Private Companies Struggle with the Sarbanes-Oxley Act

Samuel Smiles, an 18th century Scottish, writer once said, “It is possible that the scrupulously honest man may not grow rich so fast as the unscrupulous and dishonest one; but, the success will be of a truer kind, earned without fraud or injustice. And even though a man should for a time be unsuccessful, still he must be honest: better lose all and save character. For character is itself a fortune…” (Zaadz, 2005). Major corporate scandals such as Enron and WorldCom shook the business world at the turn of the century in a powerful way. The level of deception that seeped out of these scandals shocked and amazed Americans and the world. As a result, investor confidence began to decline and suspicions began to soar. Our eyes were opened and we knew that things could not stay the same. In 2002, Congress mounted a reform attempt, led by Representative Michael G. Oxley (R-Ohio) and Senator Paul Sarbanes (D-Md). Both believed that the affectionately termed Sarbanes-Oxley Act would help to restore investor confidence and deter fraud. SOX has been the most aggressive legislation targeted to U.S. Securities Law since 1934. Public companies have been scrambling to shape up their acts in order to align with Sarbanes-Oxley (SOX); however, private companies have flown under the radar screen trying to avoid the matter altogether. The main reasons private companies have avoided compliance relate to the labor and cost incurred to comply. However, analysts believe that the benefits will outweigh the cost in the long-run for private companies if they get on board with SOX now.

The Cost to Comply

Companies that have set out to comply with the Sarbanes-Oxley Act have found that there is a heavy price to pay for compliance. In their paper, Henry et. al (2005) cite a survey of board members at several large companies conducted by RHR International for Directorship magazine. The survey found that companies with $4 billion or more in revenues are spending an average of $35 million to comply with the act (Henry et. al, p. 28). In a separate survey, Financial Executives International found $3.1 million in additional costs for companies with average revenues of $2.5 billion. According to Koehn and Del Vecchio (2004), significant increases in salaries may be attributed to the cost of compliance (p. 36). In 2003, a 6% increase in finance and a 10% increase in management salaries were noted (Koehn & Del Vecchio, p.36). Audit fees assigned by the top four auditing companies climbed by 25% to 33% since the enactment of Sarbanes-Oxley. A May 2003 survey by Financial Executives International forecasted an additional 35% increase in audit fees by mid-2004. There should be no doubt about why private companies are dodging SOX. The expense of compliance is becoming astronomical. For a private company that is trying to keep its head above water, compliance may be the factor that sinks the ship.

Section 404 of Sarbanes-Oxley

One of the major requirements that emerged from the Act is section 404. Section 404 requires each annual report of an issuer to contain an “internal control report,” which shows the following:

(1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and

(2) contain an assessment, as of the end of the issuer’s fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting (AICPA, 2005).

Koehn and Del Vecchio summarize section 404 as “[the requirement of] management to organize and assess internal control systems and the independent auditor to assess their effectiveness” (p.36). They continue their discussion of section 404 by stating that some companies have estimated a 1% decrease in earnings to comply with this provision of SOX alone. It should be noted that these are not one-time cost. Internal control systems must be evaluated every year. Can a private company stand to take a chance on section 404 alone?

Currently, private companies have the option to choose to comply with Sarbanes-Oxley or not. Some companies have decided to implement only certain aspects of SOX. For example, according to Katz (2003), Cargill Inc., a Minneapolis-based private firm, has decided not to comply with section 404 (p.105). Cargill does not see the value in this provision, stating “…it’s a lot of work, it’s costly, and we don’t really see the benefits” (Katz, 2003, p.105). Again, private companies are exonerated in their defiance to submit to compliance.

Pressure to Comply

In the days following the Enron and WorldCom scandals, private companies are starting to feel the pressure of complying with the Sarbanes-Oxley Act