Sarbanes-Oxley may be helping to protect investors, but it is also hitting small public companies with a big accounting burden.The Securities and Exchange Commission established an advisory committee in April of 2005 to see how the weight of SOX could be eased for small filers. The subsequent report, issued as an exposure draft for public comment, offers several recommendations that may relieve some, though by no means all, of the burden.
Some, however, are warning that SOX requirements may be lifted from the very companies that need the most scrutiny.
The SEC declined to comment on the exposure draft, but Joseph "Leroy" Dennis, an executive partner with Minnesota-based McGladrey & Pullen who served on the advisory committee's accounting standards subcommittee, said that the problem is real and the recommendations are important.
Speaking for himself rather than for the committee or his firm, Dennis said, "We've got a lot of smaller companies struggling with issues such as how to implement SOX 404. A lot of the testimony we heard said that Sarbanes-Oxley is doing a lot of good. The struggle has been in 404 for the smaller companies. I hope the SEC commissioners study the report and see what was said in testimony and really do consider some of the recommendations the committee makes."
McGladrey & Pullen has been exceptionally active in calling for small businesses and their investors to comment on the report. Dennis said that response from these investors wasn't very strong in the research phase.
"This is the time for small-company investors to comment," Dennis said. "The SEC is listening to small investors, and if they sit on the sideline, someone else is going to dictate their future. They need to speak up. Whether SOX 404 is important or not important to them, they need to say so."
The report identified several broad concerns, including the complexity of accounting standards, diminished use of professional judgment due to fears of repercussion, lack of choice in selection of audit firms, lack of judgment concerning auditor independence rules, and lack of professional education on SEC matters among auditors.
The committee's first task was to define "small." It came up with a two-tiered system of scaling securities regulation. On one tier are "micro-cap" companies with market capitalization of less than $128.2 million. On the other are "small-cap" companies with capitalizations of $128.2 million to $787.1 million.
The report recommended that a framework for assessing internal control over financial reporting at small companies be developed. Until it is, the report said, micro-cap companies with less than $125 million in annual revenues and small-cap companies with less than $10 million in product revenue should be exempt from SOX Section 404, which sets internal control reporting requirements.
Micro-cap and small-cap companies with up to $250 million in annual revenue would be exempt from the external audit requirements of 404.
Kurt Schacht, executive director of the CFA Centre for Financial Market Integrity, served on the subcommittee and wrote a dissenting opinion, pointing out that the objectives of cost control and investor protection need not be mutually exclusive. But the report's primary recommendations, he said, make them so.
"The primary concern is that the list of companies that would be exempted from having any external oversight of internal controls is entirely too large, and it is precisely the type of companies that need some level of external review," Schacht said after the report was issued. "It's the smaller companies that statistically are the ones that have the most problem with financial reporting controls."
Schacht's dissent noted that exemptions would counter one of SOX's main purposes - to bolster investor confidence. He questioned whether the SEC has the authority to override a requirement of an act of Congress, and warned that the exemption for micro-cap companies relieved not only auditors from assessing internal controls, but managers from performing their own assessments.
Schacht also objected to the report's notion that internal controls for smaller companies are less important because they account for only the bottom 6 percent of investment.
The report carries several other primary recommendations besides possible exemption from Section 404.
Micro-cap companies would be allowed to request the same extended effective dates for new standards that are applied to private companies.
The report also recommended additional guidance on assessing materiality for all public companies with respect to previously issued financial statements. The recommendation responded to the recent increase in restatements due to undetected accounting errors.
"Our concern is that restatements are causing severe drops in price just because it's a restatement, but at the end of the day, are the errors all that material?" Dennis said.
No Big GAAP/Little GAAP
The report soundly rejected the idea of a new set of standards for smaller public companies - the ongoing "Big GAAP/Little GAAP" debate suggesting that smaller companies follow a separate set of generally accepted accounting principles.
"Such an approach would confuse investors," the report stated, "and, in many cases, the financial community would require smaller public companies to follow the more stringent accounting standards acceptable to larger companies."
Dennis said that testimony heard from smaller companies indicated that most would voluntarily adopt the more stringent standards to avoid being perceived as less sophisticated.
The American Institute of CPAs and the Financial Accounting Standards Board continue to consider the possibility of a separate set of standards for nonpublic companies. The SEC report has no direct bearing on that possibility.
The advisory committee also recommended the development of a "safe harbor" protocol for accounting transactions that would allow the preparers of financial statements to use professional judgment without legal liability when proper accounting methods are not clear.
Safe harbor protection would alleviate fears of incorrectly second-guessing regulators and predicting the arguments of lawyers. Auditors and corporate accountants have long complained that such second-guessing often results in expensive and time-consuming consultations with auditors and legal professionals. Safe harbor protection would excuse liability if preparers can demonstrate a bona fide attempt to comply.
"Making someone look back three years and requiring them to restate when there wasn't clear guidance at that point in time seems a little onerous," Dennis said. "I think it's going to be a little difficult for the regulators to actually define how that will work, but I think the idea is good."
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