A new report released this month suggests that both large and small public companies will see huge reductions in the costs associated with complying with Section 404 of Sarbanes-Oxley, as regulators are expected to soon consider whether to scale back the requirements of that provision for some companies.
The study of 404 costs, conducted by economic consulting firm CRA International and commissioned by the Big 4—Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers—is the latest survey to conclude that Year Two costs related to the internal control provisions of Sarbanes-Oxley are expected to decline. As Compliance Week reported in October, two other studies also projected reductions in the Year Two costs associated with complying with 404 (see related coverage at right).
According to the survey, “Sarbanes-Oxley Section 404 Costs and Implementation Issues: Survey Update,” total SOX 404 costs for larger companies—defined as having more than $700 million market capitalizations—are expected to decline 42 percent on average in the second year, from $7.3 million to $4.3 million.
Smaller companies—with market caps between $75 million and $700 million—are expected to decline 39 percent on average, from $1.5 million to $900,000, according to the report.
“The data suggests [sic] what many observers have said for some time—that a significant portion of first-year costs of implementation was the result of start-up and one-time factors that will diminish over time,” the firms wrote in a Dec. 8 letter to SEC Chairman Christopher Cox (see box above, right, for the letter).
The study is a follow up to and an expansion of a report issued in April 2005 that looked at data for 96 Fortune 1000 audit clients. For the follow-up study, the accounting firms provided data on the same Fortune 1000 companies, as well as 120 smaller audit clients. The original study estimated the average per-company Section 404 total implementation costs to be about $7.8 million, and projected Year Two total implementation costs to decrease an average of about 46 percent compared to Year One.
Difficult To Believe
The compliance costs associated with SOX 404 are being carefully watched, since any cost-benefit analysis of the provision is expected to factor heavily in the decision to scale back the requirements or eliminate them altogether for some companies.
The Securities and Exchange Commission is expected to take up the issue after reviewing the recommendations of an advisory committee. The Internal Controls Subcommittee to the Advisory Committee on Smaller Public Companies last week approved preliminary recommendations that would exempt microcap companies from Section 404, and would exempt small companies from the external audit requirement. The advisory committee is expected to issue its final report to the SEC in April (see related story above, right).
Davern
In comments made during the Dec. 14 meeting of the SEC Advisory Committee on Smaller Public Companies, committee member Alex Davern, chief financial officer of National Instruments Corp., said he found the conclusion of the Big 4 study “very difficult to believe.”
“What did come out of the Big 4 survey is that costs for smaller public companies are 10x what the SEC said they would be and vastly more expensive proportionately than they are for large companies, which supports the basis for our conclusions,” Davern added.
While the SEC had no specific comment on the CRA report, a spokesman for the Commision said, “We are encouraged costs appear to be coming down, but will wait for analysis by the SEC’s Corporation Finance division and the offices of the Chief Accountant and Chief Economist before drawing conclusions about Section 404’s costs. We are committed to making sure we get the maximum regulatory benefit at a reasonable, not exorbitant, cost.”
According to the study, the declines in costs and testing levels “reflect the elimination of significant start-up factors, such as initial documentation that does not need to be repeated; the benefits of experience; and reduced remediation requirements.”
Documentation, Controls, And The Learning Curve
Two other studies released earlier this year also predicted cost reductions in 404 compliance in Year Two. A September survey by the NASDAQ Issuer Affairs Committee and the American Electronics Association said Year Two SOX costs are only expected to decrease an average of 7.4 percent overall. That study found that large cap companies expect a 13.9 percent decrease in total year-two SOX costs, small cap companies estimate a 9.6 percent decrease, while micro cap companies estimate an increase of 0.7 percent in SOX costs from the prior year.
Dolan
Another study released in September by Deloitte & Touche also predicted cost reductions in Year Two, but didn’t specify how much companies expected costs to decrease. Stephen Wagner, managing partner for Deloitte’s U.S. Center for Corporate Governance, told Compliance Week at the time that he expected “overall declines approaching 30 percent or more, and possibly higher, over time.”
According to the latest CRA report, audit fees related to 404 implementation account for a minority of total implementation costs in Year One, though they accounted for a larger portion of total 404 costs for smaller companies. In Year One, 404 audit fees for larger companies account for about one-fourth of total 404 costs on average, compared with an average of about one-third of total 404 costs for smaller companies, the report said.
Both large and small companies are expected to test significantly fewer key controls in Year Two. For larger companies, the average number of key controls tested by auditors is projected to fall more than 19 percent on average, from 669 to 540 in the second year, while the average number tested by the issuer is projected to fall nearly 13 percent from 992 to 867.
For smaller companies, the number of controls tested by auditors is expected to decline nearly 22 percent on average, from 262 to 206, while the average number tested by issuers is projected to decline 17 percent from 359 to 298.
Auditors also expect to rely more heavily on the work of others in Year Two, according to the report. On average, auditors on larger company engagements project that they’ll rely on the work of others for roughly one-quarter of the audit evidence obtained in support of their opinion, up from 15 percent in Year One, while auditors on smaller company engagements project they will rely on the work of others for about 22 percent of audit evidence, up from 11 percent.
Auditors surveyed cited the same factors as the top three drivers of cost savings for larger companies and smaller companies:
Reduced documentation because of work that need not be repeated in Year Two (53.4 percent for larger companies and 41.6 percent for smaller companies).
Increased efficiency because of progress on the learning curve (17.8 percent of auditors on larger company audits and 31.5 percent for those on smaller company accounts).
Remediation efforts that should not recur in Year Two (13.7 percent of auditors on larger company audits and 5.6 percent on smaller company audits).
The complete report and related documents and coverage are available from the box above, right.
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