Former SEC commissioner assesses governance, Sarbanes-Oxley.

One thing an attendee to a teleconference, webcast or live conference can attest to--without worrying about regulators or paying large fees--is that the big subject at numerous events is Sarbanes-Oxley Section 404 and the slew of other financial-reporting regulations. While causing CFO heads to swim, commentary on the rationale, benefits, pitfalls, solutions, costs, etc. is coming from a variety of participants.

At one such conference this reporter attended at PepsiCo Inc. headquarters in Purchase, N.Y., in late August, a keynote speaker was former Securities and Exchange Commissioner Roderick M. Hills. Currently with the Washington, D.C., law firm of Hills & Stern, Hills served on the SEC during the Gerald Ford administration, yet he has much perspective to contribute to the dialogue--even now.

From a standpoint of one who was there during the 1970s--when the SEC presided over disclosure that literally hundreds of U.S. companies had made questionable payments to foreign officials and had, at that time, taken steps to remedy the situation--Hills described himself as "an embattled director from the trenches of corporate warfare."

At "Good Governance is Good Business," a day-long forum sponsored by Certus Software Inc. of San Jose, Calif., he addressed four questions relating to Sarbanes-Oxley: Did we need it? Does it work? Does it cost too much? And, what more is needed?

Hills conceded that he holds a "biased point of view on the subject of corporate governance." In 32 years as a director of 17 different companies, a member of 12 audit committees and chairman of 10, he noted he has participated in the termination of 10 CEOs and in the writing off of well over $5 billion dollars of assets that should not have been recorded as income.

Hills said that as time erases the sting of Enron-type scandals, a "chorus of complaints" about Sarbanes-Oxley is rising. Critics, he said, point out that while the stock market rose following disclosure of the scandals, it went down after passage of Sarbanes-Oxley, thus demonstrating that the public hasn't lost faith in the U.S. capital markets. Also, with over 10,000 publicly traded companies, a dozen or so scandals is not justification for saddling thousands of honorably run companies with the burden of such legislation. And, with Section 404 the object of most of the complaints, individual companies are spending in the tens of millions to comply.

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So, was it needed? Whether it was needed, Hills said, is not relevant. The issue, to his way of thinking, is "what went wrong and does it need fixing?" He said a system of corporate governance crafted by the SEC in the 1970s "ran out of gas," and did, indeed, need fixing.

Following the 1970s discovery that "hundreds of U.S. companies had created off-the-books (secret) bank accounts from which corporate officers dispensed funds without any oversight--'a great many of which were used to make questionable payments (bribes) to foreign officials'"--the SEC instituted three steps:

1) It mandated that corporations construct tougher internal controls;

2) It forced the auditing profession to adopt much tougher standards, requiring auditors to be certain that any suspicious item found in an audit be cleared with someone free of the suspicion; and

3) It caused the New York Stock Exchange to require its listed companies to have independent audit committees.

While these three steps "made a great difference," Hill said, numerous problems have since developed. Among his list of nine are:

1) The movement from the bricks-and-mortar economy, to the knowledge-based economy with a large percentage of corporate assets now being intangible. In this environment, estimates and assumptions form balance sheet values rather than historical costs, and, as a result, managers have acquired wide discretion in constructing their financial statements.

2) With valuations more complex, the Financial Accounting Standards Board (FASB) has responded with more complex standards and interpretations of those standards. Leery of lawsuits, accountants seem to encourage new rules rather than using judgment for existing standards.

3) Accountants have become more like "rule checkers," and the basic audit had come to be treated more like a commodity, and the work increasingly based on price rather than on quality.

4) The growing maze of rules became a magnet for the "fertile" minds of bankers, lawyers and consultants who were paid millions of dollars to create new corporate structures that may have satisfied the letter of accounting rules, but not their spirit.

5) Audit committees did not take charge of the audit, and auditors came to understand that their fate was in the hands of management.

Hills emphasized that while many problems exist, he believes the "vast majority of publicly traded U.S. companies are honorably run." On the other hand, he also believes that a substantial number of companies "have used these circumstances to intentionally manipulate their numbers, and an even larger number have--perhaps in good faith--regularly presented a more optimistic financial position than a realistic appraisal would allow simple because the rules allowed them to do so."

Will it get the job done? Hills views Sarbanes-Oxley as a rejuvenation of the SEC's mid-70s efforts. Section 404, he said, is "a dramatic reaffirmation of the SEC's action in requiring internal controls." By creating the Public Company Accounting Oversight Board (PCAOB), he said, Congress gave initial control over the creation and enforcement of auditing standards to an organization that has the ability to give "real teeth to the SEC's requirement that made auditors report suspicious matters." The sweeping authority given to audit committees, as well as the significant responsibility placed on them, he said, is the "logical extension of the commission's action that persuaded the NYSE to require independent audit committees."

Sarbanes-Oxley, has already had an enormous and beneficial impact on corporate governance, Hills noted. Now the external auditor must explain to the audit committee alternatives available to management in its construction of financial statements and Sarbanes-Oxley compels the audit committee to look at those alternatives and decide whether management has chosen a fair way to present its financial position.

Arthur Andersen's downfall, said Hills, came largely from its work with two clients: Waste Management Inc. and Enron Corp., and, in each case, he argued, the auditors knew there was a far preferable way to present the financial statements. "It is highly unlikely that the scandals of those two companies would have occurred had Sarbanes-Oxley been in effect, requiring Andersen to explain those alternatives to the respective audit committees."

Will it cost too much? Even as large companies talk about the high cost and smaller companies contemplate or postpone public offerings due to the real or perceived costs of 404, Hills questioned the seriousness of the problem. He said the real danger is that companies will treat 404 as a kind of "compliance tax," or a bureaucratic requirement of no practical value--just as many treated the audit as a commodity. If that is the case, Hills warned, "404 can become an expensive appendage for those companies that ignore its positive aspects and fail to see its value as a management tool."

On the other hand, he won't say that all is fine with 404. "Actual implementation may demonstrate that too much is being required--for example, some companies complain that their external auditors are insisting that they do too much additional work before attesting to the work done internally."

The most persistent complaints relate to timing. "Some [companies] have been slow to understand the amount of time that needs to be taken, and there are not enough trained accountants to meet the demand," he said, adding that the Big Four are turning clients away. Timing may prove more severe for smaller companies with "meager controls," as it may be impossible for them to comply within the present schedule. Also, as noted earlier, to avoid 404 requirements, some companies may choose to stay private.

"Whether that is a serious problem remains to be seen," said Hills. Although seemingly unsympathetic, he added, "The fact that they find 404 too onerous probably means they do not appreciate the value of internal controls."

What more is needed? Hills ended with a look at the big picture, noting that Sarbanes-Oxley "does not deal with problems associated with our rules-based approach to accounting standards, with the maze of rules we now have and with the fact that too many auditors have become rule checkers." He said there is a large and growing body of thought that wants fewer accounting rules. "Moving us away from that maze of rules to a system where more professional accountants explain the essential ambiguity of financial statements is a matter not yet properly addressed."