The Sarbanes-Oxley Act: A Dozen Years Later, Taking Stock

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The Sarbanes-Oxley Act of 2002 (more often known as SOX) was enacted after Congress took note of a series of corporate scandals such as Enron, Tyco International Ltd. (NYSE:TYC), WorldCom and others, in which investors relied upon the efficacy of financial reporting and accounting, but subsequent events belied their trust. The companies involved, and their stocks, imploded, inflicting grievous financial losses on the investors.

The Sarbanes-Oxley Act accordingly redefined the reporting responsibilities of company management as well as their relationship with professional accounting firms in their role as auditors of those companies. In fact, in the Senate the SOX was known as ‘Public Company Accounting Reform and Investor Protection Act,’ while in the House it was titled the ‘Corporate and Auditing Accountability and Responsibility Act.’ These names clearly show the intent of the Legislature.

Sarbanes-Oxley Act – Focus

The provisions of the Sarbanes-Oxley Act focused on the independence of auditors, their assessment of internal control procedures in companies, corporate governance and more arduous reporting responsibilities by these companies. The Act imposes additional responsibilities as well as criminal penalties on the various functionaries responsible for financial reporting and disclosure in corporate America.

One of the key developments arising from the SOX was the creation of the Public Company Accounting Oversight Board (or, PCAOB), a new entity setup to regulate and oversee accounting firms in the discharge of auditing duties.

The Legislature also intended to increase the role of company auditors as watchdogs over the implementation of laws against theft and fraud by corporate officials.

“The error of low standards and false profits is over; no boardroom in America is above or beyond the law,” said President George W Bush after signing SOX into law.

But at what cost?

John C Coates, Professor of Law and Economics, Howard Law School and Suraj Srinivasan, Associate Professor, Howard Business School, have authored a research note titled “SOX after 10 years: A Multidisciplinary Review” that assesses the impact of the Sarbanes-Oxley Act based on a review of over 120 research papers across accounting, finance and law.

One of the strongest criticisms against the Act was that it would increase costs for corporate America and in particular, render its financial services industry uncompetitive when compared to foreign service providers who were unburdened by Sarbanes-Oxley Act.

A key finding of the review: “While the direct costs of the Act were substantial and fell disproportionately on smaller companies, costs have fallen over time and in response to changes in its implementation.”

The authors find that direct costs relating to adherence with control system requirements of Sarbanes-Oxley Act have steadily fallen over time for all firms.

“SOX’s costs were and remain increasing in firm size, but at a decreasing rate, so that larger firms paid less for Sarbanes-Oxley Act-related services as a percentage of firm size than do smaller firms,” observe the authors.

Interestingly, Sarbanes-Oxley Act related litigation, which was expected to balloon in the aftermath of the Act’s implementation, did rise from 2000 to 2004, but subsided to levels before the enactment of SOX soon afterwards.

“Whatever the costs of Sarbanes-Oxley Act, increased litigation does not appear to be one of them,” conclude the authors, referring to litigation as a direct cost arising from SOX.

Another often-cited adverse impact of Sarbanes-Oxley Act was the apprehension that managers and boards of directors would become overcautious regarding corporate investments and entrepreneurial risk-taking, fearing liabilities from SOX. This could result in a substantial indirect cost to companies because of SOX.

After studying various research papers and surveys, Coates and Srinivasan feel that such indirect costs could be possible side-effects of SOX, “but their size and significance remain unclear.”

Durability of Sarbanes-Oxley Act

How did Sarbanes-Oxley Act weather over the past dozen years?

The authors devote a separate section that reviews the major developments in the legal, regulatory and institutional implementation of SOX.

“We describe significant developments in how the Act was implemented and find that despite severe criticism, the Act and institutions it created have survived almost intact since enactment,” observe the authors.

More particularly, Coates and Srinivasan observe that the PCAOB is now more or less a permanent and accepted feature on the corporate and auditing landscape in America – indeed, it has a staff of over 600 and an impressive annual budget of $ 180 million, though its structure has remained more or less unchanged since SOX.

The authors also observe that the relationship between auditing firms and issuer companies, though altered significantly by Sarbanes-Oxley Act, thereafter remained basically unaltered over the years – “few changes have been made to the rules governing these relationships between audit firms and public company issuers since SOX.”

On the vexed question of the expression of an opinion by the auditor on the internal control systems prevalent at the corporate issuer, the authors find that the basic mandate of the Sarbanes-Oxley Act is still inviolate. “The requirement of attestation remains intact for most public companies, and neither Congress nor PCAOB has adopted major changes to the attestation process 2007,” observe Coates and Srinivasan.

However, they clarify that criticism of the costs involved in such attestation did invite further post-SOX actions from the SEC, PCAOB and Congress in response. For example, section 404 for companies was deferred for implementation by the SEC on several occasions, and ultimately that deferral was made permanent in the body of the Dodd Frank Act in 2010. In addition, the onerous attestation requirements imposed by AS-2 of 2004 were substantially diluted by the PCAOB in 2007 when it adopted the AS-5.

“As implemented, then, Sarbanes-Oxley Act’s requirements of IC disclosures and attestation have been significantly loosened, both as to what companies are covered and to what the Act requires,” clarify the authors.

Benefits from Sarbanes-Oxley Act

Accounting quality appears to have benefited substantially after the implementation of Sarbanes-Oxley Act. The authors cite various studies which have identified improvement in accounting quality such as those below:

  • accrual-based earnings management declined significantly after 2002
  • general improvement in accounting quality
  • lower tendency to manage a ‘beat’ on analyst forecasts by manipulation of earnings
  • timely loss recognition
  • auditors more vigilant in their role in detecting and reporting fraud
  • insider trading disclosures became more informative after Sarbanes-Oxley Act
  • though the number of restatements shot up suddenly after SOX, they fell as dramatically as they rose
  • adverse section 404 auditor comments have been declining in number over time

However, the authors qualify that “while the effects documented are for the time period following SOX, the accounting quality benefits found in this literature may not have been caused by Sarbanes-Oxley Act itself,” and that “several of these benefits could have arisen from market discipline following a period where internal controls were widely seen to have collapsed.”

In addition, the authors observe that several studies reinforce the view that section 404 causally improved accounting quality.

The authors report an interesting finding on audit quality. It appears that post-SOX there was widespread restructuring leading to the exit of a number of the smaller audit firms from the market for public company audits, and usually the exiting auditors were of lower quality. Another study reviewed by the authors found from PCAOB inspection reports that small auditors who received PCAOB censure generally had clients with accounting restatements and poor accrual quality.

Another 2009 study that studied the wealth effects by examining stock market reaction for firms that lobby for, or against, the provisions of SOX, found that greater returns accrued to firms that lobbied against Sarbanes-Oxley Act – this suggests that SOX had a positive impact on corporate transparency and governance.

Research limitations

Nevertheless, the authors rue that conclusive causal evidence of benefits from Sarbanes-Oxley Act is hard to come by.

“The state of research is such that – even after 10 years – no conclusions can be drawn about the net costs and benefits of the act, effects on net shareholder wealth or other research relevant to its assessment,” say the authors.

And this is not uncommon in the spheres of financial regulation, they suggest. Though Sarbanes-Oxley Act had clear, non-trivial and quantifiable direct costs, it is extremely difficult to estimate its indirect costs as well as its benefits.

The authors suggest that in the absence of such precise estimates, Sarbanes-Oxley Act suffers from an ongoing contradiction in views regarding its efficacy.

“Absent scholarly consensus, political entrepreneