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Pacific Sunwear of California, Inc.
Author(s):
Merchant, Kenneth A.
Van der Stede, Wim A.
Functional Area(s):
   Financial Accounting
Setting(s):
   For Profit
Difficulty Level: Intermediate
Pages: 14
Teaching Note: Available. 
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First Page and the Assignment Questions:
As a publicly owned company in the United States, Pacific Sunwear of California, Inc. (PacSun) was required to comply with the provisions of the Sarbanes-Oxley Act of 2002 (SOX). Among other things, SOX required top management to test their company's system of internal controls and to certify that it is effective. It also required the company's external auditors to conduct independent tests of those controls and to express their independent opinion about the effectiveness of the company's system.

In 2006, after their second year of complying with SOX, PacSun management looked back and concluded that the process had provided a few benefits, but they thought that the compliance costs far exceeded the benefits, at least to the company. With the compliance processes now well controlled and the costs of compliance having been sharply reduced, they were turning their attention back to issues of more business relevance, such as business continuity planning and, more generally, controlling business risks.

THE COMPANY
PacSun's mission is to be “the leading lifestyle retailer of casual fashion apparel, footwear and accessories for teens and young adults.” The company's origins were as a small surf shop that started in 1980 in Newport Beach, California. The company was incorporated in August 1982, and it went public in 1993. Its stock is traded on NASDAQ using the symbol PSUN. By 2006, PacSun was a large company, with annual sales of almost $1.4 billion (see Exhibit 1). Over the years, the company's stock was split 3-for-2 six times, and was one of the fastest growing stocks on the NASDAQ stock exchange.

PacSun operated chains of mostly mall-based stores with three distinct retail concepts. As of July 29, 2006, it ran 826 PacSun stores, 102 PacSun Outlet stores, 201 d.e.m.o. stores and six One Thousand Steps stores, for a total of 1,112 stores located in all 50 states of the U.S. and Puerto Rico. PacSun and PacSun Outlet stores specialized in board sport-inspired casual apparel, footwear, and related accessories. d.e.m.o. specialized in fashion-focused street wear. One Thousand Steps, a new concept started in 2006, targeted 18- to 24-year-old customers and featured an assortment of casual, fashion-forward, branded footwear and related accessories.

In its stores, PacSun offered a wide selection of well-known board-sport inspired name brands, including Quiksilver, Roxy, DC Shoes, Billabong, Hurley, and Volcom. The company supplemented the name brand offerings with its own proprietary brands. The company had its own product design group that, in collaboration with the buying staff, designed the proprietary brand merchandise. The company also had a sourcing group that oversaw the manufacture and delivery of its proprietary brand merchandise with manufacturing contracted out both domestically and internationally.

Assignment

1.    Evaluate the process that PacSun went through to comply with SOX, and particularly Section 404. Was that process as effective and efficient as it could have been?

2.        Are the “significant deficiencies” that were identified in each of the two years of the audit evidence of control system flaws or largely irrelevant technical violations? In other words, should disclosure of these deficiencies have had a negative effect on PacSun's stock price?

3.        PacSun executives seem convinced that the costs of complying with SOX were greater than the benefits to the company. Why did PacSun not benefit from the compliance process to the same extent as some other companies? Or were their compliance costs too high?