Ask FERF about ... Sarbanes-Oxley Section 404 compliance costs.

The good news: Since January 2004, FEI has been monitoring the costs incurred by member companies to comply with Section 404 of the Sarbanes-Oxley Act of 2002, and these costs seem to have finally stabilized. The "costs" referred to are those incurred to document and test internal controls, which were then audited by external auditors. The bad news: Costs have not declined as significantly as estimated--even by the "Big Four."

FEI Compliance Costs Surveys

The FEI homepage (www.fei.org) right menu provides links to several important "Issues in Depth," one of which is the Sarbanes-Oxley Act, and which has its own Web page. On this page are links to FEI Compliance Costs surveys conducted in January 2004, July 2004, March 2005 and, most recently, March 2006.

The surveys conducted in January and July 2004 included primarily cost estimates, because the first internal control audits under Section 404 were not completed until early 2005. In July 2004, average total costs of compliance were estimated to be $3.14 million, or 62 percent more than the $1.93 million average estimate indicated in FEI's January 2004 survey.

By March 2005, when all costs were presumably accounted for, average total costs of compliance had ballooned to $4.36 million, up 39 percent from the $3.14 million estimate in July 2004.

FEI staff questioned whether these consecutive estimates of average total costs were comparable, because the same FEI members did not necessarily respond to each previous consecutive survey. So, for the March 2006 survey, members were asked for their costs during 2005 ("year two") and the percentage change from their costs during 2004 ("year one"). Responses were also segregated between accelerated filers (public float between $75 and $699 million) and large accelerated filers (public float equal to or greater than $700 million), who presumably had filed management reports on internal controls in both 2004 and 2005, from "non-accelerated" filers.

The accelerated and large accelerated filers indicated that their average total costs of compliance in 2005 were $3.8 million, and that these costs were, on average, 16.3 percent less than their total costs of compliance during 2004. Average 2005 costs of $3.8 million are 16.3 percent less than $4.5 million, just slightly more than the March 2005 average survey responses of $4.36 million. FEI staff was satisfied that their earlier cost estimates were on target.

Total costs of compliance include three components:

1) Internal people hours: accelerated filers required an average of 22,786 people hours internally in 2005.

2) External people hours: accelerated filers required an average of 4,889 external people hours in 2005.

3) Auditor attestation fees: accelerated filers paid an average of $1.4 million in 2005.

The March 2006 survey noted that average total costs of compliance for just the large accelerated filers in 2005 were $5.4 million, 18.1 percent less than their average total costs in 2004 of $6.6 million.

CRA International Survey

In December 2005, the "Big Four" public accounting firms (Deloitte and Touche USA LLP, Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers LLP) jointly released a report titled, "Sarbanes-Oxley Section 404 Costs and Implementation Issues: Survey Update." The Big Four commissioned CRA International (formerly Charles River Associates) to conduct this survey, which is available for download from FEI's website.

The CRA survey, conducted during October 2005, projected that total implementation costs for large accelerated filers would decline an average of 42 percent in 2005, the second year of implementation, from $7.3 million to $4.3 million.

CRA provided several explanations for its projected 42 percent drop in implementation costs, among them:

* The average number of key controls tested by the auditor was expected to fall more than 19 percent, from 669 in year one to 540 in year two;

* Auditors expected to rely on the work of others for approximately 25 percent of the audit evidence in support of the 404 opinion; and

* Auditors suggest that expected cost declines are primarily due to reduced documentation, increased learning curve efficiency and year-one remediation efforts that will not recur in year two.

However, the 42 percent decline projected by CRA International in late 2005 is significantly greater than the average decline of 18.1 percent indicated in the FEI March 2006 survey. As a suggestion: Perhaps FEI members and readers might compute their actual costs and assess the percentage decline in year two (from year one). If the differential is not as great as your auditors have projected, ask your auditor, "why not?"

William M. Sinnett, ([e-mail]) is Director of Research at Financial Executives Research Foundation (FERF).

contributed by FERF