and
enhanced financial disclosures. Title III addresses listed company
audit committees, including responsibilities and independence, and
corporate responsibilities for financial reports, including
certifications by corporate officers in annual and quarterly
reports, among other provisions. Title IV addresses disclosures in
financial reporting and transactions involving management and
principal stockholders and other provisions such as internal
control over financial reporting. More specifically, section 404
of the act establishes requirements for companies to publicly
report on management's responsibility for establishing and
maintaining an adequate internal control structure, including
controls over financial reporting and the results of management's
assessment of the effectiveness of internal control over financial
reporting. Section 404 also requires the firms that serve as
external auditors for public companies to attest to the assessment
made by the companies' management, and report on the results of
their attestation and whether they agree with management's
assessment of the company's internal control over financial
reporting.
SEC and PCAOB have issued regulations, standards, and guidance to
implement the Sarbanes-Oxley Act. For instance, both SEC
regulations and PCAOB's Auditing Standard Number 2, "An Audit of
Internal Control Over Financial Reporting Performed in Conjunction
with an Audit of Financial Statements" state that management is
required to base its assessment of the effectiveness of the
company's internal control over financial reporting on a suitable,
recognized control framework established by a body of experts that
followed due process procedures, including the broad distribution
of the framework for public comment. Both the SEC guidance and
PCAOB's auditing standard cite the COSO principles as providing a
suitable framework for purposes of section 404 compliance. In
1992, COSO issued its "Internal Control-Integrated Framework" (the
COSO Framework) to help businesses and other entities assess and
enhance their internal control. Since that time, the COSO
framework has been recognized by regulatory standards setters and
others as a comprehensive framework for evaluating internal
control, including internal control over financial reporting. The
COSO framework includes a common definition of internal control
and criteria against which companies could evaluate the
effectiveness of their internal control systems. 12 The framework
consists of five interrelated components: control environment,
risk assessment, control activities, information and
communication, and monitoring. While SEC and PCAOB do not mandate
the use of any particular framework, PCAOB states that the
framework used by a company should have elements that encompass
the five COSO components on internal control.
Internal control generally serves as a first line of defense in
safeguarding assets and preventing and detecting errors and fraud.
Internal control is defined as a process, effected by an entity's
board of directors, management, and other personnel, designed to
provide reasonable assurance regarding the achievement of the
following objectives: (1) effectiveness and efficiency of
operations; (2) reliability of financial reporting; and (3)
compliance with laws and regulations. Internal control over
financial reporting is further defined in the SEC regulations
implementing section 404. These regulations define internal
control over financial reporting as providing reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements, including those policies and
procedures that
o pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company;
o provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
conformity with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the
company; and
o provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the
financial statements.
PCAOB's Auditing Standard No. 2 reiterates this definition of
internal control over financial reporting. Internal control is not
a new requirement for public companies. In December 1977, as a
result of corporate falsification of records and improper
accounting, Congress enacted the Foreign Corrupt Practices Act
(FCPA). 13 The FCPA's internal accounting control requirements
were intended to prevent fraudulent financial reporting, among
other things. The FCPA required companies to: (1) make and keep
books, records, and accounts that in reasonable detail accurately
and fairly reflect the transactions and dispositions of assets and
(2) develop and maintain a system of internal accounting controls
sufficient to provide reasonable assurance over the recording and
executing of transactions, the preparation of financial statements
in accordance with standards, and maintaining accountability for
assets.
Smaller Public Companies Have Incurred Disproportionately Higher Audit
Costs in Implementing the Act, but Impact on Access to Capital Remains
Unclear
Based on our analysis, costs associated with implementing the
Sarbanes-Oxley Act-particularly those costs associated with the internal
control provisions in section 404-were disproportionately higher (as a
percentage of revenues) for smaller public companies. In complying with
the act, smaller companies noted that they incurred higher audit fees and
other costs, such as hiring more staff or paying for outside consultants,
to comply with the act's provisions. Further, resource and expertise
limitations that characterize many smaller companies as well as their
general lack of familiarity or experience with formal internal control
frameworks contributed to the challenges and increased costs they faced
during section 404 implementation. Along with other market factors, the
act may have encouraged a relatively small number of smaller public
companies to go private, foregoing sources of funding that were
potentially more diversified and may be less expensive for many of these
companies. However, the ultimate impact of the Sarbanes-Oxley Act on
smaller public companies' access to capital remains unclear because of the
limited time that the act has been in effect and the large number of
smaller public companies that have not yet fully implemented the act's
internal control provisions.
Smaller Public Companies Incurred Disproportionately Higher Audit Costs
Our analysis indicates that audit fees have increased considerably since
the passage of the act, particularly for those smaller public companies
that have fully implemented the act. Both smaller and larger public
companies have identified the internal control provisions in section 404
as the most costly to implement. However, audit fees may have also
increased because of the current environment surrounding public company
audits including, among other things, the new regulatory oversight of
audit firms, new requirements related to audit documentation, and legal
risk. Figure 1 contains data reported by public companies on audit fees
paid to external auditors before and after the section 404 provisions
became effective for accelerated filers in 2004. Based on this data, we
found that (1) audit fees already were disproportionately greater as a
percentage of revenues for smaller public companies in 2003 and (2) the
disparity in smaller and larger public companies' audit fees as a
percentage of revenues increased for those companies that implemented
section 404 in 2004. 14 For example, of the companies that reported
implementing section 404, public companies with market capitalization of
$75 million or less paid a median $1.14 in audit fees for every $100 of
revenues compared to $0.13 in audit fees for public companies with market
capitalization greater than $1 billion. 15 Among public companies with
market capitalization of $75 million or less (2,263 in total), the 66
companies that implemented section 404 paid a median $0.35 more per $100
in revenues compared to those that had not implemented section 404.
However, using publicly reported audit fees as an indicator of the act's
compliance costs has some limitations. First, the audit fees reported by
companies that complied with section 404 should include fees for both the
internal control audit and the financial statement audit. As a result, we
could not isolate the audit fees associated with section 404. Second, the
fees paid to the external auditor do not include other costs companies
incurred to comply with section 404 requirements, such as testing and
documenting internal controls and fees paid to external consultants. While
the spread between what smallest and largest public companies that
implemented section 404 paid as a percentage of revenue increased between
2003 and 2004, we also noted that, as a percentage of revenue, the
relative disproportionality between the audit fees paid by smaller public
companies and the largest public companies remained roughly the same
between 2003 and 2004. However, unlike audit fees, these costs are not
separately reported and, therefore, are difficult to analyze and measure.
Figure 1: Median Audit Fees as a Percentage of 2003 and 2004 Revenues
Reported by Public Companies as of Aug. 11, 2005
Note: Our analysis is based on companies' end of the fiscal year market
capitalization. SEC's criteria for categories of filers (accelerated
versus non-accelerated filers) are based on companies' public float as of
the end of their second quarter. Due to the timing difference, some of the
companies identified in this analysis as having market capitalization of
less than $75 million may have been accelerated filers under SEC's
criteria.
aIn addition to non-accelerated filers that were granted extensions, this
includes accelerated filers that had not filed their internal control
reports to SEC for reasons such as (1) the company's fiscal year ended
before November 15, 2004, which pushed their reporting date to late 2005
or early 2006, or (2) the company was delinquent in implementing section
404.
bSome of these companies were non-accelerated filers that decided to file
internal control reports voluntarily.
Smaller Public Companies Incurred Other Costs in Complying with the Act
According to executives of smaller public companies that we contacted,
smaller companies incurred substantial costs in addition to the fees they
paid to their external auditors to comply with section 404 and other
provisions of the act. For example, 128 of the 158 smaller public
companies that responded to our survey (81 percent of respondents) had
hired a separate accounting firm or consultant to assist them in meeting
section 404 requirements. Services provided included assistance with
developing methodologies to comply with section 404, documenting and
testing internal controls, and helping management assess the effectiveness
of internal controls and remediate identified internal control weaknesses.
These smaller companies reported paying fees to external consultants for
the period leading up to their first section 404 report that ranged from
$3,000 to more than $1.4 million. Many also reported costs related to
training and hiring of new or temporary staff to implement the act's
requirements. Additionally, some of the smaller companies that responded
to our survey reported that their CFOs and accounting staff spent as much
as 90 percent of their time for the period leading up to their first
section 404 report on Sarbanes-Oxley Act compliance-related issues.
Finally, many of the smaller public companies incurred missed "opportunity
costs" to comply with the act that were significant. For example, nearly
half (47 percent) of the companies that responded to our survey reported
deferring or canceling operational improvements and more than one-third
(39 percent) indicated that they deferred or cancelled information
technology investments.
While most companies, including the majority of the smaller public
companies that responded to our survey and that we interviewed, cited
section 404 as the most difficult provision to implement, smaller public
companies reported challenges in complying with other Sarbanes-Oxley Act
provisions as well. Nearly 69 percent of the smaller public companies that
responded to our survey said that the act's auditor independence
requirements had decreased the amount of advice that they received from
their external auditor on accounting- and tax-related matters. About half
the companies that responded to our survey indicated that they incurred
additional expenses by hiring outside counsel for assistance in complying
with various requirements of the act. Examples mentioned included legal
assistance with drafting charters for board committees, drafting a code of
ethics, establishing whistleblower protection, and reviewing CEO and CFO
certification requirements. About 13 percent of the smaller public
companies reported incurring costs to appoint a financial expert to serve
on the audit committee, and about 6 percent reported incurring costs to
appoint other independent members to serve on the audit committee. While
these types of costs were consistent with those reported for larger
companies, the impact on smaller public companies was likely greater given
their more limited revenues and resources.
Smaller Companies Have Different Characteristics Than Larger Companies,
Some of Which Contributed to Higher Implementation Costs
While public companies-both large and small-have been required to
establish and maintain internal accounting controls since the Foreign
Corrupt Practices Act of 1977, most public companies and their external
auditors generally had limited practical experience in implementing and
using a structured framework for internal control over financial reporting
as envisioned by the implementing regulations for section 404. 16 Our
survey of smaller public companies and our discussions with external
auditors indicated that the internal control framework-that is the COSO
framework-referred to in SEC's regulations and PCAOB's standards
implementing section 404 was not widely used by public companies,
especially smaller companies, prior to the Sarbanes-Oxley Act.
Many companies documented their internal controls for the first time as
part of their first year implementation efforts to comply with section
404. As a result, many companies probably underestimated the time and
resources necessary to comply with section 404, partly because of their
lack of experience or familiarity with the framework. These challenges
were undoubtedly compounded in companies that needed to make significant
improvements in their internal control systems to make up for deferred
maintenance of those systems. While this was largely true for both larger
and smaller companies, regulators (SEC and PCAOB), public accounting
firms, and others have indicated that smaller public companies often face
particular challenges in implementing effective internal control over
financial reporting. 17
Resource limitations make it more difficult for smaller public companies
to achieve economies of scale, segregate duties and responsibilities, and
hire qualified accounting personnel to prepare and report financial
information. Smaller companies are inherently less able to take advantage
of economies of scale because they face higher fixed per unit costs than
larger companies with more resources and employees. Implementing the
functions required to segregate transaction duties in a smaller company
absorbs a larger percentage of the company's revenues or assets than in a
larger company. About 60 percent of the smaller public companies that
responded to our survey said that it was difficult to implement effective
segregation of duties. Several executives told us that it was difficult to
segregate duties due to limited resources. According to COSO's draft
guidance for smaller public companies, smaller companies can develop and
implement compensating controls when resource constraints compromise the
ability to segregate duties. The American Institute of Certified Public
Accountants noted that smaller public companies often do not have the
internal audit functions referred to in COSO's internal framework
guidance. Other executives commented that it was difficult to achieve
effective internal control over financial reporting because they lacked
expertise within their internal accounting staff. For example, according
to an executive from a company that reported a material weakness in its
section 404 report, the financial accounting standards for stock options
were too complex for his staff and it was easier to have its auditor fix
the mistakes and cite the company for a material weakness in internal
control over financial reporting. Two other executives told us that their
auditors cited their companies with material weaknesses in internal
controls over financial reporting for not having appropriate internal
accounting staff; to remediate this weakness, the companies had to hire
additional staff.
According to COSO, however, some of the unique characteristics of smaller
companies create opportunities to more efficiently achieve effective
internal control over financial reporting and more efficiently evaluate
internal control which can facilitate compliance with section 404. These
opportunities can result from more centralized management oversight of the
business, and greater exposure and transparency with the senior levels of
the company that often exist in a smaller company. For instance,
management's hands-on approach in smaller companies can create
opportunities for less formal and less expensive communications and
control procedures without decreasing their quality. To the extent that
smaller companies have less complex product lines and processes, and/or
centralized geographic concentrations in operations, the process of
achieving and evaluating effective internal control over financial
reporting could be simplified.
According to SEC, another characteristic of smaller public companies is
that they tend to be much more closely held than larger public companies;
insiders such as founders, directors, and executive officers hold a high
percentage of shares in the companies. Further, CFOs of smaller public
companies frequently play a more integrated operational role than their
larger company counterparts. According to a recommendation by participants
at the September 2005 Government-Business Forum on Small Business Capital
Formation hosted by SEC, these types of shareholders are classic insiders
who do not need significant SEC protection. 18 According to SEC's Office
of Economic Analysis, among public companies with a market capitalization
of $125 million or less, insiders own on average approximately 30 percent
of the company's shares. Although the "insider" shareholders owners may
not have the same need for significant investor SEC protection as
investors in broadly held companies, minority shareholders who are not
insiders may have a need for such protection.
Complexity, Scope, and Timing of PCAOB Guidance also Appeared to Influence
Cost of Section 404 Implementation
Accounting firms and public companies also have noted that the scope,
complexity, and timing of PCAOB's Auditing Standard No. 2 contributed to
the challenges and higher costs in the first year of implementation of
section 404. PCAOB's Auditing Standard No. 2 establishes new audit
requirements and governs both the auditor's assessment of controls and its
attestation to management's report. PCAOB first issued an exposure draft
of the standard for comment by interested parties on October 7, 2003. The
Board received 194 comment letters from a variety of interested parties,
including auditors, investors, internal auditors, public companies,
regulators, and others. Due to the time needed to draft the standard,
evaluate the comment letters, and finalize the standard, PCAOB did not
issue the final standard until March 2004-more than 8 months after SEC
issued its final regulations on section 404 and part way into the initial
year of implementation for accelerated filers. SEC, which under the act is
responsible for approving standards issued by PCAOB, did not approve
Auditing Standard No. 2 until June 17, 2004. As a result of both timing
and unfamiliarity with PCAOB's Auditing Standard No. 2, auditors were not
prepared to integrate the internal control over financial reporting
attestation and financial audits in the first year of implementation as
envisioned by Auditing Standard No. 2.
