Costs Drop for Large Firms as Small Companies Face SOX

A recently released study showing a dramatic decline in costs associated with Sarbanes-Oxley in the second year of implementation seems at first blush a relief to the many companies struggling with the additional recordkeeping and audit tasks required since the passage of the legislation. But the longer term cost effects of SOX, as the legislation is called in the industry, on smaller public companies has yet to be tallied. And there is increasing evidence that the legislation has changed the cost of doing business in corporations of all sizes in ways not foreseen when the legislation was passed more than three years ago. “The largest companies jumped in early and planned, and I don’t know anybody for whom it wasn’t 50 percent to 100 percent more time than they thought,” said Dan Benson, a partner in the technology, media and telecommunications practice at Deloitte. “The small companies are going to be in the same boat. They haven’t been down the learning curve.” Since the passage of the legislation, the deadline for smaller public companies with market capitalizations under about $700 million to comply was moved back to 2007. While some of those companies have begun the job of meeting the new guidelines, many more have done nothing, hoping that they would be exempted from the regulations altogether, CPA firms say. Those hopes were dashed in recent months when the Securities and Exchange Commission turned down a recommendation by an advisory panel to exempt some of the smallest public companies and to reduce the requirements for other small-cap firms. With the vast majority of the financial restatements required since the passage of Sarbanes-Oxley occurring at companies with market capitalizations of less than $700 million, the SEC was reluctant to lift the regulatory requirements on these firms. CPA firms that provide services related to SOX say that many of their smaller clients have not yet begun the process, which has required a large expenditure of time and money and the addition of both in-house and external professional resources. Larger companies in the first year of compliance averaged expenditures of more than $8.5 million in fees and costs associated with Section 404 of SOX, the key aspects of the legislation dealing with internal accounting and auditing controls, according to a survey commissioned by Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers LLP from CRA International in Spring, 2006. Related costs for proxy audit services averaged another $2 million in the first year of implementation. But in the second year, those costs have declined dramatically. According to the study, larger public companies spent an average of $4.7 million on SOX, down nearly 44 percent from the first year and proxy audit costs related to Section 404 dropped 22.3 percent to an average of $1,570,000. “Independent auditors working on subject company engagements attribute the total Section 404 cost declines primarily to efficiencies as a result of the learning curve effect and from first-year documentation efforts that did not need to be repeated in year two,” the survey authors wrote in their report. The cost reductions at smaller companies, though still substantial, were not quite so dramatic, the survey found. After spending an average of $1,241 million to comply with SOX in the first year of implementation, costs at these companies declined by 30.7 percent to an average of $860,000 in the second year. Proxy audit costs related to Section 404 fell 20.6 percent to $423,000 from $336,000 in the first year of implementation, according to the study. Audit and accounting professionals say that the cost decline was predictable. In the first year of compliance efforts, companies had to identify and document all their accounting processes and procedures, a task that would not need to be repeated in subsequent years unless a procedure changed or a new business was added. “First year compliance costs from the company include a significant amount of effort to get the initial documentation set up,” said Bob Pearlman, partner at BDO Seidman LLP. “That part has dramatically decreased in the second year, but from the audit side, I don’t think it’s decreased.” Because of the work needed to set up for the new accounting and auditing procedures, it is possible, if not likely, that the dramatic cost savings seen between years one and two will not be repeated in year three. Meanwhile, many smaller-cap companies have not even begun work on SOX, meaning they are just beginning to incur high costs. “There were a lot of companies that were just waiting,” said Kevin Holmes, a partner with Good Swartz Brown & Berns LLP. “Several of my clients that engaged me a year ago, they just were going to wait and see. Now we know that nobody’s off the hook. By late summer and into the fall, there’ll be a big uptick in activity, but you’re going to still have companies that won’t think about it until June of next year.” With audit firms continuing to report staff shortages, these Johnny-come-latelies may have difficulty bringing in talent to assist them. But perhaps more important, smaller firms simply don’t have the in-house bodies they may need to help keep down the longer term costs of SOX. “Those that treated adopting 404 as a change in ongoing processes, they tended to be the ones that had the largest savings,” said Benson. “If you look at the large companies, they’ve added head count that really just manages 404, maybe not 100 percent, but 50 percent of the time. So you’ve got somebody that’s managing a process and can look at it and say, there’s a lot of opportunity for efficiency. The small companies don’t have the bodies to bring into it so it can become an annual process.”