You Can Be Too Careful

How the government's new corporate accounting rules impede efficiency and stifle innovation.

Brian Doherty from the January 2006 issue

(Page 3 of 3)

Stanton: Sarbanes-Oxley compliance fees between my firm and accounting firms can range anywhere from 1 percent of revenues to 3 percent of revenues, or 50 percent of profits. Sarbanes-Oxley could cut off 3 to 4 percent of market capitalization, no problem.

Companies that have been working perfectly fine for years must hire additional people just to segregate duties more clearly. People like me go into companies, and we charge anywhere from a quarter million to a few million per engagement--not just me but firms I'm affiliated with--and we don't produce anything. We don't advertise anything; we don't book any journal entries; we are not a part of the business process. We are an add-on strictly there to produce a few documents.

One thing that defies common sense is that the law requires controls to be documented, so anytime you change your process you have to go back in time to readjust your reporting. Anytime you change the way you do business, install new software, start a new line of business, you need those changes documented. So all of a sudden change is the enemy; creative destruction is a bad thing. We actively encourage clients: Don't change your system; don't upgrade anything; don't change anything for the last three months of the year.

So it really stifles innovation, stifles growth. Some of our clients are systems developers, software sellers, and Sarbanes-Oxley hurt their business, because no company wanted to change [how they do things]; they've already spent time, money, and effort to document their controls as is.

It gives businesses a bigger predisposition to choose inaction over action. There's less intelligent risk taking, a bigger plus for being static and communicating less, because one of Sarbanes-Oxley's requirements is that any document you rely on, whether electronic or paper, to get to the numbers on financial statements, you must preserve, archive it so you can produce it in event of investigation. That is a very sweeping and vague requirement, meaning if someone sends an e-mail saying, "This client said they might not pay, but I'm not sure if it's just a joke," it needs to be preserved. Now they don't want to put anything in writing anymore.

Charles Wilson: Four major public companies are currently dominating the accounting field. As a result, fees continued to go up, and smaller companies like us had to go to second-tier accounting firms to stay in the business. But even second-tier firms, because of fear of liability, have become very expensive for small public companies. I'm involved in two other private companies and have been for years, so I'm quite aware of what accounting fees normally cost for private companies compared to a public one of our size, and the costs are four times higher--and that was before SarbOx came into being.

Now our accounting firms no longer can give suggestions on how to help you do better work, because they want to stay independent, and for them to remain independent they can't tell you what to do. They can only tell you you are doing it wrong. So now you have to pay two sets of independent groups, one checking internal operations to see they all are correct and another ensuring that you are doing them the most proper way.

The other problem with small companies is what you call materiality. What's considered material to a $25 million company vs. a company doing $1 billion in business is vastly different. So a small company has to pay auditors to go over every tiny item. $10 items have to be gone over carefully, whereas for a large company $1,000 can be overlooked. So that causes more money to be spent on accounting.

We will not make any money this year by the time we pay our accounting fees. Compliance has been delayed until July 2007 for smaller companies, but we have already started setting up the new systems.

And it's not just accounting fees. It's legal fees. The lawyers want to make sure you're complying with SarbOx, so you have them checking everything too.

Reason: Are there any benefits to Sarbanes-Oxley?

Merritt: Most of the law's requirements won't help investors and won't stop Enrons and WorldComs. I don't know how regulators will look investors in the eye next time there's a big blowup.

De Coster: The hardest thing for me to admit, from a libertarian yet practical corporate finance viewpoint, is that some of what is being done in the name of SarbOx compliance is very much needed within the corporate environment. The beneficial elements of SarbOx's requirements should have already been put in place by company management. Internal controls within many Fortune 500 companies were in disarray.

According to Compliance Week, which monitors the reporting of internal control weaknesses, March 2005 had 116 companies disclosing material weaknesses in their internal control over financial reporting, up from 28 for the same period in 2004. This is because '05 was the first year that companies had to provide internal control assessments as per Section 404 of SarbOx.

So is there value in SarbOx for stockholders? Yes, there is. But the fact that government usurped private processes in reaction to a host of big business failures sets the stage for a huge regulatory era in which businesses may no longer be able to operate outside of the realm of strict oversight and congressional decree.

Should the private accounting bodies have cleaned up their act prior to the domino effect of business failures? Indeed. The profession has not done a good job of changing the way it does things. It has allowed the old system to stagnate, instead of rolling with the times. The current financial environment of short-term finagling, tax avoidance, and revenue boosting for the sake of pleasing the latest Wall Street analyst of the day has skewed the way the accounting profession does things. You can thank government's abysmal tax policies and Fed-created credit bubbles for crafting most of those problems. Artificially inspired booms, courtesy of the Fed and monetary policy, will likely lead to corporate malfeasance.

Stanton: The only benefit this law can have is reducing the number of restatements. And the number of financial restatements in any give year is maybe 1 percent, maybe 2 in a bad year, and those don't take a company worth billions and turn it into one worth nothing. It's more likely to take a 10 percent hit, so maybe 1 percent of your portfolio takes a 10 percent hit in a given year due to financial restatements in a pre-Sarbanes-Oxley world.

Most business failures have nothing to do with accounting, stated financials, or fraud. Most business failures have to do with having wrong strategy, inefficient operations, poor marketing. Sarbanes-Oxley only puts CEOs on line for accounting risk, mistakes in financials. And that will shift their focus away from the 80 percent of problems businesses are likely to face to concentrate on 20 percent of the problems, because now that's what they'd go to jail for or be fined for.

Wilson: The day Sarbanes-Oxley passed was a great day for the accountants. It was an Auditors Relief Act. Now if you could afford to have everything double-checked like this, it would be terrific: Prove you are clean as a whistle and, God forbid, if you have some problem within the company, this really shows it up much sooner. But most companies can't stay in business if they do have problems anyway, and it's a very expensive way to keep everyone on the up and up.

If you had a problem, say, in a subsidiary, in terms of knowing whether or not it's really making money or if one of your executives is faking some of the information--which happens in small companies that aren't closely monitoring their people--in the long run the new system will pick up fraud and poor performance, and the company will become more efficient. But the question is costs balanced with benefits. I couldn't run stats on it, but I do know the costs of being public today are prohibitive. We would never go public in this market, and if we could afford to buy back the stock we'd go private.

SarbOx requires us to be much more careful, but we were doing that anyway. For those who don't want to do careful accounting it might be a good idea, but there are much more efficient ways to do it. The double layer of accounting oversight is unnecessary.

reason: Will criminal liability for CEOs and CFOs whose companies' financial statements are deemed inadequate be an effective deterrent to fraud?

De Coster: SarbOx can turn a CFO into a criminal overnight. So, yes, SarbOx requirements can make officers more fastidious in regard to thefinancial information going out the door. On the other hand, the officers with the sign-off responsibilities are not in the trenches, do not know the details, and quite often do not have any ideaabout what they are signing off on. The division of labor is such that they have to trust their employees to do the best job possible, and, the financials themselves aside, they often end up signing off on stuff when they don't even have the time to glance at it. It would be unrealistic to say that they could or should spend their time absorbing such details.

Stanton: No matter how much work we do, we can't prevent fraud or collusion. We ensure segregation of duties, make sure it would take two or more people acting in concert to slip something by. But it's real easy to make a friend and find someone to commit fraud with if you're hell-bent on doing it. Having CFO certification creates a laddering effect: He relies on the controller, who relies on departmental managers, who rely on accounting staff, and they all have to watchdog on each other and create a finger-pointing environment. In that sense you can get some degree of assurance, but you can't eliminate fraud.

Reason: How have your colleagues reacted to Sarbanes-Oxley?

De Coster: The public accounting and professional servicesfirms are ecstatic over the growth potential provided by SarbOx. The accounting firm KPMGreported that respondents to a survey overwhelmingly replied that the SarbOx Act has "boosted investor confidence in corporate America," whatever the heck that is supposed to mean. The American Institute of Certified Public Accountants brags that Section 404 "opens new doors" to consulting opportunities. My profession has always supported regulation, since it enhances revenues and growth opportunities.

Recall thatthe average accountant sees government regulation and oversight as a part of daily life, a necessity for everyday business maintenance and survival. They tend toward thinking that the absence of ironclad regulations would be akin to chaotic anarchy. Theprevailing commentin regard tothe SarbOxenvironment is, "It's been good for us, making us do things that should have been done before." Laissez-faire isn't exactly rampant among my colleagues.

But the SarbOx snare has produced some serious skepticism in the corporate world. When the effects of unchecked statism come home to roost, those most affected by it firsthand eventually rise up in resistance to the lunacy of it all. The average accountant or corporate finance individual has seen the light in regard to the sheer folly of it all, from having endured microscopic attention to even the most insignificant tasks. The more ridiculous the compliance procedures get, the more the average workertends to blow it off as frivolous.

Wilson: SarbOx is definitely discouraging smaller companies from going public, and it discourages good opportunities for investing in little companies. I have friends running private companies who say going public now would be just impossible.

Merritt: I can't tell you a single public-company CFO I know who hasn't wanted to leave in the last year, but maybe they're not in the financial position or age bracket to do that. We're not in business anymore. We're just in compliance.