Is the Sarbanes-Oxley Act Working?
|By Nicholls, Curtis|
In response to the Enron bankruptcy and other accounting and corporate governance scandals (e.g.,
And crack down they did: SOX has been described as the most sweeping federal legislation concerning corporate governance since the Securities Act of 1933 and the Securities Exchange Act of 1934. But given the law's hurried passage and broad scope, critics have charged that it has had unintended consequences and that its costs exceed its benefits. Now that CPAs have had a decade of experience with SOX, it is useful to review several metrics in order to determine whether the act's touted benefits have materialized.
Review of Objectives
SOX aimed to make financial reporting more transparent and to restore investor confidence in the U.S. financial markets. Specifically, its objectives included the following:
* Enhance auditor independence, primarily by restricting the nonaudit services that a CPA firm may provide to its audit clients and by requiring audit-partner rotation.
* Address concerns about the auditing profession's self-regulation by creating the PCAOB and charging it with regulating the profession and establishing standards.
* Improve corporate governance and, as a result, reduce (ideally, eliminate) fraudulent financial reporting. SOX approached this aim by requiring executives to certify financial reports and internal controls; providing for
Criticisms of SOX
The following sections discuss several criticisms of the act:
Scope. Some refer to SOX as the toughest piece of corporate governance legislation ever enacted; others argue that although it represented a step in the right direction, it did not go far enough because it rotates audit partners (not firms), prohibits CPAs from providing only certain nonaudit services to their audit clients, and did not add accounting standards setting to the PCAOB's charge.
Costs versus benefits. One frequent complaint about SOX concerns the law's costs compared to its benefits-especially the cost of complying with SOX section 404, which deals with internal controls. Based upon studies conducted shortly after SOX took effect, average section 404 compliance costs ranged from
Some believed that these costs will drop as companies become more familiar with the law and improve their control systems. But others found that, despite remaining at manageable levels for most organizations, SOX compliance costs did increase from 2011 to 2012; thus, not all the data support the contention that costs should steadily fall ("Building Value in Your SOX Compliance Program: Highlights from
Another investigation of costs examined stock price reactions to key SOX-related legislative events, based on the notion that stock returns over key event days should reflect the expected costs and the benefits of SOX (
My discussion raises questions about popular claims that SOX has been excessively costly to firms. But I hasten to add that it would not be surprising if one-size-fits-all regulation imposed significant net costs on firms. Moreover, it is possible that SOX set off incentives to overspend on internal controls because managers and directors bear only a small fraction of the compliance costs but share disproportionately in a liability from control deficiencies. ... Presently, however, we do not have much SOXrelated evidence to support the conclusion that SOX has been excessively costly. In fact, there is evidence that SOX has increased the scrutiny public firms face, as intended by
Despite such mixed evidence, both the
In 2011, the
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 brought additional changes to SOX by exempting all public companies classified as nonaccelerated filers by the
Impact on cross-listing. Some financial professionals believe that SOX has had a chilling effect on international companies' cross-listing in U.S. markets (
On the other hand, delistings by foreign companies from the
Impact on small companies. Detractors of SOX have argued that compliance costs fall disproportionately on small firms. Indeed, some small companies are reportedly going private to avoid SOX's reporting requirements. To test this hypothesis,
Impacts on auditors. Given that SOX resulted, in no small part, from a rash of high-profile audit failures and that many of its provisions significantly affected the public accounting profession, it is interesting that accountants are not among SOX's contemporary critics. The law enabled CPAs to return to what they were trained to do (i.e., auditing, as opposed to consulting); this has been a financial boon for CPA firms, due to the requirement that auditors audit a company's controls as well as its books.
A study of changes in auditor fees surrounding SOX found that they increased approximately 74% in the post-SOX era, which more than offset a decline in nonaudit fees over the same period (
Another SOX provision created the PCAOB, which has garnered some auditor support; for example, Ernst & Young stated that the PCAOB has contributed significantly to audit quality and auditor independence and believes that opportunities to build on SOX's foundation should be pursued ("The Sarbanes-Oxley Act at 10: Enhancing the Reliability of Financial Reporting and Audit Quality," 2012). On the other hand, some executives surveyed in the wake of SOX felt that auditors, who worried about being second guessed by regulators and plaintiffs lawyers, were being too conservative and were requiring too much disclosure, as well as testing immaterial controls (
With most government regulation, it is not difficult to determine who is impacted and in which ways. Compliance costs might be estimable and the parties that bear them known, although that is more often the case with direct costs, as opposed to indirect costs. Given that regulation is usually intended to achieve objectives that benefit society as a whole, estimating the amount of these benefits is more difficult (and often impossible). Conducting a cost/benefit analysis often comes down to the proverbial question of whose ox is being gored-and it becomes a matter of judgment (often biased), rather than a simple economic analysis. As indicated in the various viewpoints above, SOX is certainly no exception to this general rule.
Possible Detriments Id SOX's Effectiveness
Short-term market pressures, greed (driven by excessive executive compensation), and cultural features might continue to influence executives to commit fraud. Ultimately, financial reporting fraud stems from a lack of ethical conduct by management, which SOX cannot correct. In other words, fraud is not so much due to poor controls as to executives who override controls when pressured to show earnings, forces that are not amenable to regulation.
SOX requires audit committees to establish procedures for receiving whistleblower complaints regarding accounting, auditing, and internal control irregularities and to provide for the confidential and anonymous treatment of employee concerns with respect to such matters. In "Don't Shoot the Messenger,"
A primary objective of SOX was to enhance auditor independence; however, potential impediments to meeting this goal remain. For example, auditors are still hired by their clients; thus, incentives-whether real or perceived-to "keep the client happy" remain. To counter any tendencies of auditors to get too cozy with management, SOX transferred the authority to appoint auditors from management to the audit committee. This represented a compromise between the status quo and more aggressive proposed solutions, such as mandatory audit firm rotation or a requirement that companies purchase financial statement insurance, with the insurance company hiring and paying the auditor. In 2013, the
Furthermore, SOX did not require that CPA firms cease all nonaudit services. For example, auditors still do tax work for audit clients, and independence can be questioned when a company defends an audit client on tax matters. Auditors might also advise their clients on internal controls, then assess those controls and report on their adequacy; this essentially places them in a position to approve their own woik. To avoid potential conflicts of this nature,
Attempting to reduce fraud via regulation that increases the independence of outside monitors (e.g., mandatory partner or firm rotation) poses its own set of potential problems: more independence reduces access to information. Although new auditors might be more independent, they are not as knowledgeable about a firm and its management as ones with long-standing tenure; this puts them in a weaker position to counter a senior management team that succumbs to the pressure to improve results and engages in collusive financial reporting fraud. Ultimately, this fact remains: the efficacy of the financial reporting process is heavily dependent upon the integrity of all those involved, something that cannot be legislated.
Evidence for and against SOX's Effectiveness
The results of two studies that examined stock price reactions to legislative events surrounding SOX were consistent with investors' anticipation that SOX would enhance the quality of financial statement information by constraining earnings management, and thus restore investor confidence (
If controls are improving, the profession should see a reduction in the number of audit reports that cite companies for material weaknesses in their internal controls. A material weakness exists when the design or operation of internal controls does not allow for the prevention or detection of a misstatement on a timely basis, and thus can result in a material misstatement. One study of 2,500 companies, conducted shortly after SOX took effect, reported an 8% rate of material weaknesses in controls; another review of 1,457 companies found a 5.6% rate (Glater 2005). In 2008,
Restatements might indicate that nervous executives (or their auditors) are addressing financial reporting problems. Using data from a study of financial statement restatements by Glass Lewis & Co. that show a marked increase in restatements after the passage of SOX,
To put these improvements in context, Glass Lewis & Co. noted that the rate of companies receiving adverse internal control opinions stood at 2% in 2010, down from 14% the first year that SOX required them; it further reported that most of the recent errors resulted from basic misapplication of GAAP (cash-flow and balancesheet misclassifications, underreported compensation expenses from backdated stock options, and lease accounting errors are leading causes of misstatements), poor systems, or unskilled or lacking personnel-not from manipulative accounting practices (
New analysis. In addition to the studies outlined above, this article's authors conducted their own analysis in order to determine the possible effectiveness of SOX. If fraud at companies has decreased, reduced media coverage reporting on financial fraud should also be observed. The authors surveyed two large newspapers (the
Predictably, the number of newspaper reports referencing the search terms peaks in 2002, with 1,267 matches-an increase of almost 360% over 2001. News reports in 2003 remained robust, with 1,068 (a decline of just under 16%). The media hits captured by this survey have steadily declined since 2005, with only 355 reports in 2008 (a 72% decline from the 2002 peak). This evidence might indicate a decline in the amount of actual fraud, but it could also represent shifting media interest; SOX caused reporters to focus on accounting and financial statement fraud, creating a du jour effect that has subsided as the memories of Enron and WorldCom have faded. In support of this theory of shifting media interest, matches to the fraud terms have started to increase again after bottoming out in 2010; this timing coincides with the financial crisis in the mortgage and banking industry that began in 2007, which drew attention away from financial statement fraud. As the financial crisis has subsided, it appears that media interest is beginning to again refocus on fraud-related topics.
The authors further analyzed the data in order to interpret the recent uptick in media interest and found that a large portion of the increase is related to articles containing the keywords "corporate governance." A simple search of articles related to this keyword indicated that "activist investor," "shareholder activist," and "activism" are important topics gaining widespread media coverage. Although corporate governance is an important topic that SOX attempted to improve, an increase in activism-related media reports may not reflect a changing incidence of fraud.
If fraud has decreased, the authors would also expect the number of SEC Accounting and Audit Enforcement Releases (AAER) to decrease. The
The financial crisis of the late 2000s compelled the
During the financial crisis,
But Eaglesham also suggested:
The falloff in accounting-fraud crackdowns by the
Eaglesham indicated that
Mixed Results and Further Study
Based upon this review, the evidence on SOX's effectiveness is mixed. The initial cost estimates might have been overblown, with the cost of compliance stabilizing at manageable levels; however, concerns about the high cost of compliance for small companies might ring hue, with more of them opting to refrain from listing or going private in order to avoid compliance costs. Furthermore, foreign businesses might not be accessing U.S. capital markets due to increased compliance costs and litigation risk resulting from SOX. Audit firms have benefited from the law because it has created new revenue from controlrelated compliance work. Evidence indicates that SOX might have improved financial reporting quality, although it might not have deterred actual fraudulent behavior. Corporate governance provisions of the act also appear to have improved overall board composition and engagement. The act also apparently caused an immediate increase in restatement activity, but little has been offered to explain the increase.
Although the authors' data implies that the incidence of fraud has decreased since SOX was enacted, a definitive statement to that effect cannot be made because the data might be the result of fluctuating media and
As accounting professor
Despite mixed evidence, both the
A primary objective of SOX was to enhance auditor independence; however, potential impediments to meeting this goal remain.
Evidence indicates that SOX might have improved financial reporting quality, although it might not have deterred actual fraudulent behavior.
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