Small Companies to Get SOX Relief

Stephen DeAngelis

December 11, 2006

According to an article in the New York Times, small public corporations that are subject to regulation under the Sarbanes-Oxley Act will get an early Christmas gift starting this Wednesday — relaxation of some of the more stringent SOX requirements [“S.E.C. to Ease Auditing Standards for Small Publicly Held Companies,” by Stephen Labaton].

The relaxed standards represent a compromise, giving a qualified victory for businesses, which had considered any regulation burdensome, and for the auditing firms, which had benefited from the imposition of stringent requirements on their clients. Section 404 of the act requires publicly traded companies to assess the controls they have put in place to ensure that their financial reports are reliable. The rule, a response to the many accounting frauds that haunted investors before the legislation, was intended to try to discourage fraud and manipulation of financial statements. But Congress left it to the regulators to determine precisely how thoroughly auditors had to examine financial controls, and the commission has repeatedly delayed imposing any rules on smaller companies until it considered their complaints and worked out details — a temporary exemption that benefited about four out of five of all public companies. The commission’s long-awaited interpretation of Section 404 is the culmination of a fierce lobbying battle. It has pitted the largest accounting firms, which have reaped huge profits from the tighter standards, against an equally influential coalition of small public companies, which has lobbied for years for relief.

This SEC action precedes the release of reports aimed at convincing lawmakers that U.S. businesses are being overregulated to the point of being uncompetitive (see my previous posts Corporations, Compliance, & Competitiveness and More on Compliance & Over-Regulation).

The proposal will, for the first time, impose a “materiality standard” — that is, auditors will be advised to scrutinize only those controls that could have a reasonable risk of having a material impact on the financial statements. It is expected to encourage auditors to rely on prior years’ work as a basis for testing controls and discourage auditors from multiple testing of the same controls. And it will encourage the auditors to use a “risk assessment” to focus the audit on the areas of greatest potential concern. Commission officials said last week that the proposal would not be an unequivocal victory for smaller companies because it would not give them what they wanted most: a blanket exemption from Section 404. Nor would it impose a sharp restriction that would limit the auditors to looking at the design of the financial controls. But the officials said the proposal would address many of the cost concerns raised by small businesses.

Its timing, coming as it does during the interregnum between a Republican and Democratic controlled Congress, may signal that the Administration doesn’t know how the Congress will react if significant steps aren’t taken before the turnover. It may also be viewed as an olive branch.

The fight over auditing standards has far broader political implications, according to officials, lawmakers and industry executives. An adequate resolution of the issue by regulators would take significant pressure off Congress to address other complaints from some business groups about the law and other corporate governance rules. Since the Sarbanes-Oxley law was adopted, small businesses have maintained that it imposed unnecessary costs and burdens. The accounting firms, which have experienced a sharp increase in their billable hours as a result of the law, have praised the provisions, while groups representing institutional investors have sought to prevent the regulators from watering down the provision in ways that could lead to more accounting abuses.

In light of this action, large public corporations are likely to increase their lobbying efforts to get relief also, but their case will be harder to make.

Some large companies have also complained about the increased audit costs, but new data suggests that the law is having beneficial effects for investors. A new study by Glass, Lewis & Company to be released this week shows that although financial restatements of public companies increased by 12 percent in 2006, they have actually declined by 25 percent among large companies. The study attributes the decline among large companies to the effects of Section 404.

With the new focus being on the adequacy of internal controls, small and large companies alike should look for solutions that automate processes. Automated processes reduce errors (and fines), increase confidence (by creating automated audit trails), and reduce costs by decreasing the number of manhours that must be devoted to compliance issues. While I see this as good news for Enterra Solutions, it should also be welcomed by small corporations. SOX isn’t going away and the new Congress has promised that it will watch closely to ensure that its provisions aren’t watered down so much that investor confidence is once again shaken.