Furthermore, according to PCAOB, auditors were not always consistent in
their interpretation and application of Auditing Standard No. 2. In
PCAOB's report on the initial implementation of Auditing Standard No. 2,
the Board found that both auditors and public companies faced enormous
challenges in the first year of implementation arising from the limited
time frames for implementing the new requirements; a shortage of staff
with prior training and experience in designing, evaluating, and testing
controls; and related strains on available resources. 19 The Board found
that some audits performed under these circumstances were not as effective
or efficient as they should have been. Auditing firms and a number of
public companies have stated that they expect subsequent years' compliance
costs for section 404 to decrease.
Costs Associated with the Sarbanes-Oxley Act May Have Impacted the
Decision of Some Smaller Public Companies to Go Private, but Other Factors
also Influenced Decision to Go Private
Since the passage of the act in July 2002, the number of companies going
private (that is, ceasing to report to SEC by voluntarily deregistering
their common stock) increased significantly. 20 As shown in figure 2, the
number of public companies that went private has increased significantly
from 143 in 2001 to 245 in 2004, with the greatest increase occurring
during 2003. 21 However, the 245 companies represented 2 percent of public
companies as of January 31, 2004. Based on the trends observed in 2003 and
2004 and the 80 companies that went private in the first quarter of 2005,
we project that the number of companies going private will have risen more
than 87 percent, from the 143 in 2001 to a projected 267 through the end
of 2005. Our analysis also indicated that companies going private during
this entire period were disproportionately small by any measure (market
capitalization, revenue, or assets).
Figure 2: Total Number of Companies Identified as Going Private, 1998-2005
Note: Includes companies that deregistered, but continued to trade over
the less-regulated Pink Sheets ("went dark") and shell companies and blank
check companies. Does not include companies that filed for, or are
emerging from, bankruptcy, have liquidated or are in the process of
liquidating, were headquartered in a foreign country, or were acquired by
or merged into another company unless the transaction was initiated by an
affiliate of the company and the company became a private entity. See
appendix II for a fuller discussion of our analysis.
The costs associated with public company status were most often cited as a
reason for going private (see table 2). While there are many reasons for a
company deregistering-including the inability to benefit from its public
company status-the percentage of deregistered companies citing the direct
cost associated with maintaining public company status grew from 12
percent in 1998 to 62 percent during the first quarter of 2005. These
costs include the accounting, legal, and administrative costs associated
with compliance with SEC's reporting requirements as well as other
expenses such as those related to managing shareholder accounts. The
number of companies citing indirect costs, such as the time and resources
needed to comply with securities regulations, also has increased since the
passage of the Sarbanes-Oxley Act. 22 In 2002, 64 companies that went
private cited cost as one of the reasons for the decision; however, that
number increased to 143 and 130 companies in 2003 and 2004, respectively.
Many of the companies mentioned both the direct and indirect costs
associated with maintaining their public company status. Over half of the
companies that cited costs mentioned the Sarbanes-Oxley Act specifically
(roughly 58 percent in 2004 and 2005 and 41 percent in 2003). For smaller
public companies, the costs of complying with securities laws likely
required a greater portion of their revenues, and cost considerations
(indirect and direct) were the leading reasons for companies exiting the
public market, even prior to the enactment of the Sarbanes-Oxley Act. 23
Table 2: Primary Reasons Cited by Companies for Going Private, 1998-2005,
by Percent
Direct Indirect Market/liquidity Private Critical Other No
costs costs issues company business reason
benefits issues
1998 12.3 5.3 14.0 26.3 15.8 3.5 54.4
1999 33.3 12.2 33.3 42.2 8.9 3.3 37.8
2000 20.0 11.1 32.2 37.8 20.0 5.6 38.9
2001 32.2 13.3 31.5 23.8 20.3 3.5 49.0
2002 44.4 13.9 35.4 22.9 16.0 1.4 45.1
2003 57.8 27.5 38.5 21.3 19.7 0.8 31.6
2004 52.7 25.7 28.6 15.9 15.5 1.2 38.4
2005 62.2 28.9 28.9 8.9 12.2 27.8
Q1
Source: GAO analysis of SEC filings and relevant press releases.
Note: See appendix II for a more detailed description of the categories
and limitation for this analysis. Because companies were able to cite more
than one reason for going private, the percentages may add up to more than
100 for each year.
Further, the benefits of public company status historically appeared to
have been disproportionately smaller for smaller companies, companies with
limited need for external funding, and companies whose public shares were
traded infrequently or in low volume at low prices. 24 As a result, issues
unrelated to the Sarbanes-Oxley Act, such as market and liquidity issues
and the benefits of being private, are also major reasons for companies
going private. From 1999 to 2004, more companies cited market and
liquidity issues than the indirect costs associated with maintaining their
public company status. Companies in this category cited a wide variety of
issues related to the company's publicly traded stock such as a lack of
analyst coverage and investor interest, poor stock market performance,
limited liquidity (trading volume), and inability to use the secondary
market to raise additional capital. 25 Smaller companies also have cited
advantages of private status such as greater flexibility, freedom from the
short-term pressures of Wall Street, belief that the markets had
consistently undervalued the company, and the ability to avoid disclosures
of information that might benefit their competitors (see app. II).
Companies that elect to go private reduce the number of financing options
available to them and must rely on other sources of funding. In aggregate,
equity is cheaper when it is supplied by public sources, net of any costs
of regulatory compliance. However, in some circumstances, private equity
or bank lending may be preferable alternatives to the public market.
Statistics suggest bank loans are the primary source of funding for U.S.
companies that rely on external financing. Some companies with
insufficient market liquidity had little opportunity for follow-on stock
offerings and going private would not have fundamentally altered the way
they raised capital. We found that almost 25 percent of the companies that
deregistered from 2003 through the end of the first quarter of 2005 were
not trading on any market at all (see fig. 3). Approximately 37 percent of
the companies that went private during this period were traded on the
Over-the-Counter Bulletin Board (OTCBB); the general liquidity of this
market is significantly less than major markets traded on the NASDAQ Stock
Market, Inc. (NASDAQ) or the New York Stock Exchange (NYSE). 26
Additionally, 14 percent were traded in the Pink Sheets and, therefore,
were most likely closely held and traded sporadically, if at all. Pink
Sheets LLC is not registered with SEC, has no minimum listing standards,
does not require quoted companies to provide detailed information to its
investors, and is regarded as high-risk by many investors. As a result,
trading on the Pink Sheets may produce negative reputational effects that
can further reduce liquidity and the market value of the company's stock,
thereby increasing the cost of equity capital. 27
Figure 3: Where Companies Traded Prior to Deregistration, July 2003-March
2005
It Is Too Soon to Determine How Sarbanes-Oxley Affected Access to Capital
for Smaller Public Companies
As previously discussed, a large number of smaller public companies have
not fully implemented all the requirements of the Sarbanes-Oxley Act,
notably non-accelerated filers (public companies with less than $75
million in public float). As a result, it is unlikely that the act has
affected access to the capital markets for these companies. Moreover, the
limited time that the act's provisions have been in force would limit any
impact on access to capital, even for the companies that have implemented
section 404. For instance, more than 80 percent of the smaller public
companies that responded to our survey indicated that the act has had no
effect or that they had no basis to judge the effect of the act on their
ability to raise equity or debt financing or on their cost of capital.
There are indications that the Sarbanes-Oxley Act at a minimum has
contributed to some smaller companies rethinking the costs and benefits of
public company status. For example, more than 20 percent of the smaller
companies that responded to our survey also stated that the act encouraged
them to consider going private or deregistering. In contrast, a number of
the smaller public companies that responded to our survey cited positive
effects associated with the implementation of the act, notably positive
impacts on audit committee involvement (60 percent), company awareness of
internal controls (64 percent), and documentation of business processes
(67 percent).
SEC and PCAOB Have Been Addressing Smaller Company Concerns Associated
with the Implementation of Section 404
SEC and PCAOB have taken actions to address smaller public company
concerns about implementation of Sarbanes-Oxley Act provisions,
particularly section 404, by giving smaller companies more time to comply,
issuing or refining guidance, increasing communication and education
opportunities, and establishing an advisory committee on smaller public
companies. In particular, SEC has extended deadlines for complying with
section 404 requirements several times since issuing its final rule in
2003 (see table 3). In its final rulemaking on section 404 requirements,
SEC stated that it was sensitive to concerns that many smaller public
companies would experience difficulty in evaluating their internal control
over financial reporting because these companies might not have as formal
or well-structured a system of internal control over financial reporting
as larger companies. In November 2004, SEC granted "smaller" accelerated
filers an additional 45 days to file their reports on internal control
over financial reporting out of concern that these companies were not in a
position to meet the original deadline. SEC granted non-accelerated filers
two additional extensions in March 2005 and September 2005, with the
latter extension giving non-accelerated filers until their first fiscal
year after July 2007 before having to report under section 404. SEC also
considered the particular challenges facing smaller companies when
granting these extensions. Further, SEC noted that there were other small
business initiatives underway that could improve the effectiveness of
non-accelerated company filers' implementation of the section 404
reporting requirements.
Table 3: SEC Extensions of Section 404 Compliance Dates
Action Date Description
Final rule June 5, 2003 SEC's rationale
SEC adopted an extended transition
period for compliance so that companies
and their auditors would have time to
prepare and satisfy the new
requirements.
The transition period would provide
additional time for PCAOB to develop
the new auditing standard for internal
control over financial reporting.
Compliance dates
An accelerated filer (generally, a U.S.
company that has public equity float of
more than $75 million and has filed at
least one annual report with SEC) was
required to comply for its first fiscal
year ending on or after June 15, 2004.
A non-accelerated filer was required to
comply for its first fiscal year ending
on or after April 15, 2005.
Final rule; February 24, 2004 SEC's rationale
extension of
compliance dates The extension would minimize the cost
and disruption of implementing a new
disclosure requirement.
The extension would provide companies
and their auditors with a sufficient
amount of time to perform additional
testing or remediation of controls
based on the final auditing standard.
Compliance dates
An accelerated filer was required to
comply for its first fiscal year ending
on or after November 15, 2004.
A non-accelerated filer was required to
comply for its first fiscal year ending
on or after July 15, 2005.
Exemptive order November 30, 2004 SEC's rationale
SEC was concerned that many smaller
accelerated filers were not in a
position to meet the compliance dates.
Compliance dates
Subject to certain conditions, a
smaller accelerated filer (generally, a
U.S. company with public float of less
than $700 million) was granted an
additional 45 days to comply.
The compliance dates for
non-accelerated filers did not change.
Final rule; March 2, 2005 SEC's rationale
extension of
compliance dates In December 2004, SEC established an
advisory committee to, among other
things, assess the impact of the
Sarbanes-Oxley Act on smaller public
companies. The extension was intended
to give the committee additional time
to conduct its work.
In January 2005, COSO established a
task force to provide guidance on how
the COSO framework could be applied to
smaller companies. The extension would
give smaller public companies time to
consider the new COSO guidance, which
COSO intended to publish during the
summer of 2005.
Compliance dates
The compliance dates for accelerated
filers did not change.
A non-accelerated filer was required to
comply for its first fiscal year ending
on or after July 15, 2006.
Final rule; September 22, SEC's rationale
extension of 2005
compliance dates The extension was warranted due to
ongoing efforts by the COSO task force
and SEC's advisory committee.
In August 2005, the advisory committee
recommended that SEC extend section 404
compliance dates for non-accelerated
filers. The extension was consistent
with the advisory committee's
recommendation.
Compliance dates
The compliance dates for accelerated
filers did not change.
A non-accelerated filer is required to
comply for its first fiscal year ending
on or after July 15, 2007.
Source: GAO analysis of SEC regulatory actions.
While SEC's final rule serves as basic guidance for public company
implementation of section 404 requirements, PCAOB's Auditing Standard
Number 2 provides the auditing standards and requirements for an audit of
the financial statements and internal control over financial reporting, as
part of an integrated audit. It is a comprehensive document that addresses
the work required by the external auditor to audit internal control over
financial reporting, the relationship of that work to the audit of the
financial statements, and the auditor's attestation on management's
assessment of the effectiveness of internal control over financial
reporting. The standard requires technical knowledge and professional
expertise to effectively implement.
While both SEC regulations and the PCAOB standard refer to COSO's internal
control framework, many companies were unfamiliar with or did not use this
framework, despite the fact that public companies have been required by
law to have implemented a system of internal accounting controls since
1977. According to SEC, smaller public companies and their auditors had
expressed concern that the COSO internal control framework was designed
primarily for larger public companies and smaller companies lacked
sufficient guidance on how they could use COSO's internal control
framework, resulting in disproportionate section 404 implementation costs.
As a result, SEC staff asked COSO to develop additional guidance to assist
smaller public companies in implementing COSO's internal control framework
in a small business environment. In October 2005, COSO issued a draft of
the guidance for public comment, and anticipated issuing final guidance
for smaller public companies in early 2006. The draft guidance outlined 26
principles for achieving effective internal control over financial
reporting and provides examples on how companies can implement them. The
draft guidance states that the fundamental concepts of good internal
control over financial reporting are the same whether the company is large
or small. At the same time, the draft guidance points out differences in
approaches used by smaller companies versus their larger counterparts to
achieve effective internal control over financial reporting and discusses
the unique challenges faced by smaller companies. While intended to
provide additional clarity to smaller companies for implementing an
internal control framework, the guidance has received mixed reviews with
some questioning whether it will significantly change the disproportionate
cost and other burdens for smaller public companies associated with
section 404 compliance. 28
In December 2004, SEC announced its intention to establish its Advisory
Committee on Smaller Public Companies to assess the current regulatory
system for smaller companies under the securities laws, including the
impact of the Sarbanes-Oxley Act. In addition to granting companies more
time to meet the act's requirements, SEC has been considering how its
section 404 guidance and overall approach to implementation might be
revised. SEC chartered the advisory committee on March 23, 2005. The
committee plans to issue its final report to SEC by April 2006.
