For Greater Transparency, Is Section 404 an Effective Response?
Section 404 of the Sarbanes-Oxley Act requires that managers certify the integrity of their internal controls for financial reporting. In the end, are shareholders getting their money’s worth? Are more costly amendments to come?
Responses to this month's column raise questions about whether Section 404 of the Sarbanes-Oxley Act, requiring that senior managers certify the integrity of the processes by which their companies' financial reports are prepared, will have much impact by itself on the issue of added transparency for shareholders and other stakeholders. The primary argument is that, without high standards of personal integrity posed from within, Section 404 will be of limited value. As John Louk put it, "I personally believe that you cannot force change from the outside... Fix what is really broken. It is really about people and ethics." B. V. Krishnamurthy concurred, saying "... the Act ... is unlikely to result in any radical transformation of the system. Such a transformation has to be an internal process with managers understanding their role as trustees of public wealth and guarding it accordingly."
Others agreed, but suggested that Section 404 could serve a useful purpose. Mike Flanagan commented that "Section 404 is a good first step ... (but) ... does fall short... If ethics and professionalism do not exist on the lower levels, then Section 404 will miss an entire group of lower level functions and staff." Rich Lanza pointed out that "(Section 404) is a necessary step ... (but) more continuous controls monitoring is needed that independently analyze company databases daily for ... rogue (journal) entries." Abhishek Gupta commented, "It is important to have faith in our leaders... But it is also important to acknowledge the wisdom of the age-old adage: Have faith in God, but tie your camel first." William Redington put it more succinctly when he said "Trust yes, but verify."
Other lines of thought suggested that Section 404 may actually have far less value than its cost. In Stephen Thomas's opinion, "... the new, exaggerated internal controls can make a company ... more risk-averse... And in aggregate it creates new risk to the U.S. economy, especially in an era of global competition, because innovation is less likely to occur." Brian Donahue warns that "an assessment of internal controls by management at a point in time is not effective because the organization—and thus internal controls—have already changed to meet the demands of the market ..."
Yet others question the premise of the article. Richard Eckel opined that "A basic misconception is that Section 404 increases transparency afforded to stakeholders... What 404 does is require that corporate leadership demonstrate that the processes used to produce the required transparency are founded upon good practice rather than creative manipulation." He suggests that this should be of special value to long-term shareholders.
These responses suggest a wide variety of views, with most coming down on the side of modest returns on investment, at best, from Section 404. It is probably far too early to tell whether the Section and the Law of which it is a part will have the desired effects. This suggests the importance of tracking both the costs and benefits of the Law. There is little or no provision to do either in the Law itself. What is the prospect that these kinds of things will be measured? If so, how should the measurements be made? And for what purpose? What do you think?
Transparency currently is one of the most frequently used terms in the corporate lexicon. In general use, it's right up there on the scale with safety. Having emerged from several years of particularly intense exposure to news of business leaders' alleged (and in some cases proven) acts to deliberately mislead investors, employees, and others, we are naturally interested in greater transparency. And it applies equally importantly to governmental, non-governmental, not-for-profit, and other organizations as well.
Transparency is defined by Don Tapscott and David Ticoll in their book, The Naked Corporation, as "accessibility of information to stakeholders of institutions, regarding matters that affect their interests." The U.S. government's response to the need for greater transparency in the wake of the scandals of the past few years is the Sarbanes-Oxley Act of 2002. Of the seventy-one sections of the Act, one probably has caused more expenditure of time and money on the part of leaders of publicly traded firms than all the rest. It is Section 404, "Management Assessment of Internal Controls." It requires, among other things, that selected managers be responsible for "establishing and maintaining an adequate internal control structure and procedures for financial reporting ..."
Perhaps even more important, it requires that managers as well as accountants certify (upon penalty of legal action against them for failure to do so) the quality of internal control structures and procedures. You can imagine how this provision has captured the attention of CEOs across the country. In response to this one section, managers of publicly traded companies are spending up to 5 percent (and in some cases more) of this year's operating income (and perhaps next year's as well) to assure an internal control structure whose integrity they can endorse in writing.
But one has to ask whether this is an effective response. After all, haven't investors (and employees who own stock) placed their faith in leaders of their organizations in the past? And isn't this what they are asked to do under Section 404, which says little about the nature of information provided to the public as a result of establishing certifiable internal control structures and procedures? In the final analysis, doesn't our faith in organizations still depend on trust placed in the leadership of the businesses in which we invest and for which we work? And doesn't that in large part depend on the amount and kind of information our leaders choose to share with us, regardless of Section 404 and other provisions of the Sarbanes-Oxley Act? In short, are shareholders getting their money's worth from Section 404?
Transparency is the result of a multi-stage process. Will the most costly section of the Sarbanes-Oxley Act address more than an early (but admittedly necessary) stage of the process? If so, will there be even more costly amendments to the Act to come? What do you think?