Community Section -
SOX Needs to Go
Ron Baker - 11/19/2010
Hat tip to Mark Bailey (a VeraSage Trailblazer) for passing along an article from CFO.com, ”Audit-Fee Fall: It’s a Matter of Trust.”
The article discusses how audit fees have fell by an average of 5% to 8% in 2008 (depending on company size), and have continued to fall in 2009, albeit at a slower pace.
Lynn Turner, former chief accountant with the SEC is quoted: “We don’t view audits as a commodity. We don’t want the Wal-Mart audit.”
He went on to say that lack of confidence among investors in financial statements has been a significant factor in the poor performance of investment markets during the past decade.
Really? This is economic illiteracy at its highest (or lowest).
You mean the burdensome Sarbanes-Oxley legislation, onerous corporate taxes (the second highest corporate tax rate in the world), costly and useless regulations, and uncertainty over government policy didn’t have more to do with the stock market’s poor performance?
Turner is blaming the thermometer for the temperature. Financial statements are nothing but lagging indicators, and to claim anything else is the equivalent of timing your cookies with your smoke alarm.
The article also discusses pushing audit efficiency, but that’s not what makes an audit effective.
Efficiency is no basis for competitive advantage, since your competitors can adopt the same tactics.
I don’t want an efficient audit; I want an effective one.
The only reason people focus on efficiency is the built-in incentive of the billable hour to reward inefficiency.
The other point the article misses is that the audit is an insurance product.
As actuaries have taught me, you can’t price risk by the hour. But look at how audits are priced.
One other interesting point: the last paragraph talks about banks not really caring about audited financial statements. They send in their own auditors to document the existence and value of assets they are lending against.
This is an example of why the audit monopoly that CPAs have needs to be relinquished.
If you really want to improve the audit, along with investor confidence, open it up to competition. There is no better protector of the investor than a robust competitive market.
The audit could stand some innovation.
Ed Kless - 05/19/2009
The Supreme Court of the United States has agreed to hear the case brought by the Competitive Enterprise Institute against the Public Company Accounting Oversight Board.
VeraSage is on record as begin against this horrible law which the American Enterprise Institute estimates has sucked a cool $1 trillion from the US economy. We, therefore applaud this decision and hope peek-a-boo and SOX are struck down.
Ed Kless - 12/23/2008
In the January issue of Reason magazine, Brian Doherty assess the impact of Sarbanes-Oxley to date.
From the article, “… Sarbanes-Oxley is more harm than help. In a 2007 survey of professional fraud examiners, three-quarters said institutional fraud was more prevalent than before the law was passed.”
Ron Baker - 09/24/2008
Paul Miller and Paul Bahnson did it again in their regular article series “The Spirit of Accounting,” in Accounting Today. I wrote previously about their Sept 8-21, 2008 article, “The perils of clinging to the status quo—Part 1.”
In the September 22-October 5 issue, they are back with Part II of their response to the status-quo CPA, “Tom,” who is defending the increasingly irrelevant historical GAAP financial statements.
They slaughter more sacred cows in this article, such as comparability—the argument that GAAP produces consistent and comparable financial statements. This, of course, is nonsense. What it actually produces is a mindless adherence to principles that produce results valuable to no one.
As they say, GAAP never asks the auditor to question if the financial statements are useful for making decisions; they only ask if they comply with GAAP.
This point especially resonates to those of who understand GAAP is increasingly outdated for a knowledge economy:
Tom and the many who agree with him miss the point that the whole purpose for accounting is to provide useful information that facilitates rational and productive economic and other kinds of analyses. Rather, they seem to think that accounting’s purpose is to help accountants do the same riskless things over and over again.
As Ed Kless taught me this last week, project management can sometimes suffer from the same problem. It becomes the ends, rather than a means to an end.
CPAs seem to be doing GAAP because they can, with a historical legacy to justify their decisions. But they are ignoring the fact that these principles are virtually worthless to users of financial information for making future economic decisions.
If all the profession wants to do is to be scribes with respect to the past, then perhaps they should be relegated to that role, while letting others enter the market of providing financial statement attestation to interested users, willing and able to pay for knowledge they value.
This path would be far more challenging and full of opportunity rather than to continue playing historians with lousy memories. Miller and Bahnson seem to agree:
Our suggestion to [Tom] and others like him is to channel their energy and talent into achieving progress, instead of trying to protect and preserve the deeply flawed status quo. They deserve a better purpose for their professional lives, specifically leading the way into the new paradigm. We have nothing but best wishes for them and high hopes that they can see the world in the same new light that we encountered ourselves only a short decade or so ago.
It is so rare to read such candor in the accounting mainstream media. Miller and Bahnson are fearless pioneers, willing to challenge the status quo. I only wish there were more like them.
To be fair, there is one other voice in the same issue of Accounting Today, Wanda Wallace. At least in this article, “Take back the professions!” she is arguing against the check-list mentality and outside regulation of the profession.
One of the hallmarks of being a profession is autonomy—Greek for “self governance.” The CPA profession is no longer self-governed, what with the alphabet soup of regulators looking over the profession’s shoulders.
Due to rent-seeking and what economists call “regulatory capture,” the profession for the most part doesn’t have a problem with this. Witness Grant Thornton CEO Ed Nusbaum comment with respect to PCAOB being found constitutional in a recent court ruling:
Personally I think it [would be] a mistake to do away with the PCAOB, he said. The PCAOB is painful at times. We don’t always agree with their comments. They’re tough. Sometimes they even bring firms up on charges. I think they’ll continue to be aggressive, so it’s not like we love them. But, on the other hand, you need some oversight. They seem to be doing a pretty good job at that, and I think it would be a mistake to get rid of them, because then there’s no regulator.
I don’t doubt he thinks that, since his firm has benefited mightily from regulatory revenue. Even absent that, there’s enormous proof that PCAOB and SOX has hurt the very investors it was designed to help.
What happened to our profession’s belief in free markets, competition and capitalism?
We seem to be willing to run to the nanny state, hat in hand, lobbying for regulations that increasingly decrease our liberty and freedom. All under the guise of protecting the investor class. How far we’ve drifted from the signers of the Declaration of Independence.
Want to protect investors? Open up markets to competition, including the auditing profession and establishment of GAAP. Let the market sort out what are the best processes.
We do this with everything else in our lives, why not the accounting profession?
There’s nothing sacred about a profession. They can and do die, especially when they no longer add value to those they are pledged to serve.
If “Tom” is representative of the thinking among the leadership of our profession, then we may very well be at the beginning of the end.
As Henry Ford said: “The man who is too set to change is dead already. The funeral is a mere detail.”
Dan Morris - 11/27/2007
Since SOX was passed and the insideous Section 404 work has been dumped upon our newest professionals, Ron Baker and I have been arguing that SOX is killing the spirit and lifeblood of our profession by forcing knowledge workers to perform boring, tedious, and useful work that is better suited for trained animals then for college educated, smart, nimble, and creative professionals.
Ron Baker - 09/10/2006
Four Years After Enron: Assessing the Financial-Market Regulatory Cleanup, by Roy C. Smith and Ingo Walter (professors of finance in the Stern School of Business at New York University), offers more evidence that the benefits of Sarbanes-Oxley is exceeded by its costs. The article is published in The Independent Review, v. XI, n. 1, Summer 2006, pp. 53-66, published by the Oakland, California based think tank, Independent Institute.
The authors point out that SOX lacks a central theory and duplicates some existing power and authorities, and they do reach some sound conclusions, such as:
These measures may have satisfied a sense of public outrage that followed a revelation of greed and misconduct, but if a cost of the clean up is to affect adversely the prospects for economic growth and to obscure rather than clarify regulatory standards for the future, in an effort to prevent a small percentage of otherwise fully regulated American companies from committing fraud, then perhaps the cost is excessive, especially inasmuch as the clean-up effort has left untreated certain important defects in the system that may surface again later.
Though I have serious misgivings with their optimism regarding the potential of SOX to be amended to reduce its most egregious costs, as when they state:
Excessive regulation causes as much harm as insufficient regulation. The Sarbanes-Oxley Act and the SEC may have pushed regulation somewhat too far. If so, time will tell, and the act can be amended or the SEC can reinterpret the requirements for its enforcement.
I can think of very few instances throughout the history of government regulation when it has been modified or eliminated. The natural proclivity is for regulatory bodies to expand, since it is in their self-interest. In fact, economists have even coined a term—regulatory capture—to describe how regulatory bodies become captured by the interests of the very industries they regulate.
