Finding Better Arguments for Amending Sarbox

Implications: Kenneth Wilcox, President of SVB Financial, believes that Sarbox has made the US economy less competitive. He disputes claims by a Big Four accounting firms that the costs are declining, with second year costs only 40% of the first year. In 2006 SVB paid over $20 million to the Big Four, for an average of about $17,000 per employee. This is more than five times as much as we paid them only three years ago. The new rules have contributed to a shortage of trained personnel while PCAOB under SEC guidance discourages the auditors from either offering advice or exercising judgment. As a result, almost 10% of all publicly traded companies announced restatements in 2006. SARBOX has greatly increased the cost of doing business, and in the author’s view to no good purpose.

Analysis:  

It is easy to sympathize with Mr. Wilcox, and his personal experiences probably reflect the universal, to a greater or lesser degree. Unfortunately, people like Senator Sarbanes, feel that such arguments are mere empty carping. Let’s explore better arguments which attack the flaws of the law, rather than its results.

First, the law itself was debated and passed without the facts that came to light during the trials of WorldCom, Enron and Arthur Andersen personnel. Mr. Oxley has admitted as much and stated the Section 404, was much too intrusive, in retrospect, as embodied by PCAOB. What we are seeing is the use, of the Precautionary Principle: see http://dieoff.org/page31.htm

“Social planning in the economy, in technology, in morality and in social initiatives all can be justified by a loose and open ended interpretation of precaution. “

Part of the construct is:

“…a willingness to take action in advance of scientific proof of evidence of the need for the proposed action on the grounds that further delay will prove ultimately most costly to society and nature, and, in the longer term, selfish and unfair to future generations.”

By Mr. Oxley’s own admission, the above reasoning was used as the basis of what proved to be too precipitous action. The Precautionary Principle is used mainly in environmental regulation or drug approval, and is not applicable to the economy because the true costs are available or should be and are calculable. Thus the intellectual basis for at least a portion or the law is suspect. It should be noted too, that such laws restrict possible future benefits which can be lost, unnoticed: medicines, products, innovative management because the rules place barriers to entry, so many potential but unquantifiable goods are lost.

Along with Sarbox, have come a large number of rules from the FASB, which have resulted in a great increase in the number of restatements. Mr. Walsh writes:

“When I ask about the causes of [restatements], I am told the following: Neither companies nor can auditors really understand all of the primary accounting pronouncements coming out of the FASB, the number of which has gone from 104 in 1989 to 159 today. Many of them are 50 pages or more in length with accompanying interpretations that may be 10 times as long as the pronouncement itself.”

In my experience, the restatements center on stock options, SFAS No. 109 (Taxes) and derivatives. These restatements are non-cash, being changes in estimates or contingencies, and are thus of little interest to the analyst. Note that Navistar has done well after being delisted by the NYSE for failure to file financial statements. Dell has not been excessively punished for the same problem. In short, financial statements are not the final word for the investor.

One issue Mr. Walsh does not mention is auditor performance on general disclosures. Early in the profession’s history, the policy was that audited statements should have clear judiciously limited disclosures. That is, just putting in a trial balance or the whole chart of accounts with values, was not GAAP. At that time, the financial statement users were more limited and more sophisticated. The profession was also trying to establish its value by providing a useful service to people with a vital interest in the company, through junior and senior instruments or credit relations.

Now in the wake of Sarbox, no one wants to take responsibility for clarity or usefulness of the financial statements. In many instances the sheer volume of information render the useful data both hard to find and difficult to use. This practice can allow companies to issue statements that are deliberately or innocently misleading. More disclosure does not increase transparency.

The SEC and the FASB pay lip-service to representing the interests of the user, but there is little evidence to support this view. Both are in the process of capitalizing forward executory contracts and various contingencies placing them on the balance sheet. The debate over capitalizing operating leases shows a woefully limited sense of how the information is used or even the economic relations involved. In other cases, solutions with strong minority support would render some types of disclosures useless such as Statements of Cash Flows.

Supporters of Sarbox point to fact that there has not been a dramatic flight of US firms abroad. These arguments are wrong-headed for a number of reasons:

-Companies moving would or choosing to start elsewhere are small and would not affect the total.

-Capital markets are foot-loose, and there is little to prevent the movement off-shore, once the US environment is shown to be too burdensome.

-It is the new companies that provide opportunity, even if they are small, they collectively are the future.

-Some companies support Sarbox, which is an effective barrier to competitive entry.

-We may never know the true cost of Sarbox, because it will close possibilities aborning, which we will never now existed.

This article like so many others fails because it discusses compliance cost, which is easily rebutted by saying the regulation is necessary. As can be seen above, users don’t need the information, and Sarbox destroys the opportunity for new companies to enter the market. It was drafted using false premises (the Precautionary Principle), based on incomplete information relating to the events (WorldCom and Enron) in question.