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36–101 PDF 2007

FULL COMMITTEE HEARING ON SARBANES-OXLEY

SECTION 404: WILL THE SEC’S AND PCAOB’S

NEW STANDARDS LOWER COMPLIANCE COSTS

FOR SMALL COMPANIES?

COMMITTEE ON SMALL BUSINESS 

UNITED STATES HOUSE OF 

REPRESENTATIVES

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

JUNE 5, 2007

Serial Number 110-26

Printed for the use of the Committee on Small Business

(

Available via the World Wide Web: http://www.access.gpo.gov/congress/house 

HOUSE COMMITTEE ON SMALL BUSINESS 

NYDIA M. VELA ́ ZQUEZ, New York, Chairwoman 

WILLIAM JEFFERSON, Louisiana 

HEATH SHULER, North Carolina 

CHARLIE GONZA ́ LEZ, Texas 

RICK LARSEN, Washington 

RAUL GRIJALVA, Arizona 

MICHAEL MICHAUD, Maine 

MELISSA BEAN, Illinois 

HENRY CUELLAR, Texas 

DAN LIPINSKI, Illinois 

GWEN MOORE, Wisconsin 

JASON ALTMIRE, Pennsylvania 

BRUCE BRALEY, Iowa 

YVETTE CLARKE, New York 

BRAD ELLSWORTH, Indiana 

HANK JOHNSON, Georgia 

JOE SESTAK, Pennsylvania 

STEVE CHABOT, Ohio, Ranking Member 

ROSCOE BARTLETT, Maryland 

SAM GRAVES, Missouri 

TODD AKIN, Missouri 

BILL SHUSTER, Pennsylvania 

MARILYN MUSGRAVE, Colorado 

STEVE KING, Iowa 

JEFF FORTENBERRY, Nebraska 

LYNN WESTMORELAND, Georgia 

LOUIE GOHMERT, Texas 

DEAN HELLER, Nevada 

DAVID DAVIS, Tennessee 

MARY FALLIN, Oklahoma 

VERN BUCHANAN, Florida 

JIM JORDAN, Ohio

MICHAEL DAY, Majority Staff Director 

ADAM MINEHARDT, Deputy Staff Director 

TIM SLATTERY, Chief Counsel 

KEVIN FITZPATRICK, Minority Staff Director

STANDING SUBCOMMITTEES 

Subcommittee on Finance and Tax

MELISSA BEAN, Illinois, Chairwoman 

RAUL GRIJALVA, Arizona 

MICHAEL MICHAUD, Maine 

BRAD ELLSWORTH, Indiana 

HANK JOHNSON, Georgia 

JOE SESTAK, Pennsylvania 

DEAN HELLER, Nevada, Ranking 

BILL SHUSTER, Pennsylvania 

STEVE KING, Iowa 

VERN BUCHANAN, Florida 

JIM JORDAN, Ohio

Subcommittee on Contracting and Technology

BRUCE BRALEY, IOWA, Chairman 

WILLIAM JEFFERSON, Louisiana 

HENRY CUELLAR, Texas 

GWEN MOORE, Wisconsin 

YVETTE CLARKE, New York 

JOE SESTAK, Pennsylvania 

DAVID DAVIS, Tennessee, Ranking 

ROSCOE BARTLETT, Maryland 

SAM GRAVES, Missouri 

TODD AKIN, Missouri 

MARY FALLIN, Oklahoma

(II) 

Subcommittee on Regulations, Health Care and Trade

CHARLES GONZA ́ LEZ, Texas, Chairman 

WILLIAM JEFFERSON, Louisiana 

RICK LARSEN, Washington 

DAN LIPINSKI, Illinois 

MELISSA BEAN, Illinois 

GWEN MOORE, Wisconsin 

JASON ALTMIRE, Pennsylvania 

JOE SESTAK, Pennsylvania 

LYNN WESTMORELAND, Georgia, Ranking 

BILL SHUSTER, Pennsylvania 

STEVE KING, Iowa 

MARILYN MUSGRAVE, Colorado 

MARY FALLIN, Oklahoma 

VERN BUCHANAN, Florida 

JIM JORDAN, Ohio

Subcommittee on Urban and Rural Entrepreneurship

HEATH SHULER, North Carolina, Chairman 

RICK LARSEN, Washington 

MICHAEL MICHAUD, Maine 

GWEN MOORE, Wisconsin 

YVETTE CLARKE, New York 

BRAD ELLSWORTH, Indiana 

HANK JOHNSON, Georgia 

JEFF FORTENBERRY, Nebraska, Ranking 

ROSCOE BARTLETT, Maryland 

MARILYN MUSGRAVE, Colorado 

DEAN HELLER, Nevada 

DAVID DAVIS, Tennessee

Subcommittee on Investigations and Oversight

JASON ALTMIRE, PENNSYLVANIA, Chairman 

CHARLIE GONZA ́ LEZ, Texas 

RAUL GRIJALVA, Arizona 

LOUIE GOHMERT, Texas, Ranking 

LYNN WESTMORELAND, Georgia

(III) 

C O N T E N T S 

OPENING STATEMENTS 

Page

Vela ́zquez, Hon. Nydia M. ....................................................................................... 1

Chabot, Hon. Steve .................................................................................................. 2

WITNESSES 

PANEL I 

Cox, Hon. Christopher, Chairman, Securities and Exchange Commission ........ 4

Olson, Mark W., Public Company Accounting Oversight Board .......................... 7

PANEL II 

Greenwood, Hon. James C., Biotechnology Industry Organization ..................... 21

Casey-Landry, Diane, America’s Community Bankers ......................................... 23

Scott, Hal, Harvard Law School ............................................................................. 25

Heesen, Mark G., National Venture Capital Association ..................................... 28

Hirschmann, David, U.S. Chamber of Commerce ................................................. 30

Schmalzl, Richard, Graydon Head & Ritchey LLP ............................................... 32

APPENDIX 

Prepared Statements: 

Vela ́zquez, Hon. Nydia M. ....................................................................................... 45

Chabot, Hon. Steve .................................................................................................. 47

Cox, Hon. Christopher, Chairman, Securities and Exchange Commission ........ 49

Olson, Mark W., Public Company Accounting Oversight Board .......................... 56

Greenwood, Hon. James C., Biotechnology Industry Organization ..................... 75

Casey-Landry, Diane, America’s Community Bankers ......................................... 84

Scott, Hal, Harvard Law School ............................................................................. 93

Heesen, Mark G., National Venture Capital Association ..................................... 99

Hirschmann, David, U.S. Chamber of Commerce ................................................. 104

Schmalzl, Richard, Graydon Head & Ritchey LLP ............................................... 111

Statements for the Record: 

Independent Community Bankers of America ...................................................... 119

Institute of Management Accountants ................................................................... 126

(V) 

(1)

FULL COMITTEE HEARING ON 

SARBANES-OXLEY SECTION 404: 

WILL THE SEC’S AND PCAOB’S 

NEW STANDARDS LOWER 

COMPLIANCE COSTS FOR SMALL 

COMPANIES? 

TUESDAY, JUNE 5, 2007

U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON SMALL BUSINESS, Washington, DC. 

The Committee met, pursuant to call, at 2:10 p.m., in Room 2360 

Rayburn House Office Building,Hon. Nydia M. Vela ́zquez [Chairwoman of the Committee] presiding. 

Present: Representatives Vela ́zquez, Larsen, Clarke, Ellsworth, 

and Chabot. 

OPENING STATEMENT OF CHAIRWOMAN VELA ́ ZQUEZ 

ChairwomanVELA ́ ZQUEZ. I call this hearing to order. 

This afternoon the Committee will examine implementation of 

Section 404 of the Sarbanes-Oxley Act and consider whether the 

new standards that the SEC and PCAOB approved last month will 

lower compliance costs for smaller companies. 

Small firms continue to be supportive of the intent of the Sarbanes-Oxley Act and many have benefited from the stronger corporate government’s culture that it encourages. What we continue 

to find is that many aspects of complying with SOX, and particularly those associated with Section 404, are disproportionately impacting small companies. These continue to make me believe that 

these new regulations should be delayed. 

This additional time is especially important for smaller companies which often operate with limited human and financial resources and may be unreasonably burdened by these high costs. We 

may jeopardize some of our country’s most innovative endeavors if 

we fail to adequately balance investor protection with the associated regulatory burden. 

Last month new management guidance and an auditing standard 

for Section 404 were approved. The result of nearly 2 years of 

work, this new standard seeks to make Sarbanes-Oxley compliance 

more efficient and cost effective for companies of all sizes. While I 

am encouraged by this, I am concerned about the proposed timeline 

under which small firms will have to comply with the new regulations. 

2

An important step to mitigating this will be, prior to the SEC’s 

approval of the auditing standard, the Commission should undertake a full analysis as prescribed by Section 603 of the Regulatory 

Flexibility Act. This will ensure that this regulation is appropriately tailored. 

Earlier this year Ranking Member Chabot and I wrote to Chairmen Cox and Olson and expressed our concern that the proposed 

implementation timeline was inadequate to assess its effectiveness. 

Postponing the December 2007 and December 2008 deadlines by at 

least 1 year would allow for the new standards to be tested and for 

evidence to be collected that could confirm that the new standards 

do, in fact, lower costs for small firms. 

Small businesses are significant sources of research and development, job creation and innovation in our economy. It is critical that 

the SEC and PCAOB work to ensure that SOX 404 is implemented 

in a way that contributes to increased investor confidence, but that 

also does not hamper America’s competitiveness. Postponing the 

compliance deadlines for at least an additional year would allow us 

to make this determination. 

A delay will also provide training for small companies and auditing firms. It will also permit the PCAOB’s efficiency inspectors to 

assess whether audit firms are implementing the new standards in 

the manner intended. At a minimum these steps will help ensure 

a more effective implementation of these new standards and recognize the unique situation that many companies find themselves in. 

These new standards come at a time when small businesses are 

already spending 45 percent more than larger firms on regulatory 

compliance. To ensure that these burdens become more manageable we should not be piling new regulations on until they have 

been thoroughly reviewed. Today’s hearing will help us accomplish 

this, and by doing so, it will demonstrate that a delay is necessary 

to better balance the cost and benefits of these new standards. 

I would like to take this opportunity to welcome Chairman Cox 

and Chairman Olson and also to thank the members from the second panel that are traveling from across the country to be here to 

shed some insight regarding the implementation of Section 404 on 

small firms. 

Now I recognize Mr. Chabot for his opening statement. 

OPENING STATEMENT OF MR. CHABOT 

Mr.CHABOT. Thank you, Madam Chairwoman, and thank you for 

holding this hearing on Section 404 of the Sarbanes-Oxley Act and 

its impact on small businesses. 

The Sarbanes-Oxley Act has been described as the most important and far-reaching securities legislation since the Securities Act 

of 1933 and the Securities Exchange Act of 1934, which were 

passed following the stock market crash back in 1929. Signed into 

law in 2002 in response to the bankruptcy of Enron Corporation, 

the WorldCom scandal and other corporate failures, the SarbanesOxley Act established the Public Company Accounting Oversight 

Board, a private-sector, nonprofit organization that oversees public 

company auditors and enacts auditing standards. The act also restricts accounting firms from performing a number of other services 

3

for companies which they audit and requires new disclosures for 

public companies and officers and directors. 

While the act has generally been viewed as necessary to restore 

public and investor confidence in our capital markets and improve 

the reliability and transparency of commercial financial reports, 

concerns have been raised about the burden and cost of compliance 

for small- and medium-sized companies. 

One of the most controversial provisions, Section 404, management assessment of internal controls, requires management and 

auditors to assess internal controls over financial reporting and requires external auditors to report on management’s assessment 

and certify to the effectiveness of internal controls. 

The Securities and Exchange Commission greatly underestimated the amount that it would cost small businesses to comply 

with Section 404. According to an April 2006 Government Accountability Office study, small businesses expend a disproportionately 

greater amount of time and money as a percentage of revenues 

compliant with Sarbanes-Oxley than large public companies. Firms 

with $1 billion or more spend 13 cents per $100 in revenue for 

audit fees to comply with Sarbanes-Oxley regulations, while small 

businesses spend more than $1 per $100. 

It is generally agreed that Sarbanes-Oxley has had a positive effect on investor protection and confidence, but its burden on small 

business has not only affected their bottom line, but also their competitiveness in our global academy. 

GAO found that small businesses used resources for SarbanesOxley compliance rather than for other business activities. Recently, the Kauffman-RAND Center for the Study of Small Business and Regulation said that Sarbanes-Oxley caused small firms 

to exit the public capital market. Last year the Securities and Exchange Commission announced that it would delay the application 

of Section 404 to the smallest companies until later in 2007. 

Earlier this year the chairwoman and I together urged the SEC 

to delay implementation of the new internal control standards to 

allow small businesses additional time to comply. On May 23, 2007, 

this year, the SEC announced it would not allow such an extension. 

At its May 23, 2007, meeting the SEC adopted rules designed to 

reduce costs for compliance with Section 404 for all businesses. In 

addition, the Commission adopted proposed rules examining the 

general disclosure requirements for small companies wanting to go 

public. This represents an excellent opportunity for the Commission to examine the cumulative impact of its rules on small companies and reduce those while still striving to maintain investor confidence. 

Madam Chairwoman, I commend you for holding this hearing on 

Section 404 compliance. I want to note that in addition to our panel 

of experts we have with us an attorney from Cincinnati, my district, who has real-world experience in helping small public company clients to deal with the challenges of Section 404 compliance. 

I look forward to this hearing from each of our witnesses. We 

want to thank them in advance for their testimony. 

And I also want to welcome to Washington, D.C., my brother, my 

younger brother, 10 years younger, Dave, and his wife Ellen who 

are with us today with their four beautiful children and they are 

4

in the back there. How about the whole family stand up back there. 

Kids, come on and stand up. We don’t have visitors up here all that 

often. There are a whole bunch of them there. So those are Chabots 

back there. And that’s how we pronounce it, even though it gets 

pronounced all different ways up here. 

ChairwomanVELA ́ ZQUEZ. And welcome to my club. 

Mr.CHABOT. Exactly. That’s right. I yield back my time.

ChairwomanVELA ́ ZQUEZ. Thank you. 

Our first witness is our former colleague, the Honorable Christopher Cox. He is the 28th chairman of the Securities and Exchange Commission. He was appointed by President Bush on June 

2, 2005, and unanimously confirmed by the Senate on July 29, 

2005. During his tenure at the SEC Chairman Cox has brought 

groundbreaking cases against a variety of market abuses, including 

hedge fund insider trading, stock options back-dating and securities scams on the Internet. 

Prior to joining the Securities and Exchange Commission, Chairman Cox served for 17 years in Congress where he held a number 

of positions of leadership in the U.S. House of Representatives. 

Honorable Christopher Cox, you are welcome and we are very 

grateful that you are here with us today. 

STATEMENT OF THE HONORABLE CHRISTOPHER COX, 

CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION 

Mr.COX. Madam Chairwoman, thank you very much for your 

gracious introduction to my colleagues. I am very, very honored 

with the opportunity to be here, along with Chairman Olson, to 

talk about this very important subject. 

The Committee has a very important charge, and we share a 

good portion of what you are responsible for within our sphere at 

the Securities and Exchange Commission. We all have a responsibility to the millions of small businesses in America and, in that 

way, to our economy. 

For our part, the SEC is charged by statute with the protection 

of investors, fostering efficient markets and the promotion of capital formation. Small business needs all of these in order to survive. 

So like every member of this Committee, the SEC is completely 

committed to fostering a climate of entrepreneurship. That climate 

is necessary to help promote small business growth, and it is necessary to the creation of the many jobs and goods and services in 

our country that are produced by small business, 

Today, as every member of this Committee well knows, there are 

over 6,000 public companies that are smaller businesses that still 

aren’t required to comply with Section 404 of the Sarbanes-Oxley 

Act of 2002. Generally that is every public company with securities 

registered with the Commission if it has less than $75 million in 

public equity. 

The Commission has, as you have noted, delayed Section 404 

compliance for smaller companies precisely because of the disproportionately high costs that they face compared to larger companies. Our experience in the first 3 years of compliance after the enactment of SOX told us that the way that 404 was being implemented was too expensive for everyone. And imposing that system 

5

on the smallest companies would impose unacceptably high costs 

from the standpoint of the companies’ investors who would have to 

pay the bills. 

So the Commission and the Public Company Accounting Oversight Board set out to address the unique concerns of small business; and as you are aware, the Commission has carefully phased 

in application to the 404 requirements. We have repeatedly deferred 404 compliance for smaller companies with the very positive 

result of this determination to phase in 404 for smaller companies 

being that we and they have had and will have the opportunity to 

field test the requirements first. 

Now we are using what we have learned thus far and we will 

continue to use what we learn to lessen the burden for smaller 

companies that eventually will have to comply with Section 404. 

We have little doubt that the SEC’s new guidance, specifically for 

management, and the PCAOB’s new standard, which Chairman 

Olson will talk about in a little more detail in a moment, will be 

of significant help to smaller companies when, beginning with their 

SEC annual filings in 2009, they eventually comply with the audit 

provisions of Section 404. In the meantime, for their filings in 

2008, they will have to comply only with the management assessment portion of Section 404. 

For this purpose, the SEC’s new guidance should be especially 

helpful. It is written in plain English. It suggests that certifying officers at smaller companies ask themselves two basic questions: 

First, do my employees understand what they need to do to prepare 

reliable financial statements; and second, what information do I 

need to be sure that they have done those things. 

The answers to these questions needn’t be complicated or costly. 

And certainly our guidance won’t make them so. In fact, the guidance clearly highlights the areas where cost-effective implementation has been a challenge for small companies in the past so that 

these pitfalls can be avoided, and it explains how a small company 

might approach 404 differently than a large company. None of this 

should be unduly difficult for most companies, and it certainly does 

not require the 404 audit that has had smaller companies so concerned about cost. 

As we meet here in mid-2007, the requirement of an internal 

control audit under Section 404 won’t apply to smaller public companies with calendar and fiscal years until their filings in the 

spring of 2009, almost 2 years from now. In the meantime, those 

smaller companies can begin to get ready for full SOX 404 compliance by undertaking their own assessments of internal controls beginning with their SEC reports in 2008. 

So, in response to suggestions that the Commission should extend 404 compliance for another year, the answer is that smaller 

companies won’t be required to come into full compliance with SOX 

404 until their report is due in March 2009, almost 2 years from 

now. This schedule gives smaller companies the benefit of doing an 

initial internal assessment of their controls without the added burden and cost arising from an external audit. We fully expect that 

by the end of 2008 management’s familiarity with the 404 process 

and its documentation of internal controls will make it easier and 

6

less expensive to do an external audit than it would have been 

under the previous system. 

Madam Chairwoman, the focus of this hearing is on whether the 

SEC’s new guidance for management and the PCAOB’s new standard for auditors will lower compliance costs for small companies. 

The answer to that question is ′′yes.′′ we expect the unduly high 

costs of implementing Section 404 of the act under the previous auditing standard will come down. They should come down because 

now a company will be able to focus on the areas that present the 

greatest risk of material misstatements in the financials. That is 

what the law has always intended we be focused on. It is always 

what investors care about; it is what is important for achieving reliable financial reporting. 

Compliance costs should come down because the new SEC guidance that has been developed specifically for management will 

allow each small business to exercise significant judgment in designing an evaluation that is tailored to its individual circumstances. Unlike external auditors, management in a smaller 

company tend to work with its internal controls on a daily basis. 

They have a great deal of knowledge about how their firm operates. 

Our new guidance allows management to make use of that knowledge, which should lead to a much more efficient assessment process. 

Compliance costs should also come down for the minority of 

smaller public companies that had already complied with Section 

404 under the old auditing standard. In recognition of the fact that 

many of those companies have already invested considerable resources in the design and the implementation of their processes the 

Commission’s guidance does not disrupt or require any changes to 

what they are now doing. 

While these smaller companies should benefit from the top-down, 

risk-based, materially focused and scalable nature of both the 

SEC’s new guidance and the PCAOB’s new auditing standard, they 

should not have to expend new resources to do so. 

The goal of our collective efforts in this area, the SEC and the 

PCAOB, is to implement Section 404 just as Congress intended in 

the most efficient and effective way to meet our objectives of investor protection, well functioning financial markets and healthy capital formation by companies of all sizes. We won’t forget the failures that led to the passage of the Sarbanes-Oxley Act in the first 

place, and we won’t forget that for small business to continue to 

prosper, both strong investor protection and healthy capital formation must go hand in hand. 

These past few weeks have witnessed several positive steps for 

small business at the SEC. Not only are we approaching the finish 

line in our work to rationalize and improve the 404 process for 

smaller companies, but also we are tackling several other issues of 

importance to our Nation’s small businesses. The most important 

of these is our effort to modernize and improve capital raising for 

small business and to simplify SEC reporting for small business. 

Many of these proposals would implement key recommendations 

made by the Commission’s Advisory Committee on Smaller Public 

Companies. 

7

Our concerns for small business go hand in hand with our responsibility to protect investors. It is, after all, investors who are 

injured and whose money is lost when the small businesses in 

which they invest can’t get affordable access to new capital. 

Madam Chairwoman, the SEC takes extremely seriously and 

equally seriously each element of its tripartite mission. The 404 reforms, the capital-raising improvements that I just mentioned and 

the reporting simplifications that we proposed to benefit small 

business will, I am certain, help our country to accomplish all three 

of these objectives. 

Thank you again for the opportunity to speak on behalf of the 

Commission, and of course I will be happy to answer your questions. 

ChairwomanVELA ́ ZQUEZ. Thank you Chairman Cox. 

[The prepared statement of Mr. Cox may be found on page 49 of 

the Appendix.]

ChairwomanVELA ́ ZQUEZ. Our next witness is the Honorable 

Mark Olson, who became chairman of the Public Company Accounting Oversight Board on July 3, 2006. The PCAOB is a private-sector, nonprofit corporation created by the Sarbanes-Oxley 

Act of 2002 to oversee the auditors of public companies. 

Prior to his appointment to the PCAOB board, Mr. Olson served 

as a member of the Federal Reserve Board of Governors and the 

Federal Open Market Committee. Before becoming a member of the 

Federal Reserve Board, Mr. Olson held a number of positions in 

the banking industry and was a partner with the accounting firm, 

Ernst & Young. 

Welcome, sir. 

STATEMENT OF MARK W OLSON, CHAIRMAN, PUBLIC 

COMPANY ACCOUNTING OVERSIGHT BOARD 

Mr.OLSON. Thank you very much. Madam Chairwoman 

Vela ́zquez and Ranking Member Chabot and members of the Committee, I am delighted to be here today on behalf of the PCAOB. 

I am pleased to be here with Chairman Cox, whom we have worked 

closely with in this effort. The full text of my statement has been 

submitted for the record, but I would like to make a couple of summary comments and then be happy to answer any additional questions that you might have. 

I think at the outset it is important to remember—and I know 

that all the members of the Committee do, but just as a reminder—

the 404 does not apply to all small businesses. Section 404 applies 

to small businesses that choose to access the U.S. capital markets; 

and that is a critical distinction, because in exchange for your willingness to access the U.S. capital markets, the management has 

been asked to accept a heightened level of responsibility for the internal controls over financial reporting. 

That new responsibility, I think, helps provide stability to the 

U.S. capital markets, but very importantly, it helps build confidence in markets for the average investor. And that is critically 

important because, as all of the members know, I am sure, over 

half of U.S. households are now equity holders in one form or another. In my mind, it is the essence of Sarbanes-Oxley 404. 

8

And I agree with Ranking Member Chabot when he says that is 

probably the most significant legislation since the 1933 and the 

1934 Acts. But what it does is provide a level of confidence that 

wasn’t there before. But it is the third time Congress has chosen 

to act and to act in a way that has mandated internal controls over 

financial reporting. The first was the Foreign Corrupt Practices Act 

and the second was in FDICIA. 

That said, we are working in a number of ways to specifically 

focus on small business at the PCAOB in two particular ways that 

I would like to highlight: first of all, the fact that most of the registrants that registered with us, the accounting firms, the auditing 

firms that registered with us, are themselves small businesses. 

I was surprised, when I looked closely at the statistics regarding 

the PCAOB, that there are 1,700 accounting firms, auditing firms, 

that have registered with the PCAOB, which means that there are 

1,700 firms that either now do or wish to audit companies that are 

traded in the U.S. public markets. Of those 1,700, 1,000 them are 

in the U.S., and of those 1,000, only 150 have 5 or more publicly 

traded companies that they audit. So 800-some—850 roughly—

firms that register with us either audit fewer than 5 or are not listed currently as the auditor of any, but they choose to. And that 

number is growing so that there is an increasing number of small 

firms around the country. There are 129, for example, in New York 

alone and 1934 in Ohio alone that fit this category. 

Also we have been working very hard to make sure that as we 

get closer to the implementation for the small, nonaccelerated filers 

that the small firms can be ready; and let me give you a couple of 

examples of what we are doing. 

First of all, we are hosting seminars around the country for the 

small accounting firms and, in some cases, members of audit committees. We have done those with 21 different firms in 14 different 

markets, that have been attended by over 2,000 people, where we 

have acquainted them with the PCAOB; but more importantly, 

helped them understand and recognize the extent to which the responsibility will be for auditing under Section 404, particularly for 

the nonaccelerated filers. 

Point number two is that we are working with a group of 12 accounting firms now to specifically focus on developing guidance for 

the smaller firms, so that as they are getting ready to audit on 404, 

we can help them identify how they would identify the key controls 

and how they would identify a control environment that would be 

more applicable to a small firm, so that it can reach the point that 

you mentioned, Congresswoman, when you talked about the disproportionate burden that would fall to small business if we don’t 

aggressively address that point. That is precisely the effort that is 

under way. 

Point number three, Chairman Cox indicated, which we have just 

passed and sent to the SEC for their review, the AS 5, the 

scalability portion of that adjusted standard, specifically focuses on 

ways that we can be scalable to address the smaller and less complex businesses. 

And I think, very importantly, as Chairman Cox mentioned, the 

fact that we are now linking the AS 5 with the management guidance that have been produced by the SEC will in fact answer the 

9

question that you asked at the outset, which is, will the revisions 

bring costs down. And I agree with the chairman, there is no reason why those costs should not come down because of the fact that 

we have made the standard that much more scalable and that we 

have reduced the wording that would have resulted in unnecessary 

procedures being made by the external auditor. 

As to the delay, the bill was passed, as I said, in 2002. It has 

now delayed full implementation until 2009. To delay it a year, 

until 2010, would mean that full implementation would have taken 

the equivalent of four terms in the House of Representatives. And 

I think, in our judgment as we have looked at the manner in which 

we have delayed, and particularly what the SEC has done in staging the dates of compliance, it seems to me that there is adequate 

time built into it now for the firms to be ready. 

[The prepared statement of Mr. Olson may be found on page 56 

of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Thank you, sir. 

ChairwomanVELA ́ ZQUEZ. Chairman Cox, I know that you will not 

be able to stay to hear the testimony of the second panel of witnesses this afternoon, so I want to pose to you the question that 

I expect will be central to the second panel of witnesses. 

Will you support further postponing SOX 404 compliance dates 

for smaller public companies? 

Mr.COX. Chairwoman, I think because this has been the subject 

of my formal testimony and also Chairman Olson’s, that I should 

ask you with respect to the upcoming panel—by the way I want 

you to know that the SEC will be here in full force to listen to that 

testimony—

ChairwomanVELA ́ ZQUEZ. I understand. 

Mr.COX. —but to make sure that we are addressing ourselves to 

the same question, are you focused on the 404 audit? 

ChairwomanVELA ́ ZQUEZ. Yes. 

Mr.COX. Because I think what we have taken pains to explain is 

that while there will be required compliance with 404(a)—404 is 

very short, it has part (a) and part (b), and 404(a) compliance will 

kick in for smaller companies in 2008 and 404(b) won’t kick in 

until filings in 2009. 

ChairwomanVELA ́ ZQUEZ. And I will have a question for you in 

terms of those dates. 

Mr.COX. Right. 

And so is what you are asking, are we thinking about 2010? 

ChairwomanVELA ́ ZQUEZ. Well, Mr. Chairman, in reading the testimonies that will be presented here this afternoon and in the 

meetings that we have had with the sectors that will be impacted 

by this, it seems that small companies do not feel that because they 

will have until 2009 to comply with the PCAOB—that the problem 

is that in order to comply with the SEC in 2008, they will have to 

incur expenses that have to relate to 2009. 

And I am going to ask you this question so that you can see why 

there is so much concern, not about the fact that you are coming 

here and saying, ′′But they will not have to comply with those 

guidelines until 2009,′′ but in order to comply, for the 2008 reports 

that they have to present to SEC in 2008, they will have to incur 

10

expenses that are supposed to be related to the reports that they 

have to submit to the PCAOB in 2009. 

In your testimony—

Mr.COX. Madam Chairwoman—

ChairwomanVELA ́ ZQUEZ. I am going to try to explain in this 

question. 

In your testimony you highlight that a further delay in the compliance date is at this point unnecessary. Explaining this point, you 

emphasize that small companies will not have to come into full 

compliance until March 2009. This reasoning assumes, however, 

that management is willing to sign annual reports for fiscal years 

ending on or after December 15, 2007, without an outside auditor’s 

review. 

Because of reasonable concerns about potential liability associated with information included in such reports, I expect that the 

December 2007 deadline is likely to force a number of smaller public companies to implement both the SEC’s and PCAOB’s new 

standard during the second half of 2007. 

Do you agree that this is a likely consequence of the SEC’s existing SOX compliance timeline for smaller firms? 

Mr.COX. No, Madam Chairwoman, but I think it is very useful 

to have that question asked publicly and answered publicly. 

That is not at all the intention of what the SEC is doing, nor is 

it the intention of what the PCAOB is doing, I think fair to say, 

although I will let Chairman Olson comment for the PCAOB. 

What we are seeking to do is completely the opposite, and that 

is to stage compliance for smaller companies. There is absolutely 

no question, given all of the evidence that we have received—and 

as you know, we have been very carefully consulting with small 

businesses across America in a variety of formal ways. All of the 

evidence that we have received suggests that the costs that are of 

particular concern in Section 404 compliance relate to the 404 

audit. As a result, by letting management for the first time have 

guidance directly from the SEC on what it should do as a company—not relying on its auditors, but what it should do to assess 

its own internal controls—and to be sure that its style is scaled for 

smaller companies so that their approach needn’t be the same as 

it is for a large company, we think that they will have a very different opportunity than they would have had if they had to comply 

with what I am going to call ′′old 404′′ and ′′old AS 2.′′ after they 

have a year’s experience with that process and after they get to 

watch other larger companies work with the new standard, AS 5, 

then and only then would they be required to file, themselves, financial reports that include as part of the integrated audit a 404 

audit. 

ChairwomanVELA ́ ZQUEZ. Mr. Olson, you don’t see the concern 

coming from small companies regarding compliance with PCAOB’s 

and expenses that they will have to incur in order to comply with 

SEC by the year 2008? 

Mr.OLSON. Well, we do see the concern. I think a number of 

things have been done to alleviate—I think the concern and the 

linkage between the management guidance that the SEC has just 

come out with on their 404(a) and the new audit standard that we 

have done on 404(b) help address that issue. 

11

I think it is very important because the management guidance 

was designed as guidance for management, obviously. And what 

that guidance does is to outline for the management of a company 

that is already very much aware of the internal control environment that they have. And for the companies that already have good 

internal controls, the management guidance will still be that important guidance; but for companies that have postponed taking a 

careful look at their internal control environment, this will tell 

them what management is to do. 

And as you indicated, they will be required to file that a year 

from now. Then the external auditor, which is the standard that 

we have provided—the external auditor will then have until the following year to have completed the audit. 

Part of what was not addressed—and I think that this is part of 

the concern—is that in the AS 2, the AS 2 guidelines which were 

very specific were sometimes taken as the de facto standard for 

management. What the SEC has done now is to give them a much 

more manageable guideline that I think will help address that concern. 

ChairwomanVELA ́ ZQUEZ. Well, let me ask you both, didn’t you 

think that small companies will seek an outside audit opinion in 

order to sign off on the submissions, as requested by the SEC? 

Mr.COX. Of course they will have audited financials. 

ChairwomanVELA ́ ZQUEZ. But you said that, no, the costs will be 

lower since they don’t have to comply until 2009. But in order to 

comply with the report that they have to send to you, they will 

have to seek an outside auditor’s opinion. 

Mr.COX. But that audit, just to be clear, if we are talking about 

2007 and 2008, that audit will not be a 404 audit of the company’s 

internal controls, but rather it will be the financial audit that is 

necessary for all public companies and has always been necessary 

for smaller public companies. 

ChairwomanVELA ́ ZQUEZ. Let me ask you, in your testimony you 

confirm that the new standards will reduce SOX 404 compliance 

costs for small firms. In this afternoon’s second panel, we will hear 

testimony from experts indicating that it is impossible to know 

whether compliance costs will go down until the new standards are 

implemented in a small business environment. 

Can you share with the Committee how you know that the new 

standards will lower compliance costs for smaller companies and by 

how much you expect the compliance costs to decrease? 

Mr.COX. Well, of course the benchmark for measuring any reduction that might be anticipated in compliance costs has to be what 

it costs today to comply. There are companies, including companies 

with a below-$75 million public float that have, for whatever reason, come into compliance early, and those companies provide a 

benchmark. There is absolutely no question that AS 5 is going to 

be more flexible for the reasons that I outlined, more top-down, 

more risk-based, more materiality focused and more scalable than 

it is predecessor, AS 2. 

For all of those reasons compliance is going to be much less costly. The necessity for what I would consider to be redundant, unnecessary or immaterial work will be eliminated. The focus will be on 

what truly matters. 

12

This is not to say that it will be a cost-free exercise. But what 

we are seeking to do is bring the costs more in alignment with the 

benefits. Since this is real work, it is intended to produce real benefits. The investors are paying; the investors deserve those benefits. 

ChairwomanVELA ́ ZQUEZ. But you come here, sir, and you testify 

to the fact that this is going to lower compliance costs, that they 

will go down. In 2003, the Security and Exchange Commission forecast that the average cost of SOX compliance will be $91,000; this 

forecast proved to be a significant underestimate of the actual compliance costs. 

My understanding is that the SEC intends to release the new 

management guidance and auditing standard without a cost estimate. Can you tell us why this is? 

Mr.COX. In fact, the cost-benefit analysis that the law requires, 

that the Regulatory Flexibility Act requires, will be included as 

part of our submission to the Office of Management and Budget, 

which I believe we are making today—if not today, it will be tomorrow. 

And with respect to that 2003 analysis of what SOX compliance 

was expected then to cost, as you know, in 2003 I was a Member 

of the House of Representatives and a member of the Financial 

Services Committee; and like you, I voted for the legislation with 

the understanding that Section 404 would provide great benefits to 

the country and to investors and then would not be unduly burdensome or cause waste. 

The evidence that we have all seen since then indicates that not 

only was that estimate wrong, but I think our estimation as legislators of what was going to happen in consequence of 404, modeled 

as it was on FDICIA, was also in error. And that is why I am so 

firmly convinced that this needs to be changed to bring it into 

alignment with congressional intent. 

ChairwomanVELA ́ ZQUEZ. Well, I am a member of the Financial 

Services Committee, and I do support the spirit of the law. And we 

all know the problems that we saw in terms of corporate America 

scandal. We understand that. 

In my role as the Chair now and ranking when we passed the 

law, I consistently raised the issue about the impact that Section 

404 would have on small companies. The fact of the matter is that 

we have the Regulatory Flexibility Act that requires for agencies 

to conduct a full economic analysis, impact analysis of the regulations. What we have seen and what we have read about the regulatory flexibility analysis that you have conducted, it looks to me 

to have been quite limited; and we are concerned about that. 

So I would like to see if you have more data or information as 

to the regulatory flexibility analysis that you conducted to share 

with this Committee. 

Mr.COX. Well, of course we will share with the Committee any 

analyses that we have that you think would be of interest to you. 

Beyond that, I think it is important to point out that because we 

are staging compliance for smaller companies differently from larger companies who will have to come into compliance in 2008, we 

will have the benefit of that year. And if the Commission learns 

that our estimations are in error, that what we intend to happen 

13

is not what is happening, then we will have the opportunity to consider further postponement of compliance. 

ChairwomanVELA ́ ZQUEZ. I am glad to hear that. 

And now I will recognize Ranking Member Chabot.

Mr.CHABOT. Thank you, Madam Chairwoman. 

And, Chairman Cox, I will begin with you if I can. Would you 

review for us what educational efforts the Commission is undertaking for small businesses to make them more aware of the new 

Sarbanes-Oxley Section 404 compliance requirements? 

Mr.COX. I would be pleased to do that. 

We are right now in, essentially, the planning stages for that effort because we don’t yet have a new standard that is in effect. And 

our management guidance, while it is, as I mentioned, going to be 

404(b), the review will not be completely final for a short while. 

When that occurs and when we can go out and talk about our new 

management guidance and our new audit standard, we intend to 

have a special focus on communicating with small business, not 

only in the usual ways through speech making and our liaison with 

small business, but also through our Office of Investor Education 

and Assistance. 

We hope to prepare brochures that will be specially designed for 

small business to accompany the management guidance, which already was written with small business in mind, meant to be flexible and so on. And I will do everything that I can in a small business friendly way to communicate in ways that small business can 

understand without hiring expert help. 

Mr.CHABOT. Thank you. 

Should the SEC be concerned that some small businesses are deciding to list their stocks on foreign exchanges in order to raise 

capital and avoid compliance with Sarbanes-Oxley Section 404? 

Mr.COX. Yes. There is no question that when companies list in 

the United States that are stronger investor protections. And so to 

the extent that U.S. investors are going to end up owning any of 

these issues, we are all better off from an investor protection standpoint if that activity occurs in the United States. 

So we are focused, as you might imagine, on ensuring that our 

regulations and our entire theme is focused on getting the maximum amount of investor protection with the maximum amount of 

activity in U.S. capital markets. 

Mr.CHABOT. If the Commission prepared a final regulatory flexibility analysis, did it estimate the cost of compliance for small companies seeking to go public? 

Mr.COX. While we do not have a dollar figure attached to that, 

it is, as I mentioned, because we will have the benefit of a year of 

real-world experience before that requirement kicks in. 

Mr.CHABOT. I yield to the chairwoman. 

ChairwomanVELA ́ ZQUEZ. In order to comply with the Regulatory 

Flexibility Act, you have to do a full cost analysis, so where is the 

cost? 

Mr.COX. We did in fact comply fully with the requirements of the 

Regulatory Flexibility Act, including Section 607. 

ChairwomanVELA ́ ZQUEZ. But then you have a cost. What will be 

the cost for small companies to comply? 

14

Mr.COX. Well, all I can tell you beyond that, because I have been 

assured by both the Commission’s counsel and the Division of Corporation Finance that this is the case, that the very same package 

that we are providing to OMB, I believe this day, we will be able 

to happy to provide in real time to the Committee. 

ChairwomanVELA ́ ZQUEZ. And will you commit with this Committee that if it doesn’t have a full cost analysis, compliance will 

be delayed until such an analysis is conducted? 

Mr.COX. Yes, of course; and compliance is already delayed. But 

I will absolutely assure this Committee both today and prospectively that we will be in full compliance with the Regulatory Flexibility Act. 

Mr.CHABOT. Reclaiming my time, Mr. Olson, I will turn to you 

now if I can. 

There is no doubt that the audit standard requires a fair amount 

of exercise of independent accounting judgment by auditors. What 

is the likelihood that the exercise of such judgment will increase 

the cost of audits? 

Mr.OLSON. Congressman, there is an element of accounting judgment that goes into many accounting transactions, and—because 

even as precise as our accounting standards are, there still is a significant amount of judgment it involves. 

The role of the PCAOB when we do the inspections is that we 

look at the manner in which the accounting has been audited. So—

it is the audit component of it that we look at, and so what we do 

is, we look at the extent to which the auditing standards have been 

followed with respect to the accounting, and where we see accounting treatment that we think is questionable, it is at that point we 

refer that to the SEC. 

But—it is the audit component that we look at, but one of the 

reasons, as I think you are pointing out—and it takes a great deal 

of skill to do this—is the fact that there is a lot of judgment required in many of the accounting treatments. 

Mr.CHABOT. Thank you. 

Will the board entertain recommendations from smaller companies and their auditors as they gain experience with the new audit 

standard in an effort to further reduce the cost of the audit standard? 

Mr.OLSON. We meet continuously with the accounting profession, 

with the audit profession, in a number of venues; and our examination process is very dynamic, which is to say that we are changing 

it continuously as we learn more. 

You may remember, as you know, that we are a 4-year-old organization; we have completed 3 full years of doing inspections, and 

it was an inspection methodology that we had to build from 

scratch. So we have been developing that continuously and we have 

been working to improve it continuously. As we have learned more 

and as the environment has changed, and more importantly, as the 

auditing profession has changed, we have changed our approach 

too. 

So the answer to that is definitely ′′yes.′′

Mr.CHABOT. Thank you. I am pleased to hear that, and I would 

strongly encourage the board to take into consideration what the 

15

small business folks and the auditors say as time goes on, as they 

become more familiar with it. 

And so I am glad to hear that. 

Madam Chair, I yield back the balance of my time. 

ChairwomanVELA ́ ZQUEZ. Ms. Clarke. 

Ms.CLARKE. Thank you very much, Madam Chair, for holding 

this hearing today on this very critical issue. We must ensure that 

these new guidelines being discussed today provide small business 

the relief they so desperately need. 

I would like to also just sort of highlight, Madam Chair, your 

focus on the unintended consequences of this timeline that is set 

forth to implement AS 5 and the management guidelines. The rollout is where we really need to focus right now, and I think that 

has been some of what you have been hearing from the Committee. 

Chairman Cox, I wanted to ask that while the SEC approved 

new management guidelines on May 23 to help navigate the burdensome provision of the Sarbanes-Oxley Act, your administration 

said it was not necessary to give smaller companies additional time 

to comply with Section 404. But now it appears, based on your testimony here today, that you are willing to reconsider your decision. 

Can you explain to us, why the sudden change in your position? 

Mr.COX. Well, I don’t believe that I have been articulating different positions. I am merely trying to make it clear that there are 

different timelines in place. 

The management guidance that we are talking about is a separate piece from AS 5, which the PCAOB is talking about. That is 

going to go into effect a year later for smaller companies, so we already have a built-in delay until 2008 for management guidance 

and 2009 for AS 5, the PCAOB’s audit standard. 

And then, in response to the Chairwoman’s question about what 

would happen if we learned as a result of the built-in year of experiential base that we will have looking at AS 5 being utilized by 

our companies, if that doesn’t turn out as we intend, would we then 

consider further extension, the answer to that is absolutely ′′yes.′′

And that has been our view consistently. We expressed that at 

our recent public meeting. I think all the Commissioners are of 

that view. It is expressed in the formal written testimony that we 

provided though this Committee. 

And by the way, because we are a five-member commission and 

that written testimony presented, it has been voted upon and approved by all five commissioners. So I think I speak very much for 

all members of the Commission that is our view. 

Ms.CLARKE. And let me ask, you told Congress that your administration would not require smaller public companies to have a Section 404 audit until the new guideline and the new auditing standard were available. 

Now that you are reconsidering delaying the rules, what standards will you examine to develop effective guidelines for small businesses? Has that been identified? 

Mr.COX. Well, in fact the very guidance that we are talking 

about hasn’t yet gone into effect. No smaller companies yet had the 

benefit of it, and we don’t have any empirical basis to know whether it is achieving its intended result. But very soon we will. And 

we have done our level best at the SEC, and I assure you at the 

16

PCAOB, that people have been working very, very hard on this 

with small business uppermost in mind, to make sure that this, unlike what preceded it, which in the case of the SEC was absolutely 

nothing—there was no guidance for management and people had to 

rely for the guidance on auditors—and in the case of the PCAOB 

was AS 2, that this will be much better and different. 

And so we will soon benefit from all of that from companies that 

have already had to comply with SOX 404. And as I said, I strongly 

believe this is going to result in lower costs for them. That is the 

intent. It should. 

And then a year later, when smaller public companies come on 

line, they should have the benefit of all of that experience and 

knowledge, and we should be very highly confident at that point 

that this is going to work as intended. 

Ms.CLARKE. Well, I would like to suggest, Mr. Cox, that you 

make sure that this Committee is briefed as you go along through 

this process; and that the triggers that are in place to alert your 

agency as to whether there is going to be an undue burden, that 

you closely monitor that. 

I think that SOX 404 is critical. It is very important to the investors and to the public trust. However, we don’t want to sink businesses in the process that are not at a capacity to be able to absorb 

these new regulations in a way in which it will be meaningful for 

their entry into the public arena in providing us with the goods 

and services that we require as a nation. So I hope that you will 

really monitor that very closely. 

Thank you very much, Madam Chair. 

ChairwomanVELA ́ ZQUEZ. Mr. Larsen. 

Mr.LARSEN. Thank you, Madam Chair. 

Just a few questions, Chairman Cox. Glad to have you before the 

Committee. I am sure you are enjoying it as much as we are. 

A quick question; this is certainly related to Mr. Chabot’s question about investor protection versus the listing in foreign exchange 

markets. Are you seeing, assuming it has a relationship to what we 

are dealing with, but maybe not direct, maybe indirect—are you 

seeing a difference between new listings being more predominantly 

focused on foreign exchange markets versus a migration of existing 

public companies? Rather than choosing to enlist here for their initial public offering, choosing somewhere else versus existing public 

companies seeking to raise dollars elsewhere or list separately 

overseas, is there a difference at all in that which you are seeing 

as a result of SOX? 

Mr.COX. Well, the focus has been on IPOs. And of course it is 

much easier to make that election up front. But particularly with 

respect to smaller companies we have not seen a great deal. 

There is no question that the vast majority of offerings occur in 

the United States and not oversees, albeit if one takes a look at the 

percentage changes in overseas markets, such as AIM, you will see 

the trend is up. 

Mr.LARSEN. With regards to the management guidance and AS 

5, I just want to get this straight. 

What exists to ensure that the 404 guidance and AS 5 won’t migrate to companies above the line? That is, we want to ensure that 

small businesses can comply so we are giving them some extra 

17

time. Can we be assured that—obviously we want SOX to be implemented for the reasons we saw a couple of years back; can we be 

assured that no one else is going to come and try to raise that line 

of who has to comply? 

That is, it is going to be focused on small businesses for the 

delay, and as we see this thing test out, can we be assured that 

higher cap companies aren’t going to return and say, well, we want 

in on this too, we want to be delayed too? Because we are seeing 

problems with some of these smaller companies and we experience 

the same delays, can we be assured that the SEC is going to stay 

focused on moving forward with SOX compliance? 

We are really only talking about helping out the small business 

side on this. 

Mr.COX. In fact we were talking about helping out all companies, 

but as you point out, in a very different way. 

With smaller companies it has been through deferral while we 

craft a better, more suitable standard that they could comply with 

in a scalable way. With larger companies they are already in compliance with 404; they have had to comply. And so what we are 

doing for them is changing what had been an overly complicated 

and overly expensive and cumbersome standard to one that is more 

flexible and more focused on the true material risk about which investors care the most. 

And so, in that way, I think that the new standard will benefit 

companies of all sizes. But there is no reason to think that we are 

going to take companies that are already in compliance and tell 

them they can come out of compliance. 

Mr.LARSEN. Thank you, Madam Chair.

ChairwomanVELA ́ ZQUEZ. Mr. Ellsworth. 

Mr.ELLSWORTH. Madam Chairwoman, I don’t have any questions 

for this panel. 

ChairwomanVELA ́ ZQUEZ. I do have more questions. Mr. Olson, 

the Advisory Committee on Smaller Public Companies to the Securities and Exchange Commission and the biotechnology, electronics, 

semiconductor, telecommunications and venture capital industries 

have all recommended that the new standards should include a 

revenue filter. As I understand it, the new standards employ neither a gross revenue number nor an indicator, like product revenue. 

Why did the SEC and PCAOB opt not to follow the recommendations of the advisory committee? 

Mr.OLSON. That is a very good question. We looked at the extent 

to which we could make the standard scalable particularly for 

small business, and as you may recall, in the standard that we 

have produced in December the whole portion on scalability was focused on small business. 

And as we looked at that carefully the debate that went on was 

whether or not—what were the thresholds or what were the 

metrics that would determine whether or not a firm should be in 

one category or another. And what we carefully wanted to avoid 

was having what we would call buckets, that we would pull this 

amount of revenue or this amount of revenue and then have that 

apply to everybody in that category. 

18

What we wanted to do instead was to have a standard that was 

idiosyncratic; that is to say, that could focus on the size and complexity of that individual company. And the manner in which the 

standard is now written, it is part of the auditor’s responsibility to 

define at the outset the extent to which size and complexity impact 

the manner in which they have scoped the audit. 

So I think that in fact we have addressed it in a way that will 

be more applicable to the specific needs and the specific size and 

complexity of the entity itself. For example, I know that there are 

some very small banks, not very many of them, but there are some 

very small banks that have very complex balance sheets, and they 

will take one sort of internal controls. There are also some very 

large companies that are relatively not complex and the control 

structure that they would put in place ought to reflect that. 

With particular respect to the technology industry what you tend 

to get is some very well-capitalized companies that have very low 

revenue. I think for that reason they are saying we in fact should 

be put in a category with some smaller firms. 

In effect, we have done that by the manner in which we have 

redone the scalability section by removing the small business focus 

and making it applicable to entities of all size. 

ChairwomanVELA ́ ZQUEZ. Chairman Cox, would you like to comment on that? 

Mr.COX. Just technically, the SEC has not yet voted on AS5. We 

will have an opportunity after exposure to public comment to do so. 

So far we have been able to collaborate with the PCAOB on drafting it, and I am certainly very familiar with the discussion that you 

just had. 

ChairwomanVELA ́ ZQUEZ. Mr. Olson, since the new standards are 

principle-based and provide flexibility for auditors to employ their 

professional judgment, the standards will create significantly lower 

compliance costs only if they are implemented properly. This 

means that the PCAOB’s efficiency inspectors have a very important role to play if the new standards are to result in lower SOX 

404 compliance cost. 

So my question is how many efficiency inspectors doesPCAOB 

have on staff and what month would the PCAOB begin inspecting 

audited firms’ implementation of the new standards? 

Mr.OLSON. First of all, you are exactly right. In terms of the implementation, it is my sense that we have the words right in the 

new standard and the key to it being more cost effective is the implementation. 

With our inspections of auditing firms, the inspections include 

right now that we look at the efficiency and the effectiveness on the 

audit of internal controls over financial reporting only for those 

companies at this point, of course, that are the accelerated filers. 

The same people do both. And there are about 250 that we have 

in the field right now who are doing those inspections. 

ChairwomanVELA ́ ZQUEZ. Two hundred fifty. 

Mr.OLSON. Two hundred fifty. When we get to the point—and, 

remember, it is the expectation that as the audits are done that 

these will be integrated audits, so the audit of internal controls and 

the financial audit will be done in an integrated fashion. So it is 

19

important as we look—as we go out and do the inspections that we 

are looking at both simultaneously. 

We would like to have in the area of 300 or so inspectors. We 

think at that level we will have a full complement. That is not exactly a fungible commodity out there, people with audit experience, 

so we are having trouble finding enough good people. 

ChairwomanVELA ́ ZQUEZ. Chairman Cox, both the PCAOB and 

SEC have used the term ′′right size′′ to describe what the recent 

revisions will do to audits. What is meant by this term and what 

do you envision a success? 

Mr.COX. This is related to the discussion that the Chairman and 

Madam Chairwoman just had about complexity. Companies come 

in all different shapes and sizes. The check-the-box mentality was 

thought to be the Achilles heel of AS2. AS5 takes a completely different approach. Our guidance for management takes this same 

principle-based approach and also permits reliance on judgment, 

reliance on the work of others. It permits focus on materiality, on 

things that truly matter to the financial statements. 

By focusing on the control environment of a particular company 

and making sure that what management understands it is tasked 

to do is to assess its internal control system, not to design an internal control system that is reverse-engineered for the audit, it is 

going to make a big change. 

ChairwomanVELA ́ ZQUEZ. What do you envision a success? How 

would you measure it? 

Mr.COX. In two ways. We hope to get higher-quality financial 

statements because we are focusing on the jugular and no longer 

focused on the capillary. We are also hoping to reduce the cost of 

compliance. This is not alchemy. 

ChairwomanVELA ́ ZQUEZ. But you don’t have the cost yet, the cost 

of compliance, do you have it? 

Mr.COX. We certainly have current costs and we will very quickly 

have empirical evidence about costs under the new standard and 

the new guidance. 

ChairwomanVELA ́ ZQUEZ. I am sorry; what was your answer 

about the fact that you don’t have a cost for compliance? 

Mr.COX. It is our estimate that costs will be significantly lower 

for the reasons that we described. The precision of our estimate is 

going to be in the putting, if you will—that is to say, since companies are already in compliance with a standard that we believe is 

more difficult than what we are replacing it with, there is no one 

who has worked on this that doesn’t believe that costs ought to 

come down. This is the purpose of the exercise. 

ChairwomanVELA ́ ZQUEZ. If it doesn’t come down? 

Mr.COX. Then of course we will revisit it immediately. 

ChairwomanVELA ́ ZQUEZ. What would be the time line for that? 

Mr.COX. With respect to smaller companies, which I know you 

are focused on intently in this Committee, the point of having an 

opportunity to look at this for a year first is so that we will have 

the benefit of that experiential base. 

ChairwomanVELA ́ ZQUEZ. Okay. Any other member has a question? Mr. Chabot. 

20

Mr.CHABOT. Thank you, Madam Chair. In the interest of getting 

to the next panel I will just have one final question here, and either or both of the witnesses could answer if they want to. 

Do you believe that the audit standard places the proper emphasis on fraud risk, or should the standard be further amended to impose a greater focus by the auditors on fraud risk? Either one or 

both are welcome. 

Mr.OLSON. Congressman, one of the significant revisions that we 

made in the final draft was to move up within the standard itself 

the focus on fraud risk, because we think that is very important 

and we wanted to make sure that the standard highlighted the procedures that they ought to be taking in order to attest for fraud 

risk exposure. 

So I think with respect to the audit component of it, have given 

it appropriate priority in the standard. 

ChairwomanVELA ́ ZQUEZ. I have a last question for Chairman 

Cox. Next month when the SEC receives public comments on AS5, 

e small business community will be able to comment on the proposed new auditing standard. So what input will be most likely to 

encourage you to support a further extension of the SOX 404 compliance for small companies? 

Mr.COX. I think that input would have to be in parallel with 

comments on AS5 because AS5 doesn’t contain the schedule. I honestly don’t want to tell the small business community what they 

should be telling us. I think our point is we need to listen, we need 

to be attentive to what they have to say. But we will be. I think—

ChairwomanVELA ́ ZQUEZ. And you will be listening. 

Mr.COX. The important thing is that we are taking this very, 

very seriously because we know, not only for companies that are 

already public but for companies that have no publicly traded 

shares and no IPO plan, their ability to raise capital near term is 

in some measure a function of investors’ sense that someday they 

will be able to tap the public markets. So for companies of all sizes, 

not just those on the verge of an IPO, this is really important, and 

we understand that. 

ChairwomanVELA ́ ZQUEZ. Any other member? 

Mr.CHABOT. Madam Chair, one final question. Sorry. Mr. Cox is 

now obviously the head of the Securities and Exchange Commission, but before—as you mentioned—that, he had a distinguished 

career here in the House of Representatives. I’m curious: Is it more 

fun to be up here asking the questions or answering them? You 

don’t have to answer that but you are welcome to. 

Mr.LARSEN. I am sure it is a great pleasure for him to be here 

answering our questions. 

Mr.COX. Well, you gave me the option of not answering. I will 

say being invited to a congressional hearing and offered the opportunity to not answer questions is truly enjoyable. 

Mr.CHABOT. Thank you. I yield back. 

ChairwomanVELA ́ ZQUEZ. No other member has any comment or 

question. Then the first panel is excused and I want to thank both 

Chairmen Cox and Olson for their time, and I welcome you back. 

I especially remind you, once again, the answers that we are expecting regarding the Regulatory Flexibility Act, full cost analysis, 

it is important for us too. 

21

With that, I excuse the first panel. 

I will ask the second panel of witnesses to take their seats and 

the hearing will resume shortly. 

[Recess.] 

ChairwomanVELA ́ ZQUEZ. We are going to resume our hearing. I 

want to welcome you all and thank you for your patience. 

So our first witness is the Honorable James C. Greenwood. He 

is President and CEO of the Biotechnology Industry Organization 

in Washington, D.C., which represents more than 1,100 biotechnology companies. Prior to that he represented Pennsylvania’s 

Eighth District in the U.S. House of Representatives from January 

1993 through January 2005. While serving in Congress Mr. Greenwood was a leader on health care issues, authoring numerous bills 

signed into law, including legislation to promote pediatric labeling 

for pharmaceuticals and reform medical device review and approval. You are welcome. It is good to see you back here in the 

House of Representatives. You will have 5 minutes to make your 

presentation. 

STATEMENT OF JAMES C. GREENWOOD, PRESIDENT AND CEO, 

BIOTECHNOLOGY INDUSTRY ORGANIZATION (BIO) 

Mr.GREENWOOD. Thank you very much. Chairwoman Vela ́zquez, 

Ranking Member Chabot, and other members, I thank you for providing the opportunity for us to testify before you today on reforms 

to the Sarbanes-Oxley section 404 adopted by the Securities and 

Exchange Commission and the Public Company Accounting Oversight Board. 

I am Jim Greenwood, President and CEO of the Biotechnology 

Industry Organization. I am privileged to be here today on behalf 

of BIO, an organization, as the Chairwoman said, of more than 

1,100 biotechnology companies, academic institutions, and other organizations in all 50 U.S. States and 31 nations. 

The promise of biotechnology is immense, as our members combine in biology and technology to deliver new treatments for unmet 

medical needs, improved crops that are more drought-resistant and 

have reduced environmental impact and create cheaper, more environmentally friendly fuels and consumer products. Biotech is one 

of the most innovative, high-growth sectors of our Nation’s economy 

and one in which the United States maintains global leadership. 

First, I would like to start by providing a short answer to the 

Committee’s question posed in the title of this hearing as to whether or not we believe the SECs and PSAOB’s new standards will 

lower compliance costs for small companies. In summary, it is a 

marginal ′′yes.′′ as this Committee well knows, it has been the implementation of section 404 that has gone awry. 

The situation that many emerging biotech companies face is that 

funds that would be otherwise spent for core research and development of new therapies for patients are instead having to be used 

for overly complex controls or unnecessary evaluation of controls. 

As a conferee for this legislation in 2002, I know it was not intended to be a windfall for auditors nor pile on the compliance 

costs for small companies. 

The scale of the problems that section 404 has created suggest 

that Congress should closely monitor the implementation of these 

22

revisions to ensure that its original intent is achieved. It is critical 

to ensure that these new rules provide the greatest possible flexibility and scalability for small public companies. 

For most biotech companies, the actual cost of section 404 compliance, including both internal cost as well as external auditor 

costs, are substantial. In fact, the opportunity costs of section 404 

for smaller companies can be even greater, impeding the ability to 

invest in and, in some cases, to continue critical research and development activities for treatments of an array of diseases from 

cancer to multiple sclerosis. 

The current problem with section 404 are not merely growing 

pains. Current implementation of section 404 imposes the same requirements, steps and reviews by the same individuals year after 

year. The Commission and the PCAOB have taken steps to address 

the problems that have manifested in the implementation of section 404. Both agencies suggest that these new requirements are 

to be scaled, risk-based, and flexible. While the SEC’s final guidance is not yet public, we hope that it will provide a more flexible 

principles-based set of rules for management. On the other hand, 

the new standards adopted by the PCAOB could still be improved 

to enhance flexibility and auditor judgment. 

Furthermore, one could fairly say that in its revisions to its initial December 2006 draft, the PCAOB has actually taken a step 

backward. 

Included in both the Commission’s and the PCAOB’s draft proposals were objective measures auditors could use in determining 

what is a smaller company, mainly one with a market capitalization of less than $700 million and reported annual revenues of 

$250 million or less. This was consistent with the recommendation 

of the Advisory Committee of Small Public Companies. Who suggested that an objective test, particularly a revenue filter, be used 

as a tool to define a smaller public company than scaling the audit. 

Unfortunately, this definition of the small company has been removed from the final PCAOB-adopted rule. 

Rather than maintaining the proposed objective definition of a 

smaller company and then expanding it to include the subjective 

criteria that could also be applied to parts of larger companies, an 

approach which BIO supports, the PCAOB removed the objective 

criteria altogether, and that is our largest complaint. By eliminating any reference to market capitalization or annual revenues, 

the PCAOB has taken away the only objective criteria for 

scalability included in the rule. In doing so, PCAOB appears to 

have moved from the presumption that a company meeting those 

thresholds is a small company that should be subjected to a scaled, 

less burdensome audit, to a presumption that every enterprise 

should be subject to the fullest, most comprehensive audit, unless 

the auditor determines otherwise using the subjective criteria in 

the rule. 

As a result of this change BIO believes that the new standards 

may do less than the PCAOB’s initial December 2006 revisions to 

counterbalance the incentives for auditors to be overzealous in 

their work. Consequently, while we were hoping for greater relief, 

it is now clear that PCAOB rules will lead to substantially lower 

audit fees or reduced burden on emerging biotech companies. 

23

BIO has consistently advocated for scalability indicia that are 

most reflective of complexity, and we still believe that both the 

SEC and the PCAOB should recognize product revenue as an important indicator of complexity. 

In addition, BIO member companies have raised concerns that 

after changing auditors they experience new interpretations of material weakness. Even within the context of a principles-based approach to auditing, some further clarification on this guidance is 

needed. BIO believes that clarification in the PCAOB-adopted rule 

should accomplish this. 

Lastly, we strongly believe that a rigorous economic study of the 

costs and benefits associated with the implementation of section 

404 is imperative to understanding if the current reform proposals 

are meeting the objectives, and I believe that the SEC analysis is 

qualitative and not quantitative, in answer to the Chairwoman’s 

questions. We urge the SEC to provide an additional exception for 

non-accelerated filers. The Commission has the ability to make the 

much needed changes that we have mentioned. 

In conclusion, BIO appreciates the efforts that both agencies 

have taken to improve SARBOX implementation. It is unclear, 

though, whether these reforms will fully match the rhetoric surrounding their adoption. However, we remain hopeful that this is 

just the first of several steps that both the PCAOB and the SEC 

will take in reducing the unnecessary burdens of Sarbanes-Oxley 

on America’s emerging and innovative companies. 

I thank you for your time and your consideration of BIO’s views 

and I would be happy to answer any questions. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

[The prepared statement of Mr. Greenwood may be found on 

page 75 of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Our next witness is Diane CaseyLandry. She is President and CEO of America’s Community Bankers, a national trade association committed to strengthening the 

competitive position of community banks. Prior to joining ACB in 

2000, Ms. Casey-Landry served as Principal and National Director 

of Financial Services for Brand Thorton LLP. Her past experience 

also includes serving as Executive Director of the Independent 

Community Bankers of America, and as a bank examiner for the 

Federal Reserve Bank of Cleveland. 

Welcome, and you have 5 minutes. 

STATEMENT OF DIANE CASEY-LANDRY, PRESIDENT AND CEO, 

AMERICA’S COMMUNITY BANKERS (ACB) 

Ms.CASEY-LANDRY. Thank you, Madam Chairwoman Vela ́zquez 

and Ranking Member Chabot and members of the Committee. 

I am Diane Casey-Landry, President and CEO of America’s Community Bankers. Thank you for holding this very important hearing today and for the invitation to appear today to present to you 

our views on section 404 of the Sarbanes-Oxley Act and the recent 

changes on the management guidance and auditing standards 

made by the SEC and the PCAOP. 

America’s Community Bankers is the national trade association 

for the Nation’s community banks of all charter types and sizes. 

24

Our members represent $1.7 trillion in assets, they are located 

across this country and they are both stock, public and private, as 

well as mutually owned institutions. 

Sarbanes-Oxley was a well-intentioned law, and ACB has also 

supported strong internal controls under the banking laws and regulations. No other publicly traded company is subject to the same 

scrutiny as a publicly traded bank. Because banks have been governed by numerous internal control reporting and assessment requirements long before Sarbanes-Oxley became law, this creates 

both unnecessary and duplicative burdens on the banking system. 

The FDIC Improvement Act of 1991 dictates bank management’s 

responsibility for financial statements and internal control assessments and attestations. This law actually served as the model for 

section 404. However, the implementation of 404 has been much 

more costly and burdensome. 

As a meaningful reduction of this burden, ACB is supporting 

H.R. 1508, which has been introduced by Representatives Greg 

Meeks and Tom Feeney, which would create an exception from Sarbanes-Oxley section 404 based on a company’s size. We are also 

supporting, similarly, the provision in H.R. 1869 which would relieve community banks with up to $1 billion in assets from the 

costly internal controls attestation reports of Sarbanes-Oxley, a 

similar change which was made by the FDIC 2 years ago for the 

FDICIA banks and which ACB had requested. 

We applaud the efforts of both the Commission as well as the 

PCAOB to improve the implementation and reduce the compliance 

costs of section 404 through this principles-based approach. We are, 

however, very disappointed that the SEC decided against a further 

extension of the compliance states for non-accelerated filers despite 

several requests for such a delay, including one from this Committee. Accelerated filers have had 3 years of experience with the 

implementation process and they are the best able to incorporate 

changes brought about by the SEC and the PCAOB’s recent action. 

Community banks that are non-accelerated filers are very much 

concerned about the cost and burdens of compliance. Non-accelerated filers are the very companies that can least afford to add personnel, consultants and systems to comply with section 404. This 

is particularly true if the Commission’s new management guidance 

and the PCAOB’s revised auditing standards prove unsuccessful in 

reducing the costs and other burdens associated with implementing 

section 404 as a result of the actions by the accounting firms who 

have to implement these changes. 

With the filing deadline just 6 months away, we remain hopeful 

that additional consideration for a reasonable 1-year extension be 

given on this important issue. We are also calling upon the Commission to update the Exchange Act threshold for registration OF 

a public company from the 500 shareholder level that was first imposed in 1964. Changes in market composition and participation illustrate a need for the threshold to be moved to a much higher 

range in order to provide overdue regulatory relief for smaller companies that choose to be public but choose not to be listed on an 

exchange. 

Much has been said about the impact section 404 has on our capital markets and on our Nation’s ability to compete, and the situaVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
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tion is really very grim from the standpoint of small companies. 

Section 404 compliance costs have caused many companies to either remain private or to consider going private because the costs 

associated with being a public company outweigh the benefits. For 

community banks, mergers and acquisitions are frequently motivated by regulatory burden and they often cite section 404 of Sarbanes-Oxley. 

For example, as of today, the America’s Community Bankers 

NASDAQ index is comprised of 517 banking companies. It has a 

market capitalization of $193 billion. Every year since the index inception in 2003, approximately 50 companies have left the index 

primarily because of mergers, but also because of delistings. ACB 

has estimated that as many as 20 percent of the departures each 

year from the index are because of a decision to delist, triggered 

primarily by efforts to reduce burdens created by Sarbanes-Oxley. 

And when community banks disappear, local communities lose. 

Notwithstanding the importance of internal controls, there must 

always be balance with the costs and burdens imposed on smaller 

public companies, and part of achieving this goal is to reduce the 

amount of unnecessary regulatory burden hampering the ability of 

small companies and small community banks to compete domestically. 

I very much appreciate the opportunity to appear before you 

today and for your continued work on this important issue and I 

would be pleased to answer any questions you will have. Thank 

you very much. 

ChairwomanVELA ́ ZQUEZ. Thank you very much. 

[The prepared statement of Ms. Casey-Landry may be found on 

page 84 of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Our next witness, Mr. Hal Scott. He is 

the Nomura Professor of the Program on International Financial 

Systems at Harvard Law School. He teaches courses on international finance and securities regulation. Professor Scott is the director of the Committee on Capital Markets Regulation and past 

Governor of the American Stock Exchange. Before joining the Harvard faculty, Professor Scott clerked for Justice Byron White. Welcome, sir. 

STATEMENT OF HAL SCOTT, NOMURA PROFESSOR, DIRECTOR 

OF THE PROGRAM ON INTERNATIONAL FINANCIAL SYSTEMS, HARVARD LAW SCHOOL 

Mr.SCOTT. Thank you, Madam Chairwoman, Ranking Member 

Cabot, and members of the Committee. Thank you for giving me 

the opportunity to testify on this important issue on behalf of the 

Committee on Capital Markets Regulation which I will refer to, 

just to make it clear that it is our committee versus your Committee, as the CCMR. 

I would ask that my full written statement be incorporated into 

the hearing record. 

The CCMR is independent and bipartisan, composed of 23 corporate and financial leaders drawn from the investor community, 

business, finance, law, accounting and academia. CCMR issued its 

interim report on the state of the U.S. public equity capital marVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
26

kets on November 30th 2006. The CCMR’s purpose is to explore a 

range of issues related to maintaining and improving the competitiveness of U.S. capital markets. 

In my remarks today I would like to make three central points: 

First, the debate over section 404 is a debate about the health 

and future of small business as much as anything else, because the 

costs of compliance, as you well know, fall hardest on those entities 

least able to afford them. This issue is about Main Street, not Wall 

Street, and it is important that you are focused on that. 

Second, you are right to press on the questions of costs of compliance. As I will explain in a moment, neither we nor the SEC or 

PCAOB know the answer to your question, and that is a big problem if we are regulating in the dark on something so central to the 

U.S. company. 

Third, there is an action that the SEC can take that would be 

helpful here. It should again delay applying both its rules and the 

PCAOB’s rules to small business so we can develop a stronger factual record on the question of cost. 

There is no denying that the costs of section 404 have been significant. According to the Financial Executives International, on a 

per-company basis SOX implementation costs are 4.4 million in the 

first year, 3.8 million in the second year, and 2.9 million in the 

third current year. 

Despite the trend downward, 78 percent of the 200 executives 

surveyed by FEI said the cost of SOX section 404 still outweigh the 

benefits. 

Recent actions by the SEC and PCAOB are a mixed bag. On the 

positive side, certain important improvements have been made that 

were called for by our committee. We strongly support a top-down, 

risk-based approach that allows auditors and management to make 

use of their judgment in tailoring their evaluations of controls to 

the individual circumstances of companies they audit, so-called 

scalability. 

We support eliminating the requirement for an auditor to examine management’s evaluation process. We support the increased 

flexibility provided for auditors to rely upon the work of others and 

to limit the testing of low-risk controls. Finally, we also commend 

the PCAOB’s focus on fraud controls. 

While we are supportive of these actions, we remain very concerned about something that the agencies should have done but 

have not. They have failed to provide a quantitative standard for 

material, as applicable to both section 404 and financial statement 

audits. Our committee recommended that materiality for scoping 

an assessment should be defined as it was traditionally, in terms 

of a 5 percent pretax income threshold. This standard will be consistent with the overall risk-based approach advocated by both the 

SEC and the PCAOB. In cases where the 5 percent test would not 

be meaningful, the agency should allow companies and their auditors to exercise their reasoned judgment. 

We are very concerned that without a presumptive quantitative 

standard, the costs of compliance with section 404 will not be sufficiently reduced. 

Our committee also recommended the completion of a thorough 

cost-benefit analysis before the revised standards were applied to 

27

small companies. This the agencies have not done. Instead they intend to apply the new standards to all companies, big and small, 

at the same time: 2008, the management standards; and 2009 for 

the auditing standards. 

To our way of thinking it is a real problem that no real cost-benefit analysis has been done for any companies, at least as part of 

the proposal. This appears inconsistent with the requirements of 

Sarbanes-Oxley and Administrative Procedures Act, as explained in 

more detail in my written testimony, as well as sound public policy. 

With all due respect, it is not sufficient for the SEC to release 

a cost-benefit analysis with apparently no empirical evidence after 

adopting its rule. If the agencies were to begin by only applying the 

standards to companies over $75 million in capitalization savings, 

they could field test for the cost of the standards—I know I am 

running over my time, I will wrap up shortly. They could field test 

for the cost of the standards to the smallest of these large companies, for example, those between 75 to 100 million in market capitalization. This could give us a good idea what the cost would be 

for even smaller companies. 

Bear in mind that for small companies that have been not yet 

required to apply section 404, a key issue is how much the new 

standards will bring down first-year costs. Historically, $4.4 million. 

Our committee found that a substantial portion of the 404 costs, 

as high as 75 percent, were due to the management’s implementation of 404. Thus, these costs are not avoided by only deferring to 

the PCAOB auditing rule. The SEC’s management rule goes into 

effect this year for 2008 statements. 

In our view, if the SEC determines the benefits justify the cost 

after field testing, the results of this determination, both for management and for auditor implementation, should be made public as 

part of a rulemaking procedure so that we all have a chance to see 

what the data is and to comment on it. Everyone— companies, 

Congress and the public—is entitled to know and comment on what 

the cost reductions would be. 

By the way, Madam Chairwoman, one further thought. You 

made the point, and I think quite insightfully, that it raises a significant problem to implement the management part of the 404 before we implement the auditing part, because this puts the management of these small companies in a position of having to certify 

with high liability without the comfort of an auditor review. I don’t 

think this is a tenable situation for the management of small companies to be in. Thank you very much. 

ChairwomanVELA ́ ZQUEZ. Thank you, Professor Scott. 

[The prepared statement of Mr. Scott may be found on page 93 

of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Our next witness is Mr. Mark Heesen. 

He serves as President of the National Venture Capital Association. Since joining NVCA in 1991 he has worked on behalf of 

NVCA’s 480 member companies to demonstrate the positive impact 

of venture capital investment on the United States economy. Prior 

to coming to the NVCA Mark was an aide to a former Governor of 

Pennsylvania. Who was that? 

28

Mr.HEESEN. Dick Thornburg, many, many years ago. 

ChairwomanVELA ́ ZQUEZ. Welcome. 

STATEMENT OF MARK G. HEESEN, PRESIDENT, NATIONAL 

VENTURE CAPITAL ASSOCIATION (NVCA) 

Mr.HEESEN. Thank you very much. Good afternoon. 

Venture-backed companies accounted for 10.5 million U.S. jobs and $2.5 trillion in revenues in 2006. Venture-backed companies 

such as Google, Genentech, Starbucks, FedEx, Intel and Microsoft 

were all once small and privately held, waiting for the opportunity 

to go public. Today the next Microsoft is waiting, but has yet to go 

public because of burdensome SOX compliance. 

In 2006 there were only 57 venture-backed IPOs on U.S. exchanges but there were also 17 venture-backed IPOs on foreign exchanges, something unheard of before Sarbanes-Oxley. What is 

even more concerning is that what we are now seeing is that companies that are viable U.S. IPO candidates are deciding to be acquired instead of going public, mainly in an effort to rid themselves 

of the SOX burden. 

Imagine if Google had been acquired by Microsoft or if Genentech 

had been acquired by J&J. Perhaps the innovation would have survived, but the market value, the jobs, the revenues all would have 

been diluted substantially. 

We commend the SEC for its recognition of the SOX problem, yet 

we do not believe that the combined SEC and PCAOB guidance 

goes far enough to effect the necessary changes to relieve the SOX 

burden for our smaller companies. We believe that three drivers 

are critical in this regard: 

First, we are gravely concerned that the accounting profession 

will not change its high-cost practices and the guidance provided 

by both the SEC and the PCAOB regarding materiality is not specific enough to compel them to do so. 

Second, the algopathy that exists for 404 audits leaves no choice 

for small companies in terms of service providers. 

Lastly, because of these first two concerns it is imperative that 

prior to adoption all proposed measures are fully field tested to confirm that they indeed will reduce costs. 

One area of guidance that we have had significant concern about 

is the determination of what is material to sound financial reporting. The original SOX language set the probability threshold extremely low. Any area in which there was, quote, more than a remote likelihood, unquote, for an error to result in a material mistake on the financials was required to be examined, documented 

and reported to the company’s audit company. This language comprised just about everything. 

Proposals put forth by both the SEC and PCAOB suggest changing this language to, quote, reasonable possibility, unquote. This 

general statement does nothing to distinguish itself from the original language, leaves everything open to interpretation, and will do 

little to reduce costs. 

Although we support the move to enact principles-based guidance, we feel there should be an objective threshold if we are going 

to properly balance risk and cost. Since SOX was enacted, the relationship between the Big Four accounting firms and ventureVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
29

backed companies has become increasingly problematic. Many of 

our small companies have lost the attention of their Big Four auditors, who are favoring larger public companies that offer lucrative 

404 auditing engagements. Those who do maintain their Big Four 

relationships do so at a 404 cost that averages close to a million 

dollars annually. 

As Sarbanes-Oxley allows only for accredited accounting firms to 

complete 404 audits, our companies are basically held hostage to 

this oligopoly. We would not have these concerns if we had any 

comfort level that the Big Four accounting firms support SOX reform, but the profession has publicly warned the supporters of reform that, quote, they shouldn’t expect a dramatic reduction in 

costs, unquote, with the adoption of these proposals. Anecdotally, 

our members are already being told by their auditors don’t expect 

much, if any, savings in audit fees from the proposals as they are 

presently written. 

While one would believe that private companies can bypass the 

Big Four and engage a second-tier accounting firm, this is frankly 

not a viable option. Investment banks that take these companies 

public or sell them require a Big Four audit as a sign of a clean 

bill of health. There is no competition. 

The SEC should allow and Congress should support the ability 

of accredited accounting professionals beyond the Big Four to perform 404 attestations. By doing so we will create a healthy, competitive ecosystem where the market will set the right place for 

services rendered. 

Despite an urgent need for reform we will ask today that the 

SEC move forward cautiously while formalizing the proposed guidance. Blindly adopting recommendations without field testing them 

first would be akin to a venture capitalist purchasing a company 

without doing due diligence. Field testing ensures that, one, the 

recommendations will indeed reduce costs; two, all the players, including the accounting profession, are operating in the spirit of reform; and three, that there are no unintended consequences. 

Field testing will also allow the SEC to make the adjustments as 

necessary without having to reopen a new process. Let’s prove that 

reform works before declaring victory. 

In conclusion, we are really at a critical inflection point. The good 

work of all involved will be for naught if the accounting profession 

does not get on board with cost reduction or if implementation of 

these proposals fail. Taking the time to field test and placing the 

needed pressure on the Big Four to join the effort is required. We 

have waited way too long for this reform to take place, but we are 

willing to wait longer to make sure reform is right. 

Thank you very much. 

ChairwomanVELA ́ ZQUEZ. Thank you, Mr. Heesen. 

[The prepared statement of Mr. Heesen may be found on page 99 

of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Our next witness is Mr. David 

Hirschmann. He is the Senior Vice President of the U.S. Chamber 

of Commerce and President of the U.S. Chamber Center for Capital 

Markets Competitiveness. Mr. Hirschmann is a member of the U.S. 

Chamber’s management committee and in this position helps shape 

30

the strategic direction of the world’s largest business federation, 

representing more than 3 million businesses. Prior to joining the 

U.S. Chamber in 1992, Mr. Hirschmann worked as a legislative director for former Congressman Toby Roth. You are welcome. 

STATEMENT OF DAVID HIRSCHMANN, PRESIDENT, U.S. CHAMBER CENTER FOR CAPITAL MARKETS COMPETITIVENESS, 

U.S. CHAMBER OF COMMERCE 

Mr.HIRSCHMANN. Thank you, Chairwoman Vela ́zquez, for having 

me here today, Ranking Member Chabot, and members of the Committee. I want to join the fellow panelists on this Committee in 

commending you for holding the hearing and I would like to make 

really four points: 

First, we welcome the changes that the SEC and the PCAOB 

have made to try to reflect in their rules what Congress intended. 

We view the PCAOB’s new auditing standard as well as the SEC’s 

guidance for management as significant steps forward. 

We do think Chairman Cox and the Commission and Chairman 

Olson and the Board should be commended for the leadership effort 

they are putting in and we believe they are trying to get it right. 

However, we will only know these efforts have been successful after 

we see how they are implemented by the auditors and companies 

and enforced by the PCAOB. 

Third, until we have a full year of experience, we agree with others who have called for a delay in implementing the new rules. We 

believe it would be a mistake to make small businesses the guinea 

pigs for the application of these new rules. 

It is important to remember that these rules are in place for fiscal years that are currently running. In other words, they are going 

to apply to activities that have happened in companies already for 

5 months; and management and the accounting staff, which is very 

limited in small companies, are having to prepare already for an 

activity, even though they won’t file the reports the next year, it 

is for things that are currently happening. So in a way, small businesses are already having to comply with rules that have not even 

been published. This is profoundly unfair and sets up a train wreck 

because, at the end of the day, the SEC won’t know why it failed, 

if it does fail, and we hope it doesn’t. They won’t know if it was 

because the calendar they put in place was unworkable or the new 

rules themselves have not achieved the job. We think this is an 

avoidable train wreck that can be handled by a further delay. 

Fourth, we urge Congress and the SEC to work together to address the additional critical issues that are making it harder and 

harder for leaders of smaller public companies to access the capital 

markets in order to grow their businesses and create jobs. The 

Chamber strongly supported many of the reforms in SarbanesOxley, including more active and independent boards and board 

committees. Effective internal controls are an essential part of good 

financial governance for all companies. However, the implementation of section 404 has led to costs and compliance burdens which 

are far beyond what Congress intended and well in excess of any 

benefits that can be accrued to shareholders and management. This 

is amplified among smaller public companies to the economies of 

scale. 

31

Companies feel they are getting less effective advice from their 

auditors, and auditors are increasingly being second-guessed by 

their new regulator and the trial bar. The result is predictable. 

Companies increasingly find the cost of being a public company 

outweigh the benefits. 

For well over a century this has been the greatest country on 

Earth for entrepreneurs and innovators to access low-cost capital 

to start and expand a business. Transparent and liquid markets 

have been a key part of this. 

The flawed implementation of Sarbanes-Oxley section 404 has a 

disproportionate impact on the cost of capital for small businesses 

that have already had to comply. For example, a $1- to $2 million 

compliance price tag is an enormous burden for companies that 

have $3 million in net income. Literally, we have heard from companies that are forced to choose between providing health care to 

their employees, buying new equipment, investing in R&D, or complying with section 404. That is an impossible choice to put a growing company through. 

As Chairman Cox has noted, Congress never intended for the 404 

process to become inflexible, burdensome and wasteful. The Chamber has consistently called for a series of changes to fix SarbanesOxley 404, clarifying the terms such as material weakness, significant deficiency and materiality, ensuring that the rules are both 

risk-based and scalable, allowing for greater use of the work of others, providing specific guidance for IT systems and controls. We believe the SEC and PCAOB have tried to address each of these 

areas and others; however, we remain concerned about the extent 

to which the new standards will improve on-the-ground implementation. 

We also understand that SOX 404 has become somewhat of a 

catch-all term to refer to a broader set of issues facing public markets and smaller public companies in particular. U.S. companies 

are facing changing retroactively applied accounting rules that are 

ever-increasing in complexity. As a result one in ten public companies is forced to restate their earnings last year. This system is not 

working for companies, for investors and for auditors. 

America’s securities class action litigation system is broken. It 

provides an inadequate compensation to injured parties without deterring future wrongdoers. It fails to protect small, undiversified investors who seldom receive more than pennies on the dollar, while 

attorneys on both sides rake in millions of dollars in fees. The system is not working, and security regulators struggle to keep up 

with the speed of technology changes in today’s rapidly changing 

markets. The system is not working and our Nation is losing a key 

competitive advantage much. 

The challenge is clear and the voices are growing. We need to 

work together to ensure that U.S. capital markets remain the fairest, most efficient, transparent and attractive in the world. 

Chairman Vela ́zquez, Ranking Member Chabot, I thank you for 

the opportunity to discuss these issues and for paying such serious 

attention to such important issues as capital formation in our country. 

ChairwomanVELA ́ ZQUEZ. Thank you, Mr. Hirschmann. 

32

[The prepared statement of Mr. Hirschmann may be found on 

page 104 of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Now I recognize Ranking Member 

Chabot for the purpose of introducing his constituent. 

Mr.CHABOT. Thank you very much. I have the distinct honor to 

recognize our next witness who is actually from my congressional 

district in the city of Cincinnati. It is Richard G. Schmalzl who is 

with Graydon Head & Ritchey, which is one of the top law firms 

in our area. He got his law degree, J.D., from the University of Virginia School of Law and LLM from Georgetown University Law 

Center. He is a partner with the firm, as I mentioned, of Graydon 

Head & Ritchey which is in Cincinnati, Ohio. Mr. Schmalzl serves 

as co-chair of the firm’s Business and Financial Client Service Department. His law practice has an emphasis on securities law, 

mergers and acquisitions, private equity, venture capital, corporate 

governance. Mr. Schmalzl’s recent publications include an article 

entitled ′′Sarbanes-Oxley: Coming Soon To Your Family Business.′′

we welcome you here this afternoon, Mr. Schmalzl. 

STATEMENT OF RICHARD SCHMALZL, PARTNER, GRAYDON 

HEAD & RITCHEY LLP, CINCINNATI, OHIO 

Mr.SCHMALZL. Good afternoon, Madam Chairwoman Vela ́zquez, 

Ranking Member Chabot and members of the Committee. Thank 

you for inviting me to testify on the new 404 standards. 

My name is Dick Schmalzl and I have practiced securities laws 

for 25 years, primarily in Cincinnati, Ohio. I work closely with 

large and small public companies in a variety of industries. In recent years I have been on the front line with CEOs, CFOs and 

boards of directors in helping them become Sarbanes-Oxley compliant. I hope the Committee will find my real-world experiences helpful to your consideration. 

The views I share with the Committee today are my own views 

and should not be attributed to my law firm, Graydon Head & 

Ritchey, or to any client of my law firm. 

I will address three primary topics: One, the most significant 

problems that 404 has caused for public companies, particularly 

small public companies; whether the new standards are likely to effectively address those problems; and thirdly, to urge the Committee to continue to evaluate the bigger picture of whether 404 is 

serving its intended purposes. 

My first topic is—I want to emphasize for you based on my firsthand experiences—the three most troubling real problems that 404 

has caused. 

First, as you well know, public companies are experiencing at 

least a doubling of out-of-pocket audit costs. We all know, and it 

has been well documented, these costs are disproportionately burdensome to the smaller public companies. 

The second problem that sometimes doesn’t get as much attention is substantial internal human resources must be devoted to 

404 compliance. This is especially problematic for smaller companies who, even though they have highly qualified CFOs as controllers, these persons must also play key roles in operating and growVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
33

ing their businesses. Compliance takes away from their ability to 

enhance shareholder value. 

The third problem is that 404 has been a major contributor to 

a deteriorating relationship between public companies and their 

independent outside auditors. If companies have to ask their auditors for advice on how to account for certain items, the simple act 

of asking the question has raised the risk that the company would 

be deemed to have a material weakness in their internal control 

even though the outside auditors often didn’t have definitive answers either. So companies stopped asking questions. They use 

their best judgment or hire a different audit firm for advice, even 

though that second firm doesn’t know their business as well as 

their main auditors. This is not healthy in light of increasingly 

complex accounting rules. 

These problems have also had more far-reaching consequences as 

some of my fellow panelists have noted. Public companies are increasingly looking at going private. For smaller public companies, 

their boards and officers would probably not be prudent fiduciaries 

if they didn’t at least examine the going-private alternative. 

Also, successful private companies and dynamic new ventures 

have virtually no aspiration to go public, regulatory burdens being 

the number one obstacle. When I talk to potential clients and existing clients about going public, they dismiss that idea out of hand. 

Thirdly, even investment banking firms are looking for ways to 

avoid SEC registration for their clients by setting up unregistered 

stock trading systems. These developments are not healthy for 

small companies that want to grow by accessing the public capital 

markets or for U.S. markets in general. 

My second primary topic is whether the new standards will effectively alleviate these most troubling 404 problems. I want to commend the SEC and PCAOB on their extraordinary efforts in identifying and analyzing these problems. I believe, and my clients seem 

to agree, these new standards do an excellent job in theory to address the above problems. However, a high level of skepticism exists as to whether the new standards will work in actual practice. 

Out-of-pocket audit costs are not expected to reduce significantly, 

by 10 to 15 percent at best. One of my small non-accelerated filers 

has already been told by its accounting firm that instead of having 

a 125 percent increase in audit fees, it may only be 100 percent; 

i.e., a doubling of their cost. Also, no substantial reduction at all 

is expected in the internal resources needed to comply with the 

new rules. And then, most importantly, significant concern exists 

whether the outside auditors will buy into the new standards. 

Without auditor buy-in, these standards can’t work. Company officers realize that the auditors have all the power, and they have 

to do what the auditors want in order to obtain a clean 404 audit 

report. The SEC and PCAOB can only strongly emphasize to auditors the importance to buy in, but the regulators are probably limited in their ability to do this. 

Also accountants likely and reasonably are concerned about their 

risk of liability, and perhaps some protection from liability would 

be warranted here as well. I think everyone who has spoken here 

today, except the SEC and PCAOB, have agreed that more time is 

needed for implementation. I certainly echo that feeling. With reVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
34

spect to 404(a) and 404(b), management cannot put these controls 

in place without knowing their auditors are going to sign off. 

Lastly, I want to ask the committee to continue to evaluate the 

bigger picture of Section 404. Cost effectiveness is not the only 

problem. My conversations with officers and directors of public 

companies are uniform; they do not believe that 404 has significantly improved the quality of their financial reporting. Rather, 

they think it has created a lot of additional documentation, much 

of which is minutia. They also believe that they had good internal 

controls before 404 came into play and continue to do so. And perhaps most importantly, they are adamant that 404 will not prevent 

another Enron type fraud. 

In summary, I would like to say, the implementation of 404 has 

been a significant burden for public companies, particularly smaller 

ones. While the new standards provide some relief, 404 compliance 

is likely to be burdensome on public companies for years to come. 

Small public companies need more time to comply, if not a permanent exemption. And lastly, the jury should remain out and continue to evaluate whether 404 works at all. I appreciate the opportunity to have addressed these issues with you. I will welcome any 

questions that you might have. Thank you. 

[The prepared statement of Mr. Schmalzl may be found on page 

111 of the Appendix.]

ChairwomanVELA ́ ZQUEZ. Thank you. 

Professor Scott, I would like to address my first question to you. 

You chair the Capital Markets Regulation Committee and you examined the high cost of SOX 404 compliance and even recommended that smaller public companies should not be directed to 

implement SOX 404 until compliance costs are contained. In fact, 

your committee recommended a thorough cost-benefit analysis of 

SOX 404 should be conducted before a small company would be directed to become SOX 404 compliant. 

In your estimation, how long will it take to conduct a thorough 

cost-benefit analysis of the new standard, and what sort of data 

should be collected? 

Mr.SCOTT. I am going to give you my guess on these questions 

because I have not really thoroughly considered them and talked 

to a lot of people. But I would say that this certainly could be done 

within a year. We would need a year of actual implementation of 

these standards to large companies, to all companies other than the 

small companies, so we could assess what the impact would be. As 

I said, during that period, what we should be doing is looking at 

the closest cohorts to the small companies, the $75 million to $100 

million companies, because that will give us a pretty good idea of 

what the impact is going to be on the smaller ones. Also, during 

this year of implementation to the large companies, which under 

the SEC’s proposal won’t fully be done until statements are filed 

in 2009. So I would say that we are really talking about doing this 

between 2007 today and during 2008. And I think, in addition to 

kind of getting information from the closest cohorts, they could 

interview in depth small companies. I sit on a board in which the 

auditors come forward, as does management, and tells us what it 

is going to cost. And I think we could have the SEC and PCAOB 

35

interview these small companies and ask them directly, what are 

these standards going to cost you? What are the auditors going to 

charge? How would you estimate the time and effort management 

was going to spend? And as I said, Madam Chairwoman, the highest percentage of these costs is for management. So it is really no 

answer to tell us that we are going to defer the auditing piece of 

this for small companies and implement the management piece let 

alone the problem that a number of us have referred to, that the 

management is left high and dry without any real comfort from the 

auditors because they are not going to have to be Section 404 compliant for another year. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Mr. Hirschmann, you heard me asking this question to Chairman 

Cox regarding the fact that under the existing time line smaller 

public companies will not have to issue SOX 404 compliance financials until the spring of 2009. Corporate executives however will 

not sign a management report without an auditor’s attestation. 

Will you find small companies have to comply with both standards 

in advance of the December 2007 deadline? 

Mr.HIRSCHMANN. I think the result is predictable here, unless we 

grant the delay. I think it is a very good question. I think what you 

will see is that companies will have two choices: Either they will 

go ahead and get their auditors involved, and because this is coming out late in the year, they will have to compete for attention of 

the auditors and may have trouble doing so because the audit firms 

are not fully staffed yet to provide that for smaller companies this 

year. So they will have a very difficult environment with a very 

high cost if they try to go that route. 

Or they can try to do it without their auditor. But if they do that, 

they risk that next year their auditor will come in and say, wait 

a minute, what you did last year was not adequate; we are finding 

material weaknesses here. And that is an invitation for lawsuits 

and litigation and impacting the price of stock and really setting 

back the entire company. So you are really putting small businesses with two bad choices. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Mr. Greenwood, I know that your members, many of which are 

small research and development companies, are particularly concerned about the cost of complying with SOX 404. Since the new 

standard of scalable and principal-based, why aren’t they sufficient 

to address your members’ concerns about high compliance costs? 

Mr.GREENWOOD. Thank you. Fundamentally because, without 

the objective standard of using market capitalization and/or revenues, we think what will happen is that, given that the auditors 

have double incentives to maximize the compliance requirements—

one, their fees; and, two, their liability—they want to err, their 

tendency is to err on the side of requiring more. So that is why we 

fear that our companies will not gain access to the scalability benefits of the changes. 

One of the things that is unique about our companies, I think 

unique entirely to the sector, is that a biotech company may begin 

with a molecule that its scientists think will cure some kind of cancer. They then have years of research and years of development. 

Then they go into phase one clinical trials, phase two clinical trials, 

36

phase three. They make an application before the FDA. They may 

have another year to wait. All of that might take 10 to 12 years 

or more and may cost hundreds of millions of dollars and yet they 

haven’t earned a penny in all of that time of revenue. And so, if 

you think about it, I had the honor to chair when I was chairman 

of the Oversight Investigation Subcommittee, to chair investigations into companies like Enron and Global Crossing. And what 

would those scandals have been? They were largely about officers 

of companies who had stock options who wanted to exercise those 

stock options, who wanted the value of the stock to continue to inflate, who falsely stated earnings and revenues in an attempt to 

meet the street’s requirements and keep the stock pumped up. 

That doesn’t apply to these companies. These companies have no 

revenues. They have no earnings. They only have investment. And 

when you take a company that needs to spend all of its money on 

research and development and then take significant segments, sections of those invested dollars and use it for compliance that provides really no value to the investor, it is truly overburdensome. 

The final thing I would say on that, Madam Chairman, is that 

what our companies tell us is that, when potential investors ask 

them about Sarbanes-Oxley compliance, it is not because they want 

to know how well protected they will be as investors. It is because 

they want to know how much money the company is wasting on 

SOX compliance. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Ms. Casey, you mentioned in your testimony about the management of some community banks indicating that they are seriously 

considering delisting. Can you talk to us, rather than incurring the 

cost of SOX 404 compliance, can you talk to us about what are the 

negative consequences to a community if their bank chooses to 

delist? 

Ms.CASEY-LANDRY. Three years ago, we partnered with NASDAQ 

to create an index for community banks to provide more visibility 

in the capital markets for community banks and to facilitate their 

ability to raise capital. What we have found is, at the same time 

we did that, Sarbanes-Oxley came along. And so the cost of being 

a public company suddenly rose dramatically as the banks that 

were public were facing both the audit costs as well as the 404. Because the index comprises some banks that are accelerated filers, 

they have already been in compliance positions. But as they began 

to look, the same statement that was just made by my colleague 

up here, Honorable Greenwood, about companies looking at what 

the investors were saying, they are not saying, what is the value 

of the 404 to improve the financial statements? They are saying, 

are you taking away that investment that can go back into the 

community, go back into the institution and will we be better off 

being a private company? And so the decision really hinges on 

whether or not the institution believes it can better serve their 

community and stay serving that community and not be forced to 

sell out. And some of them are making a decision to stay independent, to stay as a community bank, they would be better off 

being a private company, keeping those costs for the institutions 

and not spending it with their auditors. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

37

Mr. Heesen, I just will say that Section 404, Sarbanes-Oxley 404 

is the best protection that a venture capitalist like yourself and 

your members will have regarding corporate fraud. And yet I am 

impressed by how forceful you have been in advocating to delay 

this implementation of SOX 404. Can you explain? 

Mr.HEESEN. Absolutely. I do not know of a single venture capitalist who would say the advantages of Section 404 outweigh its 

disadvantages. And that is as an investor talking. A venture capitalist wears two hats. He is an investor as well as he sits on a 

board. But I do not know literally of a single venture capitalist who 

would say the benefits outweigh the problems that have been associated with 404. It is a drain on the resources of the company. It 

is unquestionable. The money needs to go one place in a merging 

growth company, and that is into R&D. You want to grow that 

company and make it as competitive as possible as quickly as you 

can. If you have money being diverted to Sarbanes-Oxley’s cause, 

that is money being diverted from R&D. Basically that is a competitiveness issue, very simply. But it also demonstrates that our 

companies today take longer than they ever have to go public. And 

most importantly, more and more of our CEOs are saying it is not 

worth going public; I would rather get acquired. Now you are still 

going to have to be Sarbanes-Oxley compliant to be acquired, but 

they are just saying it is not worth it to basically be in charge of 

a company that I am basically a babysitter for regulation instead 

of a company builder. And so they are selling out. And that is not 

good for the economy at the end of the day. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Mr. Chabot.

Mr.CHABOT. Thank you very much, Madam Chair. 

Mr. Schmalzl, I’ll start with you if to I can. You have mentioned 

before that many of the companies that you are dealing with are 

very hesitant, if not I think it is maybe laughable to go public 

when one considers the additional burdens that are imposed. 

Would you kind of discuss maybe philosophically or with the economy in mind, what does it really matter whether companies stay 

private or whether they go public? What does that mean in the 

overall scheme of things? We are a capitalist society obviously and 

want people to be participatory in business and that whole thing. 

Could you talk about that a little bit? 

Mr.SCHMALZL. Sure. I have always viewed the main reason for 

a company to go public is that they want to be able to grow their 

company. And being able to access the public capital markets has 

been the most effective way of getting capital to grow your company. Also that provides advantages for the investing public as 

companies. You know, numerous—Microsoft, Google. As the individual investors and institutional investors can share in that 

growth, I think that is good for everyone. With the public markets 

effectively being closed to these growing companies who otherwise 

might be considering it, I think we are cutting off a lot of opportunities for those businesses, for the employees who work in those 

businesses because their growth is stunted. And I agree with Mr. 

Heesen on the inability for—you know, if these companies end up 

being acquired by larger companies, the adverse effect on their inVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
38

novation isn’t the same. I think we need to grow our own. And if 

going public isn’t a viable option for these companies I think we 

feel the effects of that in a variety of ways across our economy. 

Mr.CHABOT. Thank you. And Professor Scott, I noticed you nodding. I don’t know if it was the question or the answer. But I would 

be happy to maybe throw you that softball, too, and ask you to 

comment upon it. And maybe also keeping in mind what Mr. 

Schmalzl also mentioned: It is not just the investors; it is also folks 

that maybe would never fathom investing but ultimately are going 

to need a place to work and support their families and that sort 

of thing. 

Mr.SCOTT. Right. Another aspect of this problem which the committee thought was quite important was the fact that venture capitalists, in order to create incentives for them to invest, want to 

have a public exit. This has been the dream. The venture capitalists come along, they invest. They nurture the company, and the 

company goes public, and over a period of time, the venture capitalists cash out and make money. 

Now, if that result is limited because of the unattractiveness of 

the public markets, what we are going to see is less investment on 

the front end by venture capitalists and small companies because 

this investment is going to be less attractive to them because they 

can’t cash out in the public markets because of some of the costs 

that we have been talking about. And this is fundamental. This investment fuels this economy. Anything we do to interfere with it 

is a very serious matter. 

Mr.CHABOT. And is it accurate to say that we are trying to maintain some balance, because obviously if people are buying stocks in 

companies or they have their pensions invested in that company 

and people are crooked or doing things that they shouldn’t be 

doing, we want to protect them, but at the same time not kill the 

goose that created this wonderful economy or America that we 

enjoy. 

Mr.SCOTT. Right. I totally agree with that. We are not just focused on the cost, we are focused on the cost-benefit relationship. 

So the issue here is whether the benefits from 404 exceed the costs. 

And those benefits that we are talking about are to investors. That 

is why it is incumbent on the SEC to do a very thorough empirical 

analysis of this issue before we implement. 

Mr.CHABOT. Jim, let me start with you on this one if I can, and 

we will just go down, anybody that would like to comment. I’ll 

make this my last question so we can get to some other members. 

I believe you were all here, correct me if I’m wrong about this, 

when both Chairman Cox and Chairman Olson testified. Everybody 

was here I think during that. Could you tell me what are one or 

more, depending on how you want to take this, things that were 

said that you disagree with or that you take issue with or that concern you about what you heard when it comes to business and how 

404 and all this affects businesses in our communities around the 

country. 

Mr.GREENWOOD. I think, Ranking Member, that the point that I 

thought is most important in this entire hearing is really about the 

loss of the quantitative threshold for smallness. Mr. Olson’s testimony was that they originally thought that was a good idea and 

39

then, in reevaluating, it seemed not flexible enough. And I would 

agree with him if the issue is, well, there are companies that might 

exceed a $75 million revenue threshold that are also very simple. 

And if that is the case and if the PCAOB said maybe we want to 

give auditors the opportunity to look at a company with $80 million 

or $100 million in revenue that has very simple financials and also 

incorporate them into this more scalable methodology. That is not 

what they did. 

What they did is they did away with the quantitative threshold 

all together. And we think, without that, as I mentioned earlier, we 

think without that auditors will opt for a more complex review and 

that it will be of extreme cost to the companies really debilitating 

their abilities to do their research and development and providing 

little if any additional protection for investors. 

Mr.CHABOT. Thank you. 

Ms. Casey-Landry. 

Ms.CASEY-LANDRY. Thank you, Ranking Member Chabot. I think 

the comment that struck me the most was during the questioning 

with the chairwoman regarding implementation of 404(a) and 

404(b). The reality is that we are already in the fiscal year for community banks and for any company. And the guidance isn’t finalized. It still has to go through the OMB process, and then it needs 

to be out there. And I think the biggest challenge that Chairman 

Olson and Chairman Cox need to recognize is, once this is approved, that giving speeches and passing out pamphlets is not 

going to be enough to educate the profession with respect to how 

to handle 404 compliance for smaller companies, and at the same 

time, these smaller companies will have to begin to undertake the 

management review of their internal controls. And like everybody 

else said, banks are regulated by other entities, and they are not 

going to sign off on an internal controls report for their bank regulators much less for their auditors without these things being right. 

So I think the 1 year extension is absolutely critical. 

Mr.CHABOT. Thank you. 

Professor Scott. 

Mr.SCOTT. Three points. First of all, adopting 404 for small companies without a thorough cost-benefit analysis in advance of the 

adoption. Second, bifurcating the implementation of the management and auditor standards in two different years. And third, not 

adopting a quantitative standard for materiality in the guidance. 

Mr.CHABOT. Thank you very much. 

Mr. Heesen. 

Mr.HEESEN. I was, frankly, very surprised at the total lack of 

recognition that this regulation rule actually has to be implemented and that accountants are going to implement this and that 

you can have anything you want on paper. But if the accounting 

community doesn’t actually want to implement this, they are not 

going to implement it. And I think that is an issue that is not being 

addressed at all. I think that as it stands right now, the big four 

are holding a lot of cards here. And if they don’t want to see these 

changes implemented, they are going to have the power not to implement them. And no one that I heard from either the SEC or the 

PCAOB are talking about what I view as a very basic issue here, 

and that is implementation of these things. 

40

Mr.CHABOT. Thank you. 

Mr. Hirschmann. 

Mr.HIRSCHMANN. I have three quick points. First is, I was surprised to hear Chairman Cox say that he feels like he is close to 

the finish line. I really think this is an important step, but we are 

not yet at the finish line. And the implementation is important. I 

would hope that the SEC and the PCAOB would open to make additional changes if needed. Second, with regard to the PCAOB and 

the inspections process, until auditors feel that they will not be second guessed, if they simply don’t repeat what they have already 

been doing, I don’t think you can expect auditors facing huge liability to change the way they approach. So a change to the inspections process at the PCAOB is very important. And third is the 

cost-benefit issue. And I would just point out, there are a lot of 

good people working at the SEC. It is a good agency. But the ability to conduct a cost-benefit analysis is a material weakness at the 

SEC. They simply cannot do it consistently well. It is been the subject of litigation which they have consistently lost and this is just 

another proof that they don’t have the ability to do it. 

Mr.CHABOT. Thank you. Finally Mr. Schmalzl. 

Mr.SCHMALZL. Yes. I would echo all the same points. First, I was 

a little dismayed that it seemed to me that Chairman Cox really 

didn’t understand in practice what it takes to comply with 404(a). 

The internal resources needed that management needs to devote to 

that process is significant regardless of whether or not you add the 

out-of-pocket audit cost to that. 

Second, I didn’t think there was enough credence given to how 

much power the auditors have in this process. Unless the SEC and 

PCAOB can get some confidence that the auditors are going to buy 

into these standards, I think the people I talk with at public companies really think that the process is futile unless the auditors 

buy in. 

And then, thirdly, I believe the SEC pretty much assumes at this 

point that 404 is working and that it prevents fraud and that it is 

creating investor confidence. My clients clearly do not believe that. 

Their feeling is that the market really doesn’t care about these reports and that, as others have said, what they care about is, how 

much is it costing you to obtain that report? So I think that, to the 

extent that the SEC or PCAOB have essentially declared victory on 

the 404 point, I think that is mistaken. 

Mr.CHABOT. Thank you very much. I want to thank the entire 

panel for their answers. I yield back. 

ChairwomanVELA ́ ZQUEZ. Mr. Ellsworth.

Mr.ELLSWORTH. Thank you, Madam Chairwoman. 

Thank you all for coming. It is very informative, for you holding 

the hearing and for you all testifying. I found it fascinating. I 

guess, first, a couple of observations. One, we keep talking about 

an extension. And I come to find that if people just give me bad 

news and tell me, if they come up and tell me, hey, I am going to 

punch you in the nose right now or punch you in 5 minutes, I still 

bleed and my nose still hurts 5 minutes later. And so just an extension doesn’t sound like a fix. Is it fair to say that no one on this 

panel believes that we can achieve the intended goal of 404 the 

41

way it is written right now? I think I am safe in assuming that we 

are not achieving the goal. And I see some heads shaking. If you 

can give me that nod I’ll take that as the affirmative. 

So those two observations being said, I don’t know, Professor, 

maybe you are the first one or Mr. Hirschmann, I don’t know; what 

is the fix? If I gave you the magic wand or the magic pen, you 

know what we want to do, or what was intended here? What is the 

best way? Do we make it go away totally, wave the wand and make 

it go away, or what is the bullet point fix on this? 

Mr.SCOTT. Well, I think there should be a two-stage fix. The first 

stage is that we should adopt reforms, part of which have been 

done, but more that need to be done, particularly a quantitative 

materiality standard. And then field test this in terms of the cost 

and benefits to small companies. Now, if the costs still outweigh 

the benefits, which they may well be, then I think the Congress 

has to address this. What our committee said is, in that event, 

what the Congress should do is to exempt small companies from 

the auditor attestation requirement. At the same time, however, 

because management would not have the comfort of this outside 

auditor opinion, that the certification standard that management 

now has, which is pretty high, be lowered in terms of what management would really have to say about their confidence in the internal controls. 

But before we ever get there, Congressman, I think the first step 

is, let’s do whatever we can to make this a more efficient system. 

And I think there are steps yet to be taken. And when we do that, 

let’s figure out what the cost benefit is, a thorough study, for small 

companies. And only if that doesn’t work should the Congress come 

back into the picture. 

Ms.CASEY-LANDRY. May I just point out that the bill that was introduced by Representatives Greg Meeks and Tom Feeney would 

provide an exemption for smaller companies. And I think that 

would be something that would be worthy of Congress considering. 

But that is a broader question and some other committees get involved in that. 

Mr.HIRSCHMANN. I do think they are trying to fix the problem. 

And part of the challenge is they don’t have the tools in their 

hands to completely solve the problem. They can certainly fix the 

implementation of 404. What they cannot do is address the rest of 

the equation which is the complexity of our accounting standards, 

the fact that accounting rules are increasingly complex, interpreted 

retroactively, they are forcing one in ten public companies with an 

escalating number every year to restate their earnings. The whole 

litigation environment around auditors, there is a bigger picture 

here that goes beyond 404. And I don’t think until you address all 

those pieces you can really ultimately solve this for anybody. 

Mr.GREENWOOD. I would reiterate that the real fix is probably to 

go back and provide a complete exemption for the smaller companies. And I would base that on revenue, not on market capitalization because market capitalization can, A fluctuate wildly. A 

biotech company may have a drug. And based on the promise of 

that drug, its stock value may be here. And in clinical trials, it 

doesn’t prove out to do what the company hoped it would. So the 

market cap drops precipitously. There are still no revenues coming 

42

into the company. So I would use a revenue test for exemptions. 

And Congress should certainly seriously consider doing that. And 

I don’t think that it would be, as somebody who has spent 24 years 

in public office, I don’t think there would be a public reaction that 

would be negative. I think people instinctively understand that 

small companies are not the Enrons and the Global Crossings and 

the WorldComs. 

Mr.SCHMALZL. I would like to add to that I would agree that a 

broader exemption for small public companies defined in a different 

way would be a big advantage. And I think there should be a net 

revenue and/or gross revenue test attached to that. Also I would 

like to say that I am not at all negative on Sarbanes-Oxley. I think 

Sarbanes-Oxley has done an awful lot of good things for public 

companies. Boards of directors are more effective. Audit committees 

are much more effective. There is more information into the factor 

faster. Those are all very good positives about Sarbanes-Oxley. And 

I think we achieve all of those without 404 and without the incredible costs associated with 404. So I wouldn’t rule out the possibility 

of appealing it for everybody. But if we are not going to do that I 

would certainly try to exempt out a larger batch of those smaller 

companies, particularly ones that are still struggling to get to a 

revenue level that really can support these kind of costs. 

Mr.HEESEN. I just look at it from the angle that the SEC, Small 

Business Committee that looked at this issue came up with these 

kinds of proposals. They were rejected basically by two very strong 

votes, and that was the accounting firms. And so I think, once 

again, you have to look at this and say, what at the end of the day 

will the accounting industry feel comfortable with that businesses 

also can feel comfortable with? And that is a hard balance. But 

even from our companies, companies that are going to be acquired 

today, I don’t care how big or how small they are, they are going 

to have to be Sarbanes-Oxley compliant. A bigger company is not 

going to acquire a smaller company unless all the Is are dotted and 

all the Ts are crossed. It is just too much liability coming in. And 

so this goes beyond simply trying to say, let’s exempt X amount of 

companies and it will solve everything, because frankly it won’t. 

Mr.ELLSWORTH. Thank you all very much. I yield any time I 

might have. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Jim, you spoke about the cost for your members in terms of Section 404. My question to you is, does your organization plan to collect data that quantifies compliance costs for new members before 

and after the new standards are in place. And if you are going to 

do that, would you be willing to share that data with us. 

Mr.GREENWOOD. Absolutely we would be willing to do that. We 

have lots of anecdotal data, some of which we have shared with 

your staff, Madam Chairwoman. But we would certainly be looking 

forward to working with your committee on compiling data with 

our members that would be helpful in your decision making. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Mr. Heesen, several studies have cited evidence that the U.S. 

stock markets are becoming less competitive, and some have suggested that expensive regulation, including Section 404, may be 

partly to blame. In fact the mayor of New York, Mr. Bloomberg, reVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
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leased one of those studies. Can you comment on the relationship, 

if any, that you see between SOX 404 compliance and the apparent 

increase in the number of firms deciding to list their shares on full 

markets. 

Mr.HEESEN. I think part of it is Sarbanes-Oxley. I think it is unfair to blame Sarbanes-Oxley for everything. I think we are living 

in a much more global economy today. There are many foreign exchangers that are much better today than they were 5 years ago. 

Having said that, I think many of them have gotten better because 

of Sarbanes-Oxley. I think they have gotten much more aggressive 

in coming into the U.S. and marketing to our companies and saying 

please let’s go public on AIM or on Tokyo or somewhere else. You 

are also seeing companies that venture capitalists have backed that 

may be based in another country that in the past would have gone 

public on NASDAQ and instead today are going public on the Bombay exchange or on the Tokyo exchange. Now, part of that is because they are in their home country. But the other part of that 

is because those exchanges have gotten better and smarter and 

much more aggressive than NASDAQ has because of SarbanesOxley. So some of it actually is very much a part of SarbanesOxley. Some of it is part of just globalization in general. 

ChairwomanVELA ́ ZQUEZ. Definitely. And I did not intend to say 

that it is just only to blame for Section 404, but is the cost of regulations, including Section 404. Professor Scott, do you mind to comment? 

Mr.SCOTT. Yes. Of course, this was a major finding of our committee’s report that a number of factors were leading our public 

markets to be less competitive. In addition to regulation in general, 

which you have observed 404 is part of, we have two other concerns. First of all, the cost of litigation here, which is very high on 

the list of why foreign companies do not want to come to the 

United States. And secondly, in view of our committee, a deficit in 

the rights of shareholders in the United States compared to our 

countries. For example, other countries permit their shareholders 

to vote on the adoption of poisoned pills which are an impediment 

to takeovers. Our public company’s shareholders don’t have those 

rights. We have a possibility of having plurality voting rather than 

majority voting. So I would say in addition to regulations the cost 

of litigation and the deficit in shareholder rights. That was the conclusion. And as Mark observed, foreign markets are becoming more 

competitive. The point is, we can’t just do what we want to do anymore. This is a competitive world, and we have to accept that reality. 

ChairwomanVELA ́ ZQUEZ. Yes. 

Ms.CASEY-LANDRY. I just wanted to make one comment. Community banks don’t have the option to go to another exchange. And 

if they want to stay public and they want to have access to the capital markets then we need to have a system that is fair so that they 

can go to NASDAQ, they are going to go to the New York Stock 

Exchange, and they be listed and that they can be competitive. 

When we place undue burdens on smaller companies that can’t go 

global then we are really affecting our own base and own economy. 

And I would just point out that 404 has been a problem. And at 

the same time you do have community banks. We just added anVerDate 0ct 09 2002 09:03 Dec 20, 2007 Jkt 033615 PO 00000 Frm 00049 Fmt 6633 Sfmt 6633 G:\CLERK SB\HEARINGS\TRANSCRIPTS\36101.TXT LEANN
44

other 50 banks to our index in the past 6 months. But, I mean, 

banks that chose to go public. So there are companies that are still 

going public at the same time those are choosing to delist. But it 

is important to keep it domestically focused, too. 

ChairwomanVELA ́ ZQUEZ. Thank you. 

Any other witness? Yes, Mr. Hirschmann. 

Mr.HIRSCHMANN. I want to just agree with the point that there 

is a lot of good in Sarbanes-Oxley. But the168 words of Section 404 

we refer to as the 168 words that stole the act. So I hope that not 

the final words. And I commend the committee for holding this 

hearing and look forward to working with you to make the changes 

that are needed. 

ChairwomanVELA ́ ZQUEZ. Thank you. Mr. Chabot. 

Mr.CHABOT. Thank you, Madam Chair. 

I just want to once again commend you for holding this hearing 

and thank you for doing so and thank the panel here. I thought 

they gave us some very insightful information. And I want to especially thank Mr. Schmalzl for coming all the way from my district 

back in Cincinnati, but I thought everybody here was really very 

good and we appreciate you holding this hearing. 

ChairwomanVELA ́ ZQUEZ. I echo the remarks made by the Ranking Member. It has been a great hearing, and I believe that, yes, 

there is so much good on Sarbanes-Oxley, but we have to make 

sure that we get it right. And I don’t see the rush in terms of compliance right away without knowing and having the empirical data 

that shows that there is the cost-benefit analysis that will help the 

small companies to continue to grow and do what you do best in 

this country and our economy, and that is the research, the development, but at the end, job creation, and that is very important. 

So with that, I want to thank all of the witnesses. And members 

wishing to submit statements or documents into the hearing record 

will have five legislative days to do so. This hearing is now adjourned. Thank you. 

[Whereupon, at 4:45 p.m., the committee was adjourned.]

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