Companies Dealing With High Cost of Compliance

Few auditors and chief financial officers understood the ramifications of the Sarbanes-Oxley Act when the accounting reform law was signed in 2002. But they sure do now.

Spending by the public companies to comply with the law's regulations has been so steep, it's been cited as a reason by some of decreased profits in recent financial reports.

For some of the biggest corporations, the increased spending is being taken mostly in stride, with hardly a peep about the bills.

At San Diego-based Sempra Energy, with more than $9 Billion in revenues last year, total auditing fees rose 50 percent above the amount spent in 2003 to $13.2 million, according to the company's proxy statement.

The biggest reason for the spike was costs associated with Section 404 of the Sarbanes-Oxley Act. Last year, Sempra spent $3.66 million to ensure it was compliant with the regulation, compared with zero dollars in 2003.

Widely regarded as the most extensive provision of Sarbanes-Oxley, Section 404 requires companies to document and attest to the effectiveness of all their internal financial controls. Internal controls are the safeguards that are part of a firm's financial operations to ensure these operations are performed uniformly, and capable of detecting errors and fraud. The largest public companies had to begin adhering to Section 404's provisions starting last year.

Sempra, like many large corporations, reassigned most of the additional auditing work to existing employees.

Burden on Small Biz

But for many smaller public companies, that isn't an option. Many had to hire new employees and contract part of the project to outside consultants.

Some have cited excessive auditing fees as a reason for either taking the company private, or thinking very seriously about it.

Carl Gregory, the chief executive officer at Encore Capital Group Inc., a San Diego firm that buys charged off credit card debt from banks and collects on it, said the goal of Sarbanes-Oxley is a worthy one, but the new regulations impose unfair administrative burdens on many smaller companies. Also, it can't prevent people from breaking the law.

"At the end of the day, if you're going to do something unethical, you're going to do something unethical," Gregory said.

Because of the increased work associated with its SOX 404 project, Encore filed notice with the SEC saying it might not meet the deadline to file the reports. Encore was able to hit the deadline in the first quarter but not without some stress and higher costs. Last year, it spent about $1.2 million on auditing fees, up from about $660,000 in the prior year, according to the company's proxy statement.

To get the project finished, Encore had to hire a full-time certified professional accountant to manage it plus an assistant. It also spent "several hundred thousand dollars" on a second large accounting firm, KPMG, in addition to other fees paid to its regular outside auditor, BDO Seidman, Gregory said.

In December, Anacomp Inc., a San Diego-based provider of data storage and management services, said it planned to de-register its stock from the public markets because of the escalating costs of complying with the securities regulations.

In its filing, Anacomp, which generated $184 Million in revenues for its 2004 fiscal year, said, "In light of current and expected future regulatory requirements, especially the recent ones stemming from Sarbanes-Oxley, Anacomp estimates that the savings could range between $2.7 Million to $3.2 Million over the next two fiscal years, and may realize ongoing annual savings of approximately $1.5 Million in addition to any indirect costs."

Private Considerations

In February, PriceSmart Inc., a San Diego-based operator of club warehouse stores outside the country, stated in a securities filing that it was considering becoming a private company by reducing the number of shareholders.

"Beginning with fiscal year 2005, the direct and indirect costs associated with Sarbanes-Oxley Section 404 compliance will add significantly to the company's costs. The expense associated with implementing the additional processes and procedures necessary for Section 404 compliance and the fiscal year 2005 required attestation of those controls have been estimated at approximately $1.9 Million, several times the entire cost of the fiscal 2004 year-end audit," according to the PriceSmart report filed with the Securities and Exchange Commission.

While the aim of the accounting reform law is to prevent accounting fraud such as the kind that occurred at Enron, Worldcom and Tyco, some local public companies argue that it's impossible to regulate morality.