I also found their exhortation for “capitalists themselves should attempt to contribute to a consensus that good business is fair business” to be condescending and mamby-pamby. What businessperson doesn’t already believe this? Most executives are ethical, since enterprise is a serious moral calling. One does not become successful by ripping off one’s fellow man.
Despite my misgivings, the article is worth reading if you’re at all interested in SOX. It’s another arrow in the quiver that aims at the heart—and hopefully the ultimate elimination—of SOX.
Ron Baker - 08/20/2006
As an update to my April 6, 2006 post, Sarbanes-Oxley Needs to Go, two additional readings you might find interesting.
First, Brad Beckstead, managing partner of the audit firm of Beckstead and Watts LLP, in Henderson, Nevada, wrote an article in the August 21, 2006 issue of Accounting Today, ”Commentary: Sarbanes-Oxley: The impact on smaller firms.”
Beckstead’s firm is the one that has brought the constitutional challenge against the PCAOB’s authority, arguing that it violates the constitution’s appointments clause. One of the lawyers on the case is Kenneth Starr. You can read the full complaint here.
Beckstead’s article discusses the impact of SOX on smaller firms, and his assessments are compelling.
Second, a new book is out, The Sarbanes-Oxley Debacle: What We’ve Learned; How to Fix It, by Henry N. Butler and Larry E. Ribstein, published by the [American Enterprise Institute] AEI-Brookings Joint Center for Regulatory Studies.
The major argument the authors have against SOX is its cost and ineffectiveness, which they detail with impeccable economic logic. Not only will companies have to spend approximately $6 billion complying with SOX, the net loss to shareholders as a result of this over-reaching piece of legislation is a staggering $1.4 trillion, according to a study conducted by Ivy Xiying Zhang. This hurts the very people—i.e., shareholders—SOX is designed to protect.
Another unintended consequence of SOX is the effect on auditing firms, as Joseph Nocera of the New York Times wrote:
One of the unintended consequences—that Sarbanes-Oxley has been a financial boon to the profession, since all the big accounting firms have to audit a company’s financial controls as well as its books. “In effect, the law is giving the auditors business,” Senator Sarbanes said with a chuckle. But so what? Better that they make money doing actual auditing work than by selling themselves as consultants (Butler and Ribstein, 2006: 13).
Even though there is no evidence that consulting creates a lack of independence for auditors, SOX outlawed accounting firms from performing this type of work. The arrogance of Senator Sarbanes is outrageous, thinking he knows what the marketplace values. Isn’t it ironic that auditing firms are getting rich from a law designed in part to address their own failures?
The authors further point out shareholders can more inexpensively hedge the risk of fraud and weak corporate governance by having a diversified stock portfolio. Individual companies, however, cannot diversify the costs and waste of complying with SOX. The optimal amount of fraud is, counter intuitively, not zero, and most shareholders can more effectively diversify the risk of fraud cheaper than companies can comply with SOX.
The authors list all of the costs of SOX, both direct and indirect, some of which include:
- Direct compliance costs, Section 404 internal controls disclosures and attestations—estimated to cost companies $6 billion in 2006, approximately $4.36 million per company;
- Diversion of scarce managerial talent and intellectual capital to compliance and creating paper trails rather than risk-taking and entreprenuerialism;
- Reducing smaller firms access to public capital markets;
- Chasing away foreign firms—the New York Stock Exchange’s share of new foreign companies offerings dropped from 90% in 2000 to 10% in 2005, mostly attributed to SOX;
- The litigation time bomb which will materialize at the next inevitable market downturn.
The authors lay out several reforms that an enlightened Congress should make to SOX:
- Defuse the Litigation Time Bomb—Amend the act to provide that violations of SOX cannot be redressed by private lawsuits;
- Allow Opt-Outs or Opt-Ins—If a state imposes a regulation that costs more than it provides in benefits, corporations can leave the state. If the federal government does it, where can it go? Firms should be given the freedom to opt-out of SOX. If the regulation is as good as its proponents claim, than those firms that opt-in should see a lower cost of capital. This is the ultimate test, not whether regulators “think” that SOX will be beneficial;
- Exempt Foreign Firms from SOX;
- Exempt Small Corporations—Small firms comprise only 7% of the market capitalization of USA stock markets. Exempting them does not in anyway impose an intolerable risk on shareholders;
- Remove Criminal Penalties—The severe punishment of SOX makes the corporate suite a very risky place for law-abiding executives, who may engage in far more conservative behavior than shareholders would prefer;
- Limit Internal Control Reporting—Let management base decisions on risk management techniques, rather than the regulator’s unrealistic 20/20 hindsight;
- Leave Internal Governance to State Law—Historically, states have done a better job than Congress in this important area of corporate law. Congress not only didn’t add value with SOX, it has destroyed $1.4 trillion of shareholder wealth.
