No pain no gain

By Peter Morton
Illustration: Carey Sookocheff

Complying with the new governance rules won't be easy, say Canadian executives, but it may have its rewards

With a fleet of more than 300 helicopters operating in the treacherous conditions at oil rigs around the world, CHC Helicopter Corp. is used to heavy lifting. But little of that lifting prepared Derrick Sturge, CA, vice-president of finance and corporate secretary at the St. John's, Nfld.-based company, for the task of meeting the tough US and looming Canadian corporate governance regulations. The new rules have meant detailed reviews of all the company's processes, not just at head office but at its operations in Vancouver and in South Africa, Australia and Europe. It has been a series of on-site meetings and teleconferences on everything from CHC's details of corporate governance to the certification of internal controls, a persnickety document-intensive process still in progress.

CHC is just one of many Canadian publicly listed companies that must comply with new US financial reporting rules under the Sarbanes-Oxley Act and the Ontario Securities Commission's proposed equivalent. While there has been little debate about the pressing need for new rules on corporate governance, the transition to the new world of corporate disclosure remains a difficult one.

In an exclusive survey for CAmagazine and Resources Connection, conducted between July 14 and August 30 by communications and research firm GCI Group of New York and Toronto, Canadian CEOs and CFOs were asked how they perceive the onerous new requirements. An overwhelming number of them (83.5%) believed new regulations must be put in place to strengthen investor confidence in global markets.

Most respondents agreed that new regulations are required (84%). A smaller majority agreed that a global standard was necessary (58%). Most also agreed CEO/CFO certification/accountability will increase confidence in the markets (69%). There was strong agreement that a board of directors should be largely independent with 57% strongly agreeing and 92% agreeing. Just more than half of respondents agreed audit firms should be allowed to perform non-audit services for an audit client. And 71% agreed the proposed OSC regulation, CSA regulations and Bill 198 will strengthen investor confidence, but only 38% agreed the benefits of the proposed regulations are greater than the costs.

"The biggest thing I took from it was that it seems CFOs see a need for more regulation," says GCI's Allen Putman, who surveyed 131 senior executives of Canadian companies, of which 56 were interlisted in the US and Canada.

"But there are still a lot of questions about how [they are] going to be implemented, especially in regard to cost and effort associated with compliance."

Another 71% believe new regulations will in fact strengthen investor confidence, compared with 13.9% who do not. Interestingly, only 62.9% of the Canadian companies registered with the US Securities and Exchange Commission believe new regulations will improve confidence compared with 76.5% of those companies listed solely on the TSX.

There is no doubt it is important to reassure investors of the integrity of financial records.

Stock markets are only now struggling back from a massive sell-off in the wake of the Enron-WorldCom scandals and the resulting investigations. But investors are not yet convinced they can trust financial statements, notes James Quigley, US CEO of Deloitte, one of the four remaining major accounting firms in the US.

"Once again, we are reminded that building credibility and a strong reputation takes much longer than losing them — especially in today's world of around-the-clock media attention," he says.

In just 288 days since the collapse of Enron, the US put in place the most sweeping new securities legislation since the Depression of the 1930s. Named after Paul Sarbanes, Democratic senator from Maryland, and Michael Oxley, an Ohio Republican in the House of Representatives, it is a complex bill but at its simplest Sarbanes-Oxley:
• establishes a new government regulatory agency to oversee auditors, called the Public Companies Accounting Oversight Board;
• creates a list of prohibited non-audit services and required pre-approval from the board of all non-audit services;
• spells out corporate responsibilities, including that a CEO and his CFO certify to the correctness of financial statements;
• requires an auditor to attest to a company's internal controls;
• calls for enhanced financial disclosures and for a more independent audit committee;
• outlines record retention requirements and, due to the massive shredding at Enron, sets out penalties for improper document retention;
• demands more independent directors and audit committees made up entirely of outside directors;
• bans loans from companies to executives, prohibits executive stock sales during blackout periods, and increases criminal penalties for white-collar crime.

