Investors Like SARBOX

Stephen DeAngelis

January 25, 2007

According to a BusinessWeek article by David Henry, Sarbanes-Oxley regulations have been a big hit with investors [“Not Everyone Hates SarbOx,” 29 January 2007]. There has been no shortage of news about how unhappy businesses have been with the legislation and I’ve written several posts about their displeasure [Corporations, Compliance, & Competitiveness, More on Compliance & Over Regulation, Small Companies Get SOX Relief, and Attacks on SOX Continue]. Henry notes:

“The complaints have been so passionate that regulators are now planning to loosen the rules, probably before the year is out. Not so fast, says a growing chorus of investors. Lost amid all the boos over SarbOx, they say, are some major benefits. The biggest: SarbOx and related reforms have produced much more reliable corporate financial statements, which investors rely on when deciding whether to buy or sell shares. For them, SarbOx has been a godsend. What’s more, says Duncan W. Richardson, chief equity investment officer at Eaton Vance Management and overseer of $80 billion in stockholdings, even the act’s much disparaged requirements for testing internal financial controls could drive gains in corporate productivity and profits.”

Henry notes that earnings statements have been better prepared and have contained less spin since SOX legislation was passed. In addition, executives seem to have a much better grasp of costs. Henry writes:

“Beefed-up disclosure requirements have also meant that companies now deliver numbers with fewer adjustments for unusual charges and write-offs, which in the past have been used to make earnings look better. Thomson Financial’s Earnings Purity Index, which tracks earnings adjusted for such write-offs, shows improvements in each of the past four years. And now earnings reports reflect expenses for incentive stock options, information investors like that wasn’t available before the big accounting scandals. Just as important, executives appear to have a firmer grasp of costs when they talk about operating margins, according to Richardson of Eaton Vance. He credits the improvement to the infamous Section 404 of SarbOx, which requires documented testing of internal controls. ‘Even not-so-good management teams have good controls now, and that leads to an ability to cut costs,’ he says.”

While all of this sounds good, complaints have mostly been about costs making companies non-competitive. This is especially true for small public corporations. Henry notes:

“This isn’t to say SarbOx is flawless. Section 404 is often applied unreasonably, causing costly checks of minor book entries. It’s bad, too, that small-scale businesses find fewer benefits relative to the costs.”

Large public corporations also have reason to complain because they have met the compliance challenge by throwing money and people at it. At Enterra Solutions, we believe costs and errors can be reduced by automating compliance associated processes. Once in place, these automated processes provide corporations with a competitive edge over rivals. Despite the praise for SOX, Henry warns that investors should still be wary of financial reports.

“Lack of growth often exposes aggressive accounting estimates used to manipulate earnings. And that’s when some capital investments are revealed to have been hiding operating costs. Still, the next round of abuses to surface will probably not be as bad as it would have been without the reforms. Says Eaton Vance’s Richardson: ‘You’re always better going into any downturn with tighter rules.’ For regulators eager to start tinkering, that’s food for thought.

Corporations can dream about Sarbanes-Oxley going away, but dreaming is about all they can do. Investors, regulators, and legislators have shown no penchant for letting businesses off the hook so that they can return to the accounting practices that brought down Enron and Worldcom. Henry indicates that even those who believe that the legislation needs tweaking need to be careful about how it is done.