Academic journal article Journal of Accountancy

Section 404 for Small Caps: Ease the Learning Curve for Small-Cap Companies

Academic journal article Journal of Accountancy

Section 404 for Small Caps: Ease the Learning Curve for Small-Cap Companies

Article excerpt


* In 2005 about 3,700 large-cap ($75 million or more) companies underwent the first wave of Sarbanes-Oxley section 404 audits. Here, a firm experienced with Sarbanes-Oxley section 404 audits for accelerated fliers shares its best practices to help with compliance for nonaccelerated fliers (companies with market capitalization under $75 million), which must begin filing audit reports for fiscal years ending after July 15, 2007.

* The external auditor's section 404 responsibility is to critically evaluate the design and effectiveness of management's internal controls over financial reporting, test as necessary, form an opinion and communicate significant deficiencies and material weaknesses to management and the audit committee.

* At least one year before the deadline, management should assign a project leader, establish a time line and a project team, engage outside assistance if necessary, set scoping criteria, "assess risk" and review the section 404 plan with the audit committee and external auditors.

* Many small-cap companies with limited accounting staffs will need assistance with tax accounting, lease accounting, reviews of transactions such as last-minute journal entries, application of GAAP, staff training, IT controls, the control environment and segregation of duties and internal control documentation from sources independent from their auditors.

* The Sarbanes-Oxley Act already has had a profound impact on the accounting profession and corporate America. Companies are now more conscious of how and why they do what they do, and in many cases they have improved their processes or eliminated duplication.

Let's hope performing Sarbanes-Oxley section 404 audits of internal controls turns out to be easier for nonaccelerated fliers. Those of us who already have performed section 404 internal control audits will attest the process is long, complex, tedious and stressful. Indeed, section 404--which requires a company's annual report to certify exactly how effective its control and reporting procedures are--is proving to be the most challenging part of the Sarbanes-Oxley Act. This article describes how our firm, Marcum & Kliegman LLP of Melville, N.Y., approached section 404 audits, and shares some best practices we learned on the job.


The SEC required companies with market capitalization equal to or greater than $75 million (accelerated filers) to comply with section 404 for fiscal years ending after November 15, 2004 (see "The Value Proposition," JofA, Sep.05, page 77). Accordingly, in 2005 about 3,700 companies underwent the first wave of internal control audits. Of them, about one in seven reported material weaknesses.

Nonaccelerated fliers will commence compliance for fiscal years ending after July 15, 2007. No one knows exactly how many eventually will comply, but about 12,000 companies are listed on various national exchanges. In addition, banking and insurance companies are discussing adopting "Sarbanes-Oxley-like" initiatives for nonpublic entities. Some states have enacted tougher regulations on not-for-profits, and nonpublic broker-dealers and hedge funds soon may face increased regulation. CPA firms will be busy for a while, so it's a good time to work on skills to handle the workload.


PCAOB Auditing Standard no. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements, provides guidance for a section 404 audit. The performance and reporting directions are based on the framework developed by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. COSO'S 1992 report Internal Control--Integrated Framework describes five key components of internal control (the control environment, risk assessment, control activities, information and communication, and monitoring) and provides businesses with evaluation tools. …

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