While much of Sarbanes-Oxley focuses on the role of outside auditors, public-ly traded companies are especially concerned about two components — section 302 and 404, the corporate responsibility for financial reports and the management assessment of internal controls (how the effectiveness of controls to ensure reliable disclosure and external audit opinions are presented).

"Although there are a number of contentious Sarbanes-Oxley sections that have created debate, comments and objections, sections 302 and 404 create the most radical, ongoing and potentially onerous compliance obligations," says Tim Leech, FCA, managing director and chief executive of CARDdecisions Inc. in Mississauga, Ont.

It means that even a $1,000 error on a $10-million balance sheet can make the top executives liable, especially if there is a shareholder lawsuit. "I am suitably terrified," admits Lennie Ryer, CA, CFO at ConjuChem Inc. in Montreal. Ryer was a partner in a major Canadian accounting firm and when he left to join the biotechnology firm, he thought he was leaving personal liability behind — not with Sarbanes-Oxley. "I now have need for the family trust," he jokes. "Or maybe I will change my title from CFO to COO."

Personal liability is just one issue companies in the CAmagazine-Resources Connection survey pointed to. At the top of the list was the overall cost of complying with Sarbanes-Oxley and the mirror OSC rules. While there are concerns about "significantly increased costs," more respondents (47.6%) believe costs of implementing the new rules outweigh the benefits. Only 38% agreed that the costs justify the benefit.

"There's no doubt about it," says Jim Goodfellow, a senior partner at Deloitte & Touche Canada and co-author of Integrity in the Spotlight: Opportunities for Audit Committees. "The cost of being a public company has gone up. The cost of compliance — that's the big issue."

And the debate on costs and benefits, he says, is intense. "At the micro level, companies are saying there is pain, lots of extra costs and no benefits," he says. "But at the macro level, the debate is how do we assure the attractiveness of the Canadian capital market. Without new regulations like the US, the cost of capital goes up for all Canadian public companies."

But Sturge is one of those in the minority. "In dollar terms, the internal controls will be the biggest single effort," he says. "The initial complexity of the requirements will have costs, there's no doubt about it, but I think it will be worth it."

In Canada, the OSC, with most of the other provincial securities commissions (excluding BC's), on behalf of the Canadian Security Administrator, is busy drawing up similar rules. Though not as onerous as Sarbanes-Oxley, the OSC's draft regulations, which will affect the approximately 4,000 Canadian listed companies, essentially bring in two major changes — improved documentation and more qualifications of members of the audit committee. (See "OSC rules" on page 27.) "Because of the smaller size of Canadian companies, you can't simply take US rules and apply them here," says Bruce MacInnis, CA, CFO and vice-president of Bioscrypt Inc. in Mississauga.

MacInnis says Bioscrypt, which is developing fingerprint technology of automated teller machines and other security devices, does not trade in the US. If he had to follow Sarbanes-Oxley, "I would need three or four more people" just to handle compliance, he says.

This is also a concern shared by other CEOs. Nearly 62% of those surveyed in the CAmagazine-Resources Connection study admit to needing outside help to deal with the new regulations.

When asked about their concerns with the regulations, 54% identified cost as a concern, 36% were concerned about the time involved while 32% were worried about their ability to find staff resources. Another 19% were concerned the rules went too far.

For small companies, compliance is even more of a challenge as they lack the resources to handle the changes. "I am not against the concept of certification. In fact smaller companies are better equipped to handle what's going on," says Kelly Tomyn, CA, vice-president of finance at Ranchgate Energy, an oil and gas producer in Calgary that only trades in Canada. She says smaller companies like hers — Ranchgate has a market capitalization of about $30 million — are often better equipped to review their internal controls because the staff is so small. But few companies have written down or formalized their controls in a way acceptable by Sarbanes-Oxley or by the OSC proposed rules. Tomyn is skeptical about the results. "The costs will be higher and I don't think the end product will be any different," she says.

