Subject: File No. 4-497
From: John A. Yerrick
March 5, 2005
On December 13, 2004, the Washington Post published a thoughtful editorial relative to Sarbanes-Oxley Section 404. I believe the comments contained therein fit the type of feedback the Commission was looking for in its press release of February 22, 2005, announcing the April 13, 2005, roundtable discussion and therefore I am including the editorial in its entirety below:
TWO YEARS AGO, in the wake of the Enron scandal and its successors, Congress passed the Sarbanes-Oxley Act, the biggest overhaul of corporate governance since the 1930s. Several parts of that reform have worked as envisioned. Chief executives and chief financial officers are more serious about their responsibility to provide shareholders with truthful financial statements. Conflicts of interest have declined at auditing firms, which used to certify the accuracy of management accounts while also depending on those same managers for consulting contracts. A new oversight board for auditors has been created, and company boards are more vigorous in ensuring that auditors report to them rather than to the chief financial officers whose accounts they are supposed to be checking. All these changes should help to rebuild investors' confidence in corporate statements, ensuring that capital flows to firms that will use it most efficiently. But one part of this overhaul is proving unjustifiably costly.
The costly aspect of Sarbanes-Oxley is Section 404, which concerns companies' diligence in stress-testing their financial systems. Companies depend on a fallible mix of staff and software to track costs and revenue, and these systems need to be checked periodically. Are the invoices sent out to customers correct? Is their cumulative value properly entered into the company's computers? Are overseas sales being converted at the appropriate exchange rate? Sometimes things can go spectacularly wrong. In one celebrated case, a firm's software program logged the revenue from every sale but failed to record any reduction in inventory. As a result, the company reported glorious profits on these sales, until a check of the warehouses at year's end revealed that the inventory reported in the accounts did not exist.
The post-Enron reform requires that auditors check the quality of financial controls and that their assessments be published. This has created a corporate frenzy not seen since the panic over the potential for a "Y2K" computer malfunction in the days leading up to Jan. 1, 2000. Auditing firms are so overworked that they are dropping smaller clients, leaving them stranded. Complying with Section 404 costs the average large company around $5 million -- General Electric Co. has spent $30 million on the process -- and even corporate leaders who supported the post-Enron reform can now be heard complaining. Foreign companies with listings in the United States are muttering about withdrawing.
Not all the grumbling is justified. Much of the pain of implementing Section 404 occurs only once; maintaining good accounting controls after they are in place won’t cost much. The benefits of sound controls are clear. They are a prerequisite for accurate corporate accounts, and they underpin efficient management as well: If firms have a tight grip on sales, for example, they can practice just-in-time procurement of inputs. But the auditors have taken their new mandate too far, demanding to know how $200 pools of petty cash are safeguarded or whether expense accounts are signed properly. The cost of this minute oversight exceeds the benefits.
Regulators have made some progress in recognizing this problem. They recently relaxed the deadline for small companies to get their financial controls audited, and they have published pointers on what might constitute excessive oversight. But auditors have no incentive to hold back. If they crawl over a company's systems with a fine-toothed comb, they can be sure to avoid blame for scandals and they can bill extra as well; on the other hand, there's risk but no reward in restraining their investigations. As a result, auditors have sometimes refused to curb their efforts even when encouraged informally to do so by the new audit oversight board. It may take formal guidelines on the level of scrutiny that's required to rebalance auditor incentives."
John A. Yerrick