On March 3, 2006, the committee published an exposure draft of its final
report for public comment that contained 32 recommendations related to
securities regulation for smaller public companies. 29 Due to the number
of recommendations, the advisory committee refers to its 14 highest
priority recommendations as "primary recommendations." One of its primary
recommendations is an overarching recommendation calling for a "scaled"
approach to securities regulation, whereby smaller public companies are
stratified into two groups, "microcap" and "smallcap" companies. Under
this recommendation, microcap companies would consist of companies whose
common stock in the aggregate make up the lowest 1 percent of U.S. equity
market capitalization. The advisory committee estimates, based on data
from SEC's Office of Economic Analysis, that the microcap category would
include public companies whose individual market capitalization is less
than $128 million, approximately 53 percent of all U.S. public companies.
For the smallcap category, the advisory committee estimates that the
category would include public companies whose individual market
capitalization is less than $787 million and greater than $128 million,
and would encompass an additional 26 percent of U.S. public companies and
an additional 5 percent of U.S. market capitalization. Taken together, the
categories of microcap and smallcap companies, as defined by the advisory
committee draft recommendations, would include approximately 79 percent of
all U.S. public companies and 6 percent of market capitalization,
according to the advisory committee's analysis of SEC data. The
recommendation calling for a scaled approach for securities regulation
based on company size was also incorporated into the committee's
preliminary recommendations related to internal control over financial
reporting.
While acknowledging that some have questioned whether smaller public
companies' problems with section 404 have been overstated, the advisory
committee concluded that section 404, as currently structured, "represents
a clear problem for smaller public companies and their investors, one for
which relief is urgently needed." 30 In part, the advisory committee based
its conclusion on a belief that smaller public company compliance with
section 404 has resulted in disproportionate costs and less certain
benefits.
The advisory committee's primary recommendations related to internal
control over financial reporting address regulatory relief from section
404 for a subset of the microcap and smallcap categories described above
by the inclusion of revenue criteria. 31 Specifically, the committee's
preliminary recommendations are that:
o Unless and until a framework for assessing internal control
over financial reporting for such companies is developed that
recognizes their characteristics and needs, provide exemptive
relief from all of the requirements of section 404 of the
Sarbanes-Oxley Act to microcap companies with less than $125
million in annual revenue and to smallcap companies with less than
$10 million in annual product revenue. 32
o Unless and until a framework for assessing internal control
over financial reporting for smallcap companies is developed that
recognizes the characteristics and needs of those companies,
provide exemptive relief from section 404(b) of the act-the
external auditor involvement in the section 404 process-to
smallcap companies with less than $250 million but greater than
$10 million in annual product revenues and microcap companies with
between $125 million and $250 million in annual revenues.
By including the revenue criteria, the committee's recommendations
regarding section 404 cover a subset of the public companies
included within its microcap and smallcap definitions. The
committee estimated that, after applying the revenue criteria,
4,641 "microcap" public companies (approximately 49 percent of
9,428 public companies identified in data developed for the
advisory committee by SEC's Office on Economic Analysis) may
potentially qualify for full exemption from section 404 and
another 1,957 "smallcap" public companies (approximately 21
percent of the SEC-identified public companies)-a total of 70
percent of SEC-identified public companies-may potentially qualify
for exemption from the external audit requirement of section
404(b). 33 It is likely that a number of public companies that
would qualify for exemptive relief under the committee's
recommendations have probably already complied with both sections
of 404(a) and (b), based on their status as accelerated filers.
If adopted, these recommendations would effectively establish a
"tiered approach" for compliance with section 404, "unless and
until" a framework for assessing internal control over financial
reporting is developed for microcap and smallcap companies. Under
the tiered approach, larger public companies that do not meet the
committee's size criteria for exemption would continue to be
required to comply with both section 404(a)-management's
assessment of and reporting on internal control over financial
reporting-and section 404(b)-the external auditors' attestation on
management's assessment and the effectiveness of the company's
internal control. "Smallcap" public companies that meet the
revenue criteria would be exempt from complying with section
404(b), but the companies would still be required to comply with
section 404(a). "Microcap" and some "smallcap"companies that meet
the revenue criteria would be entirely exempt from both section
404(a) and (b). 34 The committee's two primary recommendations
related to regulatory relief from section 404 for smaller public
companies also include additional requirements that affected
public companies apply additional corporate governance provisions
and report publicly on known material internal control weaknesses.
35
In its next primary recommendation on internal control over
financial reporting, which is premised on the adoption of the
recommendation for microcap companies described above, the
committee acknowledged that SEC might conclude, as a matter of
public policy, that an audit requirement is necessary for smallcap
companies. In that case, the committee recommended SEC provide for
the external auditor to perform an audit of only the design and
implementation of internal control over financial reporting, which
by its nature would be more limited than the audit of the
effectiveness of internal control over financial reporting
required by section 404(b) and PCAOB's Auditing Standard No. 2,
and that PCAOB develop a new auditing standard for such an
engagement. While this recommendation is based on the view that
having the external auditor perform a review of the design and
implementation of internal control over financial reporting would
be more cost-effective than the work otherwise required under
Auditing Standard No. 2, the committee's report does not address
the extent to which costs for such a review would be lower than
that required under Auditing Standard No. 2 and whether the lower
costs would be worth the reduced assurances provided by reduced
scope of the external auditors' work on internal control over
financial reporting.
While not specifically focused on small business issues, SEC also
conducted a public "roundtable" in April 2005 that gave public
companies, accounting firms, and others an opportunity to provide
feedback to SEC and PCAOB on what went well and what did not
during the first year of section 404 implementation. GAO also
participated in this roundtable. Following the roundtable, the SEC
and PCAOB Chairmen noted the importance of section 404
requirements but acknowledged that initial implementation costs
had been higher than expected and noted the need to improve the
cost-benefit equation for small and mid-sized companies. Both
agencies issued additional guidance in May 2005 based on findings
from the roundtable. PCAOB's guidance clarified that auditors (1)
should integrate their audits of internal control over financial
reporting with their audits of the client's financial statements,
(2) exercise judgment and tailor their audit plans to best meet
the risks faced by their clients rather than relying on
standardized "checklists," (3) use a top-down approach beginning
with company-level controls and use the risk assessment required
by the standard, (4) take advantage of the work of others, and (5)
engage in direct and timely communication with their audit
clients, among other matters. Guidance by SEC and its staff
emphasized the need for reasonable assurance, risk-based
assessments, better communication between the auditor and client,
and clarified what should be in material weakness disclosures.
Representatives of the smaller public companies that we
interviewed indicated that the additional guidance that SEC and
PCAOB issued was helpful. SEC and PCAOB plan to hold a second
roundtable in May 2006 to discuss companies' second year
experiences with implementing section 404. Both chairs of SEC and
PCAOB have said that they would consider additional guidance if
necessary.
On November 30, 2005, PCAOB also issued a report on the initial
implementation of its auditing standard on internal control over
financial reporting. 36 The report included observations by
PCAOB-based in significant part, but not exclusively, on its
inspections of public accounting firms, which in the 2005 cycle
included a review of a limited selection of audits of internal
control over financial reporting-on why the internal control
audits were not as efficient or effective as the standard
intended. PCAOB also amplified the previously issued guidance of
May 2005, discussing how auditors could achieve more effective and
efficient implementation of the standard.
Further, PCAOB has held a series of forums nationwide to educate
the small business community on the PCAOB inspections process and
the new auditing standards. The goal of the forums was to provide
small accounting firms and smaller public companies an opportunity
to discuss PCAOB-related issues with Board members and staff.
PCAOB also established a Standing Advisory Group to advise PCAOB
on standard-setting priorities and policy implications of existing
and proposed standards. The Standing Advisory Group has considered
ways to improve the application of its internal control over
financial reporting requirements-Auditing Standard No. 2-with
respect to audits of smaller public companies.
Finally, both SEC and PCAOB have acknowledged the challenges that
smaller public companies faced and continue to face in
implementing section 404 and have begun to address those
challenges. SEC also has emphasized that smaller companies need to
focus on the quality of their internal control over financial
reporting. Data provided by SEC's Office of Economic Analysis and
other studies have pointed to the increased level of restatements
as an indicator that the Sarbanes-Oxley Act-section 404 in
particular-has gotten companies to identify and correct weaknesses
that led to financial reporting misstatements in prior fiscal
years. For example, according to recent research conducted by
Glass, Lewis and Co., the restatement rate for smaller public
companies was more than twice the rate for the largest public
companies (9 percent for companies with revenues of less than $500
million and 4 percent for companies with more than $10 billion).
37 SEC staff also noted that smaller public companies had a
disproportionately higher rate of material weaknesses in internal
control over financial reporting during the first year of
implementing section 404. Our discussions with accounting firms
confirmed that smaller public companies have had a higher rate of
reported material weaknesses in internal control over financial
reporting than larger public companies.
A major challenge in considering any regulatory relief from
section 404 is that the overriding purpose of the Sarbanes-Oxley
Act is investor protection. Investor confidence in the integrity
and reliability of financial reporting is a critical element for
the efficient functioning of our capital markets. The purpose of
internal control over financial reporting is to provide reasonable
assurance over the integrity and reliability of the financial
statements and related disclosures. Market reactions to financial
misstatements illustrate the importance of accurate financial
reporting, regardless of a company's size.
Given the anticipated regulatory changes, particularly those
relating to section 404's internal control reporting requirements,
smaller public companies may be limiting or not taking definitive
actions to improve internal control over financial reporting based
on a perception that they could become exempt from section 404.
Further, PCAOB officials noted that such a perception may have
limited smaller business involvement in PCAOB forums.
Sarbanes-Oxley Act Requirements Minimally Affected Smaller Private
Companies, Except for Those Seeking to Enter the Public Market
While the act does not impose new requirements on privately held
companies, companies choosing to go public realistically must spend
additional time and funds in order to demonstrate their ability to comply
with the act, section 404 in particular, to attract investors. 38 This may
have been a contributing factor in the reduction of the number of initial
public offerings (IPO) issued by small companies since 2002. However,
other factors-stock market performance and changes in listing
standards-likely also have affected the number of IPOs. While a number of
states proposed legislation with provisions similar to the Sarbanes-Oxley
Act, three states 39 actually enacted legislation requiring private
companies or nonprofit organizations to adopt requirements similar to
certain Sarbanes-Oxley Act provisions. Finally, some privately held
companies have been adopting the act's enhanced governance practices
because these companies believe these practices make good business sense.
Sarbanes-Oxley May Have Affected IPO Activity; however, Other Important
Factors also Influence Entry into the Public Market and Access to Capital
Small businesses that are not public companies typically rely on a variety
of sources to finance their operations, including personal savings, credit
cards, and collateralized bank loans. In addition, small businesses can
use private equity capital sources such as venture capital funds-private
partnerships that provide private equity financing to early- and
later-stage high-growth small businesses-to fund their growth. Small
businesses may also issue equity shares to other types of investors to
finance further growth. These shares may be sold through private
placements where shares are sold directly to investors (direct placement)
or through a public offering where the shares are sold through an
underwriter (going public). 40 In addition, some small companies issue
equities that trade on smaller markets such as the Pink Sheets. 41 For
those private companies desiring to enter the public market, the IPO
process has always been recognized as a time-consuming and expensive
endeavor.
However, venture capitalists and private company officials told us that,
as a result of the act and other market factors, many private companies
have been spending additional time, effort, and money to convince
investors that they can meet the requirements of the act. For example,
investors have become more cautious and demanding of the private companies
in which they invest. Consequently, private companies have hired auditors
and additional staff to make substantial changes to their financial system
and data-reporting capabilities, document internal controls and processes,
and review or change accounting procedures.
According to venture capitalists and private company officials with whom
we spoke, a private company's ability to meet the Sarbanes-Oxley Act's
requirements can significantly decrease some of the investment risk
associated with becoming a public company. For example, both groups told
us that companies with well-documented internal control and governance
policies were more attractive and able to secure investor funding at a
much lower cost. Moreover, they noted that underwriters expected private
companies to consider and comply with the act well in advance of going
public. If a private company were unable to meet the act's requirements,
venture capitalists would want the company to show evidence of a plan for
becoming compliant as soon as the company became public. If not, venture
capitalists noted that they would be less likely to invest in such a
company and look elsewhere for investment opportunities.
These new expectations may have served to increase the expenses associated
with the IPO process through changes in the professional fees charged by
auditors and potentially other costs as well. Specifically, we found that
there has been a disproportionate increase for the smallest companies when
IPO expenses were viewed as a percentage of revenue. As shown in table 4,
the direct expenses (excluding underwriting fees) associated with the IPO
represented a significant portion of a small company's revenues, relative
to larger companies, from 1998 through the second quarter of 2005. These
expenses have increased disproportionably since 2002 for small companies
going public-especially for the smallest of these companies ($25 million
or less in revenues). While Sarbanes-Oxley Act requirements could explain
some of this increase, legal, exchange listing, printing, and other fees
unrelated to the act could also account for this increase. Moreover, other
market factors also could explain the increase in IPO expenses paid to
auditors. 42
Table 4: IPO Direct Expenses as a Percentage of Company's Revenues, by
Size
$25 $25 -100 $100-250 $250-500 $500 million- Greater All
million million million million 1 billion than $1 companies
or less billion
1998 12.5 3.0 1.2 0.6 0.3 0.2 0.9
1999 17.6 3.7 1.8 0.7 1.2 0.1 0.9
2000 21.3 3.3 1.9 0.8 0.3 0.1 0.6
2001 14.3 3.0 1.1 0.8 0.5 0.1 0.2
2002 10.6 3.1 1.1 0.6 0.3 0.1 0.1
2003 17.5 5.0 1.5 0.7 0.4 0.5 0.9
2004 25.9 4.9 2.2 1.5 0.4 0.3 1.3
2005 28.1 5.3 1.5 1.2 0.6 0.3 1.0
(Q1-Q2)
1998 - 18.2 3.8 1.7 0.9 0.5 0.1 0.4
2005 Q2
Source: GAO analysis of data from SEC filings.
