The collapse of companies like Enron and WorldCom cost investors tens of billions of dollars. But that amount may be dwarfed by the cost of conforming to new laws driven by those corporate scandals--laws that are intended to protect investors. It prompts a question: Is the cost of accounting transparency worth it to investors?
At issue are various provisions of the Sarbanes-Oxley Act of 2002, including its Section 404, which will become common knowledge from Wall Street to Main Street, as well as rules promulgated by the Financial Accounting Standards Board (FASB) in recent years. This is not an issue of interest only to those of us in the U.S., as suggested by a number of investigations and recommended guidelines being put forth in several member countries of the E.U. in response to accounting improprieties at Ahold and other European companies.
Among other things, Sarbanes-Oxley seeks more independent directors on boards and in key board committee positions. It discourages companies from buying auditing and particularly large amounts of consulting services from the same supplier. And now, by means of Section 404, it will: (1 require senior executives to certify that their companies have financial controls that work, and (2 give external auditors the added task of evaluating and reporting on not only a company's numbers but also the systems that produce the numbers. Finally, public accountants will have to evaluate the work of the boards' audit committees that hired them. The bill for the additional external auditors and significant investment in hardware and software for new control systems is estimated to double. If not offset by improved productivity and lower costs, it will result in a hit to the earnings of all publicly owned organizations.
Investors will face challenges as a result of guidelines recently issued by the FASB, as well. Foremost among these are efforts to encourage more aggressive write-offs of so-called non-performing assets, such as retail stores still in operation but performing below a certain level, as well as the creation of reserves against earnings that are much more accurate and timely than in the past. As a result of these guidelines, write-offs are more frequent, at times becoming a quarterly feature of a company's earnings. Reserves are created closer to an adverse event at a time when the cost of the event may be better known. One result has been greater volatility in earnings. In short, gone are the days when various accounting practices led to earnings "management" or "smoothing," whether or not such practices resulted in more stable stock prices.
Responses such as these to recent corporate scandals prompt several questions: Are these and perhaps other "cures" worth the cost to investors? Is it possible to have too much accounting transparency? What do you think?
Readers: For your responses to be considered for publication on HBS Working Knowledge, please respond by Wednesday, November 12.