5 Years and Counting: Impact of Sarbanes-oxley

5 Years and Counting: Impact of Sarbanes-Oxley

Background

In order to better understand the issues and impact of Sarbanes-Oxley, it is critical to understand the reasons for its implementation. Elaborate, complex fraudulent accounting scandals of the late 90’s and early 21st century have a direct correlation to poorly implemented and enforced internal controls. Since the enactment of the Sarbanes-Oxley legislation, companies have had to be even more cognizant of their controls in order to provide the necessary assurances that both their internal and external outputs (e.g. financial statements) to stakeholders are accurate and reliable.

Founding Fathers of Accounting Scandals

Enron, WorldCom and Arthur Anderson represent the dark side of the accounting profession. These tales of greed, dishonesty and malfeasance have shaken the confidence of the investing public and in the public accounting profession, the protector against such evil, fraudulent activities. It is seemingly entertaining to hear the hierarchy of these multi-national corporations (MNC) defend their wrongdoings. For example, take into consideration the following excerpt that appeared in USAToday from the testimony of Jeffery Skilling, the former Chief Executive Officer (CEO) of Enron:

Boxer: Wait a minute, you have to be an accountant to know that a company could never use its own stock to generate a gain or avoid a loss in an income statement? What was your education, Mr. Skilling? I know I read it was pretty good.

Skilling: A master’s in business administration.

Boxer: A master’s in business administration, and yet you didn’t know this simple fact, is that correct? …Where did you go to school?

Skilling: Harvard Business School.

Boxer: In Harvard Business School you did not know this, is that correct?

Skilling’s rationale is simply irrational because it ignores a basic accounting principle. Consequently, situations such as this, which cost investors hundreds of millions of dollars, needed to be addressed. Thus, the Sarbanes-Oxley Act of 2002 was meant to restore the public’s confidence in the accounting profession, safeguard against internal control failures, and deter the possibility of future accounting scandals.

Compliance Costs

While Sarbanes-Oxley provides investors with higher quality information, there has been controversy on whether the benefits exceed the rather burdensome compliance costs. However, in a recent survey, 83% of companies believe that spending on compliance costs will be relatively the same or even less than last year (Papini 11).

According to Paul Larsen, an equity strategist at the Chicago Morning Star, ”compliance costs are going to decrease as the years pass because there is usually one big upfront technology cost made in the first year, and then costs are more maintenance-related the following years.” Further, software is being developed and companies are now moving toward automated controls which should bring costs down and reduce human error (Papini 11).

Section 806

One area of fundamental weakness within the Sarbanes-Oxley legislation is Section 806 dealing with the whistleblower provisions. Under this act, civil liability can be imposed on employers who take retaliatory action on other fellow employees who come forward with information about actual or potential corporate fraud involving their employer (eapdlaw.com).

Theoretically, if effectively implemented this law could be extremely advantageous in combating fraud from the source and protecting ethical employees. However, several structural areas of the law are flawed and allow it to be exploited. One weakness is the very stringent ninety (90) day statute of limitations. In the first 3 years of the laws’ existence, roughly one-third of employees who lost at the ALJ level did so because they did not satisfy the statute of limitations (Moberly 2). While legally correct, this decision ignores the substance and the spirit of the law. In addition, failure to meet the statute of limitations forces judges to disregard the materiality of the claim and the tribulations of the employee.

Another area of weakness of Section 803 is its reliance on OSHA investigations to determine employer retaliation. OSHA’s mission statement clearly states that their mission is to assure the safety and health of America’s workers by setting and enforcing standards; providing training, outreach, and education; establishing partnerships; and encouraging continual improvement in workplace safety and health (osha.gov). This broad statement fails to encompass the spectrum of employer retaliation and how it applies to the accounting profession. OSHA’s general purpose and resourcefulness do not match the requirements for successful enforcement and implementation of Section 803. This problem is most evident by OSHA’s mere 3.6% success rate for employees in the first 3 years of SOX (Moberly 1). The system would adequately function if the investigative responsibilities were given to an agency more familiar with fraudulent accounting practices such as the SEC (Moberly 4).

Section 404

Section 404 is largely regarded as another weakness within the Sarbanes-Oxley Act, which results in an enormous corporate compliance expense. Fortunately, for accounting firms, the audit fees represent a large portion of that increased cost (Pomeroy 1).

Due to the more stringent requirements, adverse opinions are being reported more frequently. In the first year of SOX compliance, 16% of filers were given an adverse opinion. On the positive side, in the following year that number went down to 10% which proves that despite the extra costs, auditors are finding material misstatements and reporting more precise information. The following is a breakdown of the most common areas of misstatement (Section 404: Where the Weaknesses Are).

Areas of Failure 2005* 2004*

Tax Accruals/Deferrals 34.5% 32.0%

Revenue Recognition 28.4% 31.3%

Inventory/Vendor Cost of Sales 23.7% 27.4%

Fixed Intangible Assets 16.0% 18.6%

Leases or Contingencies 9.3% 16.8%

Cash Flows 8.8% 8.8%

Consolidation 6.7% 9.0%

*numbers do not add up to 100% because data allows for multiple material weaknesses.

Source: AuditAnalytics.com

Another positive of Section 404 is that costs are going down! In a recent survey of 172 companies, 2006 compliance costs for Section 404 declined 23% and are continuing to decline (SOX 404 Costs Drop).

So what have we learned?

Overall, Sarbanes-Oxley has had an overwhelmingly positive, albeit burdensome, impact on the accounting profession. The industry is expanding and more jobs are being created. Furthermore, accounting firms are producing more credible, accurate and reliable financial statements to meet the stern reporting requirements. On top of that, appropriate measures are being taken to prevent future debacles and scandals thus fulfilling the accountant’s superpower of protecting the investing public and restoring faith in the profession.

Sarbanes-Oxley’s negative impact is minimal and consists of compliance costs that will decrease in time and can be absorbed through technological advances. Even Section 806, despite its deficiencies, positively affects employees and is useful in preventing fraud. Obviously, Sarbanes-Oxley has some flaws, however if Congress selectively and intelligently amends certain weaknesses the overall long-term positive impact drastically exceeds the pitfalls.