Smaller Companies Set to Join SOX; Costs Taking Bigger Bite

Welcome to the club. 

This year marks the first time smaller public companies will have to comply with Sarbanes-Oxley, the corporate reform act of 2002 inspired by Enron Corp. and other big-company scandals. 

The deadline for smaller public companies to comply is Dec. 15, meaning most already are under way with their efforts. 

A few years ago, smaller companies saw an extension on compliance. And they still could see other changes designed to make implementation less costly. 

But a debate is playing out among small companies, lawmakers and regulators as to whether the costs associated with compliance will be too high. Still, many believe the rules are necessary to restore shareholder value after the corporate implosions earlier this decade. 

Sound familiar? It is. Big companies went through a similar process in the past few years. 

But smaller companies say implementing Sarbanes-Oxley is more costly for them. Big companies spent about 0.06% of revenue to comply with the law in 2004, according to the Securities and Exchange Commission. Companies with less than $100 million in yearly revenue spent about 2.5%. 

“It’s not inexpensive for a company of our size,” said Will Pedranti, general counsel for Spectrum Pharmaceuticals Inc., an Irvine drug maker with projected sales of about $15 million this year. 

As with bigger companies, Sarbanes-Oxley’s Section 404 is the biggest point of contention. 

The section requires companies to review and report on their internal controls and then to upgrade them to standards laid out in the act. It also requires them to hire an external auditor to make sure that they’re following their own controls. 

Large public companies, known as “accelerated filers,” have complied with Section 404 since 2004. 

Smaller public companies with market values of $75 million or less are known as “non-accelerated filers.” They’ll have to provide what is known as a “management assessment of internal controls over financial reporting.” 

In 2008, small companies will have to go through a second compliance phase where external auditors will need to sign off on their management assessments. 

Many smaller public companies in OC say they already pay a higher percentage of their revenue for legal and audit fees than larger counterparts. They worry compliance could hurt them because it diverts resources from research and development. 

“Many small companies are staffed very lean and struggle to keep up with the day-to-day operations,” said Rick Smetanka, partner-in-charge of Irvine accounting firm Haskell & White LLP. “Now they are required to design, document and test key internal controls, which will likely require additional time and additional dollars, especially if the organization does not possess the requisite know-how internally.” 

Compliance has a bigger impact on smaller companies because they have limited resources and often can’t hire enough workers to oversee extra operations, said Pedranti of Spectrum Pharmaceuticals. 

“For a small company that has limited human and cash resources, the cost of compliance for us is very high as opposed to a big company,” he said. “Bigger companies often have the internal accounting, lawyers and auditors. So they can absorb some of the extra work. But for smaller companies it’s just different.” 

Despite the high costs, Pedranti said compliance boosts investor confidence. Sarbanes-Oxley helps people feel comfortable because it lets the public know that smaller companies are following ethical business practices, he said. 

Even if executives agree with the spirit of Sarbanes-Oxley, it doesn’t mean they’re happy with it. 

Paul Bowman, chief financial and chief ethics officer for American Mold Guard Corp., an Aliso Viejo-based company that offers mold prevention services to builders, said the requirements make it difficult for smaller companies to thrive in a public market. 

American Mold Guard went public in 2006. 

“The board reporting, the Section 404 compliance, the tax reporting, all of those are very burdensome, costly and very time consuming,” Bowman said. “On the other hand, I recognize as CFO that we’re a public company, we’re owned by shareholders and those things are necessary.” 

Last year, American Mold Guard did $9.4 million in sales. Bowman said the company’s external costs for compliance probably will exceed $200,000. 

“It’s not cheap,” he said. 

The costs of Sarbanes-Oxley outweigh the benefits for smaller companies, said Jeremy Whitaker, senior director of finance and accounting for Lantronix Inc., an Irvine maker of networking devices. 

“Overall, we have estimated that in the second year of implementation alone, the external cost of Section 404 compliance could approach $1 million, not to mention the cost and burden on our internal resources,” he said. 

Last year, Lantronix generated $54.1 million in sales. 

Some small public companies may have a difficult time treading unknown waters, said Rick Poole, principal-in-charge of Stonefield Josephson Inc.’s Irvine office. 

Some could run into trouble if they haven’t prepared for compliance, he said. 

“Everyone is still trying to digest the regulations. There was such a delay in getting smaller companies to comply so it made some procrastinate,” Poole said. “It will be interesting to see how small companies cope with the new developments.” 

Since compliance costs for smaller companies are high, some could end up going private, Poole said. 

“Some could go private and get bought out if they can’t handle it,” he said. “We’re not seeing it yet but it could happen.” 

Newer rules on Section 404 could soften the impact, said J. Scott Farber, partner-in-charge of Grant Thornton LLP in Irvine. 

In May, the Securities & Exchange Commission and the Public Company Accounting Oversight Board came out with an amendment to Section 404. 

The amendment is known as Auditing Standard No. 5. It’s supposed to streamline the internal-control requirements by giving management and external auditors more flexibility when conducting their assessment, he said. 

Wade Lindenberger, director of corporate governance for Irvine’s RoseRyan, which provides financial workers for companies and has worked with American Mold Guard, said AS5 would allow management to focus only on financial controls that are considered to be “high risk.” 

“The new guidelines definitely present a more straight forward approach,” he said. 

He said AS5 provides a simpler, more straightforward audit standard that should prevent what some have called unnecessary procedures and added costs for compliance. 

The revision also allows companies to develop efficiencies in compliance programs by allowing external auditors to place more reliance on the reliable work of others, allowing them to use information from prior-year audits, he said. 

Some critics have raised the issue that compliance has made companies spend money on areas that don’t present a financial risk. The new guidelines will let companies focus only on “high risks” and will minimize a company’s key controls, which will keep compliance costs at a minimum. 

Accountants say there are various things small public companies can do to make sure that they’re prepared for compliance. 

Smaller public companies need to coordinate their management activities in the first year with what the auditor is expecting to do in year two, accountants said. 

They also need to make sure that management and auditing firms give an overview of the company’s compliance plan to its audit committee. This serves as an oversight tool that helps companies keep track with their auditor and committee during the compliance process. 

The Public Company Accounting Oversight Board developed audit guidelines specifically for smaller businesses. It takes the new rules down to a smaller scale, which helps auditors and management understand how to implement them in the small-company environment, they said. 

The Committee of Sponsoring Organizations of the Treadway Commission publishes a framework of controls to help companies see how they match Sarbanes-Oxley regulations, which could help management deal with their new responsibilities, accountants said. 

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