In fact, the survey found that more than 90% of senior executives believe the new regulations will impose additional costs on their companies because of changes to the board of directors, financial system controls and costs related to staffing.

Canadians are not alone in that concern. The SEC itself predicts the initial costs of complying with the new governance rules for US-traded companies will hit about US$1.5 billion, with one rule alone — accounting safeguards — costing about US$1.24 billion in increased paperwork, legal fees and other costs.

Most (54%) respondents expect to use fewer non-audit services from their auditors in the future; 15% indicate they will use no non-audit services from their auditor in the future; and 31% will use the same or more non-audit services from their auditor in the future.

"There has been a good deal of concern about the cost of internal controls," William McDonough, chairman of the new US Public Companies Accounting Oversight Board, admitted recently. "In my view, good internal controls are cost effective and, once put in place, more than justify the expense involved."

The SEC estimates complying with accounting safeguard rules would cost an average of US$91,000 per company. Others put it higher — much, much higher.

A survey published in September by CFO Magazine found that 48% of US companies will be spending at least US$500,000 on complying with Sarbanes-Oxley.

Most respondents (62%) believed they would need help from external
professionals/consultants to comply with the regulations.

For its part, the Toronto-based OSC is much more optimistic about the impact of its proposed corporate governance rules. In a study released in June, the OSC said the costs to issuers and investors arising from complying with new corporate governance rules would be $163 million to $308 million over the next decade while benefits would be between $1 billion and $10.1 billion. (The British Columbia commission, which is not part of the OSC-led group, disputes the benefits claim.)

Besides the costs themselves, there are the intangibles such as developing a new corporate culture that even CEOs may be unfamiliar with.

"Certification [of financial reports] is certainly a big deal for CEOs, something they're unaccustomed to," suggests Michael Doty, senior vice-president and CFO of Vancouver's QLT Inc. QLT, a biotechnology company with a market capitalization of about US$1 billion and  about 30% of float trade on Nasdaq, launched a process of certification and "sub-certification" — ensuring that everyone involved in financial statements is aware of the new requirements. Sub-certification is not demanded by Sarbanes-Oxley, but Doty says the process now works well. "Everybody is being formal and it forces verbalizing," he says. "It's now a matter of routine."

When asked what services should not be restricted, tax (76%) was the most common response. Corporate finance advisory services including M&A, valuation and due diligence, as well as IT and systems advisory services were also listed as services that should not be restricted.

The CAmagazine-Resources Connection survey found 69% agree that certification of CEOs and CFOs will improve investor confidence. "As a CFO, there are a lot of things I like about Sarbanes-Oxley," says Doty. "It's a good thing to require an audit committee to have financial input and for the CFO to sign off." But there are the issues of the independent directors and the expanded role for the audit committee.

Just less than 92% in the survey support independent boards although many questioned what the definition of "independent" and "financially literate" will ultimately mean.

And just where will all these experts come from? executives ask. "There are concerns about getting a specialist on audit committees," notes Kelly Nelson, CA, CFO at High Liner Food Inc. in Lunenburg, NS, pointing to proposed OSC requirements. "They will be hard to recruit."

Also still to be sorted out is the role of the outside auditor. Arthur Andersen's role in providing both audit and non-audit advice to Enron — and the now obvious conflicts that produced — prompted Sarbanes-Oxley to sharply limit the non-auditing role of auditors. "Auditors used to sell audits as a loss leader in an attempt to get other services," says Doty. With the separation, auditing costs are rising by the double digits, he says.

According to USA Today, external audit fees rose 27% last year for companies in the Standard & Poor's 500 index. Others suggest the fees could rise as much as 90% for small to mid-cap companies.

That tracks with the CAmagazine-Resources Connection survey as well. Nearly 57% believe audit firms should still be allowed to perform non-audit services for an audit client while 85.5% said their auditors will still provide at least some, presumably allowable, non-audit services. Of that, 30.5% expect their auditors to provide the same or more non-audit services.

