Bemoaned as a Burden, Is an Investor’s Ally
Kenneth Lay, the former Enron
chief executive, at a Senate hearing in 2002 after the company
was felled by an accounting scandal.
Kenneth Lambert/Associated Press
accounting scandals like the ones that sank Enron and WorldCom in the
early 2000s have, happily, been scarce in recent years. But they may
well resurface if elements of the Sarbanes-Oxley Act, the law created
to curtail accounting fraud, are rolled back as some corporate
executives are urging.
Farley, president of the
NYSE Group, which operates the New
York Stock Exchange, is among those leading the charge. In
testimony in July, he criticized
provision requiring auditors of
publicly held companies to report on and attest to management’s
assessment of internal controls on financial reporting. The
requirement is costly and burdensome to companies, Mr. Farley said,
and helps to explain why the number of public corporations in the
United States is declining.
He urged lawmakers
to review the requirement because markets had evolved since it became law.
comments notwithstanding, it seems smart to have an outside auditor check on
management’s oversight of financial reporting. If a company does not have solid
controls in place, how can investors trust its financial reports?
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But investors do not seem to be a concern for Mr. Farley, who was
speaking about the law (known as SOX) as an advocate for the big
companies that list their shares on the New York Stock Exchange.
“Designing, implementing and maintaining complex systems required to
satisfy SOX’s internal controls over financial reporting requirements
can command millions of dollars in outside consultant, legal and
auditing fees, in addition to other internal costs,” he said.
spokesman, Mr. Farley declined my request to expand on his views in an
companies have been required by law to have effective internal controls over
their financial reporting. But many failed to comply, as the subsequent
accounting frauds and numerous financial restatements showed. That is why
Congress decided in 2002, as part of Sarbanes-Oxley, to make auditors attest to
corporate controls on financial reporting.
Lynn E. Turner, a
former chief accountant of the Securities and Exchange Commission and a
trustee of the Colorado Public Employees’
Retirement Association, said he knew well that many companies hate having
auditors assess their internal controls. But the regulation has done a lot to
prevent devastating accounting frauds, he said.
like Enron, WorldCom and Tyco cost investors hundreds of billions of dollars and
the NYSE and Nasdaq trillions of dollars in lost market capitalization,” Mr.
Turner said. “And they were a worldwide embarrassment to the United States.”
Critics of the
provision on financial reporting contend that it has not prevented accounting
fraud, but a new academic study shows otherwise.
analysis concludes that the external auditor
requirement on corporate financial reporting is a highly effective warning
system for corporate fraud. The study was recently published in Auditing: A
Journal of Practice & Theory, a journal from the American Accounting
Its authors are
Matthew S. Ege, an assistant professor of
accounting of Texas A&M University, and
Dain C. Donelson and
John M. McInnis, both of the University of
Texas at Austin. They say their work is the first to link weak internal controls
on financial reporting with a higher risk of undisclosed accounting fraud at
public companies. And proof of this link is an important consideration when
weighing the costs and benefits of Sarbanes-Oxley.
collected auditors’ opinions on internal controls at companies with more than
$75 million in publicly held stock — about 3,500 companies per year — from 2004
through 2007. They searched for those with material weaknesses. Then they
compared their findings with reports of financial fraud in S.E.C. and Justice
Department enforcement actions from 2005 through 2010 as well as settled
securities class-action lawsuits during the period.
identified roughly 1,500 reports of material weakness at companies. And within
three years, 127 of those companies faced legal actions that revealed fraud, the
That’s not a big
number. But here’s where the study gets compelling. Auditors had identified
material weaknesses in financial reporting at about 30 percent of the companies
that later disclosed accounting problems. Chief executives were named in 111 of
the 127 fraud cases, and chief financial officers were identified in 108 of the
“Over all, we
believe this link should be of interest to regulators and the general public,”
Mr. Ege said in an interview. “We need to ensure that entity-level weaknesses
are being reported and not withheld.”
reason to keep the financial reporting audit requirement: Research indicates
that companies with weak financial reporting controls significantly underperform
those with stronger setups. A 2007
study by Glass, Lewis & Company, for
example, found that companies disclosing material weaknesses in their financial
reporting during each of the prior three years were conspicuous market laggards.
of Sarbanes-Oxley prefer to focus on its vexing costs, an
analysis in May by Ernst & Young, a big
accounting firm, highlighted the law’s benefits. They include a “decreased
severity of financial restatements and increased investor confidence,” the firm
those raised by Mr. Farley of the NYSE Group and other corporate chiefs about
accounting rules are nothing new, Mr. Turner said. During his years as the
S.E.C.’s chief accountant, from 1998 to 2001, officials from the New York Stock
Exchange would regularly request exemptions from reporting rules, he said. “I
never once agreed to what they were asking for,” Mr. Turner recalled.
Clearly, investors will be hurt the most if this provision of Sarbanes-Oxley is
watered down. Which raises a question, according to Mr. Turner: Why should a
public company be able to raise money from investors if it can’t generate
accurate reports for them?
A version of this article appears in print on September 10, 2017, on
Page BU1 of the New York edition with the headline: Oversight Law
Under Attack Aids Investors.
© 2017 The
New York Times Company