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Section 404’s Costliness Hinders Act’s Effectiveness

In our current post-Enron world, there is general agreement that since Sarbanes-Oxley was implemented the financial reporting requirements are tighter, internal controls have improved and there is more transparency in the overall auditing process than pre-Enron. However, the estimated cost of implementing Section 404 has greatly surpassed original estimates and has brought into question the actual net benefits of the entire act.

The result of Congress’ knee-jerk reaction to Enron is the outsourcing of America’s century-old lead in world capital formation due to self-inflicted policy wounds.

When we ask how America is actively chasing away capital investment, a chorus responds with “Sarbanes-Oxley 404,” referring to the section of the act consisting of only 161 words. Our competitors agree as we see with the London Stock Exchange advertising itself as a “SOX Free” zone. Even New York Gov. Eliot Spitzer (D) is admitting that “we are in danger of losing our pre-eminence as the financial center of the world,” according to U.S. News & World Report.

The report released earlier this year by New York Mayor Michael Bloomberg and Sen. Charles Schumer (D-N.Y.) warned that the “thicket of complicated rules” could result in a loss of 60,000 new jobs in the New York-based financial services industry. We already are seeing the beginning stages of these estimates becoming reality. In 2006 there were 557 non-U.S. companies with initial public offerings in the London Stock Exchange and 28 non-U.S. company IPOs in the New York Stock Exchange. Thus 95.2 percent of IPOs listed on the LSE, and 4.8 percent listed on the NYSE. Global IPO value has declined in the U.S. from 50 percent to 5 percent since 2000.

It is time to protect the pre-eminence of the United States in the capital markets. Sadly, regulatory bodies that have jurisdiction are clearly reluctant to take the necessary steps to create a friendly environment for not only IPOs but also continued listing in the U.S. markets.

The Public Company Accounting Oversight Board and the Securities and Exchange Commission recently have approved Auditing Standard No. 5. The PCAOB has looked at many suggested changes to Section 404 that would get the U.S. capital markets back on the right track but failed to make the sufficient changes.

The economy is facing continued assault with the current credit crunch and the looming foreclosure numbers yet to come. A study published by the American Enterprise Institute by Henry Butler and Larry Ribstein concluded that SOX has imposed a net cost of $1.4 trillion on the American economy. That is roughly a 10 percent regulatory tax on the entire gross domestic product of the United States. The time to act is now. Rep. Gregory Meeks (D-N.Y.) and I introduced the Competitive Open Markets that Protect and Enhance the Treatment of Entrepreneurs Act in an attempt to begin correcting the knee-jerk reaction that is SOX Section 404.

The COMPETE Act addresses many provisions that the SEC and the PCAOB have looked into but not corrected. This legislation would exempt smaller public companies defined as having a total market capitalization of $700 million and having a total product or service revenue of $125 million, and the issuer must have fewer than 1,500 record beneficial holders. The PCAOB looked at scaling the audit based on company size but decided against changes at this time.

Secondly, this legislation would call for the audit of internal controls to be risk-based, focusing on those controls that are critical to the accuracy of the financial statements. The determination of the controls that create the greatest risk to the company should be done in consultation with management and relate to industry norms. A “base year” audit would take place in year one followed by subsequent audits every three years.

The legislation also provides for the SEC to develop a standard for materiality based on whether the internal control has a material effect on the company’s financial statement. The wording of Section 404b also is clarified to state that the auditor shall attest to and report on the assessment made by the management of the issuer. The audit should focus on the process and the system used by management to identify and manage risk.

Through the COMPETE Act we have addressed the duplicative audits that occur as a result of examiners’ inability to communicate with internal auditors. The independent auditor should be able to work with management’s internal auditor to determine the controls to be tested and the scope of work while testing and assessing internal controls.

Finally, the legislation would promote auditor competition to eliminate problems that have arisen with only four large accounting firms capable of servicing the larger public issuers. The SEC and the PCAOB should work to increase the number of qualified accounting firms. It is only possible for greater transparency through enhanced internal controls and prohibitions on conflict of interests if auditors are able to take on the workload.

I believe it is time to review the effects of Sarbanes-Oxley; keep that which is a net advantage to investors, and reform or eliminate those provisions that are a net disadvantage to investors. Congress needs to help restore America’s lead in the world’s capital markets.

Rep. Tom Feeney (R-Fla.) is a member of the Financial Services Committee.

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