I probably shouldn’t even be writing about this, since it forms a large part of my income, but the National Review had a fine article on Sarbanes-Oxley. This was the law passed after the Enron and WorldCom scandals and the wreck of Arthur Andersen.
Among other things, it requires an annual assessment and report on every public company’s internal control system. The company’s outside auditors must certify the control system, but they are not allowed to design, document, or test it.
The law applies to all public companies, and you would be surprised to know how small some of them are. Public companies with a market capitalization of less than $75 million have some extra time to implement it, but a company with $100 million in market capitalization usually does not have a lot of excess accounting personnel. Many companies are reporting increases in audit fees of 30% – 50%, and about that much again for outside consultants to pull the documentation together and perform the testing.
As an investor, I’m not thrilled with the government’s efforts to protect me. Every nickle a company spends to comply with Sarbanes-Oxley is a nickle out of the bottom line, and out of my dividend. The market already has a means of dealing with fraud — it’s called bankruptcy. Investors sell as fast as they can when they suspect accounting fraud. A company that consistently just makes its EPS estimate is usually punished, because investors know enough to suspect that earnings are being manipulated. The possibility of fraud raises the risk of holding an investment without raising the return, so the price drops. Stockholding is voluntary, and no one except the Enron employees was restricted from selling. Civil and criminal actions against the perpetrators are perfectly appropriate, but if you are not willing to consider the possibility that the jockey is crooked, you should stay away from the betting window. A rigged race is only one way to lose money, and there are a million others.
The law will not even cure the problem that inspired it. Enron and WorldCom could not have happened without the connivance of their auditors, the late and unlamented Arthur Andersen firm. Andersen was getting millions in audit and consulting fees from those companies and had a powerful incentive to let them cheat. The inherent conflict remains: auditors are paid by the people they are supposed to be keeping honest. They are supposed to be furnishing information to the investing public, but they are paid by someone who may have an interest in concealing or spinning that information. Taking a hard line against “iffy” accounting policies can result in losing the client. Until someone can figure out a way to link the auditors’ incentives to their public responsibilities, there will be more problems. You can bet the rent on that.