Is it time to reform the Sarbanes-Oxley Act?

Bob Dole and Tom Daschle have an op-ed in today's Wall Street Journal calling for reform of the Sarbanes-Oxley Act (SOX), which encourages ethical behavior by our publicly-traded corporations. I don't exactly trust these two former Senate Majority Leaders, but let's see what they have to say:

SOX and the corporate scandals have led corporate boards and executives to focus like never before on issues of proper accounting, internal controls, fraud detection and appropriate reporting of financial results.

Yes, this is true. And accounting and IT consulting companies have greatly benefited from this need. SOX had a short timeline, almost guaranteeing companies needing outside help to get to the new regulatory level.

SOX has imposed across-the-board guidelines for all publicly-traded companies so that both investors and the public have a higher confidence that companies are reporting financial results in a similar manner.

This I'm not so sure of. I think investors are appreciative of the increased rigor of SOX-compliant companies, but I bet they are being more careful too. I suspect investment has been spurred more by the reduction of capital gains taxes than by the reduced fear of fraud due to SOX.

Now for the downside.

Although increased auditing fees amount to a small burden for Fortune 500 companies as a percentage of revenue, the doubling or tripling of auditor bills, accompanied by additional accounting and legal fees, can be the difference between a profit and a loss for emerging businesses. Studies have shown that the additional cost per company for compliance averages $1.4 million to $4.4 million. Recognizing the significant burden on small-cap companies, the SEC extended (for a year) the time for companies with under $75 million in market capitalization to comply with SOX's internal control requirements.

So, it costs a lot of money to comply (big surprise), and smaller businesses are exempt. Which businesses are more hungry for capital? Which businesses still don't offer the kind of security blanket SOX offered? Was SOX really intended to strengthen people's belief in their own retirement plans at their faceless corporation?

Dole and Daschle seem to agree:

The Wall Street Journal reported that the number of companies delisting their shares from the stock exchanges tripled in 2003. When public companies go private, investors lose potentially beneficial investment options. More importantly, emerging businesses often cannot grow to their maximum potential unless they can afford access to the public markets—to the detriment of both competition and innovation.

So what do they prescribe? A less intensive process for smaller businesses:

It could grant the SEC the authority to require certifications for smaller businesses less frequently than once a year. Smaller companies, with revenues of less than, say, $500 million, which necessarily pose less risk to the economy, could be permitted to undergo less intensive audits in most years, with auditors providing so-called "negative assurance" that nothing came to their attention following a less intensive review. These smaller companies could have the more intensive review every other year or every third year to reduce costs but still ensure appropriate auditor oversight.

“Less risk to the economy”? This is not about risk to the American economy, this is about risk to the investor in American markets, I thought.

Another area where smaller businesses are particularly affected is the accounting change to treat options as a compensation expense. Although there were sound reasons for the change, smaller companies have difficulty attracting and keeping top talent without option-based compensation. Consequently, the requirement to expense options can be a real impediment to growth.

Expensing options makes no sense at all, after all. Options dilute the value of the stockholders. They are not an expense! While it is important to report the dilution of stockholder value, doing it as an expense is silly.

Accurate financial reporting by public companies is the goal of SOX reforms. These changes to SOX may come in the form of revisions to SEC regulations or, if necessary, new legislation. When Congressional hearings or regulatory review take place, there are likely to be a range of good ideas about how to achieve public protection and lower costs. Fine-tuning legislation or regulations is never glamorous work, but some reform of the reforms can preserve the important benefits of SOX while curbing its unintended consequences for emerging businesses and the competition and innovation they provide.

Congress loves fine-tuning. It allows tearing down any compromises that have been reached and granting favors to those that will support incumbents. I don't think anything offered here does much for the individual investor, so it's not fine-tuning, it's putting lipstick on a pig!

The real question is what measures would restore investor confidence, especially individual investors. SOX seems a lot like early work on quality within the various big firms. And, I think, the real value is in looking at accounting with the same quality focus that manufacturing and marketing have done over the past few decades. Who uses the data? Why? Is it current? Is it correct? Is unnecessary work being stopped? Is something important missing? SOX focuses on accuracy, and, above, they raise an issue of relevance. Still, this is a minor adjustment to a baby step in this area.

Josh Poulson

Posted Monday, Oct 3 2005 07:22 AM

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« Carnival of the Cats #80
The Real Story of Informix Software and Phil White »





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