BioWorld Today Columnist

I bet most biotechers skipped right over that 5-inch column in the May 24 Wall Street Journal titled "Sarbanes-Oxley Is Eased." One group that found the SOX news riveting - our industry's CFOs.

The Securities and Exchange Commission decided to officially provide specific guidance for how company execs can evaluate the internal controls in their financial reporting.

OK, I hear that snoring! This is important! I freely admit it took one of biotech's top CFOs, Sharon Tetlow at Cell Genesys, along with a friendly former accounting partner to help me understand why it's important.

According to Tetlow, the 2002 SOX legislation included many components that have worked out well, especially requirements for independent boards and audit committee members. "The one colossal failure is implementation of Section 404, which says the audit firms must give an opinion about a client's internal controls along with rest of audit."

Internal controls are the procedures you put in place to make sure that your financial statements are accurate and in sync with Generally Accepted Accounting Procedures (GAAP). They are analogous to the Good Manufacturing Procedures used to validate your drug manufacture process.

Here's the problem: Potential risk must be balanced by potential reward. The accounting firms are well aware that SOX heightened their potential liability, and after watching what happened to Arthur Anderson and KPMG, they are feeling just a teensy bit vulnerable.

Their reward used to come from the lucrative consulting projects that they did for their audit clients. The audit projects typically were bid low to lure business away from competing firms, and consulting projects raked in the big bucks. A big chunk of those consulting projects were implementing the computer systems that ran internal controls!

But now the accounting firms are not allowed to audit their consulting clients, and vice versa. Industry insiders point out that the conflict-of-interest concern had been brewing for a while - SOX simply formalized it. Audit and consulting now must generate their own profits, without sharing clients. Some consulting groups split off into new companies.

Consequently, accounting firm profitability is impaired, potential liability is increased and nowhere in the 168 words of Section 404 did the SEC spell out exactly how they should ensure their clients have good internal controls.

One former accounting partner said, "There always was a component of evaluating the internal controls. It's like manufacturing controls. You can't audit all the client's transactions - you take samples and audit those. The auditors evaluate how the client's team does inventory, for example. Does the team have adequate instruction, are people doing backup counts, etc. If the auditors saw adequate control, they could choose a random sample to audit and give an opinion based on that sample plus a letter to the board commenting on any areas needing improvement.

"Now, SOX states you must formally back up all those statements, which means the billable hours mount up. And because of the liability around SOX, you don't want to miss anything."

The first year post-SOX, accounting firms often did two separate audits - financial and SOX, essentially double-billing their clients. The SEC said, "OK, cut that out."

Double-Billing, Or Worse

The more insidious problem was that audit firms became terrified of providing advice or even discussing how clients should handle complex accounting matters - because providing help might look like consulting, which you couldn't do for audit clients.

Companies found themselves forced to go to another accounting firm and pay big fees for extensive consultation on the proper manner to handle a transaction. But there can be big variations in how different firms see things, and even between different offices of the same firm. Clients might find themselves paying another big chunk to their original audit firm to scrutinize the analysis of the second firm. Meanwhile, the legal bills can mount because each accounting proposal must be reviewed for legal ramifications.

For a biotech company with net earnings far in the future and big clinical trial bills coming up, spending cash on what looks like double-billing can be very painful.

As smaller companies protested that those rules would impose a crushing burden on their ability to fund their businesses, the SEC made it clear that this was an unintended effect of SOX 404. They clarified that auditors should discuss how to handle things with the client prior to the final audit.

Tetlow noted, "This important change helps us quickly get past the variations in practice among the experts to agree on proper accounting treatment of transactions. But they still get to charge us while they run it by national.

"A cottage industry - more of a MacMansion industry - emerged as a result of all the 404 implementation. The SEC and the audit industry initially forecast an average of $91,000 per company to implement 404, but even for small companies it's a great deal more than that."

For the larger firms, it ratchets up quickly. Word on the street is that Pfizer spent $40 million in the first year of SOX.

The big accounting houses are like big pharma. Their huge infrastructure needs feeding. If you tinker with how they get the money, they still have to get the money unless they restructure significantly.

So, can biotechs go to another group that has a more cost-efficient infrastructure? Sure - that's what's behind all those "passion" ads from smaller accounting houses like Grant Thorton.

Is Help Ahead?

The recent SEC guidance is "intended to right-size the evaluation and assessment efforts of management, and it's intended to do that for companies of all sizes," says SEC Chairman Christopher Cox. The Public Company Accounting Oversight Board approved the new Accounting Standard 5, intended to replace AS2, the dreaded manual for implementing Section 404. Those two actions are expected to reduce the cost of compliance enough that even small public companies (read: most biotech firms) can be required to comply with the full SOX regulations.

The good news is that compliance may have been made a bit easier. The bad news is that virtual double-billing still will exist and more of the sector will be required to comply with all of SOX - maybe even as early as this fiscal year.

Cell Genesys's Tetlow raises a final thought: "Are shareholders really benefiting from 404? Maybe not as much as they should. If you follow the money trail, someone is certainly benefitting."

Will Congress rescue our companies? Stay tuned for the next exciting installment of "As the BioWorld Turns"!

Robbins-Roth, PhD, founding partner of BioVenture Consultants, can be reached at biogodess@earthlink.net. Her opinions do not necessarily reflect those of BioWorld Today.