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. However, the 245 companies represented 2 percent of public companies as  of January 31, 2004. 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. The  committee plans to issue its final report to SEC by April 2006. GAO also participated in this roundtable. 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. 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. 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. 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. 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. 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. 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    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   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. 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. 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 doing so, we may have missed some companies going private. This limitation is insignificant in the context of this  report.
Why GAO Did This Study

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 Found

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.