External Audit of Internal Control of Companies Improves Reporting: Research
According to a new study by an US academic, the Sarbanes-Oxley 404 rules on the way internal controls are evaluated have been successful of meeting their objective. The aim was to improve the quality of financial reporting.
A report by Albert L. Nagy, who is an accounting professor at John Carroll University, Cleveland, says that the rules which require an annual external audit of companies’ internal controls significantly reduces the likelihood that companies will issue misstated financial statements.
Nagy has published his findings in Accounting Horizon. It is the journal of the American Accounting Association.
The report shows that 20% of the company who did not have compliance with the rules, submitted financial reports which had to be reissued because of material misstatements. Only 14.5% of companies who had compliance with the rules had to be reissued their financial reports.
This finding has suggested that companies who did not comply with the rules were more than 40% likely to restate accounts than those who did.
Nagy has however acknowledged the fact that other factors are involved as well. Misreporting was high in companies which had recently sustained losses, those which had achieved four successive quarter growths and those which admitted that they had weaknesses in their internal control systems.
While allowing all these factors, Nagy concluded in his report that companies’ compliance with Sarbanes-Oxley rule reduced the probability of misstatements by them by 6.3%.
Nagy studied more than 1000 firms during a two year period. During that time, they issued 1,951 financial statements together. 375 were found to be eligible for restatement.
Nagy is of the opinion that “the audit report arguably gives S404 its teeth”. He also further added that evaluation of internal controls was a subjective issue.