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Three years after Congress passed the Sarbanes-Oxley Act, public companies have experienced a profound escalation in operating costs. But just how much is compliance with SOX costing companies? The law firm Foley & Lardner discovered in a study last month that Section 404, the internal-controls provision of SOX, had the biggest impact on companies in fiscal year 2004. The results of the study are based on responses from 147 public companies and on the 2005 annual meeting proxy statements of more than 700 public companies, obtained by Standard & Poor’s. The study found that the average cost of being public for a company with annual revenue of under $1 billion increased 33 percent in 2004, from $2.6 million in 2003 to $3.4 million. The average cost of being public for a company with annual revenue of more than $1 billion increased 45 percent, from $9.8 million in 2003 to $14.3 million. The most important factors in the increases were fees paid to outside auditors and estimated costs for lost productivity. JUMP IN AUDIT COSTS One of the more interesting findings was that the percentage increases in fees paid to outside auditors were disproportionately greater for smaller public companies. These costs mainly resulted from companies’ compliance with the internal-control provisions of SOX. The findings for companies with annual revenue of less than $1 billion and for S&P small-cap (companies with a market capitalization of $300 million to $1 billion) and midcap (those with a market capitalization of $1 billion to $2 billion) companies are of particular interest to businesses in the Washington, D.C., area. The D.C. metropolitan area includes more companies in these categories than in the larger corporate categories. While fees paid to outside auditors have continued to increase by double-digit percentages each year since SOX was enacted, the increase accelerated dramatically in 2004. According to the 2005 S&P database, audit fees increased across the board. For instance: • For S&P small-cap companies, average audit fees in 2004 were $1 million, an 84 percent increase over 2003. The annual increases in average audit fees were 17 percent in 2003 and 34 percent in 2002. • For S&P midcap companies, average audit fees in 2004 were $2.2 million, a 92 percent increase over 2003. The annual increases in average audit fees were 19 percent in 2003 and 33 percent in 2002. • For S&P 500 companies (companies with a market capitalization of $4 billion or more), average audit fees in 2004 were $7.4 million, a 55 percent increase over 2003. The annual increases in average audit fees were 19 percent in 2003 and 38 percent in 2002. • The average audit costs of companies with annual revenue of under $1 billion in 2004 were $1 million, a 96 percent increase over 2003. The annual increases in audit costs for such companies were 14 percent in 2003 and 37 percent in 2002. • The estimated audit costs of companies with annual revenue of $1 billion or more in 2004 amounted to $5.7 million, a 58 percent increase over estimated 2003 audit costs. In addition to audit expenses, lost productivity continued to represent a major cost for all companies responding to the survey, particularly for smaller ones. Average costs associated with lost productivity increased from $160,000 in 2003 to $1.1 million in 2004 for companies with annual revenue of under $1 billion, compared with an increase of $2.5 million to $2.9 million in 2004 for companies with annual revenue of more than $1 billion. Although the survey did not ask respondents to describe the nature of the costs constituting “lost productivity,” it did ask for an estimate of the financial impact of lost productivity associated with the requirements of SOX, Section 404. Companies with annual revenue of under $1 billion estimated an average financial impact of $426,000, while companies with annual revenue of $1 billion-plus estimated $1,147,000. MORE ADVERSARIAL Responses from executives responsible for implementing Section 404 show the increasingly adversarial relationship between companies and outside auditors. Here are some of their comments: • “We used to work together; now the auditors are the policemen/adversaries, not consultants/advisers.” • “The relationship is much less client-service oriented and collaborative. Consultations with our external auditors are much more formal and less frequent.” • “It has created an adverse relationship with the auditors. They are no longer an adviser the company can count on during the normal course of business. Public company auditors are now privatized regulators for the SEC.” Also among the study’s key findings: 20 percent of respondents noted that they are considering going private. Ten percent of respondents have considered selling their company, while 14 percent have considered merging with another company. The vast majority of respondents (82 percent) also expressed concern with the strictness of new corporate governance laws, a 15 percent increase from a similar study the previous year. While Congress’ original intent was that SOX be applied equally across the board, the requirements and compliance costs of Section 404 have proved to be disproportionate to the size of the company. As the results of the study demonstrate, smaller companies have experienced a much larger percentage increase in audit fees than larger companies. Most companies with a market capitalization of $75 million or more began to develop and document their internal-control processes in fiscal 2003. And fiscal 2004 was the year in which the outside auditor’s verification and internal-control audit requirements were imposed on such companies. The good news for companies with a market capitalization of less than $75 million is the Security and Exchange Commission’s recent extension of the deadline date for complying with the internal-control reporting, attestation, and audit requirements until the first fiscal year ending on or after July 15, 2006. SEC officials appreciate that the costs of compliance with Section 404 have been higher than anticipated and that they have had a disproportionately adverse effect on smaller companies. As a result, the deadline date for compliance with the SEC’s rules will most likely be further extended and the materiality and other substantive requirements relaxed. In fact, the SEC reported on June 21 that the 404 subcommittee of its Advisory Committee on Smaller Public Companies unanimously recommended that the “SEC should again postpone the Section 404 requirements for smaller public companies until the committee completes its work” and an internal-control framework for smaller companies is formulated. Smaller public companies, therefore, should defer finalizing or making substantial investments in the development of their SOX 404 internal-control systems. Along with the expected additional extension of the compliance deadline, consideration of changes so that Section 404 is not a one-size-fits-all regime, as it is now crafted, is very likely. For example, consideration may be given to whether the thresholds for documentation could be reduced and whether Section 404 requirements could be done every three years, rather than every year, for a smaller company that has corrected all of its internal-control deficiencies. There is no doubt that SOX has resulted in three years of significant increases in the cost of being a public company. And as to whether the statute has been effective, most people generally believe that SOX will contribute to reaching its goals of improved quality and transparency of financial reporting and audit effectiveness. But it will be difficult, perhaps impossible, to identify and compare the relative importance of the provisions in SOX that will be responsible for the expected improvement. After all, it will be tough to distinguish the consequences stemming from the recent widely publicized criminal convictions of corporate wrongdoers from the consequences of the implementation of the various SOX provisions.
Arthur H. Bill is a partner in the Washington, D.C., office of Foley & Lardner. The firm’s study “The Cost of Being Public in the Era of Sarbanes-Oxley” is available at www.foley.com.

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