Sarbanes-Oxley and Smaller Reporting Companies: There is a Better Way

I apologize for the long interval between this and my last posting – especially to those of you who have privately thanked me for material just boring enough, and long enough, to induce a good night's sleep. Tax blogs, I am told, are much too potent unless one is planning to spend an entire holiday weekend in bed.

This long-awaited naturopathic sleep remedy is based on Floyd Norris' recent critique of efforts to roll back some of the provisions of the Sarbanes-Oxley Act. Roughly in descending order of offensiveness, we have movements afoot to:

1. Place the FASB under the supervision of a systemic risk agency, which would in turn be heavily influenced by the banking interests who still blame fair value accounting for the financial crisis;
2. Rescind for companies that have a public float of less than $750 million the requirement that an auditor attest to management's assertions regarding the effectiveness of internal controls (S-OX 404(b));
3. Challenge the constitutional legitimacy of the PCAOB; and
4. A House of Representatives committee vote to exempt the 6,000 'smaller reporting companies' (i.e., market cap. < $75 million) from complying with S-OX 404(b).

If I had been writing a blog back in 2002 as S-OX was being rushed to a vote in spasms and fits of self-righteous bipartisanship (did blogs actually exist?), I would have predicted something like this would be happening about now. Having nothing whatsoever to do with the philosophical leanings of the party in the majority, such is the formula by which U.S. political dramas are scripted. Declarations of war (figuratively and literally) through zealous and hastily enacted statutes are inevitably followed within just a few years by reversals to more moderate positions. Regarding the securities laws (and holding the frightening prospect of IFRS adoption aside), we are clearly in a period of moderation, albeit more misguided than usual.

While I echo Norris' sentiments on the first three items, I had only a few weeks ago expressed my glee that requiring smaller public companies to comply with S-OX 404(b) might soon be trashed. I had previously observed that S-OX 404(b) attestations have appeared to devolve into a go-through-the-motions exercise. Those suspicions are validated to some extent by a recent ruling against defendant Deloitte on a motion for summary judgment in a lawsuit alleging that Deloitte failed to adequately report on internal control deficiencies at WAMU. Jim Peterson of the Re: Balance blog avidly follows the solvency tightrope that each of the Big Four is walking as they try to fend off litigation arising out of 'traditional' public company audits. His view is that auditors should walk away from S-OX 404(b) work while they are still ahead. 

There Must be a Better Way

Even though S-OX could have, and should have, been more tightly focused on measures to prevent another Enron or WorldCom from happening, something was missing in the securities laws for providing reasonable assurance that management public companies, both large and small, are taking their financial reporting responsibilities seriously enough. I just don't agree that S-OX 404(b) was the right way to go about it.  Notwithstanding other merits of a financial reporting regulation, a windfall to gatekeepers, especially those sharing the blame for a lack of confidence in the system, is a reason for any reasonable person to be suspicious. 

Given that change is in the offing, now may be the time to bring back my old war horse, mandatory audit firm rotation. The resistance to mandatory audit firm rotation in the wake of Enron and WorldCom came from the AICPA, which couldn't bear the thought of auditors being audited by other auditors. Their main stated argument had been that switching costs would be too high, as audit efficiencies in the client's environment take a few years to be realized.

Even accepting the AICPA's excuse, which I absolutely do not, it is a fact that the vast majority of audits of smaller firms are much more straightforward. That should mean that the successor auditors can, relatively speaking, take over from predecessors without breaking stride. I would like to suggest to Mary Schapiro that, instead of pushing against the bipartisan will of Congress to let smaller reporting companies out of S-OX 404(b), she should promote mandatory audit firm rotation. There is nothing to suggest that it will impose anywhere near the scale of costs engendered by S-OX 404. With little at risk, it could actually transform audits from a make-the-client-happy exercise to one that moves the U.S. toward the forefront of global capital markets just in terms of basic integrity.

Let's pick 2,000 smaller reporting companies at random and require that they switch auditors within a year; another 2,000 next year, and 2,000 the year after that. If done right, there should be a wealth of data for the SEC and academics alike to analyze. For the next time we take a whirl on the regulate/moderate merry-go-round, we will at least have some hard evidence to take along.

(By the way, I recommend that you try Kevin LaCroix's D&O Diary blog for excellent non-technical summaries of current developments in securities litigation.)

Comments

[Independent Accountant]

TS:
I couldn't disagree more. We need to repeal the 1995 Litigation Reform Act and the Stonerridge decision and let the plaintiffs' bar sue away. Why not have mandatory rotation for GE, IBM, Goldman, Fannie, Freddie, etc.? Real rotation, not one Big 87654 to another. There was nothing "missing in the securities laws for providing reasonable assurance that management of public companies ... are taking their financial reporting responsibilities seriously enough', except a lack of enforcement.