Extending its reach

Congress passed the Sarbanes-Oxley Act of 2002 in the wake of corporate failures and fraud at Enron and WorldCom.

On the surface, Sarbanes-Oxley was meant to put more stringent rules and regulations on public companies and their auditors. As public companies have been affected by the new regulations, private companies are also feeling the effects of them.

The major changes required by Sarbanes-Oxley for public companies are as follows:

* Corporate responsibility for financial reports, including officer certifications that submitted reports do not include any untrue statements or omission of material facts, and that the financial statements are presented fairly in all material respects

* Enhanced financial disclosures, including off balance sheet transactions and special purpose entities

* Prohibition of personal loans to executives

* Management assessment of internal control policies and procedures

* Code of ethics for senior financial officers

* Increased criminal penalties under the Securities Act of 1934, including penalties for altering documents

* Use of an auditor registered with the Public Company Accounting Oversight Board

The cascade effect

Private companies have also been affected because of the cascade effect, which occurs when laws and regulations are created at the federal level, but over time trickle down to the state level. The Sarbanes-Oxley Act specifically requires that state regulatory agencies that oversee CPAs should make their own independent determination of the applicable standards that should apply to any CPA firm in their state that is not registered to audit public companies. Incidentally, the overwhelming majority of CPA firms in the country are not registered to audit public companies.

Ohio has not added any requirements, but states such as California and New York have added provisions, similar to Sarbanes-Oxley, that would apply to services provided by CPA firms to all clients, including nonpublic companies and not-for-profit companies.

Limits on new services provided by CPAs

Sarbanes-Oxley prohibits auditors from performing certain services for their clients, such as bookkeeping, information systems design, valuation services, internal auditing outsourcing, and a catch-all, any other service determined to be impermissible.

Over the past five years, CPA firms have become multidisciplinary, providing a full range of services to their clients, such as investment management, valuation services and a variety of consulting services. Companies like to use one trusted adviser, their CPA firm, that understands their business and financial goals, to provide these services, and it is more cost-effective than contracting with different vendors for these services.

Due to the cascade effect, CPA firms cannot predict what portions of Sarbanes-Oxley will trickle down, and what will and won’t be an allowed service. Firms are watching and waiting to see what happens and carefully evaluating whether to provide new services to their clients. This affects every size business, public or private, as companies may need to segregate their service providers.

Compliance is costly

Many large, private companies consider going public to finance their growth. Going public is an expensive proposition to begin with, but now, companies must also assess the cost of compliance with Sarbanes-Oxley on an annual basis.

Section 404 of Sarbanes-Oxley requires public companies to evaluate internal controls every year, and their auditor must issue a report on the effectiveness of the internal controls. Many large, private companies do not have a large enough staff to perform the documentation and testing of their internal control structure, so they need to hire additional employees or outsource this function, which adds another layer to the cost of compliance for a company considering going public. Recurring costs of compliance with Sarbanes-Oxley are limiting some private companies’ access to public markets.

Sarbanes-Oxley has had a tremendous effect on public companies, and private companies are starting to feel the shock waves, also. Only time will tell how much farther-reaching the regulations will become. Jim Dannemiller, CPA, is director of accounting & auditing at Saltz, Shamis & Goldfarb Inc., the tax and accounting division of SS&G Financial Services (www.SSandG.com. Reach him at [email protected] or (330) 668-9696.