Treatment of Section 404 Compliance Costs
The Accounting and Tax Effects of Sarbanes-Oxley

By Linda A. Hall and Christ Gaetanos

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A primary goal of SOX is to improve the quality of financial reporting and thus increase investor confidence in financial markets. Section 404 requires an annual report from management stating its responsibility for the financial statements as well as for establishing and maintaining an adequate system of internal controls over financial reporting. This report is to include management’s assessment of the effectiveness of internal controls, the framework used to evaluate controls, disclosure of any material weaknesses in the system of controls, and a statement that the company’s auditors have issued an attestation report on management’s evaluation of internal controls over reporting.

While companies have an existing obligation to maintain an adequate system of internal accounting controls under the Foreign Corrupt Practices Act, preparing an annual report on controls by management involves additional costs. Moreover, compliance is not a one-time effort or a one-year project; it is an ongoing process requiring extensive investment. For example, senior management must be involved in the evaluation of controls; internal audit departments may need to be enlarged, or in some cases formed; consultants may be engaged to analyze and design control systems; the company may need to purchase additional computer software or hardware; and audit fees will undoubtedly increase. Additional section 404 compliance costs are attributed to documentation, legal requirements, detailed policy development, self-assessment, attest requirements and certifications, and staff training. Information technology consultants believe that companies will also invest heavily in technologies such as workflow, document management, and identification management tools to automate section 404 compliance processes.

Accounting Treatment of Section 404 Compliance Costs

Most accountants apply the matching principle in determining when to recognize expenses—that is, matching the costs incurred with the related revenues earned. Absent a direct revenue relationship, costs should be recognized as expenses in the period they benefit or allocated to periods benefited in a systematic, rational manner. Guidance from FASB with respect to the recognition of certain expenses provides that, in general, costs for which no future benefit can be identified or no rational allocation scheme devised are normally expensed in the period in which they are incurred. Treatment of certain costs incurred by companies in establishing, maintaining, and improving internal controls over financial reporting may not be clear-cut. While the general principles point to expensing compliance costs immediately, such costs may provide future benefits to the company.

Particular compliance-related costs that may be either expensed or capitalized are software development costs. Treatment of the costs of software acquired from others or developed internally for internal use is addressed in AICPA Statement of Position (SOP) 98-1. For software to be considered under SOP 98-1 as internally developed, it must be designed or modified to meet a company’s internal needs. This includes the costs to customize software purchased from others. In addition, the company must have no intention of marketing the software externally. Costs subject to capitalization are those incurred from the application-development stage forward. All prior costs must be expensed as incurred. SOP 98-1 requires that general and administrative, overhead, and training costs be expensed, even though they may be associated with the internal development or acquisition of internal-use software. When internal-use software is purchased from third parties, the purchase price often includes charges for training and subsequent maintenance. If not separately specified in the contract, these contract costs must be allocated among the capitalizable portion and the training and maintenance expense portions. The company should allocate training and maintenance costs over the periods covered.

SOX calls for the SEC to examine the viability of adopting a more principles-based (rather than a rules-based) financial reporting system. Professional judgment should be relied upon in the application of standards. While the rules set forth in SOP 98-1 are quite specific, one could argue that software development costs incurred in the systems analysis stage create assets that have significant future benefit to a company. When rules-based standards exist, managers are more likely to structure transactions in order to achieve desired financial reporting outcomes. When standards provide room for interpretation, managers are less likely to engage in structuring and more likely to rely on convincing auditors that their interpretation of the standard reflects the economic substance of the transaction.

A related area of current research addresses the capitalization of intangible costs, primarily research and development (R&D) costs. Some say the immediate expensing of R&D distorts reported earnings and violates the matching principle; others defend the immediate recognition of R&D expense as conservative. Just as the immediate expensing of R&D front-loads the costs of innovation, the immediate expensing of section 404 compliance costs may overstate future earnings as the benefits of these costs are realized. This treatment may be relevant in the case of technology-based assets such as computer programs, information systems, and technical and procedural manuals. The capitalization of internally developed software and the valuation of intangible assets will likely require further attention as the costs of section 404 compliance are incurred and reported by companies.

If purchase-type or development-related costs incurred by a company to establish or improve internal controls over financial reporting provide future benefits to the company, an asset has been created. This treatment may be appropriate for items such as purchased or internally developed systems software. In addition, certain “one-time” costs, as opposed to annual charges to establish or improve systems of internal control, may provide future benefit, and thus should be capitalized. Because the goal of SOX is to deter fraudulent reporting and increase public confidence in financial reports, the profession should be clear as to both the accounting and the tax treatment of section 404 compliance costs by companies.

