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June 8, 2005 – The Sarbanes-Oxley Act of 2002 is getting mixed reviews on Wall Street and in boardrooms. Advocates argue that the rules help eliminate fraud by making corporate leadership accountable. Critics counter that they place an undue burden on smaller companies and dissuade privately held businesses from going public. Two chief financial officers and one accounting professor took a break from the books to respond to questions posed by Small Times’ Candace Stuart.
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What adjustments have you made in your day-to-day work to comply with the Sarbanes-Oxley Act?
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Jankowski: We have more formal authorizations in place, particularly with respect to disclosure controls and internal controls. Prior to the passage of the act, we had solid controls that were often exercised informally.
Nanophase is not a large company. We have always operated in an environment where we were confident in our processes and our reporting. Now, we are spending more and more time documenting and testing workflows and controls that used to work effectively without the formalized load atop them.
Sankaran: The largest area of change has been in the documentation of controls. Historically, we found that our controls were generally in place, however, they were not always documented. For example, every payment and journal entry was always reviewed by the appropriate person, however the reviewer was not always diligent in writing their initials to document their review.
Now we always document each control. Also, we’ve communicated the importance of having a strong control environment to all employees, and I’ve seen a noticeable improvement in attitudes toward things like purchasing controls, headcount requisitions, expense reports, etc. Employees have embraced the need for running a well-controlled company.
White: From an educational perspective, the Sarbanes-Oxley Act and the events leading to its passage have had a profound impact on our day-to-day approach to accounting education. As educators, we are working to inform the students of the requirements, teach practical skills necessary for understanding and implementing internal controls, and, hopefully, addressing some of the environmental issues that have led to this point.
In New Mexico, we have seen a large increase in the demand for accounting students to meet the needs of increased internal control. The demand has not only been from public accounting firms and private companies, but also from not-for-profit organizations and governmental entities.
What has been the most difficult section of the act to meet? Why?
Jankowski: Clearly, Section 404, regarding internal controls, has been the most difficult section to implement and live within. This section must be applied, by law, in a similar way among all registrants (SEC-registered companies).
In essence, Nanophase is complying with many of the same rules applied to billion-dollar companies. Although we are allowed a certain measure of “compensating controls” to allow for certain entity size issues, it’s still more or less a one-size-fits-all standard. Absent these requirements, it would be imprudent to build so much overhead, in the form of formalized controls and procedures, in the case of sub-$50 million revenue companies such as ours.
Sankaran: Clearly the first-year documentation requirements are significant. Basically, we had to document all of our business processes in each of our major locations. The good news is that this documentation effort should be much lighter going forward, since we now have the basic process on paper and need only document changes in the processes.
White: The feedback that I’ve heard is that two of the most difficult sections of the act to address have been the assessment and implementation of internal controls and ramifications to corporate governance. The internal control work has been a time-consuming and expensive proposition. A recent auditing trade publication reported that the “big four” public accounting firms doubled their audit revenues primarily due to Section 404 internal control work. Hopefully, much of this will be a nonrecurring upfront investment.
On the corporate governance side, the act increases the responsibilities of corporate board members. There is a perception that the act and the associated events have also increased the risk of corporate board membership. The combination may have the effect of making it more difficult to recruit board members.
Has the act added costs or other burdens to your company?
Jankowski: The act has added tremendous costs in implementation as well as in ongoing expenses. We will spend six-figure money every year to remain in compliance with the act as it stands. At some point, we may be required to add staffing or additional consulting time, or both, to keep up with the requirements that have been legislated.
Sankaran: Without a doubt. We spent more than $800,000 (greater than 1 percent of our total annual revenue) on our Sarbanes-Oxley Act program in the first year. These costs were for hiring an internal audit director, outside consultants, internal effort and audit fees.
White: The increase in demand for accounting positions likely indicates a shift of business resources to financial reporting and internal control activities. Recently, The Wall Street Journal reported that year-over-year ongoing audit fees had increased by 40 percent for Dow Jones Industrial Average firms.
An increase in cost due to the act is universal across companies. Opportunities for internal savings are firm-specific. For instance, I am familiar with a firm that used the act as the catalyst to replace an outdated inventory control system. The expense may be chalked up to Sarbanes-Oxley; however, it should produce long-term benefits. On the other hand, if the internal control work is just documenting already existing controls, the internal cost benefit may be small.
The SEC is exploring the idea of tailoring the law to the size of the company. Is that a welcome development?
Jankowski: That is an excellent idea. Size consideration should consider revenue volume as well as market capitalization, at a minimum. It does not benefit shareholders to have small companies forced to carry large overhead loads to comply with laws that were not truly designed with them in mind.
Sankaran: As both an investor and a CFO, I believe that these requirements should apply equally to all publicly traded companies, regardless of size.
White: I think it is a welcome development. The nature of the act provides implementation economies of scale related to transaction volume and dollar amount. The resulting impact is smaller to a very large public company than to a smaller firm.
The act may also create a barrier to businesses seeking funding. An exit strategy via an IPO is now more expensive. Business plans have to give consideration to the resource allocations necessary to create a sufficient internal control infrastructure. Firms may balk at incurring these extra costs.
If you could convince the SEC to allow one change in the law, what would that change be and why?
Jankowski: I would have Section 404 of the act allow for much less formalized internal controls in the case of smaller companies.
Without legislative relief, these added costs are going to keep small entrepreneurial companies out of the public capital markets. There will surely be fewer companies like Intel, Amazon.com, and Genentech building our economy without the support of a willing IPO market. If the cost of being public continues to mount, the bar required to take companies public will be much higher in the future. This will stifle creativity and create a risk-averse investment culture.
We would be better off as a society to disclose the risks of investing in entrepreneurial companies clearly, then let the capital markets value these small companies with the full knowledge that they represent a riskier investment, with a potentially greater return, than larger more stable companies. A limited Sarbanes-Oxley class of registrants would then represent one more factor in an investor’s decision-making process.
Sankaran: Currently, companies are documenting, testing and auditing nearly all business processes and their related controls. However, the act was intended to focus solely on controls over financial reporting. The Public Company Accounting Oversight Board and the audit industry have interpreted the act very broadly, to include nearly every activity within the company.
For example, companies are required to document, test and audit their controls over the hiring process, personnel reviews and executive management meetings/minutes. These areas have little or no relationship to the company’s financial statements. This broadening of the scope of the Sarbanes-Oxley Act is why the effort and cost has been so much larger than anticipated.
If we focused on the intended controls over financial reporting processes, I believe that financial results and reports would be far more reliable and Sarbanes-Oxley Act implementation costs would have been significantly lower.
White: I think an area of discussion that makes a lot of sense is addressing the level of allowable interaction of companies and their auditors in discussing implementation issues. If learning-curve benefits are going to be achieved for smaller firms, auditors must be allowed to offer their expertise without fear of compromising independence.
Has Sarbanes-Oxley increased investor confidence as intended?
Jankowski: I don’t think that it has. In our case, we completed our 2004 Sarbanes-Oxley audit having found no material weaknesses. Although we were proud of the audit findings, they didn’t seem to have a significant impact on our stock.
Sankaran: I’ve not heard any direct feedback from the investment community. Interestingly, the market reaction to the first Sarbanes-Oxley Act audit reports has been mixed. I think the jury is still out.
White: I think a strong argument can be made that Sarbanes-Oxley type rules would not have stopped the upper management abuses of the late 1990s and early 2000s. It is hard to say if Sarbanes-Oxley has increased investor confidence. The ultimate proof is in the willingness of investors to commit money.