Complexities of Sarbanes-Oxley aside, what is yet to be sorted out is its effect on the international corporate community. Executives in the CAmagazine-Resources Connection survey were vexed by the question of a global standard based on Sarbanes-Oxley. While 58% said there should be one global standard, nearly 35% disagreed. Interlisted companies are less likely to disagree (25.5%) with a single standard based on Sarbanes-Oxley and the Canadian regulations than are those listed only on the TSX (41.7%).

Respondents expect to need advice in a broad range of areas. The most cited was help with the internal controls including their evaluation and disclosure (47%). They also expected to need help interpreting the legislation and with the IT/systems and with taxation issues.

Sections of Sarbanes-Oxley conflict with various laws in foreign countries and there is no agreement it should be the global template. "That's a real tough one because we have global markets but not global governance," says John Crow, former Bank of Canada governor and author of Rebuilding Public Confidence in Financial Reporting, a report commissioned by the International Federation of Accountants. "I guess people duke it out, and finally the costs [of the intransigence among national authorities] become so high the markets scream bloody murder," he says.

Yet the reality of the difficulties and uncertainties in implementing Sarbanes-Oxley is if you trade in the US, you have to comply. For the 503 Canadian interlisted companies, having access to the US market is crucial. The stock market capitalization of the top 6,000 publicly traded companies in the US is US$11.3 trillion, according to Wilshire Associates Inc. The market cap of 1,319 companies listed on the TSX is $1.14 trillion.

"We need access to the US market," stresses Ryer. For a biotech firm like ConjuChem, a revenue stream from the development and marketing of new drugs such as its breakthrough diabetes treatment, GLP-1, can take years. "We need to raise equity capital two or three times during the development timeline of a new drug [which can take up to 10 years]," he explains, adding that ConjuChem would like to grow into a company with a market capitalization of US$1 billion from less than $200 million now but can only do that through the US.

Other Canadian companies such as CHC Helicopter want access to the bond market. "The US market is very important to us," says Sturge. CHC had a 145-million euro bond issue registered with the SEC in 2000 and last year sold $140 million in new equity on both sides of the border.

Obviously, Sarbanes-Oxley has had and will continue to have an effect on corporate reporting behaviour. Not surprisingly, there is skepticism among CFOs that the new rules will bring an end to corporate scandals. "I would be naive to claim that regulatory efforts can permanently prevent scandals such as Enron, WorldCom and HealthSouth from happening again," says Deloitte's Quigley, adding the test will come with the next inevitable stock market bubble. Despite the doubt, he says, "Five years from now, we will look back on Sarbanes-Oxley and say it was the best thing to have happened to us."

As for Tomyn, she hopes the tougher rules on corporate governance will restore investor confidence and bring back higher trading volumes and higher prices. But she has her qualms. "At the end of the day, there are good people and bad people, and bad people always seem to find a way around things."