To examine the accounting treatment of section 404 compliance costs, the authors examined the 10-Ks of 50 accelerated filers, chosen randomly from standard industrial codes (SIC) ranging from 2111 to 9999. A company’s report was chosen only if it made specific reference to section 404 compliance costs in absolute or relative amounts. Each filing was examined for its treatment of section 404 compliance costs and for references to capitalized costs, software development costs, and capital expenditures. The bulk of the sample reports were for fiscal years ended December 31, 2004, and were filed on or near March 15, 2005.

Without exception, companies made reference to an increase in general and administrative expenses related to section 404 compliance. The most common reason cited was an increase in professional fees or services associated with complying with section 404, namely the audit of management’s report on the effectiveness of the company’s internal control over financial reporting. Other reasons cited, consistent in origin, were increases in expenses due to internal control documentation efforts and testing of internal controls. Some companies mentioned the expense of additional human resources, training, technological enhancements and process improvements, outside information technology fees, and projects to reorganize accounting and information technology departments. The dollar values assigned to these additional expenses ranged from approximately $1,175 to $34 million. The average reported increase for the sample, $3.1 million per company, is in line with reported estimates.

Sample filings were examined for reference to capitalized costs, software development costs, and capital expenditures, with limited results. Several companies made reference to capital expenditures for computer software and hardware, business systems, technology infrastructure, and enterprise resource planning (ERP) systems, but in most cases only indirect references to the costs associated specifically with section 404 compliance were made.

An example of a filing that reported specifically on changes in internal controls as a result of enhanced technology systems can be found in the 10-K of Journal Register Co., where the Management’s Report on Internal Control Over Financial Reporting concluded that the company’s internal control over financial reporting was effective as of December 26, 2004. The filing included the following statement, which shows how compliance was met through a combination of additional expenses and capital assets:

During fiscal year 2004, the Company commenced the deployment of a new suite of software applications in a shared services environment. The new suite of applications will include (i) financial applications, including accounts payable, general ledger, fixed assets, and consolidation and reporting, (ii) circulation management applications and (iii) advertising management applications. Once fully deployed, the new software together with the change to a shared services business model is intended to further enhance the Company’s internal disclosure and controls and its operating efficiencies. As of December 26, 2004, the implementation of the financial applications is expected to occur beginning in fiscal year 2005. The implementation of the financial applications has involved changes in systems that included internal controls, and accordingly, these changes have required changes to our system of internal controls. The company has reviewed each system as it is being implemented and the controls affected by the implementation of the new systems and made appropriate changes to affected internal controls as the new systems were implemented. The Company believes that the controls as modified are appropriate and functioning effectively.

In the Management’s Report on Internal Control Over Financial Reporting section of Quality Distribution Inc.’s December 31, 2004, 10-K, the company reported material weaknesses in internal controls related to the consolidation process, segregation of duties within the purchasing cycle, and fixed-asset accounting. As a result, Quality Distribution exercised the SEC’s exemptive order that provides many companies with the right to a 45-day extension for the filing of management’s report on internal control and the attestation of an independent auditor regarding management’s assessment. In its 10-K A00 filed May 2, 2005, Quality Distribution Inc. reported the following, which shows how the company planned to comply with section 404 requirements through a combination of additional expense and capital expenditure in the future:

We are in the process of developing a plan to remediate the material weaknesses in our internal control over financial reporting discussed above. Several elements of our remediation plan can only be accomplished over time. In connection with our remedial efforts, we plan to hire four additional professionals to strengthen our accounting function by the end of the second quarter 2005. … Additionally, we expect to identify, install, and test new accounting software in 2005 with an early 2006 implementation.

In conclusion, the authors expect that as companies implement section 404, similar treatment will be afforded to related costs. Companies will opt for the immediate expensing of all costs associated with section 404 compliance, take the “big bath” in the first year, and disclose the negative impact on financial results accordingly. Major expenditures on information technology systems, either acquired or developed internally, will be capitalized and amortized over the periods expected to benefit.

Tax Treatment of Section 404 Compliance Costs

While accounting treatment and reporting of section 404 costs should be governed by principles-based standards and applied using professional judgment, the tax treatment is governed by the Internal Revenue Code (IRC), and may differ from the accounting treatment.

SOX is the most comprehensive legislation in the field of securities regulations in several decades and the most comprehensive legislation ever in the field of corporate governance. Although SOX is not nominally a tax law, it is certain to affect tax practice. The question is how.

