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.

13 thoughts on “Sarbanes-Oxley”

  1. Sarbanes Oxley has done an excellent job of increasing the pay to corporate attorneys and accountants with a minimal increase of information of value to investors.†

    The best thing that could happen to accounting reports is removal of the legal mandate for audited financials. The market of investors knows more about what constitutes adequate reporting for a company than the SEC, FASB or the Big (and shrinking) Five. Conforming to GAAP has become a game that is played to see how far the rules can be bent with out breaking them. The spirit is honored only by the breach. If managements had to stand by the numbers they report without the firewall of a public auditor they would be more attentive to what investors need and they would save money.

    That is not to say their is no place for a third party review, only that it should not be mandated and designed by law. The market is perfectly capable of getting what it wants or punishing a company. If the legal requirments were removed, the market could be more agressive in getting what it wants.

    As far as having truly independent auditors, the problem is who chooses and pays. It is hard to imagine a system in which the selection and payment is made by anyone other than the management. The board could make the choice and pay the firm directly, but this would make the relationship of the auditor and management more adversarial. The British practice of changing firms every 7 years is an idea that makes a lot of sense in approaching this goal.

  2. Very apropos Mitch. I’m working on a Sarbox project as we speak. I can tell you, from the front line, Sarbox is the biggest scam yet imposed on corporate America. It more or less amounts to a transfer of wealth to the Big 4. I’m guessing their lobbyists in DC had something to do with it. But you’re on the money. Like all government imposed quick fixes, it’s causing more problems than it purports to fix. Iíve been meaning to write something or other on Sarbox, but surprise, nothing like government mandates to create busy work. Iím biting the hand that feeds me obviously, but I have my ax to grind. Iím also getting headhunted, so I should free of Big Brother pretty soonÖ

  3. Does anybody else find it funny that the U.S. Congress and Senate would try to outlaw shady accounting practices?

    Certainly no other organization in the country would be more familiar with the subject matter though.

    I guess the old idea of leading by example was abandoned early in the deliberations.

  4. Mr. Davis — there is a provision in the law calling for a study of mandatory auditor rotation every five years. I don’t think that idea is going anywhere. I like your idea of optional certification, sort of like the ISO process.

    As a personal aside, I interviewed with one of the Big 4 accounting firms’ compliance practices, mostly devoted to Sarbox and SAS 70 work. It was pretty scary. I actually withdrew from consideration.

    As for Congressional leadership, a friend of mine is from Baltimore and he had a few remarks about Sen. Paul Sarbanes. He nominated Sarbanes for one of those celebrity dead-or-alive contests the radio stations run from time to time. He also said the guy is mostly inert, which is a good thing considering that the one piece of legislation with his name on it is a total screw-up. This seems to be an unfortunate departure from form.

  5. I’ll jump in bits and pieces at a time.

    The biggest problem with Sarbox is that like gun control, you’re only punishing the companies who play by the books. If you’re going to commit massive fraud, Sarbox isn’t going to stop you. It turns out to be just another added cost to doing business.

  6. Mitch,

    ISO is an excellent example of what I had in mind! Thanks for the example.


    Economists have been libelled!

    From his website:

    “Sarbanes received an academic and athletic scholarship to Princeton University (A.B. degree, 1954). He was awarded a Rhodes Scholarship that brought him to Oxford, England (First Class B.A., 1957). Sarbanes then returned to the United States and attended Harvard Law School. After graduating in 1960, he clerked for Federal Judge Morris A. Soper before going into private practice with two Baltimore City law firms.

    In 1970 he was elected to the United States House of Representatives, the first of three terms. While in the House, from 1971-76, Sarbanes served on the House Judiciary Committee, the Merchant Marine and Fisheries Committee, and the Select Committee on House Reorganization. It was during his service in the House, in August 1974, that Sarbanes was selected by his Democratic colleagues on the House Watergate Committee to introduce the first Article of Impeachment, for obstruction of justice, against President Richard Nixon. On November 2, 1976, Sarbanes was elected to the United States Senate. He was re-elected in 1982, 1988, 1994, and 2000.”

    No hint of economics, though he may have had Paul Krugman as a TA in Econ 101. Just your garden variety Rhodes Scholar attorney who has screwed things up for people who actually build and do things to help the economy and their fellow man

  7. Mr. Davis,

    You are right and I stand corrected! I hereby apologize to all economists, former economists and wannabe economists — though not to Paul Krugman, who probably wishes that all economists were more like Sen. Sarbanes.

