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The Monthly Blend
July 2006
Corporate Governance at Private Companies: Should You Comply with Sarbanes Oxley? 
Submitted by: Laura Keith, CPA
The terms "Sarbanes Oxley" and even "SOX" have entered the business world's dictionary as terms meaning good corporate governance. The rules and regulations that have become law since Congress passed the Sarbanes Oxley Act of 2002 apply only to public companies; that is, companies with securities that are registered under the federal securities laws. However, there are situations in which even private companies might consider adopting certain governance practices mandated for public companies by Sarbanes Oxley.
CONSIDERATIONS FOR PRIVATE COMPANIES WITH REGARD TO SARBANES OXLEY
Your Company is Considering a Public Offering of Securities
Private companies that are considering a public offering of debt or equity securities should comply with the internal controls provisions of Sarbanes Oxley well in advance of the filing of the registration statement for the securities offering. This is necessary so that auditors and investment bankers can perform their due diligence. Moreover, the certifications of your CEO and CFO as to the adequacy of the financial disclosures and internal controls required under Sarbanes Oxley will cover periods prior to the public offering, so your CEO and CFO will want to make sure that the company had compliance procedures in place during these pre-public periods. There are harsh penalties for an inaccurate certification. Public offering underwriters will also likely advise clients to adopt Sarbanes Oxley controls as early as possible.
Your Company is Considering Being Acquired by a Public Company
Private companies that anticipate being acquired by a public company should comply with Sarbanes Oxley's rules on internal controls several quarters in advance of such an acquisition. For example, the company should have a documented policy setting forth exactly how all financial information and non-financial information (such as a contingent liability) is surfaced to the CEO and CFO each quarter end. In these situations, it is the CEO and CFO of the combined organization who must certify as to the consolidated financial statements of the new company for periods before the acquisition and who will demand that there have been compliance with Sarbanes Oxley well before the acquisition closes. This will also mean that the degree of Sarbanes Oxley compliance will dictate the risks of the transaction to the buyer and, therefore, the purchase price the buyer is willing to pay. You might even get a premium for your business if you can demonstrate good governance.
Your Company is Considering Outside Financing Even if Not Involving Public Offering of Securities
Many lenders or investors, particularly venture capital investors, will expect that your company will be ready for a "liquidity event" such as an initial public offering. Venture capitalists increasingly are familiar with corporate governance rules. For example, these investors will likely expect in the Private Placement Memorandum for their investment the same level of disclosure as is found in the "Management Discussion and Analysis" section of a public company's annual report. They may also require representations and warranties and covenants in the financing documents that demonstrate compliance with the financial disclosure and other internal controls requirements of Sarbanes Oxley. While venture capitalists will often require board seats, Sarbanes Oxley would require that the board of a public company have a majority of independent directors. A representative of the venture capital company likely would not be considered independent. So, a company contemplating a venture capital financing should be thinking about who will be the independent directors of the company if it does go public.
Your Company is Being Asked to Document Internal Controls by Independent Auditors
Many private companies are reporting to us that their independent auditors are asking for "Sarbanes Oxley documentation" of internal controls. The accounting profession has come to believe that even if clients are not subject to Sarbanes Oxley, greater documentation by clients of internal controls that might prevent or detect fraud will lessen the accountants' litigation exposure in the event of fraud. It is also possible that if a new accounting firm is engaged, or even a new law firm is engaged, such firms might inquire as to the level of Sarbanes Oxley compliance as a convenient indicator of the quality of corporate governance at your company. Their professional liability insurers might even require that they do so.
Your Company has One or More Significant Minority Shareholders
In general, minority shareholders in a business corporation have few rights to require changes in business practices, usually limited to situations where there has been fraud or where a practice is outside the powers of the corporation. However, just as lawyers and accountants may come to use Sarbanes Oxley compliance as a benchmark for the quality of corporate governance, so too may minority shareholders. Particularly where the relationship between the majority and minority shareholders is strained, private companies might be well advised to consider compliance with one or more provisions of Sarbanes Oxley in order to demonstrate a commitment to good governance.
Your Company has Contracts with the Federal Government or is Subject to Significant Federal Regulation
Even if your company is not publicly held, if it does business with the federal government or otherwise has significant federal regulation it might be wise to adopt some of the governance principles embodied in Sarbanes Oxley. In November 2003, responding to the same corporate events that gave rise to Sarbanes Oxley, the U.S. Federal Sentencing Commission issued new guidelines that direct governing boards to oversee compliance with federal laws and regulations. This is the same sort of board oversight required by Sarbanes Oxley. The purpose of the sentencing guidelines is to provide a way for the business entity and its managers to minimize what the sentences might be if found guilty of violating federal criminal laws. Among the federal laws with significant criminal penalties are the various environmental protection laws, food and drug laws, health care fraud and abuse laws and federal procurement laws.