Note: Includes only companies with financial data available. In some
cases, pro forma or un-audited revenue data were used. There can be
significant lag between the dates when a company initially files for an
IPO and when the stock of the company is finally priced (begins trading).
The number of priced IPOs only includes those companies that initially
filed for an IPO after November 1, 1997. See appendix I for more details.
In addition to the requirements of the Sarbanes-Oxley Act and the general
increase in direct expenses, other important factors likely have
influenced IPO activity. To illustrate, the downward trend in IPOs
occurred before the passage of the Sarbanes-Oxley Act in mid-2002. It is
widely acknowledged that IPO filings and pricings tend to be closely
associated with stock market performance. As shown in figure 4, companies
generally issued (priced) significantly more IPOs when stock market
valuations were higher.
Figure 4: IPO and Stock Market Performance, 1998-2005
Note: The number of priced IPOs only includes those companies that
initially filed for an initial public offering after November 1, 1997. For
more information, see appendix II.
Companies with smaller reported revenues now make up a smaller share of
the IPO market. The number of IPOs by companies with revenues of $25
million or less decreased substantially, from 70 percent of all IPOs in
1999 to about 48 percent in 2004 and 31 percent during the first two
quarters of 2005. Venture capitalists told us that, on average, a private
company had to demonstrate at least 6 quarters of profitability before it
could go public and hire an auditor to carry it through the IPO process.
According to the venture capitalists, an increasing number of small and
mid-sized private companies have been pursuing mergers and acquisitions as
a means of growing without going through the IPO process, which now
typically costs more than a merger or acquisition.
Potential Spillover Effects of the Sarbanes-Oxley Act on Private Companies
Have Been Minimal
While the Sarbanes-Oxley Act has increased corporate governance and
accountability awareness throughout business and investor communities, our
research and discussions with representatives of financial institutions
suggest that financiers are not requiring privately held companies to meet
Sarbanes-Oxley Act requirements as a condition to obtaining access to
capital or other financial services. For example, the representatives said
they emphasize utilization of credit scoring to make decisions and may
make lending decisions using "personal guarantees" in lieu of audited
financial statements and reported cash flow on financial statements for
the smallest private companies. For larger private companies, the
representatives stated that they require audited financial statements and
cash flow information, but that their lending requirements existed well
before the Sarbanes-Oxley Act and have not changed as a result of its
passage. Overall, they noted that they do not believe that the act has
affected the way financial institutions and lenders conduct business with
private companies. They also noted that financial institutions and lenders
have always enjoyed the freedom to obtain virtually any information about
a potential borrower and to inquire about the company's financial
reporting process and corporate governance practices. For example, if it
were considered necessary to help determine a company's ability repay a
debt, a lender could ask the company to provide copies of any corporate
governance guidelines, business ethics policies, and key committee
charters that the company had adopted.
Immediately following the act's passage, several states proposed
legislation to enact corporate governance and financial reporting reforms
for private companies and nonprofit organizations. Specifically, several
state legislatures proposed instituting requirements similar to those in
the Sarbanes-Oxley Act for privately held state-registered companies.
Subsequently, three states-Illinois, Texas, and California-passed
legislation that mandates corporate governance and accountability
requirements that resemble certain provisions of the Sarbanes-Oxley Act.
For example, Illinois passed legislation in 2004 that requires enhanced
disclosures for certain nonpublic companies and additional licensing
requirements for certified public accountants and, in 2003, Texas passed
legislation that imposes strict ethics and disclosure requirements for
outside financial advisors and service providers, public or private, that
provide financial services to the state government. On September 29, 2004,
California adopted the Nonprofit Integrity Act of 2004, becoming the first
state in the nation to require nonprofit organizations to meet
requirements that resemble some provisions of the Sarbanes-Oxley Act. For
instance, nonprofits with gross revenues of $2 million or more operating
within the state of California currently are required to have independent
auditors and, in the case of charitable corporations, audit committees.
Further, two other states-Nevada and Washington-have passed legislation
that require accounting firms to retain work papers for 7 years for audits
of both public and private companies. Furthermore, based on our research
and discussions with representatives from the National Association of
State Boards of Accountancy, we found that some state boards made changes
to regulations that focus on key governance and accountability issues
similar to those mandated by the Sarbanes-Oxley Act. For example, New
Jersey adopted enhanced peer review requirements and Tennessee instituted
additional work paper retention requirements for certified public
accountants.
Based on our discussions with private equity providers and private company
officials, it appears that some privately held companies increasingly have
incorporated certain elements of the Sarbanes-Oxley Act into their
governance and internal control policies. Specifically, they have adopted
practices such as CEO/CFO financial statement certification, appointment
of independent directors, corporate codes of ethics, whistleblower
procedures, and approval of nonaudit services by the board. According to
these officials, some private companies have reported receiving pressure
from board members, auditors, attorneys, and investors to implement
certain "best practice" policies and guidelines, modeled after the
requirements of the act. They noted that the act has raised the bar for
what constitutes best practices in corporate governance and for
expectations regarding internal control. Additionally, the officials told
us that some private companies may have chosen to voluntarily adopt
certain practices that resemble Sarbanes-Oxley Act provisions to satisfy
external auditors and legal counsel looking for comparable assurances to
reduce risk, increase confidence, and improve credibility with many
stakeholders. Based on our research, we found that many of the aspects of
corporate governance reform currently being adopted by private companies
were those relatively inexpensive to implement, but information on the
specific costs associated with adopting these provisions was not
available.
Smaller Companies Appear to Have Been Able to Obtain Needed Auditor
Services, Although the Overall Audit Market Remained Highly Concentrated
Since the enactment of the Sarbanes-Oxley Act, smaller public companies
have been able to obtain needed auditor services; however, auditor changes
suggest smaller companies have moved from using the services of a large
accounting firm to using services of mid-sized and small firms. Some of
this activity has resulted from the resignation of large accounting firms
from providing audit services to small public companies. Reasons for these
changes range from audit cost and service concerns cited by companies to
client profitability and risk concerns cited by accounting firms,
including capacity constraints and assessments of client risk. In recent
years, public accounting firms have been categorized into three
categories-the largest firms, "second tier" firms (mid-sized), and
regional and local firms (small). 43 From 2002 to 2004, 1,006 companies
reported auditor changes involving a departure from a large accounting
firm. Over two-thirds of these companies reported switching to a mid-sized
or small accounting firm. Most of the companies that switched to a
mid-sized or small accounting firm were smaller public companies with
market capitalization or revenues of $250 million or less. Overall,
mid-sized and small accounting firms conducted 30 percent of the total
number of public company audits in 2004-up from 22 percent in 2002.
Despite client gains for mid-sized and small firms, the overall market for
audit services remained highly concentrated, with mid-sized and smaller
firms auditing just 2 percent of total U.S. publicly traded company
revenue. 44 In the long run, mid-sized and small accounting firms could
increase opportunities to enhance their recognition and acceptance among
capital market participants as a result of the gains in public companies
audited and operating under PCAOB's registration and inspection process.
Smaller Companies Found It Harder to Keep or Obtain the Services of a
Large Accounting Firm, but Overall Access to Audit Services Appeared
Unaffected
Our limited review did not find evidence to suggest that the
Sarbanes-Oxley Act has made it more difficult for smaller public companies
to obtain needed audit services, but did suggest that smaller public
companies may have found it harder to retain a large accounting firm as a
result of increased demand for auditing services, largely due to the
implementation of section 404 and other requirements of the act, and the
capacity limitations of the large accounting firms. Of the 2,819 auditor
changes from 2003 through 2004 that we identified using Audit Analytics
data, 79 percent were made by companies that represented the smallest of
publicly listed companies (companies with $75 million or less in market
capitalization or revenue). 45 Although fewer mid-sized and small
accounting firms conducted public company audits in 2004 because some
firms did not register with PCAOB or merged with other firms, the market
appears to have absorbed these changes effectively, with other firms
taking on these clients.
Recent Auditor Changes Resulted in Small Accounting Firms Gaining Clients
Our analysis showed that 1,006 of the 2,819 changes, or 36 percent,
involved departures from a large accounting firm. Of the 1,006 auditor
changes, less than one-third (311 or 31 percent) resulted in the public
company moving to another large accounting firm, and slightly under
two-thirds (651 or 65 percent) retained a mid-sized or small accounting
firm (see table 5). 46
Table 5: Companies Changing Accounting Firms, 2003-2004
Went to large Went to Went to No Total
accounting mid-sized small auditor departures
firm accounting accounting reported
firm firm as of
December
2004
Exiting large 311 298 353 44 1,006
accounting
firm
Average market $1,829,869,346 $172,173,323 $52,108,359 -
capitalization
Average $1,291,589,676 $138,816,527 $50,765,823 -
revenue
Exiting 18 30 147 21 216
mid-sized
accounting
firm
Average market $1,285,735,282 $59,822,406 $38,111,445 -
capitalization
Average $1,044,690,777 $53,694,660 $22,789,900 -
revenue
Exiting small 41 49 1,446 61 1,597
accounting
firm
Average market $213,223,882 $78,923,135 $18,441,598 -
capitalization
Average $92,138,114 $28,518,987 $5,039,327 -
revenue
Total gainsa 59 347 500 126
Total lossesb (695) (186) (151)
Net gain (636) 161 349 126
(loss)
Source: GAO analysis of Audit Analytics data.
Note: Average market capitalization and revenue figures are based only on
those companies with available relevant financial data.
aTotal gains represent the sum of companies that went to that particular
category of accounting firm (large, mid-sized, or small) from another
category (cells highlighted in grey for the particular column). For
example, large accounting firms gained 59 companies from 2003 to 2004 (18
from mid-sized firms and 41 from small accounting firms).
bTotal losses represent the sum of companies that left that particular
category of accounting firm (large, mid-sized, or small) for another
category of firm plus those for which there was no auditor reported as of
December 2004 (cells highlighted in grey for that particular row). For
example, large accounting firms lost 695 companies from 2003 to 2004 (298
went to mid-sized firms, 353 went to small-sized firms, and 44 that had no
auditor reported as of December 2004).
Over the same period, mid-sized and small accounting firms lost fewer
public company clients to the large accounting firms; as a result,
mid-sized and small firms experienced a net increase of 510 public company
clients-a net gain of 161 and 349 companies for mid-sized and smaller
firms, respectively. Because we had no data on companies' selection
processes, we could not determine whether mid-sized and small firms
competed for these clients with other large accounting firms or if they
received these clients by default with no competition from the other large
accounting firms. According to Who Audits America, small and mid-sized
accounting firms increased their percentage public company audit from 22
percent in 2002 to 27 percent in 2003, and by 2004 they audited 30 percent
of all U.S. publicly traded companies. 47 Small and mid-sized firms
audited over 38 percent of all public clients in 2004 according to Audit
Analytics data, which include, in addition to publicly traded companies,
other SEC reporting companies including foreign registered entities,
registered funds and trusts, and registered public companies that are not
publicly traded.
The majority of the clients the mid-sized and small firms gained were
smaller companies with market capitalization or revenues averaging $200
million or less. As shown in table 5 and figure 5, the companies leaving a
large accounting firm and retaining another large firm tended to be very
large-with average market capitalization (or revenue) of more than $1
billion. However, the average market capitalization (or revenue) of
companies leaving a large accounting firm and retaining a mid-sized
accounting firm was less than $175 million and the capitalization (or
revenue) of companies retaining a small firm was significantly
smaller-less than $53 million. Similarly, companies leaving smaller and
mid-sized firms that retained a large accounting firm tended to be much
larger than those that retained another mid-sized or small firm.
Figure 5: Average Size of Companies Changing Auditors, 2003-2004, by Type
of Accounting Firm Change
Note: This figure includes only those companies with available relevant
financial data.
Reasons for Auditor Changes May Have Included Costs Related to the Act and
Risk Assessments
While the reasons for the movement of smaller public companies to
mid-sized and small accounting firms may be somewhat speculative at this
point, the Sarbanes-Oxley Act may have contributed to this shift. Some
smaller companies may have preferred a large firm because of the
perception that large accounting firms-by virtue of their reputation or
perceived skills-can help attract investors and improve access to capital.
48 Workload demands placed on the large firms by larger public companies,
which represent the overwhelming majority of their clients, have increased
with section 404 and other Sarbanes-Oxley Act implementing regulations.
The resulting increases in workload and audit fees appear to have
constrained smaller companies' access to large accounting firms-either
because smaller companies were unable to afford a large accounting firm or
because large accounting firms resigned from smaller clients. According to
Audit Analytics, the largest accounting firms resigned from three times as
many clients in 2004 as in 2001, and three-quarters of those were
companies with revenues of less than $100 million.
Beyond resignations by large accounting firms in response to increased
demand for audit services, the act may have caused large accounting firms
to reevaluate the risk in their aggregate client portfolios by increasing
the responsibilities and liability of auditors, leading them to shed
smaller public companies. According to the large accounting firms with
whom we spoke, they did not have enough resources to retain all of their
clients after the Sarbanes-Oxley Act and cited risk as a significant
factor in choosing which clients to keep. 49 Moreover, the largest audit
firms could be applying stricter profitability guidelines in selecting
their clients, eliminating those engagements where profit margins are
smaller.
While former clients of large accounting firms may represent opportunities
for mid-sized and small accounting firms, they also represent some risks.
For example, we found that a disproportionate percentage of the companies
that left a large accounting firm for a small firm had accounting or risk
issues. Overall, about 69 percent of the companies that left a large
accounting firm switched to a mid-sized or small accounting firm. However,
92 percent of the companies that received a going concern qualification
went to a mid-sized or small accounting firm. 50 In addition, about 81
percent of the companies with at least one accounting issue (such as
restatement, reportable condition, scope limitation, management found to
be unreliable, audit opinion concerns, illegal acts, or SEC investigation)
went from a large to a mid-sized or small accounting firm. In contrast, 63
percent of the companies with no going concern qualification or any
additional "risk" issues went to mid-sized and small firms. We also found
that, if a large accounting firm resigned as the auditor of record, the
company was more likely to switch to a mid-sized or small accounting firm.
