Business Day

Sarbanes-Oxley, Bemoaned as a Burden, Is an Investor’s Ally

Fair Game

By GRETCHEN MORGENSON    SEPT. 8, 2017

Seismic 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.

Tom Farley, president of the NYSE Group, which operates the New York Stock Exchange, is among those leading the charge. In congressional testimony in July, he criticized the law’s 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.

Mr. Farley’s 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?

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.

Through a spokesman, Mr. Farley declined my request to expand on his views in an interview.

Since 1977, 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.

“Corporate frauds 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.

The 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 Association.

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.

The academics 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.

The exercise 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 study said.

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 cases.

“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.”

Here’s another 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.

Although critics 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 said.

Arguments like 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.

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