  8. On one hand, you argue that the market deals efficiently with fraud by running crappy businesses into Chapter 7. On the other hand, you claim that the conflict of interest in accounting and consulting organizations will continue to be a problem, even citing AA as a casualty in the same breath.

    So if the market has punished AA, as it has, then why should we continue to see problems? Why wouldn’t the same mechansim apply to accounting firms?

    Beyond that, I agree with your conclusions.

  9. Hi Spongeworthy
    Actually, the way I understand it, the market didn’t punish Andersen. They were organized as a partnership and its shares were not available to the public. What killed them off was the felony conviction. That made them unable to conduct audits of SEC-registered companies and would have caused their licenses to be revoked.

    About the only market discipline available would be if their name had become so blackened that their clients all deserted.

    As it happened, there were many repercussions to the former Andersen employees and partners. Many were picked up by other firms, but any partnership equity was gone. Some who had recently been admitted to the partnership had taken out loans to buy their shares. The shares are gone, but the debt remains. The punishment, if that’s what you call it, was distributed without regard to guilt.

  10. The way I see it is that the AA partners were treated exactly as shareholders in a bankrupt corporation would be–they got wiped out. Granted, what you don’t have is the quoted liquid marjet that allows you to watch the shares plummet in reaction to purported wrongdoing (see SmithKline today).

    But the negative repurcussions of wrongdoing are what should–beyond morality–preclude that wrongdoing. The economic penalties for screwing folks apply to publicly held companies and private partnerships, and that should have been reason enough for AA to police itself. Go figure, eh?

    So yes, the market in the purest sense would not be the instrument to self-regulate a partnership, but certainly the economic penalties ought to be scary enough.

  11. Shareholders in a bankrupt corporation would lose the value of their shares, which in most cases means they would not be wiped out. Some AA partners of long service, who were not involved in the scandal, lost their retirement savings. There were (and still are) fundamental problems with our corporate auditing system, and of course people who engage in fraud should be punished, but it’s possible to go overboard.

    It’s just as bad to have too much accountability as too little. Accountability should be as specific as possible WRT individuals and actions. If you make too many behaviors illegal, or decree broad punishments for entire companies, you can deter productive activity as well as fraud. Before the scandal there was formal accountability via anti-fraud law, with informal accountability imposed by the securities markets when abuses got out of hand. The markets have adjusted since the scandal, and are now more sensitive to hints of fraud, but the law has gone overboard. We have too much formal accountability now, with corporate executives liable for things which they cannot possibly control.

    The market’s informal oversight will be relaxed or extended to reflect actual business conditions, but we are probably stuck with Sarbanes-Oxley for the foreseeable future. It is bad legislation that amounts to a threat of collective punishment. It deters productive behavior as well as fraud and imposes big costs for uncertain economic benefits (though big political benefits). It protects mainly the jobs of politicians and of partners at the remaining big accounting firms.

    Pols and journalists are always giving lip service to the importance of competition in the modern international economy, but they support new rules that impose high costs on business and make it less competitive. There is always going to be some fraud, just as there is always going to be some petty theft. We could eliminate petty theft by mandating the death penalty for thieves and their families. We don’t do so, because we recognize that the net costs of such measures exceed the net gains. Sarbanes-Oxley is the corporate equivalent of a death penalty for minor crimes, with guilty, less guilty and not guilty executives punished at the same level.

  12. Certainly we agree there.

    Anybody who is “wiped out” by any business failure has violated the rule of diversity. Of course, some have little choice and many are numbskulls. But the degree of penury isn’t really at issue–the economic penalties of committing fraud are serious and should be quite enough to preclude it. That said, I am constantly amazed at how many who do defraud others are wealthy prior to the fraud. Go figure.

    Sarbanes-Oxeley is just more dopey throw-poorly-thought-out-barn-doors-shut-after-the-cows-have-bolted legislation. Fortunately, the FASB lobby got their foot in the door so the accountants should do all right. But the rest of us have real cause to be ashamed at what public outrage wreaks upon us when craven politicians smell a camera. (See Elliot Spitzer.)

    Best to all.

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