On Thursday, December 15, 2005, the NY Stock Exchange gathered a group to talk about SOX 404.  In attendance were representatives of the SEC, PCAOB, NYSE, the auditing firms, audit committee chairs and chief financial officers.  Chairman Thain led the discussion.

The notes I used to talk from are below.

My summary of the meeting is that there is still high frustration with the cost and management diversion as a result of SOX 404.  Most folks like myself would like to see it retained, but in a much changed implementation that delivers net value, not net loss, to shareholders.

My talking points:

THANKS FOR GATHERING THIS GROUP TO TALK ABOUT THIS SUBJECT

THE VIEWS EXPRESSED ARE MY OWN.

YOU ASKED AUDIT COMMITTEE MEMBERS SHARE A FEW OBSERVATIONS FROM THE FIELD AND MAKE ONE OR TWO RECOMMENDATIONS.

FIRST I WOULD LIKE EVERYONE TO HAVE A PIECE OF 404’S HISTORY. 

FOUND THAT MOST PEOPLE INVOLVED IN THIS DEBATE DON’T KNOW THAT THIS IDEA WAS INITIATED BY THE AUDITING FIRMS IN THE MID 1980S.  THE FIRMS FELT THAT THE SYSTEM OF INTERNAL CONTROL SHOULD BE AUDITED.

IT WAS A FURIOUS BATTLE BETWEEN INDUSTRY AND THE AUDITORS IN THE 1980s, BUT INDUSTRY PREVAILED AT THAT TIME.  HOWEVER, THE AUDITING FIRMS NEVER LET IT GO AND LOW AND BEHOLD WITH CORPORATE AMERICA ON THE OPERATING TABLE IT SHOWED UP IN SOX.  THIS WAS NOT AN IDEA COOKED UP BY THE POLITICIANS IN ANY RESPECT NOR INITIATED BY INVESTORS.  IT WAS THE RESULT OF A 15 YEAR BATTLE AND INIATIVE BY THE AUDITING INDUSTRY.   WE FOUGHT IT DURING THE ADOPTION OF SOX, BUT OBVIOUSLY DIDN’T PREVAIL.

IMPORTANT TO RECOGNIZE THAT OVERALL SOX WAS MUCH MORE THAN 404

  1. PCAOB CREATION WAS A POSITIVE
  2. CEO/CFO CERTIFICATION WAS A POSITIVE
  3. TOUGHER PENALTIES FOR WRONGDOERS WAS A POSITIVE
  4. EMPOWERMENT OF THE AUDIT COMMITTEE WAS A POSITIVE

WHEN PEOPLE REFER TO THE NIGHTMARE OF SOX THEY ARE ONLY REALLY REFERRING TO THE COST AND ADMINISTRATIVE BURDEN OF 404.  I DON’T HEAR MUCH, IF ANY, COMPLAINING ABOUT THE REST OF THE ACT.

OBSERVATIONS:

  1. LEVEL OF TESTING IS STILL REDICULOUSLY LOW.  TOO MUCH FOCUS ON TRANSACTION PROCESSING – 80% OF THE WORK FROM WHAT I SEE.
    1. CAUSED BY AUDIT FIRM ECONOMICS AND DEPLOYING JUNIOR PEOPLE TO DO THE WORK.  IT’S ALL THEY KNOW ABOUT OR CAN UNDERSTAND.
  2. INTERNAL AUDIT PROGRAMS AND BUDGETS CUT SIGNIFICANTLY TO PAY FOR 404
  3. FRUSTRATION IS STILL HIGH, COST IS HIGH AND NOT DROPPING AS PREDICTED. TREMENDOUS STRAIN ON THE SYSTEM AND PEOPLE IN THE FIELD - ON ALL SIDES.
  4. IT’S NOT IMPROVING INTERNAL CONTROL.  PEOPLE ARE FOCUSED ON GETTING THROUGH THE PAIN AND ENSURING COMPLIANCE.  THERE ARE NO BUSINESS EFFICIENCES BEING FOUND.  PEOPLE ARE NOT REENGINEERING PROCESSES AS A RESULT OF THIS EFFORT.
  5. ALL THE ADDITIONAL GUIDANCE FROM THE SEC AND PCAOB YET “AUDITORS ARE “6 INCHES” OFF THE GROUND NOT REMOTELY CLOSE TO 10,000 OR 30,000 FEET.

RECOMMENDATIONS:

  1. REPLACE THE COSO FRAMEWORK AND AS 2 – THEY ARE NOT EVEN CLOSE TO PRACTICAL FOR REAL WORLD IMPLEMENTATION – TOO THEORETICAL.CREATE A VERY SIMPLE FRAMEWORK FOR ENTITY LEVEL CONTROL TESTING AROUND HIGH RISK AREAS.  BE SURE THAT THE FOCUS INCLUDES RELATED PARTY TRANSACTIONS AND TRANSACTIONS WITH EXECUTIVES.
    1. TEST 100 CONTROLS MAXIMUM AT THE BIGGEST COMPANIES.  MUCH LESS AT THE SMALLER COMPANIES
    2. MUST MAKE THE COST LESS THAN THE BENEFIT AND THIS IS THE ONLY WAY I SEE IT HAPPENING
    3. EXEMPT COMPANIES UNDER $1B IN MARKET CAP.  NOT WORTH THE INVESTOR DOLLARS AT RISK.
  2. MAKE THE AUDITOR’S ATTESTATION ON MANAGEMENT’S REPORT OPTIONAL.
    1. WE NOW HAVE A FRAMEWORK FOR MANAGEMENT’S WORK
    2. WE HAVE A PROCESS FOR AUDITING IT
    3. LET THE MARKETPLACE DECIDE
    4. LET COMPANIES DECIDE IF THEY WANT TO BUY THAT EXTRA ASSURANCE FROM THE AUDITORS
    5. LET THE MARKET REWARD OR DISCOUNT COMPANIES THAT DO OR DON’T GET THAT AUDITOR OPINION.
    6. MARKETPLACE WILL QUICKLY DETERMINE COST BENEFIT