Sarbox's Unseen Costs

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Sarbox's Unseen Costs

I applaud your article detailing the costs the Sarbanes-Oxley Act of 2002 has imposed on public companies in the United States ("Sticker Shock," September). The article is one of only a few to raise the question of whether the costs of Sarbanes-Oxley compliance are worth the benefits. And it points out that the direct costs are measurable, but the benefits are not. Although executive agencies are obliged to estimate costs and benefits when promulgating regulations, Congress is not under such a stricture. Sarbanes-Oxley is the result.

The most significant costs wrought by Sarbanes-Oxley are those not readily seen. The crucial unseen cost is that of innovations foregone or delayed because resources for research and development are being used instead to pay for Sarbanes-Oxley compliance. Who would have chosen to delay by months or years the development of Prozac, Zithromax, or the insulin pump in favor of having the CEOs and CFOs of the companies responsible for the products certify the companies' financial statements?

Another important and related unseen cost is the cost of companies choosing not to become public, because of the costs of being public. By raising the cost of directors' and officers' insurance, accounting, hiring able executives, and populating the board and board committees with able directors, Sarbanes-Oxley has made raising capital in an initial public offering more expensive and difficult, thereby reducing the capital available to finance young, innovative companies that drive technological advances.

Many less-costly proposals for encouraging enhanced disclosure and curtailing corporate fraud have been advanced, such as empowering the stock exchanges to choose rules that investors value highest relative to the cost imposed on listed companies, and better enforcement of existing antifraud rules. Such rules have the benefit of an agency weighing costs and benefits before burdening productive people and capital with costs without any discernible benefit. Congress would do well to first consider ways to stimulate corporate entrepreneurism and innovation before smothering them under a mountain of compliance.

Thomas C. Klein
Member
Wilson Sonsini Goodrich & Rosati
Palo Alto, California

It is important to remember that the problem being addressed by Sarbanes-Oxley also has a very high cost. Some of the recent frauds caused companies' market values to drop by $10 billion or more. In addition, widespread decreased confidence in the financial markets due to all of the accounting scandals certainly played a role in the U.S. equity markets losing a significant portion of their value in recent periods. If we add job losses, creditor losses, and so on, the cost of accounting fraud can be staggering—in the tens of billions of dollars for large frauds.

How much will Sarbanes-Oxley compliance really cost the United States? To get a "ballpark" number, I used the data in your questionnaire (question 3 in "Sticker Shock") to extrapolate your respondents' estimated compliance costs to the population of about 15,000 U.S. public companies. For example, for the "less than $500,000" cost category, I took $250,000 (the midpoint) times 52 percent times 15,000 companies. Doing this for all five categories (using $8 million as the midpoint for the "more than $5 million" cost category) produces an estimate of about $15 billion for all public companies to comply with Sarbanes-Oxley for the first year—and this method likely produces an estimate on the high side. To put this $15 billion in perspective, if Sarbanes-Oxley can prevent one large fraud in its first year, you could argue that the legislation pays for itself—and annual compliance costs in later years are expected to decline.

A main thrust of Sarbanes-Oxley is Section 404 on internal controls. Stronger internal controls are designed to increase the reliability of financial reporting (that is, reduce the risk of fraud and other misstatements), and I believe that the intense focus on controls may push many companies' cultures toward greater accounting conservatism and transparency. Despite all of the complaining we hear, I think Sarbanes-Oxley could turn out to be relatively cheap medicine for our "fraud influenza."

Dana R. Hermanson
Professor of Accounting
Kennesaw State University
Research Fellow, Corporate Governance Center at the University of Tennessee
Kennesaw, Georgia

Microsoft on Options

Microsoft appreciates the opportunity to point out what we believe to be misleading conclusions in "Windows into Valuation." The article attempts to compare the Black-Scholes value of Microsoft employee stock options to the value employees would receive under a recently proposed stock-option transfer program. For instance, while the table included with the article correctly points out that the Black-Scholes values are based on disclosures in Microsoft's 2002 10-K, the calculation of those values appears to use the expected life of the options at the time they were granted, without addressing the fact that the options have been outstanding for a period of time, and therefore a shorter life would be appropriate.

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