Honesty Is A Pricey Policy
Starting next year, manufacturers will have to prove that they can trace their products from assembly line to customer. Temp agencies will have to show that the hours they bill match those worked by their employees. And public companies in all industries will have to document that they have similar systems to keep their books in order.
The thought is giving companies the heebie-jeebies. Execs grumble that proposed new rules will be costly, cumbersome, and often redundant. What's more, the new system could put company directors into awkward relationships with their external auditors, who have been handed a fat new source of fees as well as a much-enlarged oversight role. Shareholders could also be in for some surprises: They could find that the auditors approve a company's overall numbers but give it a failing grade on internal controls.
Welcome to the brave new world of Section 404 of the 2002 Sarbanes-Oxley Act, which requires executives and auditors to evaluate companies' internal financial controls. On Oct. 7, the accounting profession's new overseer, the Public Company Accounting Oversight Board (PCAOB), proposed standards to guide auditors and companies in how to do that. The aim is to prevent the kind of financial shenanigans that caused meltdowns at WorldCom, Enron, and a host of other former highfliers.
Section 404 isn't the only part of Sarbanes-Oxley that irks Corporate America. Requirements to add more independent directors, especially those with financial expertise, have set off a scramble for talent at scores of companies. Executives also chafe at the law's ban on loans to cover their own relocation and housing costs as well as a confusing ban on other services auditors can provide.
But the internal control rules are by far the most contentious and potentially onerous provisions. Industry experts say that as a result of these rules, auditing costs are likely to double, while the total tab for compliance could top $7 billion in the first year. Although most big companies can afford to pay, the costs could push some smaller companies into the red. Says Dennis R. Beresford, accounting professor at the University of Georgia: "This is going to be very, very expensive."
What's worse, the bulk of the extra expenses won't be one-shot outlays -- say, for auditing templates -- but will be incurred annually. For instance, the rules call for auditors to test systems every year, even if they haven't been changed.
Unless the PCAOB makes major concessions before finalizing the rules at yearend, investors will receive up to four separate notices each year vouching for a company's numbers. Says Dixie L. Johnson, a corporate lawyer at Fried, Frank, Harris, Shriver & Jacobson: "This is a massive change in the way companies have to do business."
Congress figured that improved controls could have prevented WorldCom from labeling telephone-line and other operating expenses as capital investments. Indeed, Beresford, who is also a director of WorldCom's successor, MCI Group, says: "Our controls were awful. Now, we are spending millions and millions to ameliorate them."
Still, the new rules strike many executives as overkill. "This idea that a CEO doesn't know what's going on in his company is ridiculous," says George David, chairman and CEO of United Technologies Corp. "It's belt and suspenders," says Brian P. Anderson, chief financial officer of Baxter International Inc. This year, he expects to pay nearly $10 million for auditing, twice what he spent last year. And many execs suspect they won't gain much benefit. Says Brian V. Turner, CFO of Coinstar Inc., a Bellevue (Wash.) company that operates coin-counting machines: "We know our internal controls pretty well, and any [extra] information I get will be marginal."
Companies may also face some potential conflicts of interest. The PCAOB's draft rule will require company auditors to judge how well the board's audit committee oversees the auditing of the company. In short, audit committees and auditors will be evaluating one another.
The rules may have other farcical results. Even the PCAOB foresees that an auditor might certify a company's financial statements and at the same time say its financial controls are lacking. Auditors say this could happen when a company correctly totals its overall revenues and expenses but fails to cross-check individual transactions to stop fraud. "This undercuts a major conceit of internal controls," says Lawrence A. Cunningham, a law professor at Boston College. "It shows that controls become an end in themselves and are not nearly as effective as people think they are."
Critics admit that tighter internal controls will yield some benefits. Baxter's Anderson, for example, plans to speed up productivity investments, such as centralizing more processing of its global transactions. "I expect to emerge with a much more efficient finance organization with lower costs," he says. The new rules will give law enforcers and plaintiff lawyers a powerful tool to rebut pleas by execs and auditors that they were unaware of fraud. PCAOB Chairman William J. McDonough says the board carefully considered the costs and benefits. "We struck the right balance," he says.
His view isn't widely shared in executive suites. But there isn't much companies can do. The nonstop parade of corporate scandal makes amending Sarbanes-Oxley a political nonstarter. Besides, the safeguards might reassure investors who have tiptoed back into the market. Says Margaret M. Foran, chairman of the American Society of Corporate Secretaries: "If this is the cost of increasing investor confidence, so be it." The real test of the new rules will be whether they prevent another major scandal. And that's a big hurdle.
By David Henry in New York and Amy Borrus in Washington, with bureau reports