Wednesday, October 14, 2009

COSO Updated Fraud Study Coming; Garrett Proposes Sarbox Exemption

At the PCAOB Standing Advisory Group meeting earlier today, SAG member Joe Carcello noted, "As some of you in the room know, we are working with COSO to update our study on fraud [originally published] in 1999." [NOTE: COSO's upcoming updated fraud study, like the earlier COSO fraud study, is based on SEC Accounting and Auditing Enforcement Releases (AAERs) issued during the 10 year period under study.]

Carcello, the Director of Research, Corporate Governance Center, and Ernst & Young Professor, University of Tennessee, said of the upcoming update to COSO's fraud study, "Although not done, we do have some preliminary information:"
  • Fraud continues to be a big problem, well over 300 fraud companies between 1998 and 2007, well over 1,000 enforcement releases related to those 300 fraud companies.

  • In the 1999 study we did for COSO, the size of companies was very, very small; someone could say this is only a problem for very tiny companies, although by and large fraud companies tends to be smaller; the size of companies has increased by factor of six;

  • Stock price declined approx 20%; at first disclosure that there may be an accounting problem [at the fraud companies]; bankruptcy, delisting, material asset sales, were significantly more likely than [for a] matched sample of no fraud companies.

"This is just tidbits from my memory," noted Carcello. "We are still doing a lot of additional work; the reason I mention this is for the [PCAOB] board to understand, and for the SEC to understand, this continues to be a major problem in the capital markets." (Read more about the Oct. 14 PCAOB SAG meeting in our separate post today.)

My two cents
(I remind you of the disclaimer which appears in the right margin of this blog) . When COSO's updated fraud study is released, I believe it will be important to look at statistics with respect to 'fraud companies' (i.e. the 300+ companies found to have been charged with fraud during the 10 year period, as referenced by Carcello at the SAG meeting) vis-a-vis the broader population, or the total universe of public companies, and vis-a-vis the demographic breakdown of all public companies.

For example, statistics as of March, 2005 provided in Table 3 (pdf pg. 181) of the SEC Advisory Committee on Smaller Public Companies (ACSPC) Final Report shows:

  • 31.3% of all public companies are traded on the OTC Bulletin board (1.1% of total market cap.)
  • 33.7% of all public co's are traded on Nasdaq National Market or Nasdaq Capital Market (18.6% of total market cap)
  • 35% of all public co's are traded on NYSE and Amex (80.3% of total market cap)

Additionally, Table 1 of the SEC ASCPC Final Report shows:

  • 44.2% of all public co's are 'small co's' or nonaccelerated filers as defined by the SEC (i.e. those with below $75 million market cap; these companies cumulatively make up 0.5% of total market cap)
  • 32.9% of all public co's have between $75 million and $700 million market cap, approximating SEC's definition of 'accelerated filer" (and make up 5% of total market cap)
  • 22.9% of all public co's have over $700 million market cap, approximating SEC's definition of 'large accelerated filers' (and make up 95% of total market cap)
  • 9,428 was the total number of public companies as of March, 2005, according to the footnote shown with an asterisk immediate below Table 1 in the SEC ASCPC Final Report.

This information is provided as a reference point and segues into the next item below.

Rep. Garrett Calls For Small Co. Exemption From Sarbox 404b
As reported last week by Sarah Lynch in the Wall Street Journal, House Bill Would Exempt Small Firms From SEC Auditing Rules.

The press release issued by the Rep. Scott Garrett's (R-NJ) office on October 8 states: "Garrett’s bill, the “Small Business SOX Compliance Relief Act” is aimed at permanently exempting small businesses (non-accelerated filers) from the burdensome reporting requirements contained within Section 404(b) of the SOX Act."

Garrett's bill, which proposes to exempt small co's only from the Sarbox 404b requirement for an external audit opinion on internal control - not from the Sarbox 404a requirement for a management report on internal control - followed shortly after the SEC announced the results of its cost-benefit study of Section 404, along with a final extension of time for small co's to file their Section 404b auditor's reports on internal control (extending the deadline to fiscal years ending on or after June 15, 2010.) Garrett cites in his press release a number of studies which provided a different assessment of the cost-benefit equation than the SEC came up with in its own study.

As we anticipated in our Oct. 2 post, the SEC followed up its initial announcement of the final delay in 404b for small co's, by memorializing the action in a final rule, posted by the SEC on Oct. 13.

If you missed it earlier, see our Oct. 7 post which links to related commentary by Francine McKenna, author of Re: The Auditors, and Tom Selling, author of The Accounting Onion, on the subject of AS5 and Sarbox 404b. Selling in particular - an advocate of professional skepticism - surprised me by his take on the potential value of Sarbox 404b for small public co's, or (in his view), lack thereof. (He also estimated some 'back of the envelope' calculations approximating some of the statistics listed above.) Although the general view appears to be that the Sarbox 404b issue was put to bed with finality in SEC's most recent release, Rep. Garrett's view may not be so surprising, or at least, he is not alone, when you read Selling's analysis.

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