Under the IRC of 1986, a taxpayer might treat an expense for income tax purposes in one of two ways: deduct it currently against income, or capitalize it. If an expense is capitalized, there are yet another two ways for a taxpayer to deal with the item: add it to the tax basis of a new or existing asset, recoverable upon disposition; or recover the cost over the useful life of the asset. A taxpayer can ordinarily not choose between deducting and capitalizing, nor, if an expense is to be capitalized, whether to depreciate or amortize the cost, or to postpone the deduction until the time of disposition. For reporting purposes, the taxpayer must decide which treatment is correct. Both Congress and the courts have supplied several generally helpful, if not always consistent and clarifying, guiding rules.

As for statutes, four principal sections of the IRC address the deductibility of expenses. The first, IRC section 162, allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The second, IRC section 212, generally allows deductions for expenses incurred in the production of income other than those arising from a trade or business. The third, IRC section 263, disallows deductions for amounts paid for new buildings, or permanent improvements or betterments made to increase the value of property. The fourth, IRC section 263A, applies to property produced by the taxpayer or purchased for resale, and requires capitalization of direct costs of the property and any indirect costs allocable to its production, acquisition, and holding.

Taxpayers try to fit within either IRC section 162 or 212, which afford current deductibility; correspondingly, they try to stay outside of sections 263 and 263A, which usually mandate capitalization. Taxpayers favor current deductions because they reduce their taxable income immediately rather than over time. The IRS, however, favors capitalization under IRC sections 263 or 263A, or within any of the judicially established capitalization doctrines, thus maximizing current tax revenues.

If a taxpayer must treat an expense as a capital expenditure, then the taxpayer’s preference is to have the cost recovered over the approximate useful life of the asset (or in some cases a shorter period, such as the approximate useful life of the benefit created by the expense). By reducing current taxable income, the time-value-of-money doctrine strongly encourages the taxpayer (and advisors) to develop a rationale that justifies an immediate write-off. Whether an expense is deductible or capitalized, the ultimate economic effect is the same: The expense eventually offsets income earned. The broader policy implies that, in measuring taxable income, costs ought to be set off against related income only, and only when that income is taken into account for tax purposes, not more or less, or sooner or later. The aim in either event is to clarify the distinction, which is often difficult, between expenses that are currently deductible and those that are capital expenditures which, if deductible at all, must be amortized over the useful life of the asset.

Tax authorities have tried hard to “clarify the distinction,” but they have been notably inconsistent. For example, for a taxpayer-favorable ruling, see Steger v. Comm’r [113 T.C. 227 (1999)], where a retiring lawyer was allowed to deduct a single premium payment for multiyear malpractice insurance coverage, claims under which necessarily would be made, if at all, years after the payment. For a taxpayer-unfavorable ruling, see Black Hills Corp. v. Comm’r [73 F.3d 799 (8th Cir. 1996)], where a taxpayer was not allowed to deduct all of the insurance premium for a black-lung insurance policy, claims under which necessarily would be made, if at all, years after the payment. In another case, Comm’r v. Lincoln Savings & Loan Association [403 U.S. 345 (1971)], the Supreme Court set a standard for capitalization by requiring that an insurance premium be capitalized on the grounds that the expense created a “separate and distinct asset.” This “separate and distinct asset” standard was thought to be an accurate restatement of decades-old law on point as well as a guiding light for the future, and while it caused a few serious interpretational problems, taxpayers adjusted comfortably to the standard.

“Separate and distinct” was the embodiment of the law, and tax practitioners everywhere found comfort in having a solitary, fairly uncomplicated standard—that is, until INDOPCO v. Comm’r [503 U.S. 79 (1992)], where the taxpayer was required to capitalize professional fees paid to structure a tax-free reorganization. In INDOPCO, the Supreme Court backed away from the “separate and distinct asset” test, or at least afforded the IRS an attractive alternative, with the striking observation that a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred should be a factor in determining whether the appropriate treatment is immediate deduction or capitalization. This test became known as the “future benefit” test, which, while not posited as a controlling standard, nonetheless embodied a huge departure from the “separate and distinct” test.

INDOPCO was a major victory for the IRS, but it alarmed taxpayers because it brought into question the deductibility of just about any expenditure (e.g., advertising, salaries, insurance premiums, clothing, office supplies) so long as the IRS made even the slightest case that the taxpayer benefited beyond the current tax year. The INDOPCO taxpayer was left with a capitalized item that had no determinable life, which meant in turn that the expense ($3 million plus) would be recovered only on disposition of the asset (in that case, newly acquired stock). Given the Court’s accompanying statement, that “deductions are exceptions to the norm of capitalization,” taxpayers became deeply concerned. Obviously, many expenditures have benefits that extend beyond the year in which they occur. Did INDOPCO and its “future benefits” test actually jeopardize the deductibility of all expenditures?

