JOBS Act Helps Small Businesses

Story first appeared in The New York Times.

The JOBS Act passed by Congress last week and being signed by the president on Thursday helps smaller public companies avoid for a few years the internal controls reporting and audit requirements put in place in 2002 in the wake of prominent accounting scandals.

But just a few days after the bill was passed, Groupon disclosed that it had to restate its results from the fourth quarter of 2011 and that its outside auditor had found weaknesses in its internal controls.

There are always trade-offs when it comes to enforcing rules for proper financial reporting. The question is whether this exemption is a benefit to investors who purchase shares in these companies, whether they are well-known brands like Groupon or promising start-ups just getting their bearings.  Startup companies should consider employing a New York Business Entity Formation Lawyer to confirm that they are following proper legal protocol.

Section 404 of the Sarbanes-Oxley Act was adopted in response to the accounting scandals that enveloped companies like Enron, WorldCom, and Adelphia Communications, where significant accounting frauds went undetected by outside auditors, sometimes for years.

To prevent a repeat of the scandals that cost investors billions, companies are now required in annual reports to have chief executives and chief financial officers attest to the effectiveness of the internal control structure and procedures of the issuer for financial reporting. The outside auditors also have to test the internal controls and give an opinion on their effectiveness.  Austin Business Lawyers are interested in the outcome of such tests.

The initial costs of developing the required internal controls can run as high as $5 million to $10 million for a small company once it goes public because private firms do not have to have the same accounting and compliance structures in place as larger corporations. In addition to the expense of putting in place the program for the first time, the annual review by a company’s accountants adds to the costs of the audit.

There was no more reviled provision in the Sarbanes-Oxley Act than Section 404 because of the significant costs it imposed on corporations of every size, especially smaller companies that do not have a large accounting and compliance staff already in place. The law takes a one size fits all approach to internal controls, so the burden on small firms can be much more significant.

That’s where the JOBS Act (an acronym for Jumpstart Our Business Startups) steps in to help some companies avoid those costs, at least temporarily. The law exempts an emerging growth company from the requirements with Section 404. The statute defines such a firm as one with less than $1 billion in annual gross revenue or a $700 million market capitalization, and the exemption can last for up to five years if the company does not grow too large within that period.

The new law is a boon to small companies because it will lower costs by allowing them to avoid the attestation and outside auditor review requirements for internal controls. All publicly traded companies have to make accurate financial reports, but now an emerging growth company can limit its compliance and auditing costs for up to five years.  Keeping and providing accurate financial reports are an absolute must, say Washington DC Corporate Lawyers.

Compliance programs do not generate revenue for companies, and they can lead to significant costs as a company grows and has to spend increasing amounts on internal controls. The act may allow smaller companies to skimp on this part of the business when there is no requirement to comply with Section 404.

Groupon is an example of the almost inevitable problems that can arise when a company develops a popular new market. Emerging growth companies in the technology and social media fields are the type of firms that can quickly outgrow the internal controls needed to comply with the accounting rules.

Though it does not technically qualify as an emerging growth company because its rapid growth has taken it well over the $1 billion revenue limit, in many ways, Groupon is the epitome of an early stage company. Groupon is less than four years old and already has moved from annual revenue of $14.5 million in 2009 to over $1.6 billion in 2011.

(Because it just had its I.P.O., Groupon is not yet covered by Section 404, but it will have to comply with the requirements when it files its next annual report in March 2013.)
Groupon stated that it had begun taking steps and plans to take additional measures to remediate the underlying causes of the material weakness, primarily through the continued development and implementation of formal policies, improved processes and documented procedures, as well as the continued hiring of additional finance personnel. There are no assurances that it will be successful, or that other accounting issues will come to the surface, according to Washington DC Business Lawyers.

Even before its initial public offering last year, Groupon had problems with how it presented its financial results. In one filing, it used a metric called adjusted consolidated segment operating income that gave a highly favorable view of its revenue, even though it was not sanctioned as an appropriate accounting method. Groupon later dropped that approach in favor of more traditional measures that ended up showing a much lower revenue figure. The Deal Professor called the company’s approach to its accounting “Grouponomics.”

Another provision of the act exempts emerging growth companies from putting in place new accounting rules, so there is also the potential for disparate financial reporting between newer companies and more established ones. That could present problems for investors trying to evaluate a company’s financial performance as it moves beyond the early stage and will be subject to all the applicable accounting and internal controls requirements.

The act does not encourage fraud at small companies, and emerging growth companies that hope to survive more than five years will have to plan on meeting the stringent requirements of Section 404. From one point of view, the law gives newer companies a chance to grow the internal controls environment they will have to implement at some point in time.

But they are also the firms that can face the greatest risk of internal controls issues. The new law means investors in start-ups will have to be especially vigilant because the protection afforded by Section 404 will be missing.

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