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The Case for Clarity

You know about the cost of Sarbox. What about the benefits?
Kate O'Sullivan, CFO Magazine
September 1, 2006

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."


But for those that never receive an adverse opinion, the cost of capital goes down by only 0.58 percent. "If you're a good firm and everybody knows you're a good firm, you don't appear to see as much benefit to 404," says LaFond.

One reason why companies that receive repeated clean opinions may not see much cost-of-capital benefit is that their investors assume they have good controls. That assumption of financial integrity is already priced into the stock. "Compliance is like having insurance. You don't get points for having proper insurance, but if you don't have it you get hammered," says Haskins.

In fact, such "insurance" may be part of the valuation premium that companies listing on U.S. stock exchanges enjoy. Observes Nasdaq CFO David Warren: "I don't think we've spent enough time getting people to understand that against the costs [of Sarbox] there are benefits to raising your capital in the U.S."

Foreign issuers that list in the United States see as much as a 30 percent higher valuation than companies that list only in their home markets, says Ohio State University professor Andrew Karolyi, who has co-authored a study on the topic. "We found that the valuation premium was larger for firms that come from countries that have less-developed financial markets and legal systems with fewer protections for minority shareholders," he says.

The premium reflects more than regulation, Karolyi adds. "It's about all the monitors in the U.S. capital markets, whether it's analysts, large institutional investors, lawyers, or accountants."

LaFond acknowledges that the benefits of Sarbox are difficult to quantify. "We decided with our study that we were going to look at one benefit — the cost of capital — and we can say it doesn't look like [the legislation] has been a complete loss," he says. "I'm very comfortable saying there are some benefits, and they are economically meaningful. Whether they exceed the costs, I have no idea."

Still, LaFond says, that's partly because cost estimates themselves are open to question. He notes that such estimates vary widely and may not include such amorphous elements as management time or the opportunity costs of forgoing other projects to work on compliance issues. Cost estimates may also be skewed by other motivations. "Sarbanes-Oxley has increased the monitoring of management, and nobody likes to be monitored. So management has an incentive to overstate the cost, while auditors have incentive to understate it," he says. The methodology of some cost studies, such as the University of Rochester analysis that attributed stock-market movement on the day of a Sarbox-related legislative announcement to the act, has been questioned as well.

Even so, market-watchers worry that the regulatory burden imposed by Sarbox has added now outweighs the benefit of a U.S. listing, and that as a result companies will seek capital elsewhere. At the SEC roundtable, Peter Lyons, a partner with law firm Shearman & Sterling LLP, fretted that European companies would hesitate to list in the United States "unless we can demonstrate to them that the benefits to their stock price...outweigh the costs." The buzz surrounding the London Stock Exchange's Alternative Investment Market (AIM) seems to support this concern. The AIM has seen 130 initial public offerings this year through May, compared with 48 on Nasdaq. The London exchange touts AIM as offering a "flexible regulatory environment" that does not require a company to file a prospectus or reach a minimum market capitalization.

A Toll Road to Capital
Sarbox proponents argue that companies that are attracted to such a flexible regime may not deserve public capital. "If you want public money, [Sarbox compliance] is the toll you have to pay," says Calpers's Wood. "These are the sorts of guarantees that public investors require in order for people to invest their retirement money and their life savings." She urges regulators not to cater to "lowest-common-denominator" companies in an effort to retain U.S. listings. "If the next U.S. company to go public is going to list on the Shanghai exchange because standards are lower there, my reaction is, let them go. Let other investors take the risk of investing in them."

As David Warren told a group of venture capitalists in June: "AIM can become a great feeder market for Nasdaq when those firms are ready to trade up." And, he notes, "We still see companies coming to the United States to list." (Nasdaq listed 22 international IPOs last year.)

As for small public companies that argue that Sarbox costs are threatening their ability to sustain their core business, Wood has no sympathy. "I would say to them that maybe the private markets are better suited to them."

While Sarbox critics fear the law is driving companies away from the United States, Karolyi has the opposite concern. He worries that efforts to soften its provisions will reduce the valuation premium that NYSE and Nasdaq listings currently garner. "If [the SEC and the Public Company Accounting Oversight Board] are lenient and give all sorts of special provisions and breaks to foreign issuers, the value of the franchise — the U.S. capital markets — and what it represents for these global firms may be lost," he warns.


Although the SEC has rejected the idea of exempting small companies from Sarbox, the Commission has indicated (during and after its roundtable in May) that it is willing to compromise.

While that may help satisfy critics, Karolyi worries that they will push for more. "The integrity of the law and what it represents could be why we see 30 percent valuation premiums in the U.S. markets," he says. "If we dilute the standards, that value may dissipate."

Kate O'Sullivan is staff writer at CFO.


A Bunch of Bad Apples

While beleaguered finance executives often point to Enron and WorldCom as the source of all their Sarbanes-Oxley woes, at least a hint of trouble, in the form of material weaknesses, has turned up at hundreds of companies in the second and third years of Section 404 compliance. — K.O'S.

Year Number of Companies Reporting Number of Material Weaknesses Reported % of Companies Reporting Weaknesses
2005 3,900 1,500 16%
2006* 3,000 400 7%
*Through 4/25
Source: Christopher Cox speech at the SEC roundtable in May

Frustrated Expectations

The costs of complying with Section 404 have not declined as markedly as many finance executives expected. Auditor-attestation fees, for example, which were expected to drop by 26 percent in the second year after 404 took effect, fell by just half that amount, according to a study by Financial Executives International. — K.O'S.

Expected % Decline, 2004–2005 Actual % Decline, 2004–2005
Nonaudit Fees* 39.0% 34.5%
Auditor Fees 26.0% 13.0%
*Includes internal staff time and software and consulting fees.
Source: FEI



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