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By the book
Virginia companies
feel the squeeze of Sarbanes-Oxley
by
Garry Kranz
Virginia Business
February
2005
Jones
Tallent occupies one of the most important jobs at The
Fairchild Corp. Yet less than a year ago, Tallent’s
position didn’t even exist. The former Ernst &
Young auditor was hired as manager of internal controls
to spearhead Fairchild’s compliance with the Sarbanes-Oxley
Act of 2002. The sweeping reform legislation, which
targets public companies, requires stringent new accounting
regulations.
Tallent
has implemented a system of checks and balances on hundreds
of business functions at Fairchild, a Dulles-based holding
company with 12 subsidiaries, including a retail distributor
of motorcycle gear and a manufacturer of aircraft equipment.
The diversified companies have their own sets of business
processes that now must be fully tested and documented
as part of Fairchild’s financial statements. “Hundreds
of thousands of dollars” have been spent so far
to get into compliance, says Tallent, with additional
audit fees expected to consume thousands of dollars
more each year.
The new reporting requirements require painstaking attention
to detail. Companies must report on a long litany of
activities: which employees are authorized to purchase
goods, whether goods are scanned into inventory or checked
in manually, who has access to financial data. Seemingly
innocuous things must be accounted for, such as who
answers the phone when a customer calls to place an
order.
“I don’t know how much impact this law is
going to have on companies that were cheating. But for
companies like ours that have been going by the book,
it definitely makes achieving compliance much harder
than before,” says Tallent.
Such is the price for doing business in the highly regulated
environment enveloping publicly traded U.S. companies.
Congress passed Sarbanes-Oxley to shore up eroding investor
confidence in the wake of major scandals involving Enron
Corp., WorldCom and other companies. The act makes the
financial dealings of companies much more transparent.
Those with a market capitalization of at least $75 million
were required to meet a November 2004 deadline for full
compliance, while smaller companies have until December
2005. Experts say the latest round of financial reports
this month should provide clues as to how many Virginia
public firms measure up.
What’s already clear is the fallout. Sarbanes-Oxley,
for all the good intended, is costing companies millions,
changing corporate cultures and making it harder to
fill board vacancies. Rather than clean up business,
some people worry that the law’s many tentacles
will weight businesses down so much that public companies
will throw in the towel and go private just to escape
its onerous conditions. “I think it’s going
to discourage some small companies that may have been
thinking about going public,” says Jan Alpert,
vice chair at Richmond-based LandAmerica Financial Group.
Surprisingly, though, more and more private companies
apparently see value in voluntarily grafting parts of
the new regulation as best practices. Mike Paulette,
managing director of Core Consulting in Richmond, already
is fielding more calls from private companies asking
about the regulation — some with designs on going
public one day. “This isn’t widespread now
but it will be going forward, especially because of
enhanced investor confidence,” says Paulette.
One of Sarbanes’ major requirements focuses on
public companies and their independent auditors. Companies
must establish and test internal controls over financial
information and hire independent auditors to validate
that the controls work. To discourage conflicts of interest,
the act prohibits companies from using the same accounting
firm to provide both accounting services and consulting.
And it demands accountability from executives. CEOs
and top financial officers are required to certify under
oath that financial statements are accurate and that
controls are in place on key business processes. Executives
who fail to meet their fiduciary duty to shareholders
could face severe penalties, including fines or possible
jail time. As a result, they are “spending significant
time and effort making sure that internal controls are
in literal compliance — not just that their financial
records are correct,” says Nicholas Conte, a Roanoke
lawyer who advises companies on Sarbanes-Oxley.
For now, Virginia companies don’t have to worry
about state lawmakers piling on, as has happened in
some states. Virginia legislators in 2001 took steps
to heighten accountability of public companies by passing
the Virginia Uniform Accountancy Act. The measure created
an independent Board of Accountancy to provide uniform
rules for licensing and enforcement of certified public
accountants. That made Virginia one of only nine states
to independently regulate CPAs. Among its requirements
is continuing education for accountants, including coursework
on ethics and reporting.
The stricter federal reporting brings unwanted cultural
changes at Universal Corp., a Richmond-based tobacco
leaf merchant with more than 50 worldwide subsidiaries.