The ultimate test of the efficaciousness of SOX regulations is embedded in the price of shares. This is the “wisdom of crowd” arguments, since markets have far more incentive to base decisions on accurate information than do regulators. This is because individuals shareholders suffer the consequences of their errors, where government simply imposes the costs of its errors on others.
If firms with weak governance stood to benefit the most from SOX, as its proponents claim, than the share prices of those firms would have increased after the passage of SOX. They didn’t. Instead, they declined, meaning the market judged the cost of SOX exceeded its benefits.
With the publication of The Sarbanes-Oxley Debacle, we now have empirical evidence that supports the market’s judgment. If you are at all interested in the future of the accounting profession, this book is a must read, along with After Enron, reviewed here. And my article ”Authentic Audit Reform: Relinquish the Audit Monopoly.”
Dan Morris - 06/25/2006
Symantec’s shareholder letter leads to the conclusion that what is really required is not more 404 work, but communication auditors.
Ron Baker - 04/07/2006
On February 8, 2006, The Free Enterprise Fund and the Competitive Enterprise Institute (http://www.cei.org) launched a Constitutional legal challenge to the Public Accounting Oversight Board (PCAOB) created by Congress as part of the Sarbanes-Oxley Act of 2002 (SOX).
A recent University of Rochester study concluded that the total effect of SOX has reduced the stock value of American companies by a staggering $1.4 trillion dollars. The regulatory burden of this legislation absolutely outweighs its benefits.
PCAOB is unconstitutional for a variety of reasons. It violates the appointments clause (Article II Section 2) of the U.S. Constitution. It grants significant regulatory powers and the power to tax companies to fund its activities. This violates the separation of powers.
VeraSage - 03/31/2006
William A. Niskanen, Editor
Without doubt, this is the best book written so far on why Enron happened and the public policy implications for this and other accounting scandals.
The editor, William Niskanen, is a former acting chairman of President Reagan’s Council of Economics advisor and has been chairman at the Cato Institute since 1985. The book dissects the failures leading up to Enron, from its Board (which, by the way, complied with all elements of the Sarbanes-Oxley Act, and was voted one of the five best Boards in the United States by Chief Executive magazine), internal and external auditors, its attorneys, bankers, credit rating agencies, stock analysts, the business press, and most egregious, the SEC––the watchdog that didn’t bark.
This book is the only one I’ve read that offers meaningful ideas on accounting and auditing reforms, such as the innovative idea of having the stock exchanges select which accounting standards its companies should be required to follow, as well as paying the auditors itself in order to remove the ultimate conflict that exists between auditors and their clients––the fact they are being paid by the very companies they are hired to audit. This would force competition into the promulgation of accounting standards as different exchanges would select different standards, a salutary idea. Also, the book points out PCAOB may be an unconstitutional private monopoly since it has been granted both regulatory and taxing authority––I cannot wait for a lawsuit to be brought on these grounds.
The book argues not only for PCAOB’s elimination, but also repealing the incredibly wasteful Sarbanes-Oxley Act. This book is very deep, grounded in solid economic theory, and, unfortunately––but not surprising––I’ve never seen anyone in the mainstream accounting press mention any of the ideas it contains. For true accounting and auditing reform, we must look to the think tanks, not the universities, government, or the regulatory sector. This book proves, beyond doubt, that think tanks are the modern-day “idea brokers” in the arena of public policy and have definitively eclipsed the universities as the ultimate intellectual institutions.
Other notable books: Managers Not MBAs by Henry Mintzberg, which dissects what’s wrong with the bean-counting mentality of most business education. iCon, by Jeffrey Young, a fascinating look at Apple, Pixar and Steve Jobs. The Daily Drucker, by Peter F. Drucker, who sadly passed away in November of this year, but left an incredible legacy through his prolific writings. And finally, an essay, “Reflections of a Recovering Management Accountant,” by H. Thomas Johnson, which may be one of the most thought-provoking pieces ever written on what is wrong with the accountants’ view of business, especially enlightening since Johnson is an accounting professor.
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