The Hindu Business Line : This SOX hurts

The Sarbanes-Oxley Act has created a fear factor among US companies. The Act has radical measures which are not needed to achieve its limited purpose. One can expect a toned-down version.

This year is the 4th anniversary of the Sarbanes-Oxley Act (SOX) passed in the US in 2002 to clean up reporting and disclosure norms for companies. Having been on the statute book for this long, it is time to review the efficacy of the Act. There have been loud protests in the US about the huge costs one has to bear for SOX compliance. Financials of companies are also getting hit — a recent study by the University of Rochester found that SOX had slashed the total stock value of American companies by more than $1.4 trillion.

While it is true that there have been no repeats of Enron and WorldCom, the point to be debated is whether such a radical legislation was needed. The recent experience of a company proves that SOX does more harm than good in its present form.

Hit by SOX

The company was a medium-size one in the hi-tech industry. Its main revenue areas were software and telecom hardware, and it had about 300 people on its rolls with a reported turnover of $100 million. Apparently, a transaction of $750,000 was booked as revenue.

The contract had a contingency built into it and, as per US GAAP, contracts with a contingency should be shown under deferred revenue rather than revenue.

The sales executive had not disclosed the contingency to the book-keepers, resulting in the erroneous recognition of revenue. On discovery, the accounts had to be restated. The Securities and Exchange Commission (SEC) was informed about it and it decided to probe into this. SEC probes have always been tough — they have only become tougher now. Although the SEC lightens the character of a probe by calling it an interview, it is more of giving a testimony under oath in reality.

In the company under question, the interviews were happening with the CFO and the entire finance team in the offices of the company. This had a debilitating effect on the morale of the employees since no one had a clue as to what was happening in the next room.

The e-mails of one of the directors in the company were checked and the probe went to the extent of asking him why a particular word was used in an e-mail; his advice is not to be informal and flippant in e-mails. After a long probe, the company was able to come to a settlement with the SEC — after spending $350,000 in legal fees. However, the company realised that at the end of the probe it had lost its CFO, it had lost over half of its share value and employee morale was at its lowest ebb.

The SEC does not have a list of cases that are under action, maybe due to confidentiality clauses. However, SOX has created a huge opportunity for auditors, legal counsel and information technology professionals both in the US and outside. The fact that SOX has created more problems than it can solve is probably vindicated by the fact that the above company got a thumbs-up from its auditors for compliance with Section 404 of SOX — creation and maintenance of adequate internal controls. This also throws up the fact that a clean Section 404 report can mean nothing — there could still be a wrong recognition of revenue.

Act challenged

The US Free Enterprise Find (FEF) has launched a legal challenge to SOX by saying that the Public Company Accounting Oversight Board (PCAOB) — the implementing agency for SOX — is both un-elected and unaccountable but still it can make rules and impose penalties which is unconstitutional. The FEF also argues that of the 700 cases brought against corporate executives since August 2002 only one was under SOX and that too was dismissed.

There can be no doubt that SOX has created a fear factor amongst companies in the US. However, it appears that such radical measures were not needed to achieve this limited purpose. One could expect a toned-down version of SOX in the near future.

(The author is a Hyderabad-based chartered accountant.)