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The Value of Auditor Testing of Internal Controls
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Of all the provisions found in the Sarbanes-Oxley Act of 2002, perhaps none is as controversial as Section 404(b). This section requires public company management and external auditors to independently test effectiveness of internal controls over financial reporting. The auditor issues an opinion on control effectiveness, identifying the most severe weaknesses detected.
The controversy arises over the high cost and (more subtly) the increased scrutiny placed on management when an independent auditor tests controls over the way in which corporate results are portrayed to the markets. And as companies have put pressure on Congress over Section 404, the legislature has granted large numbers of exemptions from Section 404.
As is often the case with public policies, costs are easier to measure than benefits. What is the incremental contribution of auditor testing over that of management? If management finds most problems, then the additional audit fees paid for Section 404 work are wasteful and a drag on the corporations involved.
This issue led Bentley Accountancy Professor Jean Bedard and Accountancy Executive-in-Residence Lynford Graham to study the effects of Section 404(b). Using samples from several audit firms from 2004-2005, the pair found that many companies with “clean” Section 404 audit opinions have numerous control flaws. The study proves that the public view of Section 404 findings thus understates its potential value in improving financial reporting.
The study also found that auditors, rather than management, detect 72 percent of control deficiencies. And when management does find control deficiencies, it often classifies the deficiency as less severe than the auditor. These findings imply that without auditor testing of internal controls, the quality of financial reporting will be lower. As financial reporting quality decreases, the markets are less efficient, and investors are potentially more exposed to earnings management and fraud.
Bedard and Graham’s study is a landmark in the debate over Section 404. Professor Joseph Carcello, in his recent testimony House Financial Services Committee, lauded the research: “The most compelling evidence on the value of auditor reporting on internal control comes from a study by Bedard and Graham (2011).”