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Not Everyone Hates SarbOx


There has been no shortage of public outcry over Sarbanes-Oxley, the controversial 2002 accounting reform legislation that requires top corporate executives to fill out reams of new forms and personally certify their financial reports. SarbOx, say its critics, adds millions in compliance costs, makes life miserable for corporate directors, and encourages companies to bolt to foreign stock exchanges. The complaints have been so passionate that regulators are now planning to loosen the rules, probably before the year is out.

Not so fast, says a growing chorus of investors. Lost amid all the boos over SarbOx, they say, are some major benefits. The biggest: SarbOx and related reforms have produced much more reliable corporate financial statements, which investors rely on when deciding whether to buy or sell shares. For them, SarbOx has been a godsend.

What's more, says Duncan W. Richardson, chief equity investment officer at Eaton Vance (EV) Management and overseer of $80 billion in stockholdings, even the act's much disparaged requirements for testing internal financial controls could drive gains in corporate productivity and profits. Says Donald J. Peters, a portfolio manager at T. Rowe Price Group (TROW): "The accounting reforms have been a win."

Earnings will be on investors' minds over the next several weeks as most corporations announce yearend results. The numbers will include results tallied under generally accepted accounting principles and, thanks to a Securities & Exchange Commission regulation adopted during the reform years, they'll also come with reconciliations to any nonstandard or "pro forma" numbers that companies use to try to spin their results. The reconciliations, says Peters, are "extraordinarily" helpful. "It is [now] much easier for me to have a view of the true economics" of a company, he says.

Beefed-up disclosure requirements have also meant that companies now deliver numbers with fewer adjustments for unusual charges and write-offs, which in the past have been used to make earnings look better. Thomson Financial's (TOC) Earnings Purity Index, which tracks earnings adjusted for such write-offs, shows improvements in each of the past four years. And now earnings reports reflect expenses for incentive stock options, information investors like that wasn't available before the big accounting scandals.

Just as important, executives appear to have a firmer grasp of costs when they talk about operating margins, according to Richardson of Eaton Vance. He credits the improvement to the infamous Section 404 of SarbOx, which requires documented testing of internal controls. "Even not-so-good management teams have good controls now, and that leads to an ability to cut costs," he says.

This isn't to say SarbOx is flawless. Section 404 is often applied unreasonably, causing costly checks of minor book entries. It's bad, too, that small-scale businesses find fewer benefits relative to the costs.

TRUE TEST

Nor do the reforms mean that investors can trust the numbers implicitly. These days, financial reports increasingly include ad hoc performance measures other than closely regulated earnings, says Marc Siegel, research director at the Center for Financial Research & Analysis. "Companies are going to greater extents to hide" the true stories of their cash flows, order backlogs, bookings, and same-store sales, he says. Siegel notes that Duke University scholars found executives will go far to spin their numbers: Some three-fourths said that to meet earnings estimates, they will sacrifice corporate value, even if it means postponing profitable investments, deferring maintenance, or giving incentives to customers to buy before the end of a quarter.

Of course, the real test for how much earnings reporting has improved won't come until the next economic downturn, says UBS (UBS) stock strategist David Bianco. In downturns, the lack of growth often exposes aggressive accounting estimates used to manipulate earnings. And that's when some capital investments are revealed to have been hiding operating costs.

Still, the next round of abuses to surface will probably not be as bad as it would have been without the reforms. Says Eaton Vance's Richardson: "You're always better going into any downturn with tighter rules." For regulators eager to start tinkering, that's food for thought.

By David Henry


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