Your Company is Seeking D&O Liability Coverage or Prospective Directors or Officers
It is possible that insurance companies will condition director and officer liability coverage on compliance with certain aspects of Sarbanes Oxley. Some insurance companies have also included corporate governance and financial disclosure controls as part of their risk assessment of customers. Prospective board members may insist upon enhanced governance practices and sufficient D&O coverage before accepting a nomination.
THE BEST CORPORATE GOVERNANCE PRACTICES FOR A PRIVATE COMPANY TO ADOPT
Audit Committee Mindset
Even if your board does not yet have independent directors, it would be very advisable for the full board or for a separate audit committee to take on the mindset of a public company audit committee. One way to describe this mindset would be "healthy skepticism" as to how the results of operations are being translated into the financial statements. Board members should be asking questions of employees below the level of CEO and CFO that elicit a clear explanation of the process by which financial statements are produced and laws are complied with. Committee minutes should adequately document this interaction.
Ethics Policies
No matter how close the current owners of your business might be, or even if you are the only owner, there are still third parties who will expect that your company operates ethically. For example, a simple code of ethics, adopted by the board and communicated to employees, could help reduce your liability for the unethical behavior of an employee. Similarly, clear rules on conflicts of interest, such as loans by the company to employees, could help avoid getting into transactions that start out harmoniously but end up in conflict.
A CEO who feels himself or herself losing touch with the concerns of the employees might also instituted an anonymous hotline for employees to report unethical behavior. One of the requirements of Sarbanes Oxley is that companies maintain such mechanisms for the employees to report financial disclosure fraud without fear of retaliation. Your company should already have such a mechanism for employees to report misconduct by fellow employees such as harassment. It would not be difficult to expand that mechanism to the requirements of Sarbanes Oxley.
Internal Controls
Much of what Sarbanes Oxley does with respect to internal controls is to mandate exhaustive documentation of what should most likely be occurring anyway in the governance of the business. For example, who can argue that every business should not maintain adequate internal control procedures for financial reporting and should not periodically assess their effectiveness? Even if your business does not have to document your processes for achieving this result for your independent auditors and shareholders, every private company CEO should have some level of comfort that such processes are in place.
Independent Directors
Fresh perspectives are healthy even if they occasionally do result in some criticism of or change in the current way of doing business. Do you have a trusted acquaintance with financial expertise who has time to help in the governance of your business but whom you could legitimately hold out as being independent of you and the business? If so, then you might consider inviting him or her to join your board.
Certification of Financial Statements and Evaluation of Internal Controls
Though private companies are not subject to the requirement that every periodic report be accompanied by a written statement by the CEO and CFO certifying the validity of the report, you may want to consider having key executives certify annual financial statements sent to third parties as a matter of good business practice. This may also be pertinent in the eyes of third parties, including in litigation, when assessing whether directors of private companies have fulfilled their fiduciary duties.
The company may also wish to include an internal control report in each annual report which states the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and an assessment of the effectiveness of the internal control structure and the company's procedures for financial reporting.
CONCLUSION
Sarbanes Oxley has "raised the bar" for corporate governance of public companies particularly in the area of financial management. Many private companies can expect that eventually some third party is going to ask that at least some of Sarbanes Oxley's requirements be adopted. Doing so now could help reduce the likelihood of litigation, could help minimize damage to your corporate reputation in the event of a problem and could facilitate future transactions that might be vital to the survival of your company.
Written by: Stephen A. Yoder, Partner,
Balch & Bingham LLP,Birmingham, Alabama
Contributions to article made by: Jesse Unkenholz
For more information on the above topic, please contact Laura Keith at Beason & Nalley, Inc. at 256-533-1720 or email at lkeith@beasonnalley.com.
Streamlined sales taxes: Leveling the selling field
Submitted by: Joyce K. Skinner
Nearly 20 states have joined an initiative to simplify and modernize sales-tax collection and administration across the country. The uniform, interstate system gives midsized companies the option to voluntarily collect and remit sales taxes on products and services they sell in member states.
Why would retailers and other sellers volunteer to be tax collectors under the Streamlined Sales Tax Project (SSTP)? One reason is that member states - eager to boost tax revenue - are offering sales-tax amnesty. They agree to absolve participating companies of their previous failures to collect and pay sales taxes, as well as interest and penalty. Participating companies, in turn, agree to collect and remit taxes for all current member states and those that join later.
