For many companies, complying with a key provision of the Sarbanes-Oxley law is proving to be a tough task. But who's to blame and whether the chore was worth the effort are up for debate.
The provision calls on companies to assess and -- for the first time -- report on the state of their internal controls, a system of checks and balances over financial accounting that are designed to prevent corporate fraud. In recent weeks, hundreds of public companies have warned investors either that they have significant problems with their controls or that they won't be able to finish their reports in time to meet a mandated
deadline. Meanwhile, estimates of the cost of complying with the provision keep growing.
"We're now in the final stages, and it is just a freaking mess," says Jeff Brotman, a professor of accounting at the University of Pennsylvania's law school and the managing partner of Philadelphia-based Ledgewood Law Firm.
After delaying implementing the provision several times, the
Securities and Exchange Commission
required that the larger public companies -- those with market capitalizations of $75 million or greater -- include their internal controls reports on annual reports filed beginning last month. The SEC
gave smaller companies an extra 45 days to file their reports.
With many companies' reports due by last week, the data indicate that quite a few are having problems with compliance:
Of the more than 2,600 companies that had filed their annual reports by March 16, some 289 of them -- or 11% -- had warned of material weaknesses, according to data compiled by the Corporate Executive Board . Among the companies disclosing weaknesses: OfficeMax , Chiron ( CHIR) and MCI ( MCIP).
Another 291 companies with market caps over $75 million have warned investors this year that they will be late in filing their annual reports, according to the CEB. That's up from just 65 companies last year. While not all of those are related to complying with the internal controls provision, "roughly half" are, says Eisha Tierney Armstrong, managing director of the CFO Executive Board division of the CEB. Among those asking for more time to deal with the compliance provision: Cray , PC Mall ( MALL) and Carrizo Oil & Gas .
The actual cost of complying with the internal controls provision was about 39% higher than companies were expecting to spend, according to a survey by Financial Executives International. For the 217 companies surveyed, which had an average of $5 billion in revenue, the average cost of compliance was $4.36 million, according to FEI. That was in addition to regular auditing fees, which have also been on the rise, FEI said.
Analysts have blamed compliance problems on a number of factors. Worried about their financial liability, accountants seem to have taken a hard line on internal controls, dubbing even minor problems a "material weakness," some analysts complained.
Brotman, for instance, who advises a number of corporate clients, has heard of companies being cited for "material weaknesses" for reporting information in the wrong footnote in their financial reports or because the minutes of a board meeting weren't signed by the secretary until the next meeting.
"I don't want to minimize the fact that some companies have weaknesses in their controls and are having trouble complying," says Brotman. "But there's an awful lot of false positives out there."
Others complain that federal regulators have not given enough guidance to the accounting firms on how closely they should scrutinize companies' controls. In the absence of that guidance, auditing firms have often unnecessarily duplicated internal corporate efforts, they say.
"We've ended up with the worst of all worlds, the rules weren't clear enough, and they weren't focusing on those things that really add value to shareholders," says David Hirschman, senior vice president at the U.S. Chamber of Commerce.
But other analysts think that companies have few excuses for not complying. The requirement that they have controls has been out there since the late 1970s.
"It's disappointing that companies can't meet the deadline. It's not as if they didn't know about it," says Elliot Schwartz, director of research at the Council of Institutional Investors, which represents public and corporate pension funds.
Similarly, analysts disagree about what to expect in coming years. Some believe that many of the costs and problems that have cropped up are first year troubles, typical of any new initiative. And the costs of complying are a "drop in the bucket" next to the losses investors sustained due to the accounting scandals of recent years, says Lynn Turner, the managing director of research at proxy adviser Glass Lewis.
But some corporate backers worry that the costs, at least, may continue to rise.
"The verdict is still out on that," says Grace Hinchman, senior vice president of FEI, which represents corporate CFOs, treasurers and controllers. "There needs to be
more information on how the audit in year two will be conducted."
Whatever they are, companies will likely have to continue to bear the costs and problems for the foreseeable future. Despite the complaints of business groups, Congress is unlikely to re-open Sarbanes-Oxley anytime soon, analysts say. With the trials of figures such as Bernie Ebbers keeping the accounting scandals that led to the law still in the news, there's little appetite on Capitol Hill to touch it.
"At this point, it's just too early in the cycle to go back and address it," said Jaret Seiberg, a financial services policy analyst at Stanford Washington Research Group. "It hasn't reached the point where someone
in Congress says, 'There must be something wrong.' I think we're a long way from that point."
For their part, investors seem to be taking the problems in stride. Some companies,
such as Cray, have seen their stocks hammered after reporting problems in complying with the Sarbanes-Oxley provision. But that seems to be the exception, not the rule. A survey of companies that reported material weaknesses in their internal controls indicated that in the five days following their reports, their stocks underperformed the market by just 2.9%, according to the CEB.
"That's a pretty mild market reaction," said CEB's Armstrong, suggesting that investors may be giving companies "a hall pass for the first year."
And despite the complaints of companies and their backers, many analysts feel the exercise has been worth it. That so many companies have had to report problems with their internal controls illustrates that Sarbanes-Oxley is "doing its job," said Charles Mulford, professor of accounting at Georgia Tech's college of management.
"It's helping uncover weaknesses that were either unknown or being ignored to potential peril of the company and its investors," he said.