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Common Sense: The Road Least Traveled By Steve Ernst, CPA  In a previous
article on the impact of Sarbanes-Oxley (SOX) on small-cap companies, I suggested that SOX has raised the discussion of corporate governance and the importance of sound, well-thought-out business processes, and a strong system of internal controls. But what is new about that?
Although SOX focuses its requirement on the controls for financial reporting, can the controls surrounding operations and other areas of the business where management is exercising its decision-making responsibilities be any less important? Because the reporting of financial results and position for a specific period is a reflection of the overall ongoing business, can you talk about controls over financial reporting in the abstract? I think not. You have to talk about a framework and system of controls that surrounds and supports the individual business model as a whole. Financial information reporting is but one result of the business cycle. In addition, the impact of SOX has gone way beyond the publicly held segment, regardless of the level of market capitalization. As I had previously predicted, the U.S. Securities and Exchange Commission (SEC), through comments by its chairman and commissioners, appears to be determined to go against the recommendations of its own advisory committee on smaller public companies and continue to saddle even the smallest public companies with the onerous and hyper-cost, low-ROI auditing and reporting requirements for internal controls surrounding the preparation of financial statements. This flies in the face of an obvious dollar drain as more entrepreneurs are doing what was once thought to be the unthinkable. Ongoing Impact More and more domestic entities are opting to remain private and to look for funding from private equity sources, which are looking for the long-term cash-out rather than the near-term cash-out of an IPO. Why? It is fairly straightforward — it is a rational reaction to the costs, turmoil, and legal predicament that SOX presents to most smaller-cap companies. Although one has to be somewhat sympathetic to these decisions to stay private, it is a short-term gain and it does impact, to a certain extent over time, the ability to attract additional capital for expansion and hiring. Moreover, there is a trend for some companies to give up public access to capital and return to private ownership. In addition, those foreign companies who once looked to the U.S. markets and the U.S. stock exchanges as a means of maximizing their IPOs are now avoiding the U.S. and going through initial listing on foreign exchanges. Why? It is again the reality of being forced to spend precious and hard-won fresh capital on outside experts and opinions, which fewer depend on, or looking to list in their native country when more and more countries are providing credible markets that allow companies access to solid capital markets. Common Sense In a recent Wall Street Journal article, U.S. Senator Jim DeMint (R-S.C.) and U.S. Representative Tom Feeney (R-FL) wrote about their introduction to the Competitive and Open Markets Protecting and Enhancing Treatment of Entrepreneurs (COMPETE) Act. Senator DeMint and Representative Feeney argue that there is nothing inherently wrong with the 66-page long SOX as a law. Rather, it is in its implementation where we are getting ourselves tied in knots while our smaller, fast-growing, public companies are drained of badly needed developmental funds, all in the name of compliance. "...Section 404 has proved costly, for both domestic and foreign businesses, especially small-sized to medium-sized companies. This section requires duplicative internal and external audits, and since neither the law nor regulators have sufficiently defined what needs to be included in an audit, auditors err on the side of the most complete, most costly audits possible." The article is politically correct (you would expect that, right?) when it comes to pointing fingers at the SEC and its reaction to not enact the recommendations of its advisory committee. But, the authors make a valuable argument that the Public Company Accounting Oversight Board (PCAOB) has added to the confusion in this small-business debacle (they state the average first-year compliance for smaller companies is around U.S.$1.2 million) by not being clear as to the meaning of material weakness: "The Act would require the SEC to create alternative requirements for companies that wish to opt out of Section 404 and it would instruct the SEC and PCAOB to change the standard of what is a true material weakness. Auditors would be able to focus on substantial issues truly affecting the investor’s bottom line rather than auditing every insignificant transaction. Also, our legislation would allow companies conducting an internal audit to receive the technical advice from external auditors. While the PCAOB claims that guidance has been issued to address this problem, there is still significant confusion among auditors and companies on this issue." Senator DeMint and Representative Feeney describe the Act as requiring common sense changes that give companies "the technical clarity they need to comply with the spirit of SOX while helping to strike a better balance between investor safety and the bottom line." Who knows where this legislation will end up? But let us all hope common sense prevails in this argument. Irony What makes this situation for small-cap companies even more ironic is that, as I have noted before in other columns, more and more, smaller, ambitious, private companies are gravitating toward a more public structure of corporate governance coupled with solid business processes and strong systems of internal controls at an earlier stage in their life cycle. They may not be SOX-compliant, but they are moving in that direction as best practices becomes, more and more, the goal of entrepreneurs who want to spend time managing their companies for growth and the future rather than continually putting out fires. This is adding value to these companies in the eyes of the investing public, including the private-equity buyers who will have to pay a premium to avoid the post-acquisition costs of bringing the acquired company up to compliance standards. Small companies are becoming better-managed, better-controlled businesses not because of some regulatory requirement, but because it makes business sense. |
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