Good accounting is expensive, bad accounting costs more
by Bruce Meyerson - Associated Press

Stringent accounting procedures can be expensive for a small company and its investors. But sloppy and misleading financial reports can be even more costly, which is why calls to exempt small companies from new regulatory safeguards are penny‑wise and pound‑foolish.

Consider the example of CSK Auto Corp. The Phoenix‑based auto parts maker warned March 27 that it had discovered accounting problems that may force the company to correct three years worth of financial reports. In a single day, CSK’s stock fell 8 percent, costing its shareholders $55 million. After a week, the loss to investors grew to nearly $80 million.

CSK is one of the nearly 2,500 smaller public companies that a committee appointed by the Securities and Exchange Commission says should not be forced to comply with certain new regulatory rules requiring closer scrutiny of accounting procedures and systems.

The Advisory Committee on Smaller Public Companies contends that these businesses, with market values between roughly $125 million and $800 million, are unfairly burdened by the costs of paying an outside auditor to assess these internal financial controls and render a public opinion on their reliability. The panel also recommends that even smaller “microcap” companies, numbering about 5,000 on major exchanges, be excluded from the new requirements entirely until the SEC can devise rules “proportional” to their “needs.”

The report argues that “the benefits of documenting, testing and certifying the adequacy of internal controls, while of obvious importance for large multinational corporations, are of less certain value for smaller public companies, who rely to a greater degree on ‘tone at the top’ and high‑level monitoring controls, which may be undocumented and untested, to influence accurate financial reporting.”

The auditing expense is not trivial for a business with hundreds or tens of millions in revenues rather than billions. The nation’s four biggest accounting firms recently estimated that such services would average $900,000 for smaller companies, according to a report cited by the panel. That’s ten times the $90,000 a year the SEC had estimated it would cost before the rules took affect.

But the panel’s assertion that the new checks and balances required by the SEC “are of less certain value” stems from a revisionist account of recent history that’s gaining prominence as memories of corporate scandals ebb. From this vantage point, the ethical meltdown was largely the province of a few extremely bad apples in an otherwise well‑functioning barrel and the resulting regulations are overkill.

This backlash against the regulatory backlash omits the reality that, whether intentional or not, smaller companies are prone to the lax internal practices that invite accounting mistakes or abuse. At a minimum, the SEC’s new rules–by forcing companies, large or small, to gaze inward and hire an auditor to look over their shoulders–have led to a spike in revelations of faulty accounting on a very basic level.

A closer look at CSK’s accounting stumble, for example, isn’t very reassuring. The problems don’t involve accounting for complex hedging strategies or the sort of esoteric off‑balance sheet arrangements made infamous by Enron. Instead, CSK said it has found errors and irregularities related mainly to its inventories and vendor allowances–core aspects of the company’s daily life.

“None of these problems related to exotic interpretations of accounting literature for derivatives, or pensions, or anything remotely complex accounting‑wise,” Jack Ciesielski, publisher of a popular newsletter named The Analyst’s Accounting Observer, wrote in his Web log about CSK and a similarly sized company that made an appearance at the accounting confessional the same day.

The problems “related to failures of internal controls over basic transactions within each firm, the essential blocking and tackling that should take place every day,” said Ciesielski.

These slip‑ups, even if there’s no malice involved, are not rare. They’re also not without real cost to investors, as evidenced by the crisis of faith the market invariably demonstrates in CSK and other companies that disclose accounting irregularities.

Glass Lewis & Co., an advisor to institutional investors, reports that the pace of restatements of past financial reports doubled in 2005, with nearly 1,200 submitted to the SEC by U.S. companies. Of those filings, nearly 60 percent came from companies with market values below $750 million.

The SEC panel doesn’t dismiss the advantage of improved internal scrutiny, so it is forced to play on some familiar heart strings, similar in sound to the objections heard over new rules requiring that companies treat employee stock options as an expense in their profit reports.

The committee warns that the added auditing cost “makes smaller public companies less attractive as investment opportunities and impedes their ability to compete. This last factor is particularly problematic considering the crucial role smaller public companies play in job creation and economic growth.” It was argued that option expensing would snuff out a key motivational tool for innovation and growth at businesses with limited resources.

Options expensing is a reality now, and though companies have cut back, the feared apocalypse appears unlikely. It’s hard to imagine that an additional cost of $900,000 per year for more reliable accounting will mean the death of capitalism either.