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Sarbanes-Oxley: Avoiding Its Pitfalls

By Theodore F. di Stefano E-Commerce Times ECT News Network
Sep 17, 2004 6:00 AM PT

Since Sarbanes-Oxley (S0X) was enacted into law on July 30, 2002, management has been scrambling to comply with the Act. In a previous column [Theodore F. di Stefano, "Sarbanes-Oxley: Insurmountable Hurdle for Small Business?" September 10, 2004], I gave some background as to what gave rise to SOX, how Congress reacted to the public outcry, and the resultant legislation.

Sarbanes-Oxley: Avoiding Its Pitfalls

This column is intended to alleviate the fears of well-meaning management and give some down-to-earth, practical advice about how to comply and how to avoid certain pitfalls.

There has been a great deal of confusion about what constitutes sufficient compliance with SOX. Frankly, some managers are just plain scared that they might fail to comply properly and find themselves in a peck of trouble.

Act Complicated, Doable

First of all, the act is a rather lengthy and tortuous recitation of dos and don'ts of compliance. This, however, shouldn't discourage well-meaning management. The act is not impossible to comply with.

You, of course, need to consult your attorneys and auditors. Of course, the CEO and top management bear the brunt of the consequences of noncompliance.

What can you do to assure yourself that you are implementing critical procedures to protect your company against a governmental backlash for lack of compliance? The answer is rather simple.

Management must establish a code of conduct and ethical behavior that absolutely permeates the entire organization. Management must consistently set and live that code. There is nothing as demoralizing as having to comply with rules that are roundly ignored by those establishing the rules.

You might ask: What about the intricate and specific rules by which SOX burdens management? Of course, "God is in the details," and you, your accountants and attorneys must make every effort to meet the spirit of the law. However, as I mentioned in my previous column on SOX, "There is no doubt in my mind that the law will be modified, not so much to give it loopholes, but to make it more easily subject to rational implementation."

Principles of Compliance

Your attorneys and accountants can provide you with the specific sections of the law to which you should pay special attention. In my previous column, I mentioned those sections.

However, how about some basic business and accounting principles that will guide your compliance? I'll give you what I believe to be the bedrock of substantive compliance, and you will be surprised how simple these concepts are.

The overriding principle is that each and every item in your financial statements has to arise from a transaction that will stand the utmost scrutiny -- that means no conflicts of interest, no booking of income on a promise and recording all items of income and expense in the period earned or incurred.

I will go through the major items of the financial statements and give you concrete examples of how these principles can be applied.

Some Guiding Principles

Let's start with assets. There is no doubt that some time in the not-too-distant past you have read about a corporation lending money to its CEO and recording the transaction as a company loan receivable, an asset.

Even though this transaction might be technically legal, it runs afoul of the conflict-of-interest principles.

First of all, the CEO is borrowing money that rightfully belongs to the shareholders. Second, why doesn't he or she go to a bank to borrow money and keep transactions with the employer at arms-length?

Adding insult to injury, many CEOs have convinced their boards to write off the loan receivable if the CEO achieves certain preset management goals. This, in my opinion, is an offense to shareholders. The loan should never have been made, never have been recorded as a corporate asset and never have been written off.

It is this sense of entitlement that some CEOs have that got them into trouble. Always keep in mind that you should be dealing with your company at arms length and that you are an employee.

You might ask, what about a company car? Well, if the purchase of a company car is ordinary and necessary, there is no problem with your using the vehicle. But remember that it is not your car and that you should account for personal usage. The same principle can be applied to a company boat or a company plane.

Arms-Length Transaction

Another tricky financial statement item is accounts receivable. This item impacts both the balance sheet and the statement of income. Receivables must be booked on the basis of an arms-length transaction and a fully consummated sale. That means that the collection of the receivable is not subject to some future happening. It means, simply, that the sale has been made and the money is unequivocally due -- no strings attached.

This item, the recognition of income and the recording of accounts receivable, has been a major problem in the past with companies that ran afoul of the law. When times get rough, some weak CEOs are tempted to fix the books and to embellish income and receivable figures. Not a good idea -- it will invariably come back to haunt you.

As to the other side of the balance sheet, liabilities, we can apply the same principles that I mentioned above. All transactions should be at arms length, and the incurrence of the liability should be based upon a bona fide business transaction.

I'll give you an old accounting adage that is still very meaningful today: "Anticipate no profits, but provide for all losses." This idea alone, if followed consistently, will certainly keep you on the right side of the regulators. But, what about some other ideas and principles?

Let's take a look at expenses for a moment. Your expenses should be "ordinary and necessary." There are times, of course, when you have an extraordinary expense -- a settled lawsuit for example. The settling of it, however, should be necessary to your corporation's well being.

Conflict of Interest

Expenses should also be ethically incurred. By that I mean that the transaction that gave rise to the expense should be an arms-length transaction that did not come from any conflict of interest. In other words, you are not feathering your own nest with the incurrence of the expense.

A major problem in the expense category relates to expenses incurred on behalf of management: salaries, travel and entertainment. First of all, executive salaries must be approved and set by the board, and they should use some pretty transparent and reasonable standards in setting them. Second, travel and entertainment should not become a petty-cash piggy bank for an executive. You might be surprised how some company executives have bled their companies through taking improper travel and entertainment expenses.

How do you go about assuring that your financial statements comply with the above strictures? Again, it's a matter of putting policies and procedures in place and assuring yourself that they are maintained as originally intended and reviewed on a regular basis.

Compliance with SOX has so much to do with common sense. The accounting scandals that gave rise to SOX could all have been avoided if top management put into place a system of controls to assure that the financial statements presented to the public (and to the SEC) were accurate and fair. Certainly, no rocket science here.

Division of Duties

You -- the CEO or member of top management -- can't be all things to all people. You're not a practicing CPA or attorney. Certainly, you have to leave certain items of compliance to these professionals, but you must set the standards. It is you who ultimately will be taken to task for a failure in meeting the requirements of SOX. Set the standards and be sure to take a close look periodically to assure yourself that they are being maintained.

Most importantly, set ethical standards for your entire organization. Practice what you preach. Your employees will be sure to notice whether you're adhering to what you expect of them. And review employee compliance on a regular basis. You'll be happy you did.

Stay the course and stay ahead of SOX. And good luck.


Theodore F. di Stefano is a managing partner at Capital Source Partners and can be contacted at tfdistefano@aol.com.


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