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Rolling back SOX = potential disaster. But why?

Every once in a while I drift back to discussing the topic of accounting, usually because I've encountered something relevant to discuss - and because I think I can find a way to explain it to a normal person without making them lapse into a coma.

To someone not working a desk job which involves running audits or dealing with a company's finance department SOX is just another code-word, like "War on Terror" or "lolcats" - either you know what it is, or it's a just a vague term in need of explanation if you're to really understand it. 

It's a set of rules for how financial reporting and risks are to be managed and documented, and introduced after the Enron debacle, the effect of SOX is to impose discipline and standardized processes for large companies to follow. The idea being that investors are better served if how a company reports the financial informatin used to prepare its financial statements if this is a consistent and reliable process, rather than some wild "let's figure out some math on the back of a napkin" approach.

I'm grossly oversimplifying, of course, but only to make it easier for a non-specialist to understand what this potentially big and messy thing is.

Knowing this much, you may start to understand why getting rid of SOX might not be the best of ideas. For more details, read this little article about the failure of logic associated with repealing SOX - something the recently defeated Republicans in the US are trumpeting.

Wait, you just lost a historic election, one of the reasons being your excessive zeal for deregulation, and you think advocating more deregulation is the answer?

Time magazine has an eloquent article hitting on these same points - pointing out that the Republicans brought in "freedom" which went to extreme ultra-freedom which ended up sort of oddly confining - especially when you found yourself drowning in debt. The Democrats have arrived, to promise "order", which used to be popular until the 60's, when it turned into disorder. They write:

In America, political majorities live or die at the intersection of two public yearnings: for freedom and for order. A century ago, in the Progressive Era, modern American liberalism was born, in historian Robert Wiebe's words, as a "search for order." America's giant industrial monopolies, the progressives believed, were turning capitalism into a jungle, a wild and lawless place where only the strong and savage survived. By the time Roosevelt took office during the Great Depression, the entire ecosystem appeared to be in a death spiral, with Americans crying out for government to take control. F.D.R. did — juicing the economy with unprecedented amounts of government cash, creating new protections for the unemployed and the elderly, and imposing rules for how industry was to behave. Conservatives wailed that economic freedom was under assault, but most ordinary Americans thanked God that Washington was securing their bank deposits, helping labor unions boost their wages, giving them a pension when they retired and pumping money into the economy to make sure it never fell into depression again. They didn't feel unfree; they felt secure. For three and a half decades, from the mid-1930s through the '60s, government imposed order on the market. The jungle of American capitalism became a well-tended garden, a safe and pleasant place for ordinary folks to stroll. Americans responded by voting for F.D.R.-style liberalism — which even most Republican politicians came to accept — in election after election.

They go on to discuss the recent economic history of the US, noting that the pendulum started to swing back against all this free-marketeering in the mid-90's.

Starting in the 1990s, average Americans began deciding that the conservative economic agenda was a bit like the liberal cultural agenda of the 1960s: less liberating than frightening. When the Gingrich Republicans tried to slash Medicare, the public turned on them en masse.

Several of the points in that issue of Time would make my economics professors gag and convulse, perhaps with good reason. But politics ignores the truths of economics when convenient. And the grand theories of economics are like battle plans anyway. They rarely survive first contact with reality.

In light of the recent failures in the world of high finance- and the general financial implosion heralding the 2008 American recession - would it really be advisable to make it easier for a company to try and fudge its numbers and make up something that feels right rather than reflects reality?

Ah, you stop me could rightly stop me at the mention of those implosions: "wait, but if SOX is so great, why didn't it stop the 'splosions?" Good question. The problem in this case was that SOX wasn't meant to cure everything - there are other rules and regulations to keep banks from carried away when lending money.

In Canada, for example, those rules are still in place, and the economy is still humming along soundly. Well, the banks aren't imploding, anyway.

Yay Canada.

And in the US?

8 years of Bush included repealing many other regulations - including rules regarding how much money you were allowed to lend as a bank. Freed from lower ratios, banks went to town on lending too much. Not limited to a smaller pool of money, the new goal wasn't "is this a safe investment for us," but "who else can we lend money to?" to maximize hyper profits?

As soon as a bank stops being anal-retentive about its lending rules, you're setting yourself up for disaster.

And here we are.

How exactly would getting rid of SOX help? It wouldn't. It would simply be yet another repealed regulation, in turn making it easier for things to go wrong.

As if things weren't bad enough already.

The legislation can of course be improved to be more about substance over form and all those other bold prescriptions for fixing how financial statements are presented, but improving the rules themselves is another entirely.

Want to repeal SOX anyway? Leave a comment telling me why.

Posted: Nov 18 2008, 12:53 AM by Krupo | with 5 comment(s)
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Adrienne said:

First fair value took a beating over the sad state of the economy, now SOX... the problem is not bad accounting *rules*, it is based strictly on bad accounting!

Thank you for this article, although maybe you could have gone without rubbing in how well Canada has it!

# November 19, 2008 4:59 PM

Krupo said:

Heh, I wouldn't call that rubbing it in - we're suffering with the collapse of the auto industry and falling oil prices hitting both Alberta and Ontario - it's just those other "fundamentals of the economy" which are still strong, to put a gentle McCainism on it.

# November 19, 2008 6:17 PM

neilmcintyre said:

I think the lag on rolling out a strong financial instruments standard in the US made the current problems much worse than they would've been because the lack of a standards hid the problems for longer.  Just throwing that out there.

# November 20, 2008 4:34 PM

Krupo said:

That's a pretty smart theory.

# November 20, 2008 11:10 PM

When Conservative Politics Clashes with Conservative Accounting : CPA Trendlines said:

Pingback from  When Conservative Politics Clashes with Conservative Accounting : CPA Trendlines

# November 21, 2008 11:36 PM