Excessive Cost: The development of SOX (and section 404 in particular,) is described as an imaginary yet compulsory trip to some destination that was not chosen, but will be enjoyed once there (Sharman, 8). On this journey there are two players, the Securities and Exchange Commission (SEC) and its subsidiary the PCAOB. In this case the destination that Congress anticipated was “more reliable auditor certified financial disclosures” (Sharman, 8)
The trip is supposed to cost little, but because it requires travel along highways that charge, the final cost is excessive. The cost of Section 404a compliance was originally estimated that to be $91,000 per company. In some cases it has been as high as $40 million. (Sharman 8)
Loss of revenue: The significant loss of revenue for audit firms has driven up the cost of audit. Title II of the Act deals with auditor independence and places significant restrictions on the public accounting firms engagement in other services. These restrictions are designed to ensure independence of the audit process. In recent years the additional services have become a significant revenue generator for large firms. (Raiborn and Schorg, 5, 6) However, one should contrast this loss of revenue with the fact that companies now have additional billable services as a result of increased audit measures. (Bealing and Baker, 9)
Loss of knowledge: Independence came into sharp focus with Andersen’s work with Enron, which generated $25 million for audit work and $27 million for non-audit work. The SEC Chairman questioned whether the corporate watchdog could “…bark should the company attempt to steal some biscuits” (Raiborn and Schorg, 6). This should be contrasted with the likelihood of greater ability to judge issues as result of the increased knowledge gained from the long-term relationship. (Raiborn and Schorg, 5)
Reduced prestige: The so-called Red Shirt provision requires that an audit firm cannot audit a public company where that company has recruited an executive level position from the audit company. This has a negative impact on the prestige of working for a public auditing company and therefore the ability to recruit. Waste Management recruited an auditor from Andersen and then went on to exaggerate earnings. (Raiborn and Schorg, 7)
Independent audit committee: Title III Corporate Responsibility, places a requirement for there to be an audit committee. However, it is increasingly difficult to recruit to an independent committee because of the pervasive nature of litigious actions against such members. (Raiborn and Schorg, 7)
Foreign Stock Markets: There is already some evidence that the US is losing ground to more competitive markets with some US companies choosing to list their Initial Public Offerings (IPOs) on foreign exchanges. Companies are very responsive to market conditions. There are a number of reasons a public company might list abroad and as David Hyland of Xavier University concludes, SOX is just one of them. (Lewin, 59)
An IPO requires carefully prepared documents that already assess the risks to investors, so laying SOX on top of that is an unnecessary burden that impacts the daily business. The SEC Chairman believes that new IPOs could wait until the second annual report before having to comply with 404. (Lewin 61)
Others believe that the U.S. should learn from the Canadian and British systems, which require an auditor opinion of internal control processes. They argue this is better that the subjective auditor opinion required by section 404b. (Lewin, 61)
Codes of conduct:
The Enron scandal demonstrates that even the broadest of codes are ineffective when the board fails to act appropriately. Section 406 of SOX deals with corporate codes of behavior, but this section is riddled with unintended and unfortunate consequences.
Hamstrung honest executives: SOX attempts to foster self-policing through corporate codes of behavior. There is also wide range of other codes including the Security and Exchange Commission (SEC) implementing rules, New York Stock Exchange listing rules, changes to the NASDAQ stock exchange listing rules . The increasing array of code requirements may in fact hamstring honest executives from using codes effectively. (Harvard Law Review, 2141)
Visibility of incriminating evidence: In 1991 the Federal Sentencing Guidelines for Organizations Act provided that companies could reduce their liability for dishonest employees by demonstrating an effective program to detect violations. A code of conduct is an important part of such a program. However, if a company has strong internal compliance programs incriminating evidence becomes all the more visible and could result in criminal or civil liability. (Harvard Law Review, 2124)
Obtuse and meaningless waivers: The Special Investigative Committee of the Board of Directors of Enron noted that the ratification of Andrew Fastow’s involvement in related party transactions was fundamentally flawed and that the oversight and the annual reviews were meaningless. Indeed the public filings made matters worse since they were obtuse and failed to reveal the substance of related party transactions (Harvard Law Review, 2129.) A code is only as good as those who enforce it.
The company decides what to disclose: Section 406 requires that a public company must disclose whether it has adopted a code of ethics for senior officers and immediate disclosure (on Form 8-K or on the company’s websites) of any change or waiver of the code. The SEC has adopted rules for a wider range of people and conduct than SOX, but they have not specified the language or procedures that should be included. Therefore in contrast to the intention of section 406 companies are able use language to control the information that the code exposes and is subjected to the disclosure rules.
Discouraging honest executives: The theory goes that increased transparency will enable the investing community to make better evaluations and reward those companies that have detailed and effective codes. Unfortunately for a variety of reasons, including the impact of the disclosure, honest executives may be deterred from writing such codes, while the dishonest carry on as before. (Harvard Law Review, 2141)
Fewer waivers: The requirements to disclose waivers may well reduce the number put forward since fewer activities will now come under the purview of corporate codes. Companies are likely to define codes narrowly and therefore avoid the need for waivers.
Increased litigation: Companies fear that even well informed decisions to grant waivers may be viewed negatively or used with hindsight in litigation. Companies that fail to comply with their own policy or procedures may be exposed to more liability than if they had no code. Lawsuits are expensive and distracting to the day-to-day running of a business and the increased risk of litigation only compounds the likelihood of legalistic and nebulous codes of conduct. (Harvard Law Review, 2139/ 40)
Meaningless information for investors: It is said that codes will become indistinguishable form one another and therefore meaningless to investors. Over regulation leads to strict compliance, but the spirit and intention are completely lost. (Harvard Law Review, 2141)
Confusion: Tim Leech of Paisley Consulting says that SOX is needed but the way in which the PCAOB has interpreted Section 404 is very inefficient. Jay Ritter of University of Florida blames the auditing requirements for increasing costs and these costs outweigh benefits of encouraging ethical behavior. He says that 404 is brief and vague, leaving it open to interpretation. (Lewin, 60) Section 404 has a significant impact on the internal auditing process, not least in cost terms. Adverse comments from companies about the apparent nitpicking style of auditors are not eased by the inconsistent approach by audit firms and the lack of effective guidance for managers.
Inconsistent Auditing: The confusion as to how public companies should deal with SOX is exacerbated by inconsistent application of the pass/ fail test and even variability within the same CPA firm. This inconsistency has been demonstrated by research but the criterion used by auditors hasn’t even been tested empirically. (Sharman, 10)
Incompatible Guidance: A further, and perhaps more worrying, factor that creates confusion is ineffective guidance available to managers regarding effective internal controls. The SEC based its guidance on the 1992 internal controls framework of the Committee of Sponsoring Organizations of the Treadway Committee (COSO.) Unfortunately the IMA concluded that this framework was being asked to do something for which it was not designed. (Sharman, 10) It seems the SEC has abdicated responsibility by assigning the development of auditor guidance in the form of Auditing Standard No. 2 (AS2.) De facto therefore, AS2 has become the primary guidance for managers, but it is aimed at auditors and contains a maze of tests and flow charts. Even auditors employ consultants to help understand the procedures, so it is no wonder that the cost of compliance is so high. (Sharman, 10)
On December 13, 2006 the SEC announced it was to release managers’ guidance. However, the PCAOB’s impending release of new auditors’ guidance in the form of AS5 could make the problem complex once again if they fail to align with the SEC managerial guidance. (Sharman, 10) Without effective and aligned guidance, compliance with SOX becomes a nightmare for managers. To prove fiduciaries diligent, SOX required tests to document and make every internal control evident, a nightmare compliance requirement. (Habbart)
Conclusion
Laws and codes of conduct are not substitutes for ethics. Narrowing the so called “expectation gap” requires either more regulation and higher fees or public acceptance that auditing is not a seal of approval. One is too restrictive on business and the other can only undermine investor confidence, neither of these options is good for the economy. (Raiborn and Schorg, 11)
There are a number of players seeking to establish their legitimacy, the PCAOB, SEC, Congress and the accounting profession. The accounting profession has no wish to cede more power. It hopes that improved audit standards will limit future regulation and oversight in deference to continued self regulation. The future may depend on the battle under way between the PCAOB and the Auditing Standards Board (ASB), with the ASB hoping to blunt the PCAOB’s authority to regulate and extend their oversight into other areas. (Bealing and Baker, 8)
Regulations, including SOX, may be responsible for keeping the bad apples out of the barrel and additional regulations may further enhance investor confidence. However as this paper demonstrates, when government interferes, particularly in haste, it causes more problems that it solves. Self regulation is the answer and it is to be hoped that the ASB blunts the PCAOB.
In the global markets today it does not behoove the US to create too many inhibitions to free and efficient enterprise. Now maybe the time for U.S. listed companies to lobby hard, if the US is to maintain its position as the world’s pre-eminent capital market. (Lewin, 61)
Works Cited
Dan Habbart, January 2007, A Sarbanes - Oxley Meditation, Journal of
Accountancy, page 16
Cecily Raiborn and Chandra Schorg , spring 2004: An Analysis of and
Comments on the Accounting Related Provisions, Journal of Business and Management Volume 10, No 1, pages 1 to 12
Paul A. Sharman, January 2007, The Winding Road of SOX Compliance,
Strategic Finance, pages 8 to 10
Rivkah Lewin, January 2007, Strategic Finance pages 59 to 61
Notes, The good, the bad and their corporate codes of ethics: Enron, Sarbanes-
Oxley, and the problems with legislating good behavior. Harvard Law Review, pages 2123 to 2141
William E. Bealing Jr. and Richard L. Baker, Fall 2006, The Sarbanes-Oxley act:
Have We Seen It All Before? Journal of Business and Economic Studies, Volume 12, No 2, pages 1 to 9
Steven Barlas, December 2006, Strategic Finance, December Page 24
Ventana Research www.180systems/com/SarbanesOxley-news.php,
November 21, 2006