Grudging Compliance With Sarbanes-Oxley

By KATE BERRY

Staff Reporter

Nearly a year after implementation of the landmark Sarbanes-Oxley legislation, executives of Southern California public companies say they have made great progress in complying with the numerous provisions involving tighter scrutiny of corporate business.

At the same time, respondents to a survey conducted for the Business Journal by the accounting firm Deloitte & Touche complained loudly about the costs required to be in compliance with the new law, and they question the ability of the regulations to deter wayward colleagues bent on cooking the books.

Among public companies in L.A. and nationwide, senior executives and directors have spent the past 12 months with accountants, attorneys, computer consultants and others reassessing and in some cases restructuring the way they do business. What emerges from the Deloitte survey, which went out to 326 public companies in Los Angeles, San Diego and Orange counties (and was returned by 17 percent of those, mostly chief executives) is a grudging implementation of new rules and regulations that, many believe, is largely unnecessary.

“You can’t legislate against a Tyco, an Adelphia, an Enron, HealthSouth or WorldCom,” said John Palumbo, chief financial officer at Keystone Automotive Industries Inc. of Pomona, a producer of after-market parts for auto repair and a participant in the survey.

Palumbo is waiting to see how other companies implement certain rules. The company recently postponed an internal compliance effort after the Securities and Exchange Commission extended the deadlines to June 2004 for most public companies and April 2005 for small firms.

Among the survey findings:

> 42 percent of the respondents said they “might” consider going private as a result of Sarbanes-Oxley, while 12 percent said they would “definitely” consider it.

> Lack of time or resources was considered the biggest challenge in complying with financial reporting requirements of Sarbanes-Oxley (59 percent).

> 54 percent of respondents hired attorneys to help with implementing the new rules, while 44 percent hired outside accountants.

> 68.4 percent said that the SEC’s new audit committee requirements would have at least some impact on their companies’ ability to attract directors.

> Nearly twice as many respondents (60 percent) consider the new regulations overkill, although 32 percent thought the regulation was necessary to restore investor confidence.

Frustration mounts

Generally, executives complained about the cost of Sarbanes-Oxley. They also expressed frustration at those whose actions brought on the new requirements.

A sampling of anonymous responses to questions from the survey:

> “An overreaction that creates an enormous and unreasonable burden for smaller public companies.”

> “It didn’t really change our approach, but we hope it will restore confidence.”

> “Put the crooks in jail; let the rest of us run our companies.”

> “Too many accounting rules and no common sense principles.”

> “It is essential. It is very unfortunate that a few crooks have driven so much bureaucracy.”

Sarbanes-Oxley, designed to crack down on executives and auditors who knowingly falsify financial statements, is considered the biggest change in securities laws since the 1930s.

The new rules require top executives to sign off on a company’s reported financials, and institute severe penalties for those who falsify their numbers. In addition, they also are designed to increase the independence of corporate boards and require audit committees to be made up entirely of independent directors and contain at least one financial expert.

They also add a second audit of a company’s internal controls to deter management from committing fraud.

Last month, Los Angeles law firm Foley & Lardner estimated the cost of being public will rise 90 percent in the next year to $2.5 million, for a mid-size public company.

The cost can also be measured in time.

The SEC estimates that executives and auditors of public companies will spend an average of 383 hours in the first year to verify how they arrived at their financial statements.

“The requirements will be healthy for American businesses but in the short-term it’s painful,” said Jannie Herchuk, the Deloitte & Touche audit partner in charge of corporate governance services in Southern California. She added that companies aren’t as far along in compliance as many of the respondents in the survey believe.

Private stance

While a number of respondents indicated they were thinking about going private, other data show that few are actually doing so.

Nationwide, just seven companies have conducted classic “going-private” transactions this year, according to Thomson Financial. Usually, a management group or significant existing shareholder leads those deals, and the company remains essentially the same as it was prior to going private. According to Thomson, another 34 companies have gone private via their purchase by private equity firms, often being folded into a larger portfolio of companies.

While the costs of Sarbanes-Oxley are a factor in these decisions, experts say that a company’s poor performance and low stock prices may be even greater factors.

“The growing expense and the fact that many small company valuations are depressed, so the capital markets are closed to them, has a lot of companies questioning why they should be public,” said Scott Farb, a principal at Rothstein Kass & Co., a Los Angeles accounting firm.

Indeed, some private companies are considering adopting some of the practices required of public companies in Sarbanes-Oxley. A handful of states and municipalities may also follow along, although California is not yet one of them.

Particularly nettlesome to some respondents are the reporting requirements in Section 404 of Sarbanes-Oxley, which requires top executives to verify that internal financial controls are accurate.

Public companies are only required to send a one-sheet compliance letter signed by top management with their annual report, but if there were a problem, the SEC would ask to see more detailed paperwork.

Many companies have little of this documentation, which would outline controls and how the internal tests are conducted, said Herchuk of Deloitte & Touche.

“Ultimately, companies will be punished in the marketplace by investors if they have a problem,” Herchuk said.

While executives said they believe the new rules can never solve the problem of dishonest management, some agreed that it can make it tougher to get middle managers to go along with a fraud.

“I think what this will do is help employees who are on the second or third tier below management be much more aware of potential problems,” Palumbo said. “What everyone is realizing is you can’t perpetrate fraud without getting a fair number of people to help you with it.”