Preventing the next wave of unreliable financial reporting: Why US Congress should amend Section 404 of the Sarbanes–Oxley Act

Sarbanes–Oxley Section 404 calls for opinions from CEOs, CFOs and external auditors of US listed companies on control effectiveness over financial reporting. Section 404 has almost certainly proven to be the most costly regulatory intervention in the history of securities regulation, costing billions of dollars each year. Unfortunately, since Section 404 was implemented in 2004, thousands of materially wrong financial statements supported by SOX Section 404 control effectiveness assurances have been issued from CEOs and CFOs, including those at financial institutions at the center of the 2008 global financial crisis, as well as their external auditors. In light of SOX 404's poor track record and massive costs, the authors recommend that US Congress enact an amendment to Section 404 to require CEO, CFO and external auditor opinions on the ‘effectiveness of risk management processes’ – not ‘control effectiveness’. A true risk-based approach would allocate resources to the most statistically probable root causes that account for the majority of materially wrong financial statements. The authors believe that this legislative change will result in significantly more reliable financial statements, reduce long-term Section 404 compliance costs, better align with the new global regulatory focus on risk management and risk oversight and, most importantly, restore global confidence in US corporate governance and capital markets.