This is the year (2005) that fall-out from Sarbox (the Sarbanes-Oxley Act) should really hit the fan. There are several major issues that come to a head this calendar year.
Â§404 Large Company Impacts
U.S based corporations with $75M+ market capitalization must complete a Â§404 assessment (effectiveness of internal controls over financial reporting) in their current fiscal year if they have not already done so. The first assessments pertained to companies with fiscal years ending 11/15/04 and later. The first assessments and auditor attests have been hitting the streets for the last 60 days or so. The remaining ‘large’ corporations will be filing their first assessments and auditor attests until January, 2006 or thereabouts (for FYs ending in October and early November, 2005). January 2006 will start the second round of Â§404 filings for companies with fiscal years ending 11/15/05 and after.
Weaknesses in internal control are expected to cause short term dips in stock value, followed by a reasonable rebound of most or all of the stock price. This is because an internal control weakness doesn’t necessarily equate to a fundamental problem with the business drivers and long term outlook for the companies. But it does indicate a problem that must be corrected within a matter of months. Companies that report material weaknesses in sequential internal control reports (e.g. for FY2004 and FY2005) risk SEC sanctions and potential de-listing. This would cause significant harm to the stock price, management, the board, and the company.
Of note the SEC hosted a Sarbox Â§404 roundtable meeting on 4/13/05 to discuss lessons learned by accelerated filers (large companies). At the time this article was written the outcome of that roundtable was not known. It seems likely the SEC will hold additional discussion sessions through 2005 to determine how to help companies comply with Â§404.
Â§404 Small Company Impacts
The real impacts on small public companies will not be known until later this year or sometime in 2006. But decisions affecting small companies will be made this year.
About six weeks ago the SEC decided to postpone the application of Â§404 to small companies from 7/15/05 to 7/15/06. And in December, 2004, the SEC convened a task force to evaluate rulemakings as they affect small companies, to see if adjustments and/or partial relief of the rules is appropriate for small companies. While this allows small companies some breathing room (e.g. additional time for control compliance work) it is unclear whether or not there will be meaningful reductions in their compliance requirements. Later this year the task force will issue recommendations for any rulemaking adjustments, and then the small companies will have to march forward to meet their Â§404 obligations in 2006, whatever the form and extent.
Â§404 Foreign Company Impacts
Like small companies, foreign company impacts should be clearer by the end of this year. The SEC deferred application of Â§404 to US subsidiaries of foreign corporations from 7/15/05 to 7/15/06, just as it did for small U.S. corporations. However, foreign-based companies have other issues with which to content. New accounting standards promulgated by the IASB (International Accounting Standards Board) take effect this year, and most of the foreign corporations that will be subject to Â§404 in the U.S. next year must meet the new IASB standards this year. In essence the SEC granted foreign corporations an extra year to comply with Â§404 because they have a challenging compliance year ahead of them as it is.
Certain foreign corporations may elect to de-list from U.S. exchanges in an attempt to avoid Sarbox applicability, but if there are 300+ U.S. based shareholders of that company’s stock then they are subject to U.S. securities laws (and Â§404) even if they de-list). Accordingly, those foreign corporations will be deciding this year whether or not to maintain a U.S.exchange listing and/or re-purchase their stock to escape Sarbox.
Of note, the European Union (EU) is considering a pseudo-Sarbox law of its own to tighten financial disclosures and reporting for EU-listed companies. Presumably this will affect European listed subsidiaries of U.S. based corporations just as Sarbox affects U.S. subsidiaries of European corporations. However, it appears this will not occur in 2005. This may be an item to anticipate for 2006.
To borrow a quote from the 2/9/05 Financial Times by Tim Flynn of KPMG, “In year two of 404 we must work with management to find ways to sustain ongoing compliance and monitoring, effectively and efficiently. The intense, project-oriented focus that prevailed in the initial year of implementation is not sustainable in terms of either cost or human resources.”
Companies that initially approached Â§404 as a bolt-on compliance obligation in 2004 and early 2005 will re-focus on their compliance obligations in 2005 to determine how to save money and time going forward. Reducing recurring audit costs and scope and finding operational improvements will be the focus of sustainability initiatives.
Various court cases that will have significant regulatory effects will get settled in 2005. Or at least the initial verdicts will be handed down. Perhaps the most important and visible of these is the ongoing criminal case against Richard Scrushy, former CEO of Healthsouth, whose trial just finished a ‘seventh inning stretch.’ Mr. Scrushy is charged with falsifying financial disclosures and, effectively, lying on the Â§302 Certification that was borne out of Sarbox. He is the first corporate officer charged under this provision of the Act. The verdict could occur by early May. A poignant observation on this trial came from Tim Burns of Neal, Gerber & Eisenberg in the 1/31/05 issue of Financial Times: “The credibility of Sarbanes-Oxley and the government’s response to the Enron scandal rest on this trial–.If the prosecution fails, there will be calls from politicians and the public for tougher regulations.”
At the end of the day, corporations clamoring for (partial) relief from the requirements of Sarbox, and more specifically, Â§404, may see their arguments fail if the current laws are inadequate to put Mr. Scrushy behind bars.
As indicated at the top of this article, the “Sarbox stuff” hits the fan this year. And there will probably be plenty of things to clean up afterwards.
Glenn Conway is a Partner and Business Consultant with VisageSolutions, LLC, a Raleigh, NC –based company that specializes in sustainable compliance practices and business operations efficiency ( www.visagesolutions.com ). Visage has assisted their own clients and public accountancy clients with Â§404 compliance programs, risk assessments, tool selections, internal auditing and organizational issues. Glenn may be reached at firstname.lastname@example.org.