The “future benefits” rationale is very broad, and the IRS read it exactly the way the Court probably intended. Taxpayers and the IRS alike struggled with early decisions about whether to deduct or to capitalize an extraordinarily varied set of expenses, and if the decision was to capitalize them, the follow-up problem concerned whether they should be cost-recovered. What does one do with such widely disparate expenses as those for environmental cleanups, employee recruitment and training, plant closings, early-retirement bonuses, and advertising? Are expenses associated with creating or enhancing long-lasting intangibles (e.g., goodwill, bank loans, title-defense costs) deductible, or must they be capitalized?

The concern did not abate over time. Administratively, the IRS was cautious about extending INDOPCO. In contrast, during litigation in the Tax Court, the IRS was considerably more aggressive, and the Tax Court was sympathetic. It appeared that the Supreme Court had handed the IRS a powerful weapon in the “future benefit” standard. However, the IRS’s own inconsistency in applying INDOPCO, the large number of complaints, and the overall confusion about the breadth of the “future benefits” standard led to the so-called “INDOPCO regulations.”

In response to INDOPCO, the Treasury Department proposed regulations to ease the level of uncertainty surrounding the deductibility or capitalization of expenses. The new regulations generally allow current deductions for expenditures giving rise to substantial future benefits if the expenditures do not relate to separate and distinct assets. These regulations require capitalization for several categories of expenses, including acquired intangibles and specific taxpayer-created intangibles. The INDOPCO regulations are significant because, with certain exceptions, they effectively discard the “future benefits” standard as a factor in determining deductibility/capitalization treatment. In summary, the INDOPCO regulations seem to be an effort by the IRS to overrule the Supreme Court.

For SOX purposes, the deductibility/capitalization of section 404 compliance costs is fairly straightforward: Whatever the case might have been pre-INDOPCO is likely the case now. INDOPCO regulations allow current deductions for expenditures giving rise to substantial future benefits if the expenditures are not related to separate and distinct assets. Capitalization is required for expenses incurred for acquired intangibles and certain taxpayer-created intangibles, including internal-use software and enterprise resource planning (ERP) systems. At some point, however, companies may wish to interpret the INDOPCO regulations in favor of capitalization; for example, in order to take advantage of expiring foreign tax credit carry-forwards. One company in the sample above reported its implementation of income tax elections to accelerate taxable income or to delay deductions in order to maintain positive domestic taxable income (the company elected to capitalize research costs in the year incurred for U.S. income tax purposes and to amortize them over 10 years, as opposed to deducting them in the year incurred). Because the bulk of section 404 compliance costs pertain to professional services, however, they most likely are deductible.

Again, while SOX is not a tax law, it is expected to have significant implications for tax practice. In most cases, compliance costs should be deductible. One of the most salient points to make about the deductibility of section 404 compliance costs derives from an analogy to an IRS Revenue Ruling in 2000 that allows taxpayers to deduct costs of obtaining International Organization for Standardization (ISO) certifications, and the corresponding process for updating and maintaining the certification. This involves an extraordinarily thorough effort to assess quality-control processes; create a quality manual; train employees; implement an enhanced or new quality-control system; and obtain external, independent certification regarding both the nature of the ISO-mandated quality-control system and compliance with it. Because ISO certification lasts for multiple years, the current effort and corresponding expense to obtain and keep it has, by definition, a clear “future benefit.” Although ISO certification is voluntary, its value to certain companies is so high that it has become, effectively, a requirement, particularly for companies doing business internationally. Its relevance as guiding authority with respect to the deductibility of section 404 compliance costs is apparent. Both ISO compliance and section 404 compliance result in the creation of something intangible (e.g., processes, systems, and know-how), yet none of this is referable to “separate and distinct assets.” While in certain instances section 404 compliance costs might be capitalized, the general understanding should be that nearly all of these costs will be properly deductible.

Substance over Form

While most would agree that the current accounting standards are a combination of principles and rules, and that the IRC is primarily rules-based, we should not forget the underlying concept of substance over form. The structuring of transactions in order to treat items according to the applicable rules, or the liberal application of principles in order to reach desired outcomes, violates the substance-over-form principle. Companies should follow a principles-based approach to treating section 404 compliance costs for financial reporting purposes, and rely on the IRC for tax treatment.