Roughly 85 percent of the smallest companies that were dropped by one of
the largest accounting firms retained a smaller audit firm.
Mid-sized and Small Accounting Firms Continued to Operate in a Highly
Concentrated Market
Although mid-sized and small accounting firms gained clients in 2003 and
2004, they continued to operate in a market dominated by large accounting
firms. The market for audit services in 2004 changed little from the
market we described in our 2003 report. 51 For example, mid-sized and
small accounting firms increased their share of all public company
revenues by 1 percentage point in 2002-2004. The market for audit services
remained highly concentrated-a tight oligopoly, where in 2004 the four
largest firms audited 98 percent of the market and the remaining firms
audited 2 percent-and the potential market power was significant. 52
The market for smaller public company audits was much more competitive
than the overall and large public company market. As shown in figure 6,
while the market for audit services for large company clients remained
dominated by large accounting firms, the market for the smallest public
company clients appeared to indicate healthy competition. Mid-sized and
small firms audited 59 percent of all public company clients with revenues
of $25 million or less, 45 percent of all clients with revenues greater
than $25 million up to $50 million, and 32 percent of all clients with
revenues greater than $50 million up to $100 million. When these revenue
categories were combined, the large accounting firms combined with the
mid-sized firms audited 75 percent of companies with revenues of $100
million or less, while the small firms audited the remaining 25 percent.
53 As noted in our 2003 report, as companies expanded operations around
the world, the large audit firms globally expanded through mergers in
order to provide service to their international clients. 54
Figure 6: Percentage of Clients Audited by Revenue Category, 4 Largest
Accounting Firms versus Mid-sized and Small Accounting Firms, 2004
Note: Does not include companies that did not trade on the major exchanges
or over-the-counter markets, foreign companies, or bankrupt companies.
Figures omit certain small accounting firms that held a very small share
of the market.
More recently, mid-sized and small accounting firms gained more large
clients. In 2004, these accounting firms audited approximately 3 percent
of the companies with revenues greater than $500 million, up from 2
percent in 2002. However, as shown in table 5, the average revenue of the
clients lost to the largest accounting firms was $1.1 billion while the
average revenue of the client gained from the largest accounting firms was
$138.8 million. Overall, mid-sized and small accounting firms conducted 30
percent of the total number of public company audits in 2004-up from 22
percent in 2002. While these companies make up just 2 percent of total
public company revenue, they are a large segment of the market of publicly
traded clients. 55
Sarbanes-Oxley Act May Impact the Continuing Competitive Challenges Faced
by Mid-Sized and Small Accounting Firms
According to some experts, competitive challenges related to the ability
of mid-sized and small firms to compete for public companies such as
capacity, expertise, recognition, and litigation risks may have been
strengthened since the passage of the Sarbanes-Oxley Act. 56 For example,
in a recent American Assembly report, a number of industry professionals
indicated that large accounting firms' facility with new requirements was
seen as increasingly important as audits have become more complex and
time-consuming and the financial consequences of noncompliance more
severe.
Additionally, even though some experts believe that large accounting
firms' regulatory competence has been overstated, a perception may exist
among many large and some small U.S. companies as well as other market
influencers and stakeholders that only the large accounting firms can
provide the required auditing services necessary to meet the requirements
of the act. For example, the venture capital industry representatives that
we spoke with stated that this perception has been especially prevalent
for companies issuing IPOs. As shown in figure 7, companies large and
small tended to use large accounting firms for IPOs.
Figure 7: Total Number of IPOs, by Size of Accounting Firm, 1999-2004
Over the long run, the Sarbanes-Oxley Act could ease some of these
challenges. For example, mid-sized and small accounting firms have
continued to confront the perceptions of capital market participants that
only large firms have the skills and resources necessary to perform public
company audits. These perceptions have constrained firms from obtaining or
retaining many clients that the firms believed were within their capacity
to audit. However, the increase in public company audits performed by
mid-sized and small accounting firms has given these firms additional
opportunities to enhance their recognition and acceptance among more
public companies and capital market participants. Also, as smaller public
companies begin complying with section 404 in 2007, small accounting firms
will gain additional experience with the implementation of the act. Taking
on additional clients will provide an important growth opportunity.
Effectively matching company size and needs with accounting firm size and
capabilities could allow smaller public companies to find the best
combination of quality, service value, and reach.
In addition, the PCAOB registration and inspection process and the
establishment of attestation, quality control, and ethics standards to be
used by registered public accounting firms in the preparation and issuance
of audit reports could provide increased assurance of the quality of small
accounting firm audits. Similarly, as more information will become
available through PCAOB's ongoing inspection program, small accounting
firms could establish a "track record," allowing for additional
opportunities for recognition and acceptance among analysts, investment
bankers, investors, and public companies.
Conclusions
The Sarbanes-Oxley Act was a watershed event-strengthening disclosure and
internal control requirements for financial reporting, establishing new
auditor independence standards, and introducing new corporate governance
requirements. Regulators, public companies, audit firms, and investors
generally have acknowledged that many of the act's provisions have had a
positive and significant impact on investor protection and confidence.
Yet, for smaller public companies and companies of all sizes that have
complied with the various provisions of the Sarbanes-Oxley Act, compliance
costs have been higher than anticipated-with the higher cost being
associated with the internal control over financial reporting requirements
of section 404.
There is widespread agreement that several factors contributed to the
costs of implementing section 404 for both larger and smaller public
companies. Few public companies or their audit firms had prior direct
experience with evaluating and reporting on the effectiveness of internal
control over financial reporting or with implementing the COSO internal
control framework, particularly in a small business environment. This was
despite previous requirements, dating back to 1977, that public companies
implement a system of internal accounting controls. The first year costs
were exacerbated because many companies were documenting their internal
control over financial reporting for the first time and remediating poor
or nonexistent internal controls as part of their first-year
implementation efforts to comply with section 404, both of which could be
viewed as a positive impact of the act. In addition, the nature, timing,
and extent of available guidance on establishing and assessing internal
control over financial reporting made it more difficult for most public
companies and audit firms to efficiently and effectively implement the
requirements of section 404. As a result, management's implementation and
assessment efforts were largely driven by PCAOB's Auditing Standard No. 2,
as guidance at a similar level of detail was not available for
management's implementation and assessment process. These factors, in
conjunction with the changed environment and expectations resulting from
the act, contributed to a considerable amount of "learning curve"
activities and inefficiencies during the initial year of implementation.
Auditing firms and a number of public companies have stated that they
expect subsequent years' compliance costs for section 404 to decrease.
This is not unexpected given the significance and nature of the changes
and a preexisting environment that did not place enough emphasis on
effective internal control over financial reporting.
Consistent with the findings of the Small Business Administration on the
impact of regulations generally on smaller public companies, it is
reasonable to conclude that smaller public companies face
disproportionately greater costs, as a percentage of revenues, than larger
companies in meeting the requirements of the act. While facing the same
basic requirements, smaller public companies generally have more limited
resources, fewer shareholders, and generally less complex structures and
operations. Again, this is to be expected given the economies of scale and
differing levels of corporate infrastructure and resources. However, some
of the unique characteristics of smaller companies can create
opportunities to efficiently achieve effective internal control over
financial reporting. Those characteristics include more centralized
management oversight of the business, more involvement of top management
in the business operations, simpler operations, and limited geographic
locations.
The ultimate impact of the Sarbanes-Oxley Act on the majority of smaller
public companies remains unclear because the time frame to comply with
section 404 of the act was extended until fiscal years ending after July
2007 for the approximately 5,971 public companies with less than $75
million in public float. Recognizing the challenges that smaller public
companies have faced in meeting the requirements of the act, particularly
section 404, SEC formed an advisory committee on smaller public companies
to analyze the impact of the act and other securities laws on smaller
public companies. The advisory committee has issued an exposure draft of
its final reporting stating that certain smaller public companies need
relief from section 404, "unless and until" a framework for assessing
internal control over financial reporting is developed that recognizes the
characteristics and needs of smaller public companies. The exposure draft
contains specific recommendations that would essentially result in a
"tiered approach" for compliance with section 404 requirements, where
larger public companies would continue to be required to fully comply with
all requirements of section 404, while smaller public companies consisting
of "microcap" and "smallcap" companies would be granted differing levels
of exemptions until an adequate framework was in place.
We have two specific concerns regarding the advisory committee's
recommendations. First, the recommendations propose relief "unless and
until a framework for assessing internal control over financial reporting"
for smaller companies is developed that "recognizes the characteristics
and needs of those companies." While the recommendations hinge on the need
for a framework that recognizes smaller public company characteristics and
needs of smaller public companies, they do not address what needs to be
done to establish such a framework or how such a framework should take
into consideration the characteristics and needs of smaller public
companies. Many, if not most, of the significant problems and challenges
encountered by large and small companies in implementing section 404
related to problems with implementation, rather than the internal control
framework itself. In addition to having a useful internal control
framework, appropriate implementation of a framework by public companies
must be based on risk, facts and circumstances, and professional judgment.
We believe that sufficient guidance covering both the internal control
framework and the means by which it can be effectively implemented is
essential to enable large and small public companies to implement a
framework which would enable effective and efficient assessment and
reporting on the effectiveness of internal control over financial
reporting.
Our second concern relates to the ambiguity surrounding the conditional
nature of the "unless and until" provisions of the recommendations and its
potential impact on a large number of companies that would likely qualify
for the proposed exemptions. If resolution of small public company
concerns about a framework and its implementation results in an extended
period of exemption, then large numbers of public companies would
potentially be exempted for additional periods from complying with this
important investor protection component of the act. The categories of
microcap and smallcap companies, as defined by the advisory committee
recommendations, cover 79 percent of U.S. public companies and 6 percent
of the U.S. equity market capitalization when combined. Although the
categories of microcap and smallcap have been further refined by the
advisory committee through the addition of a revenue size filter for
purposes of its primary recommendations on section 404, it appears that a
large number of companies, up to 70 percent of all U.S. public companies,
would be potentially exempted. Specifically, the committee estimates that,
after applying the revenue criteria, 4,641 "micro cap" public companies
(approximately 49 percent of 9,428 public companies identified in data
developed for the advisory committee by SEC's Office on Economic Analysis)
may potentially qualify for the proposed full exemption from section 404
and another 1,957 "smallcap" public companies (approximately 21 percent of
the identified public companies) may potentially qualify for the proposed
exemption from the external audit requirement of section 404(b). These
estimates do not include those public companies trading on the Pink Sheets
that would be covered by the Advisory Committee's preliminary
recommendations. In addition, it is likely that a number of public
companies qualifying for exemptive relief under the committee's
recommendations are likely to have already complied with both sections of
404(a) and (b) of the act under the current category of accelerated
filers.
Also, regarding the committee's third primary internal control
recommendation calling for a review of the design and implementation of
internal control if SEC concludes, as a matter of public policy, that the
external auditor's involvement is required, it is not clear from the
committee's report the extent to which, particularly in the present
environment, such a review would result in lower costs than those being
associated with the implementation of PCAOB's Auditing Standard No. 2. Any
lower costs that might result must be considered in light of the reduced
independent assurances on the effectiveness of internal control over
financial reporting that would result and the potential for confusion on
the part of users of the public company's financial statements and audit
reports.
Until sufficient guidance is available for smaller public companies, some
interim regulatory relief on a limited scale may be appropriate. However,
given the number of public companies that would potentially qualify for
relief under the recommendations being considered, we believe that a
significant reduction in scope of the proposed relief needs to occur to
preserve the overriding investor protection purpose of the Sarbanes-Oxley
Act. The purpose of internal control over financial reporting is to
provide reasonable assurance over the integrity and reliability of the
financial statements and related disclosures. Public and investor
confidence in the fairness of financial reporting is critical to the
effective functioning of our capital markets. Market reactions to
financial statement misstatements illustrate the importance of accurate
financial reporting, regardless of a company's size. SEC staff and others
have pointed to the increased level of restatements as an indicator that
the Sarbanes-Oxley Act-section 404 in particular-has prompted companies to
identify and correct weaknesses that led to financial reporting
misstatements in prior fiscal years. Indicators also show that in some
respects, smaller companies have a higher risk profile for investors. For
instance, smaller public companies have higher rates of restatements
generally and showed a disproportionately higher rate of reported material
weakness in internal control over financial reporting during the initial
year of section 404 implementation. Over time, having the effective
internal control over financial reporting envisioned by the act can reduce
some aspects of the higher risk profile of smaller public companies.
When SEC receives and considers the final recommendations of SEC's small
business advisory committee, it is essential that SEC consider key
principles, under the umbrella principle of investor protection, when
deciding whether or to what extent to provide smaller public companies
with alternatives to full implementation of the section 404 requirements.
These principles include (1) assuring that smaller public companies have
sufficient useful guidance to implement, assess, and report on internal
controls over financial reporting to meet the requirements of section 404,
(2) if additional relief is considered appropriate, conducting further
analysis of small public company characteristics to significantly reduce
the scope of companies that would qualify for any type of additional
relief while working to ensure that the Sarbanes-Oxley Act's goal of
investor protection is being met, and (3) acting expeditiously such that
smaller public companies are encouraged to continue improving their
internal control over financial reporting.
First, it is critical that SEC carefully assess the available guidance,
including that being developed by COSO, to determine whether it is
sufficient or whether additional action needs to be taken, such as issuing
supplemental or clarifying guidance to smaller public companies to help
them meet the requirements of section 404. Our analysis of available
research and discussions with smaller public companies and audit firms
indicate that public companies and external auditors have had limited
practical experience with implementing internal control frameworks in a
smaller company environment and that additional guidance is needed.
Moreover, it is critical that SEC coordinate its actions with PCAOB, which
is responsible for establishing standards for the external auditor's
internal control attestations, to ensure that external auditors are using
standards and guidance on section 404 compliance that are consistent with
guidance for public companies and that they are doing so in an effective
and efficient manner. As SEC considers the need for additional
implementation guidance, it will be important that the guidance and
related PCAOB audit standards be consistent and compatible. Also, it will
be important for the PCAOB to continue to identify ways in which auditors
can achieve more economical, effective, and efficient implementation of
audit-related standards and guidance.
Second, as SEC considers whether and to what extent it might be
appropriate to provide additional interim relief to some categories of
smaller public companies, it will be important to balance the needs of the
investing public with the concerns expressed by small businesses. In doing
so, it is important to determine whether there are unique characteristics,
in addition to size, that could influence the extent that some regulatory
accommodation might be appropriate in order to arrive at a targeted and
limited category of companies being provided with potential exemptions.
For example, if these companies were closely held or have a higher rate of
insider investors, regulatory relief may raise less of an investor
protection concern. These investors may be more knowledgeable about
company operations and receive fewer benefits from section 404's enhanced
disclosures. For companies that are widely traded, regulatory relief would
raise more concerns about investor protection and relief would appear less
appropriate. Furthermore, although the "insider" shareholder owners may
not have the same need for investor protection as investors in broadly
held companies, minority shareholders who are not insiders may need such
protection. For other purposes, certain provisions of SEC's securities
regulations and the Employee Retirement Income Security Act of 1974
regulations condition different types of relief, in part, on the nature
and/or the financial sophistication of the investor, and SEC may wish to
consider whether such approaches would help serve to balance the concerns
of small businesses against the needs of investors. The criteria and
characteristics used should be linked to the investor protection goals of
the Sarbanes-Oxley Act and be geared toward limiting the numbers of
companies that would be eligible based on those investor protection goals.
In addition, the advisory committee's preliminary recommendations to
exempt "smaller public companies" from the external audit requirements of
section 404 would include a number of companies that have already complied
with section 404, and SEC needs to carefully consider whether it is
appropriate to provide regulatory relief on this basis.
Finally, we believe that SEC has an obligation to resolve section 404
implementation requirements for smaller public companies in a way that
creates incentives for smaller public companies to take actions to improve
their internal control over financial reporting. Rather than delaying
implementation, which would likely result in smaller public companies
anticipating future extensions or relief, SEC's resolution of these issues
would provide needed clarity and certainty over the scope and timing of
smaller companies' compliance with section 404 and provide incentives to
smaller public companies to begin the process of implementing section 404.
Recommendations
In light of concerns raised by the SEC Advisory Committee on Smaller
Public Companies and others regarding the ability of smaller public
companies to effectively implement section 404, we recommend that the
Chairman of SEC
o assess the guidance available, with an emphasis on
implementation guidance for management's assessment of internal
control over financial reporting, to determine whether the current
guidance is sufficient and whether additional action is needed,
such as issuing supplemental or clarifying guidance to help
smaller public companies meet the requirements of section 404, and
o coordinate with PCAOB to (1) help ensure that section
404-related audit standards and guidance are consistent with any
additional guidance applicable to management's assessment of
internal control and (2) identify additional ways in which
auditors' can achieve more economical, effective, and efficient
implementation of the standards and guidance related to internal
control over financial reporting.
If, in evaluating the recommendations of its advisory committee,
SEC determines that additional relief is appropriate beyond the
current July 2007 compliance date for non-accelerated filers, we
recommend that the Chairman of SEC analyze and consider, in
addition to size, the unique characteristics of smaller public
companies and the knowledge base, educational background, and
sophistication of their investors in determining categories of
companies for which additional relief may be appropriate to ensure
that the objectives of investor protection are adequately met and
any relief is targeted and limited.
Agency Comments and Our Evaluation
We provided a draft of this report to the Chairman, SEC, and the Acting
Chairman, PCAOB, for their review and comment. We received written
comments from SEC and PCAOB that are summarized below and reprinted in
appendixes III and IV. SEC agreed that the Sarbanes-Oxley Act has had a
positive impact on investor protection and confidence, and that smaller
public companies face particular challenges in implementing certain
provisions of the act, notably section 404. SEC stated that our
recommendations should provide a useful framework for consideration of its
advisory committee's final recommendations. PCAOB stated that it is
committed to working with SEC on our recommendations and that it is
essential to maintain the overriding purpose of the Sarbanes-Oxley Act of
investor protection while seeking to make its implementation as efficient
and effective as possible. Both SEC and PCAOB provided technical comments
that were incorporated into the report as appropriate.
As we agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution of it until 30
days from the date of this letter. At that time, we will send copies of
this report to interested congressional committees and subcommittees; the
Chairman, SEC; the Acting Chairman, PCAOB; and the Administrator, SBA. We
will make copies available to others upon request. In addition, the report
will be available at no charge on the GAO Web site at http://www.gao.gov .
If you have any questions concerning this report, please contact William
B. Shear at (202) 512-8678 or [email protected] , or Jeanette M. Franzel at
(202) 512-9471 or [email protected] . Contact points for our Office of
Congressional Relations and Public Affairs may be found on the last page
of this report. See appendix V for a list of other staff who contributed
to the report.
William B. Shear Director, Financial Markets and Community Investment
Jeanette M. Franzel Director, Financial Management and Assurance
Appendix I: Objectives, Scope, and Methodology Appendix I: Objectives,
Scope, and Methodology
Our reporting objectives were to (1) analyze the impact of the
Sarbanes-Oxley Act on smaller public companies in terms of costs of
compliance and access to capital; (2) describe the Securities and Exchange
Commission's (SEC) and Public Company Accounting Oversight Board's (PCAOB)
efforts related to the implementation of the act and their responses to
concerns raised by smaller public companies and the accounting firms that
audit them; (3) analyze the impact of the act on smaller privately held
companies, including costs, ability to access public markets, and the
extent to which states and capital markets have imposed similar
requirements on smaller privately held companies; and (4) analyze smaller
companies' access to auditing services and the extent to which the share
of public companies audited by small accounting firms has changed since
the enactment of the Sarbanes-Oxley Act.
In arriving at our report objectives, we incorporated nine specific
questions contained in your request letter. See table 6 for a
cross-sectional comparison of the nine specific questions contained in
your letter, the four report objectives, and our findings.
Table 6: Cross-sectional Comparison of Request Letter Questions, Our
Report Objectives, and Selected Findings
Request letter Report objective Findings
question
1. In investigating
the effects of the
act on small public
companies, please
assess:
(a) How requirements 1. Analyze the Because a large number of
in the act and the impact of the smaller public companies
implementing Sarbanes-Oxley Act have not yet implemented
regulations, as on smaller public all the provisions of the
adopted for publicly companies in terms act and the recent and
traded companies, of costs of ongoing actions by SEC and
affect small business compliance and PCAOB to address small
equity capital access to capital. business implementation
formation in both the 2. Describe SEC's issues, it is too soon to
stock and bond and PCAOB's efforts determine the act's impact
markets. related to the on smaller public
implementation of companies' access to
the act and their capital. Along with other
responses to market factors, the act may
concerns raised by have encouraged some
smaller public smaller companies to go
companies and the private. Going private
accounting firms reduces financing options
that audit them. available to those
companies, which must rely
on potentially more
expensive alternatives to
public equity capital.
(b) What the detailed 1. Analyze the Our analysis of Audit
costs are that small impact of the Analytics data showed that
public companies bear Sarbanes-Oxley Act the smallest companies that
in complying with the on smaller public had fully implemented the
act on both a federal companies in terms act's provisions,
and state level. of costs of particularly section 404,
compliance and spent a median of 1.1
access to capital. percent of their revenues
2. Describe SEC's on audit fees whereas
and PCAOB's efforts companies that had not
related to the implemented section 404
implementation of spent 0.8 percent of their
the act and their revenue on audit fees.
responses to Responses to our survey
concerns raised by provided the following
smaller public detailed costs for first
companies and the year of implementation:
accounting firms fees to consultants for
that audit them. services related to section
404 ranged from $3,000 to
over $1.4 million.
To help smaller companies
and their auditors develop
approaches to implement the
act's requirements, SEC
established an Advisory
Committee on Smaller Public
Companies. SEC recently
extended the section 404
compliance deadline for
non-accelerated filers
based on the committee's
recommendation, which SEC
had previously done on two
separate occasions.
Currently, a
non-accelerated filer must
begin to comply with
section 404 for its first
fiscal year ending on or
after July 15, 2007. The
advisory committee has
several other
recommendations under
consideration, including
providing conditional total
section 404 exemptive
relief for the very
smallest public companies
or staggering the 404
requirements based on
company size or other
characteristics. Both SEC
and PCAOB issued additional
guidance to help both
public companies and
accounting firms in
implementing section 404,
expecting that the
additional guidance would
help lower public
companies' costs of
compliance. As the act was
a federal law, there were
no costs for public
companies on a state level.
(c) The challenges 4. Analyze smaller Smaller public companies
small companies face companies' access to appear to have been able to
in obtaining access to auditing services obtain needed auditing
auditing services in and the extent to services, although not
order to comply with which the share of necessarily from their
the act. public companies auditor of choice. However,
audited by smaller many smaller companies
accounting firms has moved from large accounting
changed since the firms to smaller accounting
enactment of the firms and paid higher fees
Sarbanes-Oxley Act. for audit services. In
particular, smaller firms
appear to be taking on a
higher percentage of public
companies with accounting
issues. Furthermore, the
act's auditor independence
requirements caused smaller
companies to seek advice
from other sources, which
increased costs.
2. In investigating
the effects of the
act on small
private companies,
please assess the
extent to which:
(a) Financial 3. Analyze the The act appears to have
institutions require impact of the act on increased corporate
private small smaller privately governance and
companies to comply held companies, accountability awareness
with the act in order including costs, throughout the business and
to receive capital ability to access investor communities.
financing and public markets, and However, it does not appear
financial services. the extent to which that the capital markets,
states and capital notably banks and venture
markets have imposed capitalists, are denying
similar requirements private companies access to
on smaller privately capital or other financial
held companies. services because of failure
to meet Sarbanes-Oxley Act
requirements.
(b) States have or are 3. Analyze the Three states-Illinois,
considering enacting impact of the act on Texas, and California-have
provisions of the act smaller privately passed legislation with
for small privately held companies, corporate governance and
held companies. including costs, accountability requirements
ability to access that resemble certain
public markets, and provisions of the
the extent to which Sarbanes-Oxley Act. Two
states and capital other states enacted laws
markets have imposed covering auditor work paper
similar requirements retention requirements and
on smaller privately some state boards of
held companies. accountancy have proposed
rule changes affecting,
among other things,
enhanced peer review
requirements for CPAs. We
are unaware of any states
that enacted a version of
section 404 on internal
control over financial
reporting for privately
held companies.
(c) Small privately 3. Analyze the Our research and
held companies are impact of the act on discussions with
being denied access to smaller privately representatives of
capital or other held companies, financial institutions
financial services, including costs, suggest that smaller
because they do not ability to access private companies have not
meet the act's public markets, and been denied access to
requirements. the extent to which capital or other financial
states and capital services as a result of the
markets have imposed act.
similar requirements
on smaller privately
held companies.
(d) Small private 3. Analyze the We found no evidence that
companies are impact of the act on smaller private companies
incurring additional smaller privately were incurring additional
costs to comply with held companies, costs, except for smaller
any part of the act in including costs, private companies intending
order to receive ability to access to go public or
financial services. public markets, and "voluntarily" complying
Please include a the extent to which with provisions of the act.
detailed list of these states and capital However, information on
compliance and markets have imposed factors that may have
accounting costs. similar requirements encouraged smaller private
on smaller privately companies to voluntarily
held companies. comply with provisions of
the act or the specific
costs for those smaller
private companies was not
available.
(e) Compliance with 3. Analyze the We found that smaller
the act has created impact of the act on private companies wanting
significant barriers smaller privately to go public were spending
to entry for small held companies, additional time, effort,
privately held including costs, and money to convince
companies to reach the ability to access investors that they could
public markets. public markets, and meet the act's
the extent to which requirements.
states and capital
markets have imposed
similar requirements
on smaller privately
held companies.
3. With respect to 4. Analyze smaller While the number of public
small accounting companies' access to companies audited by
and auditing firms, auditing services smaller accounting firms
we request that GAO and the extent to has increased since the
review whether the which the share of passage of the act, large
market has improved public companies accounting firms continue
for these firms audited by small to dominate the market in
since GAO's accounting firms has terms of the proportion of
findings outlined changed since the market capitalization
in "Mandated Study enactment of the audited. In 2004, large
on Consolidation Sarbanes-Oxley Act. accounting firms audited 98
and Competition," percent of total revenues.
GAO-03-864 , as
required by Section
701 of the act.
Source: GAO.
To address our four objectives, we reviewed and analyzed information from
a variety of sources, including the legislative history of the act,
relevant regulatory pronouncements and related public comment letters, and
available research studies and papers. We also interviewed officials at
SEC, PCAOB, and the Small Business Administration (SBA). In addition, we
held discussions with the chief financial officers (CFO) of smaller public
and private companies, representatives of relevant trade associations,
accounting firms, market participants, and experts.
Impact of Sarbanes-Oxley Act on Smaller Public Companies
We could not analyze the impact of the act on many smaller public
companies because SEC has extended the date by which public registrants
with less than $75 million public float (known as "non-accelerated"
filers) must comply with Section 404 of the act to their first fiscal year
ending on or after July 15, 2007. 1 According to SEC, non-accelerated
filers represent about 60 percent of all registered public companies and
about 1 percent of total available market capitalization. As a result, we
analyzed public data and other information related to the experiences of
public companies that have fully implemented the act's provisions. We also
compared the information from companies that had implemented the act with
information from smaller companies that took the SEC extension to gain
some insight into the potential impact of these provisions on the
non-accelerated filers.
Audit Fees and Auditor Changes
Audit Analytics, an on-line market intelligence service maintained by Ives
Group, Incorporated provides, among other things, a database of audit fees
by company back to 2000 along with demographic and financial information.
Using this database, we analyzed changes in the audit fees companies have
paid by various size categories. Audit Analytics also provides a
comprehensive listing of all reported auditor changes, which includes data
on the date of change, departing auditor, engaged auditor, whether the
change was a dismissal or resignation, whether there was a going concern
flag or other accounting issues, and whether a fee dispute or fee
reduction occurred. Using this database, we identified 2,819 auditor
changes from 2003 through 2004.
We performed several checks to verify the reliability of the Audit
Analytics data. For example, we crosschecked random samples from each of
the Audit Analytics databases with SEC proxy and annual filings and other
publicly available information. While we determined that these data were
sufficiently reliable for the purpose of presenting trends in audit fees
and auditor changes, the descriptive statistics on audit fees contained in
the report should be viewed in light of a number of data challenges.
First, the Audit Analytics audit fee database does not include fees for
companies who did not disclose audit fees paid to their independent
auditor in an SEC filing. Second, some companies included in the
database-especially small companies-did not report complete financial
data. We handled missing data by dropping companies with incomplete
financial data from any analysis involving the use of such data.
Therefore, it should be noted that we are not dealing with the entire
population included in the Audit Analytics database but rather a large
subset. 2 Because of these issues, the results should be viewed as
estimates of audit fees based on a large sample rather than precise
estimates of all fees charged over the entire population. It should also
be noted that SEC found issues with the data on market capitalization
(used largely in our discussion of auditor changes and companies going
private) which are being addressed by Audit Analytics.
Deregistrations
To determine the number of companies that have deregistered before and
after the implementation of the Sarbanes-Oxley Act, we obtained and
analyzed data filed with SEC. From 1998 through April 24, 2005, over
15,000 companies filed SEC Form 15 (Certification and Notice of
Termination of Registration). First, we analyzed all the companies to
determine whether the company was deregistering its common stock to
continue to operate as a privately held company. During this step, we
eliminated companies that filed the Form 15 as a result of acquisitions,
mergers that were not "going private" transactions liquidations,
reorganizations, or bankruptcy filings or re-emergences. 3 We also
eliminated duplicate filings and filings by foreign registrants. For the
remaining companies, we reviewed their SEC filings and press releases and
other press articles to determine their reasons for deregistration. We
grouped the reasons into seven categories for our final analysis.
We took a number of steps to ensure the reliability of the database,
including testing of random samples of the coded data, 100 percent
verification of certain areas of the database, and various other quality
control measures. For the initial coding, we found the error rates to be
0.6 percent or lower for all years except 2001 and 1998. Because the
initial error rate exceeded 1.5 percent for these 2 years, we performed
100 percent verification and corrected any errors. However, because the
error rate for the remaining years was positive, it is unlikely that we
captured every company going private in 1998-2005. 4 We also excluded all
companies with one or zero holders of record unless that company also
filed a Schedule 13E-3 (Going private transaction by certain issuers) with
SEC. 5 In doing so, we may have missed some companies going private.
However, an outside study found only 12 companies that filed a Form 15 but
did not file a Schedule 13E-3 from 1998 through 2003. 6 Additionally, our
analysis of the companies that listed more than one holder of record on
the Form 15 should have picked up some of these types of firms. As a
result, this limitation is minor in the context of this report and does
not alter the trends also found by a number of research reports.
Survey of Public Company Views on Implementing the Sarbanes-Oxley Act
To obtain information about public companies' views on implementing
Sarbanes-Oxley Act requirements, we conducted a Web-based survey of
companies with market capitalization of $700 million or less and annual
revenues of $100 million or less that reported to SEC that they had
complied with the act's requirements related to internal control over
financial reporting. To develop and test our questionnaire, we interviewed
officials at 14 smaller public companies. We then pretested drafts of our
questionnaire with 10 companies and then discussed their answers and
experiences with our social science survey specialists. The pretests were
conducted in person and by telephone with company executives in Virginia,
Maryland, New York, Connecticut, California, Georgia, and Illinois.
To identify the smaller public companies eligible to participate in the
survey, we analyzed company SEC filings from the Audit Analytics database.
Our survey universe consisted of 591 companies that met the following five
criteria: (1) $700 million or less in market capitalization as of the end
of the company's 2004 fiscal year; (2) $100 million or less in revenues as
of the end of the company's 2004 fiscal year end; (3) completed section
404 requirements by filing related reports of management and the company's
external auditor as of August 11, 2005; (4) were not foreign companies;
and (5) were not investment vehicles such as mutual funds and shell
companies. Of the 591, we could not reach 168 within the survey period
because we were not able to obtain e-mail addresses for the CFO or other
executive. We began our Web-based survey on September 21, 2005, and
included all useable responses as of November 1, 2005. We sent follow-up
e-mails on three occasions to remind respondents to complete the survey.
One hundred fifty-eight companies completed the survey for an overall
response rate of 27 percent. Only one respondent indicated that his
company was a non-accelerated filer.
The low response rate raised concerns that the views of 158 respondents
might not be representative of all smaller public company experiences with
the Sarbanes-Oxley Act. While we could not test this possibility for our
primary questions (whether the act places a disproportionate burden on
smaller companies or compromises their ability to raise capital), we did
conduct an analysis to determine whether our sample differed from the
population of 591 in company assets, revenue, and market capitalization
and type (based on the North American Industrial Classification System
code). We found no evidence of substantial non-response bias based on
these characteristics. However, because of the low response rate we still
could not assume that the views of the 158 respondents were representative
of the views of other smaller public companies on implementing
Sarbanes-Oxley Act requirements. Therefore, we do not consider these data
to be a probability sample of all smaller public companies.
In addition to potential non-response bias, the practical difficulties of
conducting any survey may introduce other non-sampling errors. For
example, difference in how a particular question is interpreted or the
sources of information available to respondents may introduce errors. We
took steps to minimize such non-sampling errors in both the data
collection and data analysis stages. We examined the survey results and
performed computer analyses to identify inconsistencies and other
indications of error. A second independent analyst checked all the
computer analyses. Further, we used GAO's Questionnaire Programming
Language (QPL) system to create and process the Web-based survey. This
system facilitates the creation of the instrument, controls access, and
ensures data quality. It also automatically generates code for reading the
data into SAS (statistical analysis software). This tool is commonly used
for GAO studies.
We used QPL to automate some processes, but also used analysts to code the
open-ended questions and then had a second, independent analyst review
them. (The survey contained both open- and close-ended questions.) We
entered a set of possible phrases, called tags, which we identified for
each question into QPL. When the analysts reviewed the text responses,
they assign the tags that best reflect the meaning of what the respondent
has written. The system then compares the tags assigned by the independent
reviewers. Multiple tags may be assigned to a single response; thus, it is
possible for reviewers to agree on some tags and not on others. Although
it is possible to have reviewers resolve their differences until agreement
is found, for this survey we only considered tags that were selected by
all reviewers on the first pass. Tags assigned by only one reviewer were
dropped. This process allowed a quantitative analysis of open comments
made by respondents. Finally, we verified all data processing on the
survey in house and found it to be accurate.
SEC and PCAOB Efforts to Address Smaller Company Concerns
To address our second objective describing SEC's and PCAOB's efforts
related to the implementation of the act and their responses to concerns
raised by smaller public companies and the accounting firms that audit
them, we interviewed SEC and PCAOB staff on the rulemaking and standard
setting processes. We also interviewed public company executives,
representatives of relevant trade associations, and market participants
for their reaction to the agencies' rules, guidance, and other public
announcements.
During the course of our review, both SEC and PCAOB held forums and other
open meetings to allow a public discourse on the act's impact on public
companies, accounting firms, investors, and other market participants. We
attended most of these forums and open meetings and reviewed submitted
comments. Specifically, from November 2004 to February 2006, we attended
either in person or through a Web cast the following: SEC's Advisory
Committee on Smaller Public Companies open meetings; SEC's Roundtable on
Implementation of Internal Control Reporting Provisions; SEC's
Government-Business Forum on Small Business Capital Formation; PCAOB's
Standing Advisory Group Meetings; and PCAOB's forums on auditing in the
small business environment. We reviewed the guidance that SEC and PCAOB
separately issued on May 16, 2005, as a result of comments received at
SEC's section 404 roundtable.
Impact of Act on Smaller Privately Held Companies
To determine the act's impact on smaller privately held companies, we
analyzed available research and studies. We also interviewed officials of
the National Association of State Boards of Accountancy in states that
required or were considering requiring privately held companies to comply
with corporate accountability, governance, and financial reporting
measures comparable to key provisions in the Sarbanes-Oxley Act.
Further, we analyzed data and interviewed officials on whether lenders,
financial institutions, private equity providers, or others were imposing
the act's requirements on privately held companies as a condition of
obtaining capital or financial services. Finally, we interviewed officials
and analyzed available data on whether, as a result of the act, privately
held companies were voluntarily adopting key provisions of the act as best
practices or whether they had faced challenges in trying to reach the
public markets.
To assess the impact of the act on privately held companies trying to
reach the public markets, we obtained a sample from SEC's Electronic Data
Gathering, Analysis, and Retrieval (EDGAR) system, a database that
includes companies' initial public offering (IPO) and secondary public
offering (SPO) filings. Our sample contained registration statements,
pricings and applications for withdrawal filed with SEC from 1998 through
July 2005. We performed various analyses of IPO and SPO activity prior to
and after enactment of Sarbanes-Oxley, including analyses of the sizes of
companies coming and returning to the market, types and amounts of IPO
expenses, and the reasons cited by companies for withdrawing their IPO
filing. We analyzed IPO expenses as a percentage of revenue and offering
amount for companies in various size categories to determine whether the
differences between the groups changed over time and whether the
differences were statistically significant when controlling for other
determining factors.
SEC's EDGAR database is considered the definitive source for information
on IPOs since all companies issuing securities that list on the major
exchanges and the OTCBB, as well as those that meet certain criteria
listing on the Pink Sheets, must register the securities with SEC.
Nevertheless, we crosschecked the descriptive statistics retrieved from
EDGAR with NASDAQ's IPO data. However, there was no financial data
available on several companies, while others failed to provide information
to complete all of the fields. In cases where revenue was left blank,
individual filings were reviewed and actual revenue, 9-month revenue or
pro-forma data was used to determine the size of the company. In cases
were this data was not available we dropped these companies from any
analysis involving the use of such data. Additionally, there can be
significant lag between the dates a company initially files for an IPO
with SEC and when the stock of the company is finally priced (begins
trading). Because we had data on IPO filings during the last 2 months of
1997, we were able to include those companies that priced IPOs over the
1998-2005 period that initially filed for an IPO during that time.
However, any IPOs that were priced during this time but had an initial
filing that occurred prior to November 1, 1997, are not included. For this
reason the number of priced IPOs for 1998 (and to an even lesser extent
1999) may understate somewhat the actual numbers of companies coming to
the public market during that year. This limitation is insignificant in
the context of this report.
Company Access to Auditing Services and Changes in Share of Public
Companies That Small Firms Audit
To assess changes in the domestic public company audit market, we used
public data-for 2002 and 2004-on public companies and their external
accounting firm to determine how the number and mix of domestic public
company audit clients had changed for firms other than the large
accounting firms. To be consistent with our 2003 study of the structure of
the audit market, we used the Who Audits America database, a directory of
public companies with detailed information for each company, including the
auditor of record. Only domestic public companies traded on the major
exchanges or over-the-counter with available financial data were included
in our analysis of audit market concentration and the results do not
include a number of clients of the smallest audit firms. Users of our 2003
study will also note that we used the term "sales" when referring to
auditor concentration but use the term "revenue" in this report. Although
Who Audits America refers to sales, our conversations with the provider of
the data, confirmed that although the terms can be used interchangeably,
"revenue" is a better term than "sales" in accurately describing the
contents of the database.
To verify the reliability of these data sources, we performed several
checks to test the completeness and accuracy of the data. Previously GAO
crosschecked random samples of the Who Audits America database with SEC
proxy filings and other publicly available information. Descriptive
statistics calculated using the database were also compared with similar
statistics from published research. Moreover, academics who worked with
GAO in the past also compared random samples from Compustat, Dow-Jones
Disclosure, and Who Audits America and found no discrepancies. We also
crosschecked the results with estimates obtained using Audit Analytics'
audit opinion database. The results were not significantly different and
confirm the finding outlined in the body of the report. However, because
of the lag in updating some of the financial information and the omission
of a number of small public clients, the results should be viewed as
estimates useful for describing the market for audit services.
We conducted our work in California, Connecticut, Georgia, Maryland, New
Jersey, New York, Virginia, and Washington, D.C., from November 2004
through March 2006 in accordance with generally accepted government
auditing standards.
Appendix II: Additional Details about GAO's Analysis of Companies Going
Private
A number of research studies and anecdotal evidence suggest that a
significant number of small companies have gone private as a result of
costs associated with the increased disclosure and internal control
requirements introduced by the Sarbanes-Oxley Act of 2002. To provide a
better understanding of companies going private, we analyzed Form 15s
filed by companies, related Securities and Exchange Commission (SEC)
filings and press releases to determine the total number of companies
exiting the public market and the reasons for the change in corporate
structure. See appendix I for our scope and methodology. This appendix
provides additional information on the construction of our database and
descriptive statistics.
Our Database Included Firms That "Went Dark" as Well as Firms That
Completely Exited the Public Market
Although there is no consensus on the term "going private," we started
with the description used in the "Fast Answers" section of SEC's Web site:
a company "goes private" when it reduces the number of its shareholders to
fewer than 300 (or 500 in some instances) and is no longer required to
file reports with SEC. 1 To reduce the number of holders of record, a
company can undertake a number of transactions including tender offers,
reverse stock splits, and cash-out mergers. In many cases, the company
already meets the requirement for deregistration and therefore the
registrant need only file a Form 15 (which notifies SEC of a company's
intent to deregister) with SEC to meet this description of "going
private." As a result, we use the terms "going private" and
"deregistering" interchangeably. However, not all companies that
deregister completely exit the public markets; some elect to continue
trading on the less regulated Pink Sheets. 2 Companies that deregister
their shares with SEC but continue public trading on the Pink Sheets are
often considered as having "gone dark" rather than private in the academic
literature. However, our final "going private" numbers include companies
that no longer trade on any exchange and those that continue to trade on
the less regulated Pink Sheets ("went dark"). 3 It should be noted that
SEC does not have rules that define "going dark" and the term is used here
as it is used in academic research.
The companies contained in our database include only those companies that
deregistered common stock, were no longer subject to SEC filing
requirements, and were headquartered in the United States. Moreover, the
database excludes most cases where the company was acquired by, or merged
into another company; filed for, or was emerging from, bankruptcy; or was
undergoing or planning liquidation. We also excluded a significant number
of companies that filed for an initial public offering and subsequently
filed a Form 15 within a year; filed no annual or quarterly financials
between the first filing with SEC and the Form 15; or filed as a result of
reorganization where the company remained a public registrant. Based on
the information contained on the Form 15, we were able to exclude four
types of filers: (1) companies that deregistered securities other than
their common stock; (2) companies that continued to be subject to public
reporting requirements; (3) companies that were headquartered in a foreign
country; and (4) companies for which a Form 15 could not be retrieved
electronically. 4
In addition to SEC filings, we used press releases located through
Lexis-Nexis to investigate whether the companies experienced any of the
disqualifying conditions (bankruptcy, merger, acquisition, liquidation,
etc.). Companies that were merged into, or were acquired by, another
company were only included if the transaction was initiated by an
affiliate of the company (either the company filed a Schedule 13E-3 with
SEC or our analysis found evidence of a "going private" transaction in the
case of Over-the-Counter Bulletin Board (OTCBB) and Pink Sheet-quoted
companies). 5 Moreover, if the transaction resulted in the company
becoming a subsidiary of another publicly traded company or a foreign
entity, or if the transaction met any of the other disqualifying
conditions, that company was excluded from our final numbers.
Each Form 15 also contained the number of holders of record. We excluded
all companies with one or zero holders of record unless that company also
filed a Schedule 13E-3 with SEC. A test of a random sample of 200 of these
companies found that merging, bankrupt, and liquidating firms typically
reported one or zero as the number of holders of record. 6 Because there
may have been some companies that went private by way of merger that did
not file a Schedule 13E-3, our database may have excluded some companies
going private as a result of using this qualifier. However, this
limitation is minor in the context of this report (see app. I for
additional information on data reliability). In total, these exclusions
left us with 1,093 U.S. companies going private from 1998 through the
first quarter of 2005 out of the 15,462 Form 15 filings initially provided
to us by SEC. 7
Consistent with Outside Studies, We Found That the Number of Companies
That Went Private Increased Significantly from 2001 through 2004
The number of public companies going private increased significantly from
143 in 2001 to 245 in 2004 (see fig. 8). Based on the number of companies
going private during the first quarter of 2005, we project that the number
of companies going private will increase, to 267 companies by the end of
2005. While these numbers constitute a small percentage of the total
number of public companies, the trends we identified suggest that more
small companies are reconsidering the cost and benefits of remaining
public and raising capital on domestic public equity markets. As figure 8
shows, the number of companies going private increased significantly,
whether or not we excluded the types of companies explicitly considered as
speculative investments by SEC-blank check and shell companies. 8 Overall,
these companies, identified as such by Standard Industry Classification
code, represent 17 percent of the companies going private in 2004 but just
2.5 percent of the companies going private during the first quarter 2005
and 8.4 percent of the overall sample. 9
Figure 8: Total Number of Companies Identified as Going Private from 1998
to 2005
Notes: Includes companies that deregistered but continued to trade over
the less regulated Pink Sheets ("went dark") and public shells and blank
check companies. Does not include companies that have filed for, or are
emerging from, bankruptcy, have liquidated or are in the process of
liquidating, were headquartered in a foreign country or that have been
acquired by or merged into another company unless the transaction was
initiated by an affiliate of the company and the company became a private
entity. The estimate for 2005 is projected based on the number of
companies going private in the first quarter and the pattern of
deregistration activity found in 2003 and 2004.
aPartial year, only includes the first 2 quarters of 2005.
A number of research reports have also found that the number of companies
exiting the public market has increased since 2002. Although there are
differences in the search methodologies and types of companies included,
each study found similar trends and reached similar conclusions (see fig.
9). For example, in Leuz et al. (2004) the number of companies going dark
or private increased from 144 to 313 between 2002 and 2003. Moreover the
authors found that the bulk of the increase was made up of companies that
continued trading on the Pink Sheets after deregistration. Engel et al.
(2004), which was based on a smaller subset of deregistering companies,
found a statistically significant increase in the rate at which companies
went private. Marosi and Massoud (2004) excluded all merger-related
transactions and found that the number of companies going dark increased
from 71 in 2002 to 127 in 2003. 10
Figure 9: Companies Going Private or Dark, by Research Study
Note: Leuz et al. data includes going private and going dark companies in
1998-2003. The Marosi and Massoud data only includes companies going dark
in 2001-2003. The Engel study includes data on going private transactions
based on 13E-3 filings in 1998-2003. Additional differences in the types
of companies excluded exist across these samples. GAO's number for 2005 is
projected based on the number of companies going private in the first
quarter and the pattern of deregistration activity found in 2003 and 2004.
aPartial year, only includes the first 2 quarters of 2005.
We Grouped Reasons for Company Decisions to Go Private into Seven
Categories
In analyzing company decisions, we used various sources to determine why
the companies included in our database deregistered their common stock.
Because companies did not always disclose the reasons for their decision
in an SEC filing, we also searched press releases and newswire
announcements using the Lexis-Nexis search engine. We then used the
reasons given in the various filings and other media to construct seven
broad categories, summarized in table 7. Because companies often gave
multiple reasons for the decision to deregister (go private) and it was
difficult to tell which were the most important, we allowed up to six
reasons for each company included in our database. 11 For example,
Westerbeke Corporation went private in 2004 and cited the following
reasons for the decision: "a small public float," inability to use its
stock as currency for acquisitions, benefits the company would receive as
private entity such as "greater flexibility," the ability to make
"decisions that negatively affect quarterly earnings in the short run,"
and the costs and time devoted by employees and management "resulting from
the adoption of the Sarbanes-Oxley Act of 2002." This company is included
in our database with following coded reasons for going private: (1)
market/liquidity issues; (2) private company benefits; (3) direct costs;
and (4) indirect costs.
Table 7: Reason for Going Private, by Category Descriptions
Direct costs Company cites the costs associated with being a
public company. Includes listing costs,
regulatory compliance costs, expenses paid for
outside advice, audit and attestation
requirements, other expenses directly related to
the implementation of the Sarbanes-Oxley Act,
taxes at the corporate level, and costs related
to shareholders and shareholder accounts.
Indirect costs Company cites the amount of time and effort
required to meet periodic reporting requirements,
adhere to securities laws, and service
shareholders. Includes time and company resources
spent on Sarbanes-Oxley-specific requirements
instead of regular business activities.
Market/liquidity issues Company cites thinly traded stock or general
illiquidity of company shares, poor market
conditions, an undervalued or low stock price,
lack of analyst coverage, or disinterest on the
part of investors. Includes inability or
difficulty in raising capital through follow-on
offerings or using stock as currency for mergers,
acquisitions, or employee compensation.
Private company benefits Company cites benefits of becoming a private
company including ability to act quickly without
market pressure, keep information from
competitors, or provide more flexibility in
corporate operations. Also includes normal
business decisions, changes in strategy, and
belief that going private would provide better
growth and investment opportunities.
Critical business issues Company cites negative business prospects or
critical issues that could undermine the ability
of the company to remain profitable or continue
as a going concern. Includes lawsuits, SEC
actions, exchange delisting, general bad
business, intense competition, or failure of
plans that could have made the company more
viable.
Other Company cites reasons not covered by the listed
categories.
No reason Company provides no information on why it decided
to deregister. Includes companies that indicated
they deregistered simply because they met the
requirements to do so.
Source: GAO.
More Companies Have Cited Costs as Reasons for Going Private Since 2002
Although companies go private for a variety of reasons, in recent years,
more companies cited the direct costs of maintaining public company status
as at least one of the reasons for going private. As shown in figure 10,
the number of companies citing costs as at least one reason for going
private increased from 64 in 2002 to 143 and 130 in 2003 and 2004.
However, the percentage of companies citing cost as the only reason for
exiting the market has increased significantly in recent years. While only
21 cited costs and no other reason in 2003 (15 percent of the total citing
cost), 43 did so in 2004 (33 percent of the total citing cost). During the
first quarter of 2005, nearly 50 percent of the companies mentioning cost,
cited costs as the only reason for going private.
Figure 10: Companies Citing Costs as One of the Reasons for Going Private
aPartial year, only includes the first 2 quarters of 2005.
Companies Going Private Typically Were among the Smallest of Publicly
Traded Companies
By any measure (market capitalization, revenue or assets), the companies
that went private over the 2004-2005 period represent some of the smallest
companies in the public arena (see figs. 11 and 12). Because these
companies were on average very small, they enjoyed limited analyst
coverage and limited market liquidity-one of the primary benefits cited
for going or remaining public. The median market capitalization and
revenue for these companies was less than $15 million.
Figure 11: Average and Median Sizes of Companies Going Private, 2004-2005
Note: Only includes companies with financial data available.
Figure 12 also illustrates that companies going private were
disproportionately small, which reflected that the net benefits from being
public likely were smallest for small firms and the costs of complying
with securities laws likely required a higher proportion of a smaller
company's revenue. For example, 84 percent of the companies that went
private in 2004 and 2005 had revenues of $100 million or less and nearly
69 percent had revenues of $25 million or less. 12 We also found that a
significant portion of these companies-12.5 percent of those that went
private in 2004-2005-had not filed quarterly or annual financial
statements with SEC in more than 2 years; therefore, we did not have
access to recent financial information.
Figure 12: Revenue Categories for Companies Going Private, 2004-2005
Note: Only includes companies with financial data available.
Appendix III: Comments from the Securities and Exchange Commission
Appendix III: Comments from the Securities and Exchange Commission
Appendix IV: Comments from the Public Company Accounting Oversight Board
Appendix IV: Comments from the Public Company Accounting Oversight Board
Appendix V: GAO Contacts and Staff Acknowledgments
GAO Contacts GAO Contacts
William B. Shear (202) 512-8678 Jeanette M. Franzel (202) 512-9471
Acknowledgments
In addition to those named above, Harry Medina and John Reilly, Assistant
Directors; E. Brandon Booth; Michelle E. Bowsky; Carolyn M. Boyce; Tania
L. Calhoun; Martha Chow; Bonnie Derby; Barbara El Osta; Lawrance L. Evans
Jr.; Gabrielle M. Fagan; Cynthia L. Grant; Maxine L. Hattery; Wilfred B.
Holloway; Kevin L. Jackson; May M. Lee; Kimberly A. McGatlin; Marc W.
Molino; Karen V. O'Conor; Eric E. Petersen; David M. Pittman; Robert F.
Pollard; Carl M. Ramirez; Philip D. Reiff; Barbara M. Roesmann; Jeremy S.
Schwartz; and Carrie Watkins also made key contributions to this report.
(250224)
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Highlights of GAO-06-361 , a report to the Committee on Small Business and
Entrepreneurship, U.S. Senate
April 2006
SARBANES-OXLEY ACT
Consideration of Key Principles Needed in Addressing Implementation for
Smaller Public Companies
Congress passed the Sarbanes-Oxley Act to help protect investors and
restore investor confidence. While the act has generally been recognized
as important and necessary, some concerns have been expressed about the
cost for small businesses. In this report, GAO (1) analyzes the impact of
the Sarbanes-Oxley Act on smaller public companies, particularly in terms
of compliance costs; (2) describes responses of the Securities and
Exchange Commission (SEC) and Public Company Accounting Oversight Board
(PCAOB) to concerns raised by smaller public companies; and (3) analyzes
smaller public companies' access to auditing services and the extent to
which the share of public companies audited by mid-sized and small
accounting firms has changed since the act was passed.
What GAO Recommends
SEC should (1) assess sufficiency of internal control guidance for smaller
public companies, (2) coordinate with PCAOB to ensure consistency of
section 404 auditing standards with any additional internal control
guidance for public companies, and (3) if further relief is deemed
appropriate, analyze the unique characteristics of smaller public
companies and their investors to ensure that the objectives of investor
protection are met and any relief provided is targeted and limited.
Regulators, public companies, audit firms, and investors generally agree
that the Sarbanes-Oxley Act of 2002 has had a positive and significant
impact on investor protection and confidence. However, for smaller public
companies (defined in this report as $700 million or less in market
capitalization), the cost of compliance has been disproportionately higher
(as a percentage of revenues) than for large public companies,
particularly with respect to the internal control reporting provisions in
section 404 and related audit fees. Smaller public companies noted that
resource limitations and questions regarding the application of existing
internal control over financial reporting guidance to smaller public
companies contributed to challenges they face in implementing section 404.
The costs associated with complying with the act, along with other market
factors, may be encouraging some companies to become private. The
companies going private were small by any measure and represented 2
percent of public companies in 2004. The full impact of the act on smaller
public companies remains unclear because the majority of smaller public
companies have not fully implemented section 404.
To address concerns from smaller public companies, SEC extended the
section 404 deadline for smaller companies with less than $75 million in
market capitalization, with the latest extension to 2007. Additionally,
SEC and PCAOB issued guidance intended to make the section 404 compliance
process more economical, efficient, and effective. SEC also encouraged the
Committee of Sponsoring Organizations of the Treadway Commission (COSO),
to develop guidance for smaller public companies in implementing internal
control over financial reporting in a cost-effective manner. COSO's
guidance had not been finalized as of March 2006. SEC also formed an
advisory committee to examine, among other things, the impact of the act
on smaller public companies. The committee plans to issue a report in
April 2006 that will recommend, in effect, a tiered approach with certain
smaller public companies partially or fully exempt from section 404,
"unless and until" a framework for assessing internal control over
financial reporting is developed that recognizes the characteristics and
needs of smaller public companies. As SEC considers these recommendations,
it is essential that the overriding purpose of the Sarbanes-Oxley
Act-investor protection-is preserved and that SEC assess available
guidance to determine if additional supplemental or clarifying guidance
for smaller public companies is needed.
Smaller public companies have been able to obtain access to needed audit
services and many moved from the largest accounting firms to mid-sized and
small firms. The reasons for these changes range from audit cost and
service concerns cited by companies to client profitability and risk
concerns cited by accounting firms, including capacity constraints and
assessments of client risk. Overall, mid-sized and small accounting firms
conducted 30 percent of total public company audits in 2004-up from 22
percent in 2002. However, large accounting firms continue to dominate the
overall market, auditing 98 percent of U.S. publicly traded company sales
or revenues.
*** End of document. ***