Good money after bad

There’s good news and bad news in the world of Sarbanes-Oxley. The good news is that costs associated with the regulation of public companies are going down. The bad news is that overall spending has hardly declined at all, because the money that had been spent on Section 404 programs is simply being reshuffled into other categories.

That’s a nutshell version of the results of an annual survey on corporate compliance costs. Conducted by the law firm Foley & Lardner, the study invited input from directors and executives at nearly 9,000 public companies. A total of 114 responses were received and sorted based on company revenue – under or over $1 billion.

The survey also reports on audit fees listed in proxy statements filed through mid-May for fiscal year 2005. Figures from more than 850 public companies were recorded in three categories: S&P 500, MidCap 400 and SmallCap 600.

According to the survey, overall compliance costs for companies with less than $1 billion in revenue were down an average of 16 percent in 2005 compared to the previous year. Companies with more than $1 billion in revenue saw a 6 percent decrease. 

‘We’ve been conducting this study for four years, and this is the first year that overall costs of compliance have decreased,’ says Tom Hartman, survey director and partner at Foley & Lardner. ‘But it’s not quite as simple as that.’

The major areas in which reductions are taking place are legal fees, setup costs, lost productivity of staff – whose attention had been diverted from their usual business responsibilities – and other Sox-related expenses. Many of these are short-term implementation costs that were incurred as the regulation provisions came into effect.

However, at many companies, these reductions are being offset by significant increases in areas such as audit fees, director compensation and insurance.

An ongoing cycle

The average audit expense has risen every year since Sarbanes-Oxley was enacted. As the numbers go up, it becomes evident that small and midsize companies incur the biggest increase in compliance-related costs as a percentage of revenue, which earlier reports predicted.

In the first years of the regulations, the increases reported by companies of all sizes were relatively equal. When Section 404 requirements were phased in, small-cap companies saw the increases get larger. Between fiscal year 2003 and 2005, small caps reported a 141 percent increase in average audit expenditures, while mid-caps saw a 104 percent increase. By contrast, audit fees for S&P 500 companies rose 62 percent.

Small and midsize companies also continue to see a higher proportion of audit expenses. The study reports that compliance costs for companies with revenue under $1 billion have averaged $2.9 million, 174 percent higher than pre-Sox figures.

One thing is certain: expectations of lower second-year audit costs, as suggested by some experts, have proved misguided. In fact, some frustrated executives have begun referring to Section 404 as the ‘accountants full employment act,’ and the survey doesn’t do much to counter that label.

Audit fees now comprise more than 50 percent of out-of-pocket compliance expenses paid by companies with revenue under $1 billion. Over the last year, audit costs for small-cap companies increased 22 percent. Mid-caps showed a 6 percent increase, while S&P 500 companies paid a mere 4 percent more.

‘When restrictions came out against doing unrelated accounting work, audit fees dropped pretty significantly,’ says Hartman. ‘But it’s interesting that after the 404 audit requirements came out, costs went back up. The average fees that companies are now paying are the same, or even higher, than before.’

Fees paid to auditors categorized as ‘other’ decreased 97 percent between 2001 and 2005, attributed primarily to reduced consulting work. Despite that reduction, total auditor fees paid by public companies since 2004 have boosted total spending back to their pre-regulation levels.

As public companies become increasingly reliant on outside auditors, a good working relationship is a key factor in the compliance process. However, the study offers an inside peek into a situation that can best be described as dysfunctional. Many respondents indicated that relationships with their auditors are weaker and have become less collaborative. Company executives claim that audit firms are reluctant to address specific questions or provide definitive answers. Among the comments made by respondents about their outside auditors were ‘distant and sometimes adversarial,’ ‘focus is entirely driven by attempt to minimize their use’ and ‘frequently change their answers.’

‘Audit firms feel they have their necks on the line because the SEC hasn’t been specific about defining requirements,’ says Hartman. ‘Until the commission provides some kind of safe harbor, auditors will be reluctant to do anything that reduces the audit scope but potentially increases their liability.’

Indirect costs soaring

One increase that is being seen across the board is higher director compensation. Since 2001, small companies have increased director compensation an average of 71 percent. Compensation for directors at midsize companies has risen 64 percent, while board members at large firms have reported a 58 percent increase.

While increased workloads are driving a rise in director salaries, it is other payments that are making the greatest difference. A review of previous surveys reveals that NYSE companies pay higher annual directors’ fees – an average of $40,000 in fiscal year 2005 – compared to Nasdaq companies, which paid an average of $27,000. But fees for Nasdaq directors rose more: 88 percent higher than in 2001, while directors’ fees at NYSE firms rose 58 percent.

‘The amount of time and effort involved with being a public company director has increased, along with the perceived risk,’ says Hartman. ‘They want better compensation, so companies are either paying them more cash or expensing options, which increases the end cost.’

The market for directors and officers (D&O) insurance continues to fluctuate. Companies with revenue exceeding $1 billion have seen a 157 percent increase in D&O insurance premiums since 2003. This is one category in which smaller companies have been less affected, reporting only a 26 percent increase between 2001 and 2005.

Opportunity costs dominate

When it comes to compliance-related expenditures, cash isn’t the only outlay. The arrival of Sarbanes-Oxley has also brought a significant loss of manpower at companies under pressure to comply. In fact, lost productivity remains the second highest compliance-related cost.

The cost of lost productivity at companies under $1 billion in revenue rose a staggering 1,124 percent in the years after reform, according to the survey. In 2004 – the first full year that Section 404 was implemented at most companies – productivity loss registered 556 percent higher than the previous year.

Hartman says large companies were generally in a better situation to handle the demands, or at least pass them off. ‘Much of the increased work could be doled out to outside consultants, but financially that’s not always an option for the smaller companies,’ he notes.

While many public companies are learning how to deal with the effects of compliance, a majority of respondents still feel pinched. For example, for the first time in the survey’s history, no one feels the reforms aren’t strict enough. In the first survey, 38 percent felt the regulations were ‘about right.’ This number has dropped to 18 percent.

Clearly, the increased demands of Section 404 have ushered in a change of opinion. In the 2004 survey, 67 percent of respondents felt reforms were too strict. This figure rose to 82 percent in both 2005 and 2006.

Making the adjustment

Though the regulations may be viewed as onerous, more companies claim that they are finally getting a handle on compliance-related expenses. For the first time, the majority of respondents report an ability to better predict the costs of governance. But nearly one third disagree and say their compliance costs are too unpredictable.

Public companies also appear to be successfully tolerating the budgetary requirements of increased compliance costs. Only 34 percent attribute any budget or staffing cuts in critical areas of their business to Sarbanes-Oxley. But of these positive responses, 95 percent also feel the regulations are negatively affecting company’s earnings.

Perhaps as proof of the decrease in administrative expenses, only 54 percent of respondents say Sox had ‘a great deal’ of impact on their administrative costs, compared to 70 percent last year. But even though the financial burden may be somewhat lighter, 84 percent still report increases as ‘somewhat’ or ‘a great deal’ higher than in previous years.

Getting away from the regulations completely is still on the minds of some. Twenty-one percent of respondents indicate they’ve considered taking their companies private – a slight increase from last year. Another 18 percent are considering a sale or merger. Most of these respondents are companies with less than $1 billion in annual revenue. 

When asked for suggestions to modify the compliance process, not surprisingly most respondents focus on the excessive requirements of Section 404. Some suggest there should be a greater focus on director effectiveness. One respondent in particular feels the requirements handicap US companies in the global market, and many criticize the one-size-fits-all approach of the regulations. Another seemingly exasperated respondent refers to the process as ‘the revenge of the internal auditor.’

Overall, the survey seems to indicate that Sarbanes-Oxley continues to be a significant weight on public companies. And while Hartman acknowledges that the survey isn’t conclusive evidence, it does document the changing tides. ‘Audit fee information came from S&P data, so I’d call those results statistically significant,’ he says. ‘And while some of the other responses aren’t definitive, they clearly indicate developing trends in the process.’

As compliance regulation moves into yet another stage, the discussions of balancing cost and effect will undoubtedly continue. Hartman thinks the din of unrest heard up to this point will become a roar once small companies are required to comply, and changes may become necessary.

‘The real question is what the stock market or economy get from 404 as opposed to its cost,’ he says. ‘If dealing with 404 requirements ends up being 90 percent of the cost, does that provide 90 percent of the benefit? That will be the ongoing debate and where the interest will be seen next year.’