New regulations regarding internal controls

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New regulations regarding internal controls

The SEC is in the process of adopting further rules on accounting and the role accounting firms will be required to play in the near future. The most significant of these rules is that auditing firms must conduct an in-depth review of the firm’s internal controls. This is a significant change, and no doubt reflects the consequences of the sins of Enron.

It is estimated that this new requirement will drive auditing costs up another 25 to 35 percent. This is over and above the Sarbanes Oxley reforms which more-than-doubled auditing cost. These reforms will not only require a review of all of the corporate controls on both booking assets and recognizing revenue and expenses, but also on related “significant” matters.

These related matters can only mean a further step toward the European listing requirement of full risk disclosure. (This should not be a surprise, as the U.S. and the EU have been working towards a “harmonized” accounting standard for many years.) The process of full risk disclosure is one whereby the risks – system, market, internal, obsolescence, litigation, intellectual property, et cetera – are thoroughly reviewed, discussed, and addressed in a detailed narrative fashion for disclosure.

It is also likely that the new disclosure and review forced on U.S. companies will likely be internally governed by a new board of directors committee on risks and controls that will be independent of the audit committee. The outside members of this committee will need to come to the committee with real risk assessment and management experience. Specific business knowledge will come from the company members of the committee.

Increasing regulation on all firms is a knee jerk reaction to the unconscionable behavior of a few major firms. An anticipated consequence of the increased regulation and supervision requirements on accounting firms is a further reduction in the number of firms that conduct public company audits. According to industry insiders, the number of firms qualifying for public company audits has been reduced by 67% through recent legislation. Increased regulation has simultaneously increased the cost of compliance, and reduced those able and willing to perform the required services.

Another effect of increased of regulation of all firms will be that many smaller public companies will see the cost of being a public company rise exponentially. What had been an expense of ten to twenty thousand dollars may now cost fifty to sixty thousand dollars. That is if they can find a firm that will take them on. In consequence, many smaller companies will be looking to reduce, defer, or share this expense. This is an environment that is ripe for fraudsters plucking up a few public companies here or there and fleecing them. Expected methods of fleecing will be mergers, “privatization” deals, and “international listing.”

Another consequence is that while a company may be eligible for public trading, it will choose to de-list, that is remove itself voluntarily from having its shares publicly traded. This is the worst of both worlds for the shareholder. The value of the shares decreases dramatically since there is less transparency in the company’s matters. There is no liquidity in the shares, since they are no longer traded and many shareholders will end up as minority shareholders in an illiquid investment in a company that no longer has any reporting requirements. We have seen this many times, and the companies most often get fleeced by the senior management, and the shareholders get a worthless piece of pretty paper.

In judging any policy or measure, five questions must be asked:

1. What problem is the policy or measure trying to solve?

2. How can it fail in practice?

3. Given the failure modes, how well does it solve the problem?

4. What are the costs, both financial and social, associated with it, and flowing from its unintended consequences?

5. Given the effectiveness and costs, is the policy or measure worth it?

Clearly, nobody wants a repeat of an Enron or a Tyco or a WorldCom. And those of us not actually making hundreds of millions of dollars would like to see some restraint of greed. Nonetheless, we leave it to the reader to evaluate the prudence or imprudence of the new legislation according to the above five questions. Meanwhile, we suggest you be very careful when purchasing shares in a small-company. You may own them forever

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