The price of being public

After years of spiraling fees and countless work hours it appears as though the costs of complying with Sarbanes-Oxley, and of being a publicly listed company in general, are finally starting to get under control.

That’s according to a recent survey from Foley & Lardner, ‘The cost of being public in the era of Sarbanes-Oxley’. The law firm worked with KRC Research and utilized data from Standard and Poor’s Investment Services custom business unit to gauge the financial impact of corporate governance reform on public companies. The survey includes both empirical figures and analysis about costs, as well as personalized responses regarding attitudes toward reforms among top executives.

The study finds that, overall, the growth in SOX compliance spending decreased in 2006. Author of the study Thomas Hartman, a partner at Foley & Lardner, finds that this decrease is at least partially due to the fact that ‘multiples have been good and the M&A market has been strong over the last 12 to 18 months.’ But in spite of this recent decrease in costs borne out of compliance to SOX, ‘expenses increased due to reforms’ since financial year 2006.

Despite the comprehensive decrease, spending in certain areas, including fees paid to auditors, continue to rise, albeit at a slower pace than in previous years. Most of the savings being realized by companies during 2006 are a result of improved internal efficiency. Another recent study conducted by Financial Executives International (FEI) that was released in May this year finds that the cost of complying with SOX dropped 23 percent during financial year 2006. It was concluded that this saving was a direct result of ‘increased efficiencies in complying with Section 404.’

Brass out-of-pocket

As companies become more efficient at analysis and reporting on their internal controls it would be fair to expect a comparative reduction in overall compliance costs. This is not proving to be the case and one reason may be the increase in out-of-pocket expenses, many of which go to groups outside the corporation. Audit fees, board member compensation and legal fees are three of the main areas of increase in out-of-pocket expenses for US-listed companies.

It is important to note that 47 percent of all out-of-pocket expenses for companies with revenues less than $1 billion are a result of audit fees associated with governance compliance. This figure rises to 60 percent for companies with annual revenues greater than $1 billion.

Expectations that auditor efficiency would improve over time and lower costs have not yet come to fruition. Though these audit costs have plateaued, the consistently large compliance costs are pushing companies to search for alternatives. The average increase in audit fees from 2005 to 2006 for all companies in the survey ranged from 4 to 6 percent. A quarter of the companies surveyed indicated desires to go private to avoid governance fees, 16 percent are considering selling and 14 percent are considering mergers.

During the web conference announcing the results of the compliance costs survey, one participant aired serious concern about the affect SOX is having on US capital markets.

Hartman said that if he could solve the question as to how to assuage those costs, he’d go into private business. He did advise, however, that companies should ‘look at bills, look at who’s charging what and what they’re actually doing and to challenge bills where appropriate – where you don’t think you’re getting service for what’s being performed by the service provider.’

Aligning views

This year, in the face of increasing criticism about rigidity and lack of coherent guidance, the SEC has taken steps to streamline the auditing process and reduce the burden on companies. The SEC and PCAOB have collaborated to align the tone and wording of Section 404 and the new audit standard 5 (AS5). Adopting a top-down risk-based approach, they focused on issues like fraud risk assessments, which have stymied auditors for the past several years.

While broadly welcomed by business leaders, the long-term effects of the streamlining remain to be seen. Final adoption of the reworked AS5 and the new SEC guidance is scheduled for late 2007.

Evening out

Audit fees have shown some sign of smoothing out, however. The 6 percent increase seen at S&P 500 companies for the 2006 financial year is considerably lower than the year-on-year changes seen in previous years. The Foley report shows that, prior to 2005 and 2006 average audit fees increased by double-digit percentages year-over-year since the enactment of SOX in 2002. As could be expected, 2004 saw the most dramatic year-on-year increase as Section 404 was phased in and took effect for most companies late in that year.

The assumption is that companies are becoming better at performing internal checks and auditing and accounting firms are reaching a better understanding of the risks and processes relating to internal controls.

Improvements in auditing internal controls will become increasingly important as Section 404 broadens its grasp. The SEC recently ruled that small companies, which up to this point had been exempt, must file Section 404 reports. Two thirds of companies in the study still believe that small companies shouldn’t have to file, and that the SEC’s threshold for what qualifies as a small company ($75 million), should be raised to $250 million. Hartman agrees, and says ‘Section 404 makes a lot of sense at large companies that can afford it and not a lot of sense at small companies that can’t.’

As demonstrated in the study, audit fees are only one part of the cost picture when it comes to SOX. The slowing in the growth of audit fees is welcome news although it is important to note that overall, audit fees remain extremely high and are a significant expense for companies of all sizes.

A good director is hard to find

One often-overlooked element of the cost effects of SOX are director fees. Over the past several years companies of all sizes and in all sectors have pointed to the fact that it has become far more difficult to attract and retain qualified directors. As the supply of experienced people willing to take up board positions diminishes, annual director fees are steadily growing. The study reports that, overall annual director fees have increased an average of 70 percent for small companies, 98 percent for mid-cap firms and 93 percent for S&P 500 companies between 2001 and 2006.

The picture goes much deeper than this. Given that more and more companies are now in the habit of using professional director recruitment firms to help them locate new board members, and fees are often tied to annual payment, the cost of recruiting directors is also on the rise.

Changes in accounting rules, according to the Foley report, requiring the expensing of stock options have affected the behavior of many companies in relation to how they compensate directors. As stock options continue to fall out of favor with the governance and regulatory community, companies are limiting the number of new options being granted. In many cases, the loss of potential income that would be available to directors via such options payments is being made up with cash-based incentives. It is predicted that this trend will continue to drive director recruitment and retention costs in the coming years.

Legal losses

The survey also highlights an increase in legal fees, something that had been on a gradual decline in previous periods. It is estimated that the financial year 2006 legal fees related to SOX will be 53 percent higher than in 2005.

This increase in outside legal costs is potentially disturbing since costs of this type fell significantly during 2004 and 2005. And corporate governance system set-up costs also went up during 2006. As smaller companies will now be required to comply with Section 404, it is reasonable to expect that this is one area where we will see significant increases during 2007 and beyond.

Overall, companies are striving to improve internal processes and in many ways have been successful in developing a better understanding of their own systems of internal controls. As efficiency gains become harder to achieve it is likely that companies will look to reduce outside costs related to auditing and legal fees. All eyes will be on the impact the newly revised AS5 and SEC guidance will have on the efficiency of the audit process and the adoption of a truly top-down risk-based approach to the ever-growing scheme of governance and compliance activity.