Friday, November 10, 2006

Mending the Holes in SOX

The Sarbanes-Oxley rules is again in the headlines as the SEC weighs petitions from public companies to ease requirements for management review of internal control and financial reporting processes as well as the follow-up tests by outside auditors. It is covered in Section 404 of the Sarbanes-Oxley legislation. Many public companies, large and small alike, consider the management review requirement as redundant and not effective in producing more reliable financial reports.

What business is really crying about is the high cost of the review by auditors. This is work separate from the regular annual or quarterly audit of the financial results. Mindful of the possibility of costly litigation, auditing firms have chosen the path of greatest safety - for themselves. In the absence of guidance from the SEC, auditors have given Section 404 a very literal interpretation, requiring public companies to “dot all Is and cross all Ts” and have back-up personnel to verify each pen-stroke.

Of course, such meticulous review and the subsequent implementation efforts cost money. In the July 14, 2006 post, “On the Calendar,” I discussed how the burden is felt most acutely by smaller companies, which often rely on all personnel to wear many hats to conserve scarce working capital.

The SEC has been promising guidance on how to interpret Section 404 requirements. The SEC issued a
Concept Release on such management reports in July 2006 and took comments until mid September. See my post on August 15, 2006, “Small-Cap Reprieve” for a recap. Now they have promised to issue guidance before year-end.

A more rational interpretation of the spirit and letter of Section 404 will be welcomed eagerly by public companies. The next question is whether audit firms contracting for these reviews will see themselves as on sufficiently firm legal ground to relax their test requirements. Indeed, if audit firms continue to perceive a litigation threat they can continue to interpret the SOX rules with as much stringency as ever.

No comments: