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Friday, December 17, 2004

Sarbanes-Oxley: Killing Enterprise to Save It

by Fred E. Foldvary, Senior Editor
The Progress Report

In reaction to corporate scandals, greed, failure, and fraud, Congress in July 2002 passed the Sarbanes-Oxley Corporate Reform Act, named after Sen. Paul Sarbanes (Democrat, Maryland), at the time chairman of the Banking, Housing and Urban Affairs Committee) and Rep. Michael Oxley (Republican, Ohio) to more strictly regulate corporate accounting. But this law has created awful costs that far exceed the benefits, and which have hampered the economic recovery and have contributed to slow employment growth.

Only a few corporations committed deceptive accounting and engaged in and aided a massive looting of shareholder assets. Sarbanes-Oxley is an over-reaction that illustrates the basic problem of regulation: all are required to incur great costs to fix the problems caused by a few. The law requires 12,000 firms to file complex financial statements with the Securities and Exchange Commission. It's like the smog tests required of car owners in most states, where millions of car owners have to incur an expense even though only a small proportion of the cars cause most of the pollution.

The total compliance cost in terms of money spent is over $5.5 billion per year. Much of the cost is passed on to consumers, which then reduces sales, and some is borne by the investors, stifling the expansion of the company. That does not take into account the much greater cost to the economy of enterprises not expanding or starting, because "Sarbox" makes it too costly.

"The more complex the company, the more internal controls are needed. Large global companies have hundreds of controls. The reason Sarbanes-Oxley is so expensive is that it requires companies to delve into each of these controls and document that they are effective. That is time consuming and a drain on manpower. Then an external auditor must be paid to attest that it has been done adequately" ( "Sarbanes-Oxley: Dragon or white knight?" by Del Jones, USA TODAY).

Section 404 of Sarbanes-Oxley requires corporations to establish many new controls for financial reporting. A study by Financial Executives International finds that the average compliance cost for large companies is $4.6 million, including 35,000 hours of internal labor, $1.3 million for consulting and software, and extra audit fees of $1.5 million. That does not include the time spent by executives on that law, rather than concentrating on production.

Maurice Greenberg, chairman of AIG, the world's largest insurance company, told shareholders that Sarbanes-Oxley was costing them $300 million per year. General Electric said that it pays $30 million per year in compliance costs ( Bruce Barlette ).

The law also affects firms which are not corporations, if they do business with the government or report to government agencies. Foreign companies are also forced to comply if their shares are included in the stock exchanges in the US. Smaller companies have a relatively greater burden than big ones. For example, hardware wholesaler Moore-Handley, which had 2002 sales of $151 million, had a compliance cost of $250,000, compared to profits of $300,000.

Like any activity, internal controls have benefits, such as preventing fraud, but also costs, and the optimal policy is where the extra costs of increasing controls just equal the extra benefits. The additional benefit from greater controls diminishes with increasing amounts of control. At some amount, the cost of greater control is more than the cost saved. But the law sweepingly applies to all firms, regardless of their individual costs and benefits.

The problem is made worse by the vagueness of Sarbanes-Oxley, which creates uncertainty and induces even more spending. "Michael Koss, CEO of stereo headphones maker Koss, says it's all but impossible to know what the law requires, so it has become a black hole where frightened companies throw endless amounts of money" (Del Jones, USA TODAY).

There are some good features of "Sarbox". It reduces conflicts of interest between auditors and firms, and requires better disclosure of items such as off-balance sheet assets and liabilities. Its increased penalties for fraud are probably an improvement. But its attempts at micro-management are destroying enterprise in order to save it.

Far better reforms would be to have clear statements of corporate policy and to encourage better corporate democracy. The accounting requirements of Sarbanes-Oxley should be repealed and replaced with a requirement for clear statements of the accounting policies, so that investors then know what kinds of controls the company has, and can then make their investment decisions accordingly.

(Thanks are due to Robert Finocchio, Jr., for assembling the sources for the Sarbanes-Oxley law for a session of the Civil Society Institute's "Economics Colloquium" for students at Santa Clara University, California.)

posted by Brian Moran @ 11:29 AM   1 comments

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