The Public Policy

Time to Reform Sarbanes-Oxley

Blaming every other company in the U.S. for the Enron and WorldCom scandals has been a bonanza for accountants and a killer for small companies especially. Congress need to correct a very bad law.

By 3.29.06

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To address reform of the Sarbanes-Oxley Act of 2002 (Sarb-Ox), recall that it was passed in the political furor following the Enron and WorldCom scandals to try to prevent future accounting frauds. Let's start with its most obvious, largely unintended, consequences. Sarb-Ox, with its notorious Section 404 requiring internal control certifications in particular, has created a tremendously expensive amount of paperwork and bureaucracy. In the Sarb-Ox economy it seems that everybody audits everybody else.

Not only is this exceptionally costly, but it is far more costly -- about 50 times more -- than the SEC estimated it would be. Virtually every audit committee around the country has helplessly watched its audit fees escalate dramatically. The explicit costs alone are extremely high and disproportionately high for smaller companies.

The implicit costs of diversion of employee and management effort are also high. The opportunity costs are high. The total costs far outweigh the benefits that are likely to arise from them, especially for smaller companies.

Part of the reason for this disproportional impact on smaller companies is that the implementation of Section 404 in particular has taken a brute force approach, like the airline security line, where respectable citizens have to take their coat, belt, and shoes off. Similarly, accountants are going through companies with no sense of proportion or materiality.

In sum, Sarb-Ox represents an Orwellian principle that imposes huge costs on the shareholders, who have no choice as to whether they wish to bear these costs or not, in the name of protecting these very same shareholders. The fundamental approach is that everybody must pay because of the malefactors in few egregious cases.

A Bonanza for Accounting Firms
Sarb-Ox has had marvelous economic consequences for the large public accounting firms. For them it's been a bonanza. One journalist called it the greatest wealth transfer of modern times, from shareholders of corporations to accounting firms.

At the same time, Sarb-Ox creates an enormous conflict of interest for these firms. The more massive the Sarb-Ox routines, the more detailed their reviews, the more memos, procedures, and risk control descriptions that are generated, the more often they are reviewed, the more meetings, and the more time it takes, the more profitable the accounting firms become. No wonder these firms take out advertisements praising Sarb-Ox.

In response to this, the "Pollock Proposal" is to expand Sarb-Ox to cover the accounting firms themselves. If they are going to impose costs and procedures on everybody else, they should have to go through the same routines as a prerequisite to practicing on other people. I expect their views and reviews would become more reasonable.

A Sampler of Quotations
Here, from various study papers and filings, are some instructive quotations on the burdens Sarb-Ox creates:

"Smaller companies spent an average of $3 million on compliance with section 404, and larger ones an average of $8 million. The initial SEC estimate of costs was $91,000 per company on average, suggesting that the SEC staff had little understanding of what their regulation actually required." (Peter Wallison and Cameron Smith, "Reforms for the First 1000 Days")

"Through a study of stock market reactions...the evidence reveals that investors likely consider the Act to be bad news for business." (Ivy Xiying Zhang, "The Economic Consequences of the Sarbanes-Oxley Act")

"The Senate passed the Sarbanes bill unanimously, and the market fell an additional 283 points." (Wallison and Smith, op. cit.)

"The data do not support the view that the legislation will improve corporate governance." (Roberta Romano, "Quack Corporate Governance")

"Concentration on minutia... redundant and inefficient... adversarial relationship with audit firm... form over function... unrealistic requirements on small and developing companies.... Based on initial quotes, we expected direct implementation costs to be $300 thousand. Out actual direct costs exceeded $1 million and indirect costs exceeded another $1 million. These costs are borne by shareholders." (Apex Silver Mines Limited, Letter to the SEC)

"Dealing with risks on the basis of a remote likelihood not only imposes huge costs but also makes this a nitpicking process." (Confederation of British Industry, Letter to the SEC)

"An atmosphere of near paranoia...the public accounting firms have increased their aversion to risk to an extreme degree." (Mortgage Bankers Association, Letter to the SEC)

And finally: "External auditors are reluctant to give advice with regard to interpretation and application of complex accounting rules in order to avoid possible criticism in regards to their independence." (Commercial Federal Bank, Letter to the SEC)

Consultation regarding the proper application of accounting standards may be viewed as an internal control deficiency! This is the reduction to absurdity of the behavior induced by Sarb-Ox.

Regulatory Response
Consider the response of the two regulators in this matter, the SEC and the Public Company Accounting Oversight Board, or PCAOB. When faced with overwhelming evidence of the results of how their own rules generated this expensive morass of bureaucracy and paperwork, the SEC and the PCAOB blamed the accountants.

Confucius described taking responsibility as follows: "The way of the higher man is like the archer. When the arrow misses the center of target he seeks for the cause of the failure in himself."

The SEC and PCAOB did not follow the way of the higher man as described by Confucius.

Reform of the Sarbanes Oxley Act
Congress has now had three years to observe how its good intentions have resulted in remarkably adverse unintended consequences. Following the Confucian principle, it needs to take responsibility for the results of its actions in the fevered political environment that fostered Sarb-Ox. It is time, learning from experience, to consider reforming the Sarbanes-Oxley Act.

Here's what Congress should be thinking about:

1. Enacting the provisions of HR 1641, introduced last year by Congressman Jeff Flake of Arizona. HR 1641 would make Section 404 of Sarbanes-Oxley voluntary, as opposed to mandatory. This approach would be well suited to a market economy and a free society.

If investors actually want the kind of heavy internal control documentation 404 demands, then the companies will do it because investors will demand it. Investors will punish those companies that opt out.

If, on the other hand, investors conclude that resources would be better spent elsewhere -- on research, or introducing new products, or customer service, for example -- then companies will do that and the investors will react accordingly.

2. If a totally voluntary approach is politically impossible, at a minimum making Section 404 voluntary for small public companies. Exemption from these requirements for these companies is in the process of being recommended by the SEC's Advisory Committee on Smaller Public Companies. "Voluntary with disclosure and explanation" would be a better concept than simple "exemption" -- then investors could make up their own mind.

3. Instructing the PCAOB to change its standard from "other than a remote likelihood" to "a material risk of loss or fraud."

4. Stating clearly that Congress does not have the naive belief that accounting is something objective, but understands that it is full of more or less subjective judgments, estimates of the unknowable future, and debatable competing theories -- and that therefore consultation and professional advice on the application of accounting standards is expected and demanded of accounting firms.

5. Establishing by statute a PCAOB Ombudsman, who would report directly to the Chairman, with whom companies or accountants could communicate on a confidential basis.

6. Moving PCAOB assessments, as they are for any other regulator, to the regulated entities: namely the accounting firms.

7. Instructing the PCAOB to require a Section 404 regime for the public accounting firms themselves, as a condition of their public trust, on the same standards as apply to public companies.

8. Mandating a report from the SEC and the GAO comparing the British principles-based Turnbull Guidance on corporate risk controls to the Sarb-Ox approach for large companies.

9. Bringing PCAOB under Congressional control as a regulatory agency should be, subject to appropriations, oversight and a normal appointments process.

10. Finally, enacting a sunset or reauthorization requirement for Sarb-Ox five years from now. That would be 2011, a decade after the scandals that gave it birth, with correspondingly greater experience, knowledge, and perspective for all concerned.

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About the Author

Alex J. Pollock is a resident fellow at the American Enterprise Institute.