Business leaders should be aware that the SSTP amnesty offer does have several key limitations, says Kristi Magill, the national managing director for RSM McGladrey's state and local tax practice. For example, the SSTP covers only sales tax and not other liabilities such as consumer use, income or franchise tax. Efforts are under way to help resolve some of these tax issues in a coordinated manner through the Multistate Tax Commission. Any business considering SSTP amnesty should take a close look at the fine print, balance the risks and rewards with other tax-amnesty or voluntary disclosure programs, and consult a tax professional before taking any steps, Magill says.
Background on the SSTP
The streamlined sales-tax initiative took effect nationally in October 2005. It ushered in sweeping changes in how companies collect taxes.
The stated purpose of the SSTP is to streamline sales-tax collection and administration. The system employs standardized rules and definitions. Given the archaic and complicated nature of state and local sales-tax systems, this is a laudable and necessary goal - in theory. However, the spin by many government officials - that it's a simple and positive thing for businesses and includes no cost implications - leaves many small and midsized businesses begging to differ.
Many tax experts believe that the real purpose of the agreement is not only simplifying tax collection but increasing state coffers by collecting taxes through out-of-state mail-order and online sellers. However, the agreement has affected businesses far beyond those that the project targets. The SSTP enables participating states to levy taxes on sales by nonresident companies, provided they can entice those out-of-state companies to volunteer for the program.
To date, the program has 13 full-member states and six associate-member states. Full members have brought their respective sales-tax laws into compliance with SSTP principles. Associate members are still making progress toward conformity.
Origin- vs. destination-based sales taxes
As the streamlined tax initiative gets under way, smaller businesses have noted several key challenges. One of the biggest issues - and one that often divides large companies from smaller businesses - is the change from an "origin-based" to a "destination-based" sales-tax collection model. This provision applies at both the state and local levels, and it has created a new collection burden on many smaller companies whose sales are mostly in-state.
For example, under the old origin-based model, a pizza parlor that made deliveries to many different suburbs may have collected just one sales tax - the one for its location. Under the destination-based sales-tax model, this pizza parlor must now know and collect the sales tax due where it delivers each pizza.
State-provided tools still unavailable
Small and midsized businesses also are struggling to comply with the SSTP provisions because they lack the sales-tax administrative outsourcing and software capabilities the project promised. Member states had agreed to provide certified service providers or system software to participating businesses, but they still are developing these tools. In addition, recent recommendations from the project call for providing this assistance only to companies that do not have nexus, which could be a big blow to companies expecting some help to defray the costs of SSTP administration. Under current proposals, intrastate businesses will not qualify for assistance. Interstate businesses will not qualify for assistance in states where they have nexus, which can be triggered by as little as sales representatives soliciting within state borders. Resolution of this issue is critical for the project and is a significant focus for both government and businesses. Mandatory compliance may be coming
The days could be numbered for the voluntary nature of the Streamlined Sales Tax Project. Pending legislation in both the U.S. House and Senate (H.R. 3184 and S. 1736) would make the agreement mandatory. Companies should be prepared for change regardless. If the national legislation passes, it would give states authority to collect taxes from remote sellers that have no physical presence within their boundaries. In other words, businesses that have not voluntarily registered for the uniform system could be compelled to do so. Even without national legislation, legislative changes at the state level could affect how many businesses must administer sales-tax collection.
For more information on the above topic, please contact Joyce Skinner at Beason & Nalley, Inc. at 256-533-1720 or email at jskinner@beasonnalley.com. Coffee Talk
Darryl Walker was presented the National Contract Management Association (NCMA) Huntsville chapter's 2006 Professional of the Year award for his outstanding contributions to educating the government contracting workforce.
Darryl Walker presented "DCAA Hot Issues" at the CFO Roundtable luncheon, hosted by Beason & Nalley.
Welcome to Fallon Cornett who has joined the Accounting Services Department as a Consultant.
Congratulations to Melissa Anderson on completing the Leadership Huntsville/Madison County Connect Program.
Stephanie Kingsford attended "Tax Increase Prevention and Reconciliation Act" and "Estate and Financial Planning Techniques" seminars.
Sandra Baker and Vicky Lanier attended the Association for Accounting Administrators (AAA) Conference held in Indianapolis, Indiana.
Carolyn Scarborough and Mandy Kerce attended the Society for Human Resource Management (SHRM) Conference held in Washington, DC.
Congratulations to Don Nalley's daughter Tiffany. She will be marrying Wesley Stiles on August 5th. Related Information:
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