This was a newsy little tidbit affecting thousands of small public companies, but it was mostly relegated to the back pages of newspapers, if it was covered at all.
The Securities and Exchange Commission announced recently that small public companies will no longer get a reprieve from complying with the Sarbanes-Oxley Act of 2002.
Next year, they will have to hire auditors to attest to the adequacy of their companies’ internal control systems, and that means heavy additional expense. Internal control basically refers to the way a company tracks inventory, accounts payable and cash.
If there are cracks in the internal control system, the data used to compile the financial statements could be flawed. Before Sarbanes-Oxley, only the company’s financial statements had to be audited, but under Section 404 of the law, a second report is required on the adequacy of internal controls.
Until now, companies with market capitalization below $75 million did not have to comply with Section 404. In fact, the SEC delayed their compliance four times over the years.
Business groups have intensely argued that they would have to pay disproportionately high costs for these audits because of the fixed-cost nature of compliance. As it turns out, they are right.
Reliable data on the cost of Section 404 compliance for small companies has been slow in coming, but a Pennsylvania State University finance professor said his research shows that small firms are in fact taking a big hit.
Big hit for small firms
Professor Peter Iliev said he nailed down the cost of Section 404 compliance by examining companies with market caps just above $75 million and those just below it. Those below that cap have not had to comply until now.
“We needed a control group that didn’t have to comply,” Iliev said. “This allowed us to look at those who did comply and attribute any differences to the new regulation.”
What he found was that there were some rim-rocking costs associated with auditing internal controls. These smaller firms had to pay an additional $697,890 in audit fees in 2004 – the year he examined – which amounted to a 98 percent increase over the companies not in compliance.
These companies had a median market cap of just over $110 million, which is not very big. Many companies have market caps of $100 billion or more.
As it turned out, the average earnings for these firms were negative $1.4 million in that year, meaning a good chunk of the loss could be attributed to the additional audit expense.
“Small firms pay disproportionately. The burden was large, and this is a recurring cost,” Iliev said.
Does law go too far?
The Sarbanes-Oxley Act was passed in 2002 in response to the high-profile scandals at Enron Corp., WorldCom Inc. and other companies that used accounting tricks to vastly overstate their profits. The law’s purpose was to improve the quality of financial reports and to give investors more confidence in what companies report.
Perhaps the act has done that, but the question is whether the costs of compliance at smaller firms are worth the benefit.
Or more specifically, does the burden of Sarbanes-Oxley go beyond what Congress intended? I put that question to Iliev, and his response was, “For small companies, yes.”
