Undoing SOX's Unintended Consequences

Debates about the Sarbanes-Oxley Act continue, but one thing is clear: its implementation has created unintended consequences. As every Member of Congress knows from many constituents, it has caused a tremendously expensive amount of paperwork and bureaucracy. And the smaller the company, the greater the proportional burden that has been imposed.

Resident Fellow Alex J. Pollock
Resident Fellow Alex J. Pollock
Such reflects the actual implementation of the act, not its hoped-for goals. In particular, the cumbersome implementation of its Section 404 by regulators and accounting firms wins the prize for harmful unintended consequences and unforeseen overhead costs.

Consider the quite specific expression of Congressional intent from the Senate Banking Committee (then chaired by Senator Sarbanes) Report on Section 404's requirement for audit certification of internal controls: "The Committee does not intend that the auditor's evaluation be the subject of a separate engagement or the basis for increased charges or fees."

As everybody knows, exactly the opposite has happened. Sarbanes-Oxley implementation caused separate engagements and caused fees charged by accounting firms to soar dramatically. It thus caused a profit bonanza for the partners of accounting firms at the expense of corporate shareholders, who have absolutely no say in the matter.

At the same time as the public accounting firms have received this unintended, windfall enrichment, they have also become excessively risk-averse and reluctant to give professional advice to their clients on the application of America's complicated rules-based accounting standards. Moreover, having been guided by implementing regulations to focus on remote possibilities and operating in fear of criticism, they appear to have lost all sense of materiality.

The SEC and the PCAOB (the accounting oversight board created by Sarbanes-Oxley) have sharply criticized the accounting firms for what Sarbanes-Oxley implementation has become. Neither, however, has accepted any responsibility for its own role in generating the huge, unproductive costs for shareholders and profits for accountants.

Business voices from all over the country, especially smaller companies, have been petitioning Congress for redress of the burdens and bureaucracy which were unintentionally imposed.

Fortunately, they are being listened to by some legislators. Congressman Tom Feeney (R-Florida) introduced HR 5405, the "Compete Act" on May 17, joined by 13 co-sponsors. The bill would address the problems created by Sarbanes-Oxley implementation, bring its costs into better balance with the benefits, and clarify for accounting firms what is expected of them. Senator Jim DeMint (R-South Carolina) introduced a similar Senate bill, S 2824, with six co-sponsors.

The principal provisions of the Compete bill constitute an excellent reform of Sarbanes-Oxley implementation.

They address:

Smaller Companies

The Advisory Committee to the SEC has recommended that smaller companies be exempted from the onerous Section 404 requirements. In a consistent, but more subtle approach, the Compete Act would allow smaller public companies to voluntarily opt-out of these requirements.

If accompanied by an explanation to the shareholders of how the company addresses internal controls, this approach is better suited to a market economy and a free society than what Sarbanes-Oxley implementation has become.

Section 404 implementation true believers assert that investors will prefer companies which spend the money for 404 audits and so will pay higher prices for their stock. If that is so, it is a great argument for a voluntary standard.

If investors actually want the vast internal control documentation that 404 as implemented by regulators and accountants demands, then the companies will voluntarily do it because investors will pay up for it. But if investors conclude that the resources would be better spent elsewhere--on research, new products or customer service, for example--then companies will manage accordingly.

The stockholders, especially of smaller companies who are most burdened by the Sarbanes-Oxley implementation, deserve a say in how their money is spent and how much they pay for being "protected."

Audit Frequency

The Compete Act would reduce the heavy cost of 404 audits, either voluntary or mandatory, by making them less frequent after the first year of compliance. After that, audits would be done on a random basis for a certain percentage of companies each year. This is a simple and very sensible idea.

Materiality Standard

In an essential reform, the Compete Act would direct the SEC and PCAOB to change the audit review standard from "other than a remote likelihood," which has caused Sarbanes-Oxley to be everywhere associated with nitpicking and trivial paperwork, to a reasonable "material weakness" criterion.

Auditor Advice

In another essential reform, the Compete Act would clarify the idea of "independence" to correct its current unfortunate effects on accounting firm behavior, and assure that prudent, professional advice and interaction with clients is encouraged.

A Principles-Based Alternative

U.S. accounting is generally recognized to suffer from its excessively rules-based approach. Sarbanes-Oxley implementation has the same problem.

The Compete Act would mandate a study of the principles-based British guidance on corporate internal controls, comparing and contrasting it with the expensive American experiment with Sarbanes-Oxley implementation to date.

Congressman Feeney and Senator DeMint should be congratulated for getting the ball rolling on addressing this critically important issue in the competitiveness of American companies and capital markets.

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