Compliance: Is Sarbanes-Oxley Working? - ' SOX by the Numbers '
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SOX by the Numbers
One measure of Sarbanes-Oxley's effectiveness is the rising number of earnings restatements since the law went into effect. Glass, Lewis & Co. LLC is a San Francisco-based firm that tracks the volume of do-overs by public companies. Its March 2006 report, "Getting It Wrong the First Time," shows 1,295 restatements of financial earnings in 2005 for companies listed on U.S. securities markets, almost twice the number for 2004. "That's about one restatement for every 12 public companies—up from one for every 23 in 2004," says the report.
Research analyst Mark Grothe, the study's primary author, sees a direct correlation between SOX and the wave of restatements. "It's precisely because of the heightened auditing standards mandated by Sarbanes-Oxley that investors today are getting a true sense, finally, of just how much work remains to be done before they can feel confident about the accuracy of the financial statements prepared by corporate managers," he writes.
"These restatements aren't just about revising subjective judgments or complying with esoteric, complex accounting pronouncements. In hundreds of instances, they stem from basic misapplications of simple rules or critical breakdowns in corporate controls and competencies. . . . Careful scrutiny of these controls, through independent testing and reporting by outside auditors, is what Section 404 of Sarbanes-Oxley mandated. By and large, this testing is what uncovered the weaknesses."
Mike Lofing, another Glass, Lewis analyst, says he believes the number of restatements will drop off over time, although perhaps not to a pre-SOX level. "There was a lot of catch-up going on, and there were probably a lot of controls that should have been in place but were not," he says. "Once those controls are in place, it becomes maintenance."
Are the restatement numbers really such a clear-cut argument for the power of SOX? The Securities and Exchange Commission says that only 12 percent of companies restating their financial reports last year gave SOX Section 404 as the reason for the restatement. But that figure is itself extremely squishy. Just 50 percent of restating companies gave a reason of any sort for their redos, so the overall percentage driven by Section 404 may be much higher. Meanwhile, panelists at an SEC roundtable in May argued that the vast majority of restatements have no material effect, as measured by the response of the stock price, but that the relationship between restatement and "material weakness" in the underlying numbers and process is "almost axiomatic."
Another way of measuring the impact of restatements is by considering the subsequent behavior of the companies involved. Wayne Landsman, a professor of accounting at the University of North Carolina's Kenan-Flagler Business School, has been studying the relationship of companies that restate their financial reports to moves by those companies to different accounting firms. "Most of the switches by companies are lateral among the Big Four firms," he says. "Auditors aren't dropping companies that restate for being too risky from their client rolls."
Landsman says he has a hard time attributing causality for behavior by companies and investors directly to SOX, and he eschews simple answers. "In economics, it's a social welfare question, like evaluating a tax bill. It hurts some and helps some. Is it having its intended effect? We don't know what we would have observed without it."
Story Guide:
Learning to Live With SOX
What Does "Working" Mean for SOX?
SOX by the Numbers
Burnt Offerings: SOX and the IPO Market
The Real Problem with SOX
Sidebar:Larry Ribstein on the Holes in SOX
Next page: Burnt Offerings: SOX and the IPO Market
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