The hidden costs of Sarbanes-Oxley

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Instead of making investments that would create 75 jobs, Max & Erma's Restaurants is spending half of its profits on Sarbanes-Oxley compliance. The company will go private to avoid the regulatory hassle, but that limits the company's access to the capital markets-and everyday investors' access to opportunity. (John Berlau and Anastasia Uglova, "Sarbanes-Oxley 'reform' harming economy", Pittsburgh Post-Gazette, Nov. 13, 2005

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Sunday, November 13, 2005 By John Berlau and Anastasia Uglova

The Sarbanes-Oxley corporate governance act is one of the biggest expansions of government regulation in 70 years -- and businesses say it's more costly and complicated than ever imagined. Defenders counter that the 2002 law is still needed to protect the public from corporate abuses.

Yet recent news has made it harder to argue that Sarbanes-Oxley, hastily passed in response to corporate scandals at Enron and WorldCom, has benefited the "little guy."

The mandates of Sarbanes-Oxley cost substantial time and money, and companies frequently have to divert employees from the company's core business. And a growing number "are looking to India's information-technology outsourcing firms" to farm out the work to, according to the Wall Street Journal.

But actually, this shifting of work to India is the least of Sarbanes-Oxley's damage to the U.S. economy and that of Pittsburgh. Since the law's passage, Sarbanes-Oxley has meant hidden costs for workers, consumers and businesses. It has inhibited job growth, while providing little in useful benefits for shareholders.

Although Sarbanes-Oxley was sold as a cure for Enron-like corporate misbehavior, the law mostly fails to target the real wrongdoers and instead punishes all public companies as a class. Its costliest part, called Section 404, mandates that auditors not just sign off on a company's numbers, but also its "internal controls."

The problem is that an "internal control" can be whatever a company's accounting firm determines it to be, such as business software and other items that are only tangentially related to financial statements. The Economist magazine reported that one auditor even insisted on signing off on every purchase a company made that was $100 or more. Documenting such minutiae is costly, wasteful and obscures meaningful data for shareholders.

Nevertheless, companies will pay $35 billion a year to comply with Sarbanes-Oxley's "internal control" mandates, according to the American Electronics Association. The average public company will also devote

30,700 manhours a year, according to Financial Executives International. This is time and money that could be devoted to creating new products, new businesses and new jobs. And ironically, it's the Big 4 accounting firms -- the ones the statute's supporters said the law would go after -- that are getting even richer from Sarbanes-Oxley's mandates.

Yet it is innocent small public companies that are really paying an unfair price for Enron's sins. Take, for example, Max & Erma's Restaurants Inc. The growing chain, which recently opened its 100th restaurant, made $1.1 million in profits last year and there has never been a hint of scandal associated with the business. The firm has used these profits to create new jobs and now employs 6,000 in the United States and 725 in the Pittsburgh area alone.

But that growth will be cut short by Sarbanes-Oxley. The law will cost the company $500,000 to $600,000 a year, according to Bill Niegsch, Max &Erma's chief financial officer. This is about half of the company's profits, money that otherwise would be put into growing the business. "That is the opportunity cost of opening one restaurant per year and giving 75 Americans in Pittsburgh a job," Mr. Niegsch said.

Because of these costs, Max & Erma's plans to voluntarily delist from the stock market. This is a step that was once unheard of for a profitable company, but that more and more firms are taking because of Sarbanes-Oxley's enormous burdens. But even this step is not cost-free. It will restrict the restaurant chain's capital resources and affect job growth for two to three years, Mr. Niegsch says.

Multiply Max & Erma's by the number of entrepreneurial firms in America, and it's easy to see why the economy still doesn't seem to be operating at full tilt.

Ironically, the outsourcing now resulting from the law might end up being a good thing if it forces lawmakers to realize that their reforms are wreaking havoc on the American economy, rather than saving it from corruption. How many jobs will have to be lost to India -- how many more Max &Erma's will have to delist -- before Congress rethinks its careless "reform?"

(John Berlau is a fellow in economic policy at the Competitive

Reply to
John
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J> The problem is that an "internal control" can be whatever a company's J> accounting firm determines it to be, such as business software and J> other items that are only tangentially related to financial J> statements. J> The Economist magazine reported that one auditor even insisted on J> signing off on every purchase a company made that was $100 or more. J> Documenting such minutiae is costly, wasteful and obscures meaningful J> data for shareholders.

You want meaningless and obscure; most of my job is centered around FASB Interpretation 46(R) which, while not directly related to SarbOx, it is related to the same knee jerk reaction that brought on the piece of regulation. FIN 46 is concerned with who has control of the special purpose entities (SPEs) now calling them variable interest entities (VIEs). As a homebuilder, we enter into land option contracts to get a supply of land without having to purchase it outright. Generally the seller will create an LLC, or some other holding entity, whose sole asset is the land. This protects the land seller's other assets in case the homebuilder sues for damages and protects the homebuilder if the seller goes bankrupt. We contract with that new LLC, putting up a minimum amount of earnest money to secure the land until we are sure it will be feasible to build upon. Here's where it get screwy, the EM we put up is not considered an investment in this shell company and thus we have to determine if we will be the primary beneficiary of any gains or losses the entity _may_ incur. If we are deemed to be the primary beneficiary, we have to consolidate it. That's right, we get to put on our books the assets and liabilities of this entity that we had no hand in forming, have no control over and have no access to it's books. To "simplify" matters, we simply record the land as an asset with an offset to minority interest. The name of the inventory account is "Inventory Not Owned". Oh yeah, an asset we do not own is now on our books. So, to the general public we have just grossed up our books with meaningless info. My personal belief is that much of this is driven by our external auditors. They spend a considerable amount of time on this little aspect of our business while all but ignoring, in the same department, the funds that actually go out the door. I presume there are very few who deal with this nonsense since I have asked repeatedly in many accounting groups, but no one seems to know what I am talking about.

Reply to
Joker

entity that we had no hand in forming, have no control over and have no access to it's books. To "simplify" matters, we simply record the land as an asset with an offset to minority interest.

So, big deal. Who cares what is on your books anyway. it's just some numbers on a piece of paper. If anybody doesn't like it, they can deduct off both sides of the balance sheet.

Reply to
mrs. eliza humperdink

Any company that takes themselves private may avoid SOX, but they're not going to avoid accountability for long, at least not if they hold information on 10,000 or more U.S. citizens.

This past week the Senate approved the Personal Data Privacy and Security Act, which says that any organization (private, public, non-profit, or otherwise) will need to have a risk assessment processes and data protection policies in place. This holds true even for the little guy who outsources everything.

Though the bill is not yet law, the House is expected to concur on the legislation sometime in 2006 (my guess is before the summer, especially if there are one or two more large information leaks).

Respectfully,

Adam

Reply to
Adam W. Montville

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