Company officials worry their decentralized system of
management will gradually disappear as the company is
forced to make operations more uniform. “We’ve
always followed a philosophy of hiring strong local
management and letting them do their jobs,” says
Hartwell Roper, Universal’s chief financial officer.
“But to some degree, this law puts bureaucracy
into our company that we really don’t want.”
For example, Universal now must maintain controls on
about 280 significant accounts, nearly 260 key business
processes, and another 500 or so “subprocesses”
that fall under the purview of the new law. Local managers
are required to sign off on the internal controls governing
these business functions. Nearly 40,000 hours of planning
and “thousands and thousands of dollars”
were spent to ensure that Universal’s overseas
and domestic operations follow the same reporting guidelines.
Universal devoted its entire audit group of 12 people
to manage first-year compliance efforts, forcing the
postponement of revenue-generating activities such as
collecting on open invoices. “We have little standardization
in our company, but we [are required] to document all
these various processes. Because of that, our cost of
compliance is huge,” with audit fees alone doubling
to about $3 million in 2004, says Roper.
In fact, U.S. companies on average are spending more
than $5 million to reach compliance, with ongoing compliance
costing another $3.7 million. That’s according
to a survey by Korn/Ferry International, an executive
recruitment firm based in Los Angeles. “The perception
among CEOs and directors is that [Sarbanes-Oxley compliance]
is incredibly expensive and not the best use of capital
by any means,” says Charles King, who heads Korn/Ferry’s
global board services practice.
One of the largest cost increases for businesses are
yearly audit fees, which jumped 40 percent on average
in 2004, according to Financial Executives International
of Florham Park, N.J. That accounting firms are reaping
a windfall from the stepped-up oversight is highly ironic
and a tad irksome to executives. Now-disgraced Arthur
Andersen — once one of the “Big Five”
accounting firms — helped trigger the Enron debacles
with off-books accounting schemes. “While admitting
that certain parts of this legislation are virtuous
and to the good, most CEOs don’t feel the potential
business benefits are large enough to offset the cost
and the ongoing incremental effort” needed to
comply, says Dave West, an analyst with Davenport &
Co. of Richmond.
Following the example of other public companies, Glen
Allen-based LandAmerica Financial Group uses two accounting
firms: one for its financial records and another to
assess internal controls. LandAmerica’s financial
audit fees topped $1.5 million in 2004, with compliance-related
internal audits estimated to cost an additional $800,000
to $1 million. Meanwhile, the company has hired three
full-time compliance experts to manage ongoing compliance.
Says Chief Financial Officer Bill Evans: “The
biggest burden is the level of documentation required
to prove that your controls work.”
Sarbanes-Oxley also raises the stakes for paid directors
of public companies. Board members are expected to exert
more oversight over a company’s operations and
could be personally liable for noncompliance issues.
“Much more is now required of boards of directors,
including understanding the nuances of their own company’s
financial statements. They’re also expected to
have a better understanding of business processes,”
says Conte.
The heightened liability was brought home last month
when former WorldCom directors agreed to pay millions
out of their own pockets in a tentative agreement to
settle a class-action settlement suit brought by investors.
(WorldCom’s successor, MCI Inc., is based in Ashburn.)
The potential for personal liability is making it tougher
for companies to fill board vacancies. The number of
people declining invitations to join boards of directors
more than doubled since Sarbanes-Oxley became law —
jumping from 13 percent in 2002 to 29 percent in 2004,
according to Korn/Ferry’s study. Cronyism also
is targeted. Greater disclosure now surrounds the nominating,
auditing and compensation committees of public companies.
Directors serving in those roles must be completely
independent of the company. This requirement adds its
own level of complexity. For instance, if a private
board member retains an attorney whose firm has performed
work for the company, that relationship could constitute
a conflict of interest. “That has pushed more
boards to look outside their inner realm of contacts”
when filling vacant seats, especially on vital committees,
says Tom Visotsky, president of Corporate Board Executive
Search in Richmond.
Stricter corporate governance and disclosure reforms
are driving some public companies to consider abandoning
public markets altogether. Foley and Lardner LLP, a
Chicago-based law firm, found that 21 percent of 115
public firms surveyed last year have considered going
private, up from 13 percent in 2003.
So far, the regulations haven’t prompted any of
Virginia’s public companies to revert to private
ownership. Besides, there’s incentive to comply
with Sarbanes-Oxley; namely all those still smoldering
embers of scandal.
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