Viasat Inc., a Carlsbad-based manufacturer of satellite communications equipment, said through the third quarter of its last fiscal year, ended March 31, it spent about $700,000 on SOX 404 compliance. The company had to hire an internal auditor and outside consultants to get the SOX 404 work completed, but declined to state what its estimated total auditing bill would be, according to spokesman Bruce Rowe.

Kintera Inc., a San Diego-based software firm, estimated its SOX 404 costs would be $800,000, but when all the bills were tallied, it was closer to $1.2 million. "Like a lot of other companies, the bill got to be bigger as time went on," said Kintera Chief Financial Officer Jim Rotherham.

AeA, a trade group for the high-tech manufacturing industry formerly known as the American Electronics Association recently completed a study of the SOX 404 costs, and concluded that the law's implementation "is the quintessential example of the law of unintended consequences, with the biggest victim being small business."

Accounting firms charged with signing off on the SOX 404 reports have adopted a "one size fits all" approach, applying the same standards to small companies as those having multi-billions in revenues, the report said.

Big Numbers

AeA estimated the national cost for all companies to comply with SOX 404 at $35 billion, or more than 20 times greater than the SEC estimate in 2003.

"In essense, Section 404 is a very high regressive tax rate on small and medium companies, businesses that are serving as the job growth engine of the U.S. economy." the AeA report stated.

While SOX 404 applies to only public companies regulated by the SEC, many private companies are also documenting and testing their internal controls, and racking up excessive auditing fees. Most of these private companies aspire to eventually become public, and are mirroring auditing done by the public firms to show their customers and potential buyers (public companies) their financial systems are all SOX compliant, say some audit professionals.

Continuous Computing Corp., a San Diego private company that makes hardware and software equipment for telecom networks, decided that complying with the SOX 404 provision was the right strategy for the $45 million revenue company."

"One of our corporate goals from day one was to become a public company," said CFO Erez Barnavon. "But even if we don't go public, going through this process would benefit us by showing that we have good financial and IT (information technology) controls."

Barnavon estimated the base cost for the SOX 404 project at $300,000 to $500,000, but because the company has six foreign offices, that would double. Travel, translation expenses, and blending different types of IT systems all complicate, and increase project costs, he said.

At the very least, the company's auditing costs this year will be about double what it paid in 2003, Barnavon said.

Planning for Continuous Computing's SOX 404 project began this year, but the firm still isn't certain how much of the work will be done by contractors, and how much will be handled in-house.

"We could bring a few full-time employees and do it in-house, or we could bring outside consultants," Barnavon said. "We'll probably bring in one or two people initially to write the documents, and then use outside consultants to conduct the testing and review."

The kind of professionals Barnavon said would be needed to complete the project are experienced auditors or certified public accountants who would command salaries in the range between $75,000 to $150,000.

Congress' passage of Sarbanes-Oxley may have caused more than a few gray hairs for financial officers, but it was a good thing for the auditing industry, many industry observers said.

"No question about it, Sarbanes-Oxley is one of the biggest job creating acts we've seen in a long time," Barnavon said.

Quotable Quotes

"The only protection under securities laws is to disclose, but it's a two-edged sword. If you put more information out, you will have more to be held accountable to, but it's the only way to stay out of trouble. Maybe that will help us in the end."

- Scott Stanton, a partner at the San Diego office of Morrison & Foerster LLP

"The personality of every company takes on the personality of the CEO. So if you look at someone like Dennis Kozlowski at Tyco, who was an imperial ruler, it was possible for him to do some of this stuff with his accountants before the regulations were strengthened."

- Stan Crum, a retired vice president and controller of Hughes Aircraft, says that the Sarbanes-Oxley Act of 2002 - particularly the separation of the audit and consulting functions of accounting firms - has been largely responsible for reining the outlandish behavior of many chief executive officers.

"No question about it, Sarbanes-Oxley is one of the biggest job creating acts we've seen in a long time."

- Continuous Computing, Former CFO, Erez Barnavon

"At the end of the day, if you're going to do something unethical, you're going to do something unethical."

- Carl Gregory, the CEO at Encore Capital Group Inc.