The Case for Clarity

The cost estimates bandied about by critics of the Sarbanes-Oxley Act are truly staggering. By the end of the year, U.S. companies will have spent $20 billion to comply with the law since it was passed in 2002, according to AMR Research. One study from the University of Rochester attributes a $1.4 trillion loss in stock-market value to the demands posed by Sarbox.

The question this inevitably raises is whether the benefit of Sarbox outweighs the cost. The purpose of the law, after all, is to restore investor confidence in the financial results reported by publicly traded companies, whose integrity was called seriously into question by accounting scandals involving Enron, WorldCom, and a host of other companies. Greater confidence in financial results should translate into a lower cost of capital, but this potential upside has received far less attention than Sarbox's downside.

CFOs themselves are skeptical that greater confidence has materialized — or will do so — as a result of the law, according to a recent survey. The study, conducted earlier this year by Financial Executives International (FEI), found that just 56 percent of the respondents believe that investors are more confident in the reliability and accuracy of their companies' reported results thanks to Section 404, which requires the documentation and attestation of internal controls. As a result, more than 8 in 10 say the benefit does not outweigh the cost.

However, that survey did not ask about another benefit associated with Section 404 — improved business processes. According to a more recent survey by CFO, 7 out of 10 finance executives at public companies say they have seen at least some benefit from Section 404; 93 percent of those cite business-process improvements. If gains from improved operations were combined with a lower cost of capital, the overall benefit of Sarbox might be significant indeed.

Yet few respondents to the CFO survey have seen their cost of capital improve. And in the eyes of many CFOs, business-process improvements alone are not enough to justify the cost of compliance. "I think Section 404 is a very unfortunate misspending of money," says Sharon Tetlow, finance chief at Cell Genesys, a biotechnology company. "There are dollar costs that are large enough that they affect our ability to conduct business. We can spend a half a million or a million dollars to implement Sarbox — that's money we should have spent on clinical trials." Tetlow also criticizes 404 as "a real source of income for audit firms" and questions whether costs will decline as long as those firms have financial incentives to conduct exhaustive audits.

Such concerns have generated an intense backlash against Sarbox, including a slew of proposals to change the 2002 law. At a roundtable discussion held by the Securities and Exchange Commission in May, participants pressed for clearer definitions of material weaknesses, stressed the need for risk-based auditing, and requested a scaled-down version of Sarbox for smaller companies, which many say have been disproportionately harmed by the cost of implementation.

Proponents of the law counter that survey results showing little or no cost-of-capital benefits from Sarbox should be taken with a grain of salt. "The markets needed something dramatic and real to help reestablish one simple thing, and that was faith in the marketplace," notes Mark Haskins, a professor of business administration at the University of Virginia's Darden Graduate School of Business Administration, who likens the impact of the 2001 accounting scandals to the market crash of 1929.

Adds Christy Wood, senior investment officer at Calpers, the $200 billion California pension fund: "I would ask anyone who told me 404 was too expensive, How much is too much? How much is too much to ensure the authenticity and integrity of financial-statement reporting?"

With 16 percent of reporting companies disclosing weaknesses in internal controls during the second year of Sarbox and 7 percent falling into that category so far this year, it is hard to argue that every company aside from Enron and WorldCom was trouble-free. A poll by accounting firm KPMG revealed that 74 percent of audit-committee and other board members were not surprised by the number of internal-control weaknesses identified to date. "How can a company say that 404 was a waste of money if three-quarters of board members had an inkling that something wasn't quite right?" asks Haskins.

From Weakness, Strength
Indeed, finance executives who say Sarbox has done nothing to lower their cost of capital may simply be venturing a guess, as it is extraordinarily difficult to quantify investor confidence.

One recent academic study attempted to do so by examining how investors have reacted to companies' announcements of internal-control deficiencies. The study, co-authored by Ryan LaFond, an assistant professor at MIT's Sloan School of Management, found that firms that announce control problems see a median increase of one percent in their cost of capital compared with firms that make no such announcements.

For companies that subsequently address their control problems and receive an unqualified opinion, the cost of capital goes down by a median of 1.3 percent. "The markets seem to be valuing and honoring the discovery and addressing of material weaknesses," says Haskins. "There may be a positive response to the fact that the company found the weakness."

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