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Summary
The Sarbanes-Oxley Act is far from dead, but efforts to rein in unproductive, excessive regulation are beginning to take hold. Ventana Research thinks many of the best aspects of the legislation will be with us for years to come, but the “clean room” approach to financial record-keeping seems to be giving way to a more practical mentality that will emphasize materiality by focusing only on matters that will or might have a meaningful impact on a company’s financial statements. The good news is companies that already had strong internal controls and systems will be spared needless expense by a change in regulation. The bad news is companies that were marginal in these areas will have little or no incentive to change, even though addressing root causes probably would produce measurable business benefits.

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It is becoming increasingly clear that enforcement of Sarbanes-Oxley’s notorious Section 404 will change to eliminate many unproductive aspects of companies monitoring and testing their financial controls. Indeed, it seems likely that smaller public companies will be exempt entirely from Section 404 audits. The force swinging the pendulum back from a heavy emphasis on public company regulation is a desire to keep the United States capital markets competitive. We think curbing regulatory zeal is likely to be helpful in this regard, even though some of the evidence presented to make the case (such as the relative decline in the number of U.S.-listed initial public offerings since the peak of the Internet bubble) is entirely specious.

The Committee on Capital Markets Regulation (CCMR) recently issued a report on regulatory changes needed to maintain and improve the global competitive position of U.S. capital markets for investors. The committee is an unofficial body that includes high-profile people from the auditing, legal and finance professions, as well as CEOs, corporate attorneys and investor advocates. It aims to be the cure for a Sarbanes-Oxley hangover they (and others) believe is harming the competitiveness of the United States capital markets. At the top of the committee’s wish list of several structural regulatory changes is a shift to make how companies comply with Section 404 more cost-effective. Notably, it would revise the materiality standards in Auditing Standard No. 2 to make reviews more risk-based and focused only on significant control weaknesses. It would have the Securities and Exchange Commission (SEC) define “materiality” as it applies to the audit quantitatively and consistently with the definition of materiality in financial reporting (noted above). We suspect that many of the “material weakness” opinions issued over the past couple of years would never have seen the light of day had there been some quantitative test for the threshold of materiality. Since the SEC already has indicated that it was heading in this direction, we expect this change is a sure thing.

Ventana Research believes the upside to the change in Sarbanes-Oxley enforcement is to eliminate unnecessary costs, especially for companies that already were managing their finance and IT operations well. For many companies, it will allow their finance organizations to reorient their focus to more important business issues. The downside is that public companies that have more serious system and process issues will have less incentive now to fix them systemically, even though there are likely to be real business benefits to doing this. In this respect, shareholders in these companies will be shortchanged.

Assessment
Ventana Research believes the basic intent of Sarbanes-Oxley Section 404 was to instill more of a “total quality management” approach to producing financial statements. We continue to advise companies to structure their processes and systems to this end, since it is likely to lower costs and enable finance organizations to redirect their time toward more forward-looking, value-adding analytical activities and away from low-value transaction processing. The upside to the change in Sarbanes-Oxley enforcement is that it will eliminate unnecessary costs, especially for companies that already manage their finance and IT operations well.

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