Sarbox on Ice?

Although it's not even five years old, there's no question that the Public Company Accounting Oversight Board has seen better days.

Currently the target of a lawsuit that threatens its existence, the PCAOB has also been criticized by its boss, the Securities and Exchange Commission, for burdening Corporate America via excessive internal-controls rulemaking. Caught amid an apparent widespread counter-reaction to post-Enron reforms, the oversight board has become a poster child for over-regulation.

Indeed, if the plaintiffs in the lawsuit get their way, the PCAOB—and the Sarbanes-Oxley Act that spawned it—will no longer exist. In late December, a U.S. District Court judge heard arguments from both sides in the case against the accounting board. The plaintiffs, who contend that the PCAOB setup violates the Constitution, think that if they dismantle the board, all of Sarbox will tumble in the legal wake. While the judge is likely to hand down a ruling as soon as in March, Michael Carvin, a Jones Day attorney representing the plaintiffs, told CFO.com recently, the case will almost surely be appealed by the losing side and end up in the D.C. Circuit Court.

Assuming that the board hangs around for awhile, though, it's sure to find itself on a short leash. For years, the SEC has faced heavy pressure to make the rules under Sarbox 404, which covers internal controls over financial reporting, cheaper and less burdensome for smaller companies. The commission responded late last year with new guidance on how corporations should comply with the rules and apparently pushed PCAOB to get with the program and revise its own controls standard for auditors, AS2.

Further, SEC members have laid the blame for the 404 brouhaha squarely on the accounting board's brainchild. With the SEC failing to provide guidance until it issued its recent proposal, senior finance executives and controllers defaulted to AS2 as the key compliance guideline.

And that, the comissioners contend, led to disaster. "We had an atmosphere in which what-if scenarios created mountains out of molehills — a control failure for a $500 error could be just as significant as for a $50 million error," Commissioner Paul Atkins told the Corporate Directors Forum in San Diego on January 22. "And, we had companies being told to document, analyze, and create process charts for literally tens or hundreds of thousands of supposedly key internal controls — and those numbers are for individual companies, not the market as a whole."

Even the president got into the act in a speech on Wall Street on Wednesday. "We don't need to change the law," President Bush said of Sarbanes-Oxley, "We need to change the way the law is implemented. . . [c]omplying with certain aspects of the law, such as Section 404, has been costly for businesses and may be discouraging companies from listing on our stock exchanges."

In response to such criticism, the SEC and the PCAOB are proposing that checks on internal controls should be limited to areas that could sprout the risk that a material misstatement could go undetected. By moving to a solid, agreed-upon definition of materiality, the regulators contend that they could make life a whole lot easier for corporations while still remaining rigorous.

The regulators' sharpened language is one of a bevy of signals that federal rulemakers and legislators finally seem to be easing up after five years of post-scandal tightening. Add to that an increasingly aggressive push for tort reform for auditors, and you've got the makings of a full-scale loosening of strictures that, critics say, have entangled corporate finance.

Or do you? A second look shows that there may be more sound than fury in the movement to dismantle Sarbox, et al. Outside of the plaintiffs in the suit against PCAOB, few have openly called for a revocation of the 2002 law. Even the Committee on Capital Markets Regulation, a group backed by Treasury Secretary Henry Paulson that wants to free the U.S. capital markets from what it deems the excesses of 404, has no malign designs on the act itself. "We recommend no statutory changes in the Sarbanes-Oxley Act, including Section 404. Investors have benefited from the stronger internal controls, greater transparency, and elevated accountability that have resulted from this new law," the committee said in its December 5 interim report.

At the same time, the group blames "the implementation of SOX 404 by the SEC and the PCAOB" for producing a "regime that is overly expensive." Like the SEC, its solution consists largely in raising and clarifying the standard of what might be a material weakness in internal controls. The committee recommended that the PCAOB change AS2’s existing definition of a material internal-controls error from one in which there's a "more than remote likelihood" that a material misstatement wouldn't be detected.

That definition has befuddled auditors and made them overly scrupulous, the PCAOB acknowledges. Instead, Paulson's group proposed, the definition should read: "A material weakness exists if it is reasonably possible that a misstatement, which would be material to the annual financial statements, will not be prevented or detected." The SEC and PCAOB proposals, issued shortly after committee's report, both use the new language.

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