June 2007 Vol. 105 No. 8 THE REVIEW

Fixing 404

Joseph A. Grundfest & Steven E. Bochner

Although debate persists as to whether the costs of Sarbanes-Oxley’s Section 404 regulations exceed their benefits, there is broad consensus that the rules have been inefficiently implemented. Substantive and procedural factors contribute to the rules’ inefficiency.

From a substantive perspective, the terms “material weakness” and “significant deficiency” are central to the implementing regulations and are easily interpreted to legitimize audits of controls that have only a remote probability of causing an inconsequential effect on the issuer’s financial statements. As a quantitative matter, the literature suggests that a control with a remote probability of causing an inconsequential effect has an expected value of only five one-hundredths of one percent of a firm’s net income.

Procedurally, the Section 404 rules are implemented in an economic and political environment that generates a powerful tropism for inefficient hyperenforcement. Auditors have been broadly criticized for a rash of audit failures and restatements. They do not want to be further criticized for implementing Section 404 with insufficient vigor. Auditors are also subject to significant uninsurable litigation risk. That provides an incentive to externalize risk by forcing clients to absorb greater precautionary costs that benefit auditors by reducing the probability of an audit failure. Auditors also make money selling Section 404 services to audit and nonaudit clients alike. These three forces combine to create powerful incentives for the audit industry, incentives that contribute to inefficient expenditures on Section 404 procedures much like the forces that drive inefficient expenditures on defensive medical procedures.

To address these concerns, the Securities and Exchange Commission (“Commission” or “SEC”) and the Public Company Accounting Oversight Board (“PCAOB”) should aggressively redraft the rules implementing Section 404 to eliminate the need to examine controls that are unlikely to have a material effect. At the same time, the PCAOB should monitor audit firms’ Section 404 practices and discipline auditors who promote or engage in cost-inefficient procedures.

We are not confident that these or any other reforms will be sufficient to remedy the problems already created by Section 404. The audit profession has incorporated inefficient Section 404 procedures into its integrated audit framework, and experience suggests that auditors are loathe to weaken processes already in place. While the Commission and the PCAOB should act aggressively to rationalize Section 404 costs, Section 404 as implemented under the current rules may have established an irreversible process that will continue to impose inefficient costs on publicly traded firms for years to come.

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