Corporate Reforms Irk Small Business
Martin Paravato applauds the sweeping corporate reform law that Congress passed in 2002 to protect the public from another Enron.
Mostly, that is.
“Overall, I think there are many benefits” to the Sarbanes-Oxley law, said Paravato, chief financial officer of Iris International Inc., a medical equipment manufacturer in Chatsworth. “I’m on board.”
But like a growing number of executives, Paravato is no longer on board 100%. Critics, especially in small and medium-size publicly traded companies, are fuming over the costs of a provision that was included to ensure the accuracy of a company’s financial reporting.
The measure, known as Section 404, is forcing companies to review, and in many cases change, a multitude of their basic, daily procedures -- including how they maintain records, secure computerized data and handle inventory. Companies are paying hundreds of thousands and even millions of dollars to auditors as they scramble to comply.
“It’s not right,” Paravato said. “We paid $400,000 in cash out of our own pocket, and I don’t feel like we’ve gotten anything for it.”
Under the requirement, which supporters view as a vital investor protection, companies must show in their annual reports that they have controls in place to safeguard the integrity of their financial statements.
Controls cover such nitty-gritty matters as whether a company has effectively restricted access to its computer system. The controls must be approved by independent auditors, who have been billing many added hours to meet the mandate.
Companies were given time to implement the measures, and the majority of big public companies will file their first internal control reports this spring. Most smaller ones face year-end deadlines, based on a rolling schedule set by the Securities and Exchange Commission.
Critics, however, say it makes little sense to saddle smaller companies with controls and procedures identical to those of giant enterprises that boast legions of accountants. Some also question auditors’ demands for information that may seem far afield from financial reporting.
“We have to document how we secure power to our computer room,” said Alex Davern, chief financial officer of National Instruments Corp., an Austin, Texas-based technology firm. “What does that have to do with accurate financial statements? If we break a computer, we’ll notice.”
Major business lobbyists have seized on such complaints as evidence that the SEC has gone overboard in its interpretation of Sarbanes-Oxley.
Indeed, the once-obscure Section 404 has become a cause celebre in a growing push to overturn the measure. Advocates for change contend that unhappiness with the provision extends far beyond small businesses.
“We have heard from companies of all sizes and of all industries,” said David Hirschmann, senior vice president of the U.S. Chamber of Commerce. “It has quickly become one of the largest frustrations for public companies that feel it is so time-consuming and resource-consuming, it just isn’t serving the purpose that lawmakers and regulators intended.”
Opposition to the measure has centered in the high-tech sector, which includes many small companies that went public in the tech boom of the 1990s. Their trade association, AeA (formerly the American Electronics Assn.), has led the charge, organizing meetings at the SEC to assail the cost and effectiveness of the approach.
“Enron was not a failure of internal controls,” said William T. Archey, president of AeA, who blames the energy company’s collapse on criminal collusion among its top executives.
Archey and other critics don’t want to appear as if they are shielding corporate wrongdoing. He takes pains to note that his group supports other aspects of Sarbanes-Oxley, which includes whistle-blower protections and requirements for independent auditors.
“This is not a massive attack on Sarbanes-Oxley,” he said, adding that the law “has done a good job ... and in a cost- effective way” overall. Still, he said, there is “a compelling case” to amend Section 404, which can cost small companies a significant share of their annual revenues.
Scientific Technologies Inc., which manufactures safety products in California, Utah and in a joint venture in Singapore, projects the cost of its compliance at $500,000 to $750,000. With about $60 million in annual sales, that’s not insignificant.
“How do I cover my cost?” asked Ralph Marimon, vice president for finance at the Fremont, Calif.-based company. “Do I not hire here? Should we expand in Singapore and keep our head count flat here [in California]? We don’t like the idea of doing that -- but I don’t know how you cover these costs.”
Paravato of Iris International said he reviewed the company’s financial controls after he took the job last year and was satisfied. In a company of that size -- with about $40 million in annual revenue -- he believes that a financial officer should be on top of the details and able to vouch for the books without depending on the new dictates of Section 404.
Under the rules, Iris International accountants have to sign off on decisions that seem like everyday housekeeping matters and should not require formal documentation, he said. For example, Paravato questioned the need for an in-house accountant to initial an invoice generated by an automated system, or for two individuals to review an Excel spreadsheet.
“I’m knowledgeable about the manufacturing area. I know what the sales people are doing,” he said. “I may ask, ‘Why was the legal expense twice what we budgeted for the month?’ and I get the answer. But I may not have had a piece of paper and signed off on it.”
“I can’t let the auditors dictate to us how we run our business,” he added. “I think it’s completely wrong.”
Paravato projected that the cost of auditors and in-house efforts to comply with Section 404 could hit half a million dollars annually.
Other executives cite what they consider ludicrous requirements. Davern of National Instruments said he was stunned by an auditor’s request to sit in on a staff meeting -- at $200 an hour -- to verify that it occurred.
“We want to see these guys go to jail,” he said of corporate wrongdoers. “We want to see them stay in jail. But we don’t want to be forced to choose between an employee health benefit and a federal regulation that will not work.”
The company, with annual revenue of about $500 million, has spent $3 million to meet the mandates, he said.
Not everyone is convinced that Section 404 is a problem.
Harry Gruber, chief executive of Kintera Inc., a small San Diego company that provides technology to nonprofit organizations and has annual revenue of about $20 million, said he chuckles when he hears other executives grouse.
“They want the board of directors and the officers to sign off [on financial statements], but they don’t know anything about the internal controls? What are they actually signing off on?
“Is the process perfect? No. But I think there is a benefit.”
Greg Garrison, who runs the U.S. audit practice for PricewaterhouseCoopers, acknowledges that “there’s always judgment” in interpreting regulations and that Section 404 “creates a lot of work for everybody.”
But in defense of wide-ranging controls, he points to the importance of computerized data and the need for rigorous protections, extending to backup systems and the power supply.
“If you don’t control access to a computer system or control access to changes to the program that drives it, you have a weakness,” he said. “You need controls over who can change the software, who can change the programming, who has to approve that, who provides access to the system.”
For its part, the SEC has signaled a willingness to review how its rule affects small companies. In December, officials announced the creation of an advisory panel of outside experts to consider the effect of Section 404 on smaller businesses.
“We will consider these concerns,” said Donald T. Nicolaisen, the SEC’s chief accountant. “But it’s perhaps premature to do until the first round of reporting has occurred this spring.”
In the end, small companies may find sympathy among even the most stalwart supporters of Sarbanes-Oxley.
Rep. Michael G. Oxley (R-Ohio), for one, wants to be flexible.
“If they can adapt it while ensuring full protection for investors against accounting fraud,” said Peggy Peterson, a spokeswoman, “I think he’d be open to that.”
