ACCOUNTING FOR REFORM
Sarbanes-Oxley, Two Years Later: Reforms Seen as Effective, Hindrance
By CHRIS CZIBORR
It’s been two years since Congress, looking to stem a steady stream of corporate shenanigans, passed the Sarbanes-Oxley Act.
Though few believe Sarbanes-Oxley, coupled with reform from the Securities and Exchange Commission and stock exchanges, will put an end to accounting scandals, the law has had an impact.
Among its many requirements, chief executives and directors of public companies must sign off on financial results,potentially making them liable for corporate fraud.
Meanwhile, Sarbanes-Oxley also requires accounting firms hired to do the books to report directly to the company’s audit committee. The committee, consisting of members of the company’s board of directors, must pick an audit firm and approve what the company pays its accountants.
In the past, those decisions were made by company management. Reformers argued that the arrangement created potential conflicts of interest: Accounting firms hired to do the books were often the same ones tapped as consultants to advise or restructure the company’s business operations.
Perhaps the most notorious part of Sarbanes-Oxley is Section 404. It requires annual reports to detail and evaluate a company’s internal control structure and procedures for financial reporting.
Small public companies have found Section 404 to be costly and time-consuming; larger businesses have found it to be less onerous.
The Business Journal talked to accounting executives, corporate lawyers and a public company official about the first two years under Sarbanes-Oxley. Following is an edited version of their responses.
THOMAS CRANE
Partner, corporate practice
Rutan & Tucker LLP
Costa Mesa
Has Sarbanes-Oxley been effective? Where has it been ineffective?
The act has created a heightened sensitivity among officers and directors of their regulatory and fiduciary duties.
The specter of personal liability surrounding the certification of financial statements by the CEO and CFO of a public company certainly has the attention of management. On the other hand, there is some discussion concerning the chilling effect that certification may have on corporate acquisitions.
I recently asked a Securities and Exchange Commission attorney whether any special consideration such as extra time would be given to CEOs/CFOs certifying the financials of a newly acquired company and his answer was a flat-out “No.”
Is complying with Sarbanes-Oxley a burden for public companies?
Smaller companies are really feeling the weight of the regulatory burden. A significant percentage of the public companies currently filing with the Securities and Exchange Commission probably, due to their small size, should be privately held.
Smaller companies don’t have the capability to absorb the increased regulatory costs and this burden is falling right to the bottom line. I think many companies are contemplating going private,however, due to reliance on the company’s liquidity through the public markets and the incentive afforded by freely traded shares upon the exercise of stock options, going private may not be a practical alternative.
The costs are real but they do serve a worthwhile goal,public accountability.
What’s the next wave of accounting reform?
There’s always the expensing of employee stock options. Some companies are voluntarily doing this, but it may soon become mandatory.
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DAN DONAHUE
Partner
Preston Gates & Ellis LLP
Irvine
Has Sarbanes-Oxley been effective? Where has it been ineffective?
Where it has been effective: Sarbanes-Oxley has instilled a heightened sense of responsibility and care among the officers and directors of public companies.
Independent directors, particularly audit committee members, have been invigorated by the act and have used it as an opportunity to exert more authority and control over public company management.
The act has been very effective in its emphasis on the role of independent directors and audit committee members.
Where it has not been effective: Sarbanes-Oxley was a reaction, some say overreaction, to a small number of very high-profile financial and accounting scandals.
Often overlooked is that virtually all of the activity underlying the scandals already was prohibited or regulated by existing federal securities or state corporate law.
The temptations, pressures and conflicts of interest that merged together to create the Enron, Adelphia, WorldCom and other scandals still exist and it’s debatable whether any of these scandals would have been avoided or even materially mitigated had Sarbanes-Oxley been in place prior to their occurrence.
Is complying with Sarbanes-Oxley a burden for public companies?
Through the first 12 months after the act became effective, there was a lot of anxiety over implementation that I believe led to a general impression that the act would be
quite burdensome. Much of the anxiety
was due to the act’s breadth and complexity, coupled with the fact that it was con-
sidered and passed in a very short period of time.
Moreover, many of the details were left to be determined later by the Securities and Exchange Commission and the proposed Public Company Accounting Oversight Board. Much of the success of Sarbanes-Oxley has been due to the tempered
approach the SEC and the oversight board have used in carrying out their mandates under the act.
While Sarbanes-Oxley certainly has created burdens for public companies, my impression is that most public companies have acclimated to the new regulations.
What’s the next wave of accounting reform?
During the next several years, I suspect there will be increasing interest in reconciling or bringing closer together accounting principles used worldwide.
Already many non-U.S. public companies report under U.S. generally accepted accounting principles, or at least reconcile key line items to U.S. GAAP in order to obtain a listing on an American exchange.
The European Union is striving to establish a uniform set of accounting principles for all member countries. As the securities markets become increasingly global, the pressure to have a uniform method of accounting throughout the developed countries will intensify. The U.S. is likely to be a leader in this debate.
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ROBERT GRANT
Office managing partner
Deloitte & Touche LLP
Costa Mesa
Has Sarbanes-Oxley been effective? Where has it been ineffective?
Sarbanes-Oxley has been effective in creating heightened sensitivity for the need to have independent directors and the need for the management, board and audit committee to more fully understand the financial risk and reporting issues that a company faces.
All are focused on more complete accounting disclosures in financial statements. Board and audit committees are taking their increased responsibilities very seriously and are becoming much more independent from management.
Outside auditors are meeting with audit committees on a regular basis without the presence of management.
There is some concern that Sarbanes-Oxley is causing companies to become much more risk adverse for fear of being second-guessed by shareholders or the legal community.
Is complying with Sarbanes-Oxley a burden for public companies?
The Sarbanes-Oxley certification is definitely burdensome on smaller public companies. They are subject to essentially the same requirements as larger public companies.
Many smaller firms haven’t documented internal controls to the same extent as larger public companies and more effort and cost must be expended to originate the required documentation.
Smaller companies have substantially fewer internal resources to direct to the effort. Consequently, many must rely more heavily on independent professional firms, which is expensive. This has created some incentive for public companies to become private.
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HOSHI PRINTER
Chief financial officer
Autobytel Inc.
Irvine
How has Sarbanes-Oxley been effective? Where has it been ineffective?
It has been effective because it forces companies to document and test all their processes. This can improve both the day-to-day operations and also financial controls.
Sarbanes-Oxley provides investors with peace of mind because of greater transparency and should encourage more confidence in our markets. In addition, if private companies putting themselves up for sale are Sarbanes-Oxley compliant, it would make it easier for the acquirer to understand the company’s operations and controls. Ultimately it can improve the mergers and acquisitions environment.
The main criticisms of Sarbanes-Oxley are that there is a lack of clarity and compliance is a burden on companies.
The SEC has not provided clear guidance until very recently. To wit, the SEC released their FAQs on June 23, 2004, almost two years after passage of Sarbanes-Oxley.
In addition, because of lack of clarity in what exactly Sarbanes-Oxley requires in the field of acquisitions, we may see a slowdown in mergers and acquisitions activity. There now is a perceived requirement that newly acquired companies should be fully Sarbanes-Oxley compliant by Dec. 31, 2004 and it is unlikely that many private (and some public) companies will be fully Sarbanes-Oxley compliant by year-end.
Is complying with Sarbanes-Oxley a burden for public companies?
This year Autobytel will spend about 2% of revenue, or about 5 cents a share, on Sarbanes-Oxley compliance. This includes additional spending for auditors and outside resources, as well as employees hired and dedicated to the implementation. This does not include internal people that help out with the implementation, but are not dedicated. (For example, it does not include me, although I spend considerable time on this effort.)
After this year, I think we will spend about 1% of revenue on an ongoing basis for maintenance and general compliance. Since this is a new item for all of us, it is difficult for me to forecast.
Beyond the actual cost, there is the amount of time spent in documentation and in testing of controls. And there is the management time and effort to make sure that everything is implemented by the due dates.
What is not well known is that the outside resources available to do the job are quite scarce. Under normal circumstances, you would rely on your auditors to help you and guide you. Unfortunately, the auditors are finding out about the requirements and testing procedures at the same time that companies are.
What’s the next wave of accounting reform?
Clearly, Sarbanes-Oxley was in response to massive fraud and manipulation in certain corporations, and the rest of the companies have to pay the price. Sarbanes-Oxley, in some respects, is similar to the game-changing Securities Acts of 1933 and 1934, though not as massive. I don’t expect more of this type of regulation over the next few years.
In terms of other changes, the next big one on the horizon is “convergence” or “harmonization” of U.S. accounting standards with international standards.
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STEVE RAPATTONI
Officer
Stonefield Josephson Inc.
Irvine
Has Sarbanes-Oxley been effective? Where has it been ineffective?
Sarbanes-Oxley has been a rude awakening to the accounting profession. Many in public accounting believe that unless we strongly respond to Sarbanes-Oxley requirements, the government will take over our role. Many certified public accountants have long suspected a tendency in the accounting profession not to take care of its own issues, that CPAs have been too easy on themselves in the self-policing area.
We have clients who simply do not have the wherewithal to implement the internal control requirements required by Sarbanes-Oxley; these clients have resigned themselves to negative reports in their SEC filings. Other companies who are taking Sarbanes-Oxley seriously are very concerned about their own internal ability to implement and are using outside consultants.
Many companies are attempting to hire internal audit personnel and finding that they are simply not available. The major accounting firms are struggling to keep up with these new rules in having adequate professional staff available for their clients. Accounting firms are attempting to lure retired partners out of retirement to help implement Sarbanes-Oxley. In short, good, old-fashioned accounting and auditing is back in vogue.
Is complying with Sarbanes-Oxley a burden for public companies?
According to a survey by Financial Executives International of Florham Park, N.J., Sarbanes-Oxley Section 404 is expected to cost the average public company 38% more now than attestation cost a year ago. Larger firms will spend $1.5 million more while smaller firms will spend $52,200 more.
The same survey indicates that external fees for compliance (beyond the audit) at large corporations averaged $1.4 million while smaller companies averaged $170,000.
Complying with Sarbanes-Oxley generally is burdensome, not just to certain companies, but to all companies. It is more pronounced at certain smaller and midsize companies who do not have the breadth of financial and accounting talent and do not have a separately established internal audit department. Many companies are attempting to hire outside consultants but are finding that the consultants who have capable qualifications are not available.
There is some amount of smoke-blowing and chronic complaining about government regulations. But, weighed against the cost of an Enron or other spectacular financial reporting failures, the costs of Sarbanes-Oxley are justified.
What’s the next wave of accounting reform?
If CPAs don’t clean up their act, the government will. The CPA’s choice is to gain back a reputation that has been severely damaged by Enron and WorldCom.
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DEAN SAMSVICK
Office managing partner
KPMG LLP
Costa Mesa
Has Sarbanes-Oxley been effective? Where has it been ineffective?
Many companies that KPMG deals with have identified process weaknesses during their compliance work. Right now, the focus primarily is on meeting the requirements of Sarbanes-Oxley, fixing known deficiencies and developing a sustainable compliance process.
While almost every company has identified opportunities for process improvement, the practical matter is that most companies do not have the time or resources to address these opportunities now.
They primarily are focused solely on just getting the compliance side of 404 done. We expect companies will look to process improvement opportunities in 2005 in which they can drive business process costs down and make the overall financial reporting environment more effective and efficient, once they’ve worked through the basic compliance issues in 2004.
While some companies are intending to build their own internal audit depart-ments, many will look to ousource and
co-source this function so they can concentrate on their core business.
Is complying with Sarbanes-Oxley a burden for public companies?
Has it been tough on companies? Yes. But the original state of readiness, size and complexity of a company’s systems will dictate how tough.
Rather than viewing the new requirements of Section 404 strictly from a deadline-beating compliance perspective, some organizations are taking a longer-term approach, treating the internal-control assessment process as an opportunity to broaden the compliance process to an enterprise-wide risk management perspective. It can be an investment in the future.
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K.C. SCHAAF
Founding partner
Stradling, Yocca, Carlson & Rauth
Newport Beach
Has Sarbanes-Oxley been effective? Where has it been ineffective?
It is probably too soon to tell as to
the effectiveness of Sarbanes-Oxley.
Certainly, since the act was adopted, there has not been the type of widespread financial scandals that fostered the legislation.
It remains to be seen how Sarbanes-Oxley will be administered by the regulatory authorities and used by the private plaintiffs bar.
I believe the biggest benefit of Sarbanes-Oxley to date is its positive impact on corporate governance. Most public companies now follow corporate governance principles previously followed only by a minority of “best practices” companies.
Directors definitely are feeling the responsibility of their roles with less influence of management than before. Gone are the days of the hip-pocket board votes and also gone are the days of one- or two-hour board meetings followed by golf and cocktails. On the downside, it has become more difficult to find qualified board candidates.
Another benefit is the involvement of senior management in all aspects of the public disclosure process. The chief executive officer and the chief financial officer now must have direct involvement in the disclosure process with Section 906 and 302 certifications. I think this has resulted in better public disclosures.
On the negative side, there are a number of provisions in the act that are ambiguous and arguably, overkill. For example, the prohibitions on loans to officers and directors have resulted in a number of unanswered questions. Also, I believe that there are a number of legitimate uses of loans, which now are prohibited.
Is complying with Sarbanes-Oxley a burden for public companies?
I have heard it said that the minimum additional cost for a company to be public versus private is at least $1 million annually.
Companies now are experiencing the costs and difficulties of complying with the management assessment of internal controls mandated by Section 404 of the act. Companies are having to hire a separate accounting firm to design and document internal control procedures, and will have to pay additional fees to the company’s independent auditor to make an assessment on the internal controls.
For smaller companies, this provides a dubious benefit. However, for larger companies, particularly those with operations in many locations or foreign countries, Section 404 will provide benefits, but will also be proportionately more expensive.
In my experience, many small cap companies are exploring going private options, or looking for other liquidity alternatives, such as an acquisition. Also, many private companies who previously would have considered an initial public offering, now are looking for a merger or acquisition exit.
What’s the next wave of accounting reform?
Notwithstanding intense lobbying efforts from industry groups, there’s no question that stock options and other equity forms of incentive compensation will result in current accounting charges in the near future. There is also an ongoing effort to standardize U.S. and foreign accounting principles.
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JIM SCHEINKMAN
Business, finance attorney
Snell & Wilmer LLP
Irvine
Has Sarbanes-Oxley been effective? Where has it been ineffective?
Sarbanes-Oxley has been effective in a significant number of areas including promoting greater transparency and “real-time” information in company disclosures to the public.
And, through the act and enhanced stock exchange listing re-quirements, greater director independence and oversight.
The act, however, has its limitations.
Morality can’t be legislated and new and creative examples of corporate fraud are reported and will continue to be reported each day. Corporate executives bent on misleading the public will continue to mislead, and boards of directors will continue to be duped.
While there are new director education and financial literacy requirements, it should not be forgotten that some very smart and educated directors sat on the boards of some of the companies, such as Enron, plagued by scandal.
Is complying with Sarbanes-Oxley a burden for public companies?
Where there is smoke, there usually is fire. Being a public company is expensive and the securities laws (not just Sarbanes-Oxley) impose a myriad of requirements on both big and little public companies.
In large part, Sarbanes-Oxley takes a “one size fits all” approach that impacts all companies. I worry about the smaller companies who have limited internal resources and budgets to ensure compliance. Some of these companies are stuck in “small cap” hell,little upside in being a public company because there is little liquidity in their stock and significant compliance expenses.
However, the fact that compliance is expensive doesn’t mean that it is necessarily burdensome. If you are going to take money from the public, then there also are obligations owed to the public.
What’s the next wave of accounting reform?
More accounting and securities law reforms remain before us. One of the most controversial is the perennial debate on the accounting treatment of stock-based compensation.
Snell & Wilmer recently published an alert concerning the Financial Accounting Standards Board’s proposed changes on the treatment of stock options and employee stock purchase plans. If enacted, these rules would have a significant effect on many companies, particularly technology companies, which use stock as a significant component of employee compensation.
Meanwhile, the Securities and Exchange Commission is evaluating significant changes to its proxy rules concerning the election of corporate directors. I would expect additional rule-making in other areas, possibly including more enhanced disclosure of executive compensation.
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BRUCE STUMP
Partner, assurance and advisory business services
Ernst & Young LLP
Irvine
Has Sarbanes-Oxley been effective? Where has it been ineffective?
The reforms established by Sarbanes-Oxley have been instrumental in restoring confidence in the financial reporting process. The requirement under Sarbanes-Oxley that requires management to now certify that filings reflect in all material respects the company’s financial position has been particularly noteworthy.
We’ve also witnessed firsthand the increased level of participation and dialogue among regulators, audit committees, management, auditors and the investment community, all to help ensure compliance.
We now find our auditors spending much more time with audit committees, the frequency of these meetings has increased and the level of questioning from board members has deepened and broadened.
Is complying with Sarbanes-Oxley a burden for public companies?
In general, the costs can be a greater challenge for smaller companies; however, the recent strengthening of the IPO market seems to indicate that Sarbanes-Oxley is not deterring companies from tapping the capital markets.
What’s the next wave of accounting reform?
The Sarbanes-Oxley reforms are designed for the long term and are setting the stage for the future of corporate governance and accounting. It is a work in progress, and we must keep in mind short-term and long-term needs and issues as reforms are made.
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KARI WILLIAMSON
Partner in assurance practice
PricewaterhouseCoopers
Irvine
Has Sarbanes-Oxley been effective? Where has it been ineffective?
I think it’s premature to assess what the overall impact will be from Sarbanes-Oxley.
Although it has been nearly two years since the passage of Sarbanes-Oxley, many of the sections have not yet been fully implemented, including Section 404, which some would argue is one of the most important sections of the act.
Is complying with Sarbanes-Oxley a burden for public companies?
While we have not performed a survey, my sense is that it is generally more difficult and potentially more costly for smaller/midsize companies,generally, those with revenue less than $1 billion,to implement Section 404.
This would be attributable to the following factors: the lack of an independent internal audit function; the likelihood that segregation-of-duties issues might exist; the likelihood that some portion or all of the project would have to be outsourced due to lack of resources; and the higher likelihood that internal control gaps might exist, which require remediation and, therefore, increased cost, time and effort.
I understand that the Securities and Exchange Commission and Public Company Accounting Oversight Board acknowledge this burden and may provide further guidance to address specific implementation issues related to this group of companies. There is no doubt that there are companies that are questioning the benefits of being a public company given the regulations that must be adhered to and the related costs.
The question becomes whether these factors really would cause a company to “go private” or if this even is a realistic option in most cases.
It is more likely to believe that the cost of compliance is weighing heavily on the minds of companies as they weigh the pros and cons of going public.
What’s the next wave of accounting reform?
I think we will continue to see further reform at a state level and potentially some reform that would be applicable to privately held companies.
