The Sarbanes-Oxley act (SOX) was a bill sponsored by Paul Sarbanes (D-MD) and Michael Oxley (R-OH), passed by congress and signed into law by President George W. Bush in 2002. The bill was a result of outcry from the financial industry and business world about the then-recent failures of several large companies such as Enron and MCI due to accounting scandals.
The act, also known as “Public Company Accounting Reform and Investor Protection Act,” might be better called the “Accounting Industry Protection Act” because the result of the new legislation has been in alleviating financial auditors from liability of poor work on the auditor’s part.
Specific restrictions and costs for small companies who are or want to be publicly traded are found in the details of section 404. This part of SOX regulation requires that auditors effectively do risk-assessment of the organization being audited relative to the entity’s internal controls, focusing on the effectiveness of these controls.
Under the new guidelines, company boards and executives are now forced to focus and sign off on auditor reports covering mundane details about the internal control effectiveness of the organization. In order to succeed, smaller companies often focus on higher growth revenue models that often result in higher risk and higher return. Investors generally know of these inherent risks simply by the fact that these companies have shorter trading histories, are more volatile or are smaller in revenue than a more established company.
Companies that are publically traded – small or large – should not be punished by the additional cost of implementing SOX regulations. By the US having a more complex and costly business environment than other markets in the world, it is actually diminishing the return seen by investors and making it a much more difficult environment to operate in. Companies can operate in other countries and see an immediate increase in their bottom line through reduced costs of confirming to regulation.
Certainly a significant benefit is obtained in the legislation for auditors, as their liability is decreased and shifted to management who must approve and accept full responsibility for the audit reports. This forces management to have a strong internal auditing department validating claims made by external auditors so that any misstatements on the external auditor’s part are not overlooked. Both add significant costs to the entire process for little benefit.
Creation of the Public Company Accounting Oversight Board (PCAOB) by the SOX act helps ensure that external auditors are operating properly by auditing auditors. Although this provides some level of comfort to management in the findings of external auditors, this adds only additional cost to the process ultimately burdened by companies being audited. Some estimate that the cost of SOX auditing is upwards of 3% of gross revenue for small companies, leaving such costs to have a significant impact on the cash flow of these companies.
The additional layers of audit requirements and regulation have led a shift of publically traded companies from listing on US-based exchanges such as the NYSE and NASDAQ, to foreign exchanges such as Euronext or OMX that are overseen by less demanding regulation.
The failures of Enron, MCI and the likes were spotted and brought into public light before the SOX regulation was in place. Companies that engage in fraudulent activities, or activities of unusual risk have long been chastised for their actions by the market. It is naive to think that additional layers of extremely costly regulation will prevent this from happening. The costs investors who loose in these specific situations is simply the cost of investing; that is, the cost of risk of letting someone else use your money.
A better alternative to SOX regulation, especially for small companies, is for government to support and subsidize companies who develop innovative ways that allow investors to see and validate internal operations and controls of their organizations. Instead of hoping the government’s regulations work and instead of placing decisions about risk in the hands of the auditor, extend these decisions out to the investor.
It is not appropriate for government to assess or force the use of an assessment framework for companies. Instead let companies who choose to implement such transparencies see the results themselves. These companies will find that investors are more willing to invest and both the company and investors will receive an absolute, measurable value. Today’s regulatory environment supposes that the government is the best entity to regulate and set forth risk assessment guidelines, which is simply not the case.
References
http://www.heritage.org/CDA/upload/SOX-CDA-edited-3.pdf
http://www.heritage.org/CDA/upload/SOX-CDA-edited-3.pdf
http://www.sec.gov/rules/interp/2007/33-8810.pdf
http://dodd.senate.gov/index.php?q=node/3852
http://www.infoworld.com/t/business/senator-introduces-us-competitiveness-bill-831
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=978834
http://www.pcaob.org/Rules/Docket_021/2007-06-12_Release_No_2007-005A.pdf
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