Executive view CAmagazine and Resources Connection conducted a survey of Canadian CFOs, CEOs and company presidents about their opinions and the perceived impact of sweeping changes in corporate governance. A total of 131 senior executives were surveyed, representing 75 companies listed on the Toronto Stock Exchange and 56 companies registered with the SEC and listed on the TSX. The survey was fielded by GCI Group of New York and Toronto and was conducted from July 14 to August 30 Overall, survey respondents: •  Overwhelmingly believed new regulations must be put in place to strengthen investor confidence in the global markets (83.5%) yet tellingly they also indicated a strong need (61.7%) for outside assistance along with concerns about significantly increased costs associated with complying with the new rules. •  Nearly all respondents (91.5%) believe in the concept of an independent and financially literate board of directors to better monitor the executive suite. However, many respondents indicated the lack of a true definition around "independent" and "financially literate." •  Of the companies surveyed, 56.9% believe audit firms should still be allowed to perform non-audit services for an audit client, and of those surveyed, 85.5 %  stated their auditors will still provide at least some non-audit services and of that, 30.5% of respondents said their auditors will provide the same or more non-audit services. •  Surprisingly, more respondents (47.6%) believe the costs of implementing the new regulations outweigh the benefits, with only 38.7% agreeing that the costs justify the benefit. •  Of the respondents, 75% believe the newly created responsibilities of the board of directors to nominate, compensate and oversee external auditors will strengthen investor confidence in the markets. •  Overall, the study results indicate respondents believe most of the new regulations will strengthen investor confidence in the global capital markets but view the implementation of the regulations as an effort — and cost-intensive process. •  More than 90% of the respondents believe the new regulations will have some additional financial impact on their organization. These costs will include boards of directors, external audit, financial system controls and processes and staffing.  •  Several respondents indicated a concern about a perceived limited number of potentially qualified candidates to serve on boards of directors and that the added liabilities/responsibilities that will be required of boards may be a further deterrent to potential candidates. •  In general, the perspectives of interlisted companies and those listed solely on the TSX show very few significant differences, further reinforcing the universal nature of the issues and concerns facing companies. •  Interlisted companies are less likely to disagree with one global standard based on Sarbanes-Oxley and the proposed Canadian regulations (25.5%) than those listed only on the TSX (41.7%). •  SEC-registered companies are slightly more skeptical that the new regulations will strengthen investor confidence in the markets (62.9% versus 76.5%). •  There is a slight increase in the amounts of non-audit services that will continue to be provided by auditors of TSX-listed companies than those interlisted.

Importance by effort Respondents were asked to rate the importance of the following proposed legislation and the effort they thought was needed to implement them. The matrices show how the importance and effort rating match up for each proposed legislation. For most items, respondents rated effort as low and importance as high a. The CEO and CFO must personally certify that the interim and annual financial statements and the MD&A do not contain any untrue statements and fairly present, in all material respects, the financial condition, results of operations and cash flows of the issuers without any reference to generally accepted accounting principles.     Important Not important 20% 10% High effort 60% 10% Low effort     b. The CEO and CFO must certify that they have evaluated the effectiveness of the issuer's disclosure controls and procedures and internal controls as of the end of the period covered by the annual filing, but not for each of the interim filings.     Important Not important 42% 19% High effort 33% 6% Low effort     c. The CEO and CFO must certify that they have disclosed in the annual MD&A their conclusions about the effectiveness of the disclosure controls and procedures and internal controls based on their annual evaluation.     Important Not important 36% 14% High effort 40% 10% Low effort     d. Companies will be required to disclose their accounting estimates, critical accounting policies, off-balance sheet financing arrangements and liquidity risks in their MD&A.     Important Not important 30% 3% High effort 64% 3% Low effort     e. All reporting issuers must have an audit committee comprised entirely of independent and financially literate directors.     Important Not important 16% 3% High effort 79% 2% Low effort     f. The reporting issuer must disclose whether an audit committee financial expert is serving on the audit committee and explain why no such qualified person is on the audit committee if that is the case.     Important Not important 5% 4% High effort 82% 9% Low effort     g. An audit committee will be responsible for recommending to the board of directors the nomination and compensation of the external auditors and for overseeing the work of the external auditors.     Important Not important 10% 3% High effort 79% 8% Low effort     h. The audit committee must pre-approve all non-audit services.     Important Not important 4% 16% High effort 54% 26% Low effort     i. Companies must disclose the fees paid to the external auditor for each of the last two fiscal years for the following four categories — audit fees, audit-related fees, tax fees and all other fees.     Important Not important 4% 2% High effort 72% 22% Low effort     j. The audit committee will have the authority to communicate directly with auditors and to engage and compensate independent counsel and other advisers as required.     Important Not important 11% 7% High effort 75% 7% Low effort     k. If a reporting issuer has not engaged an external auditor to review its interim financial statements this fact must be disclosed.     Important Not important 1% 3% High effort 90% 7% Low effort

Peter Morton is the Washington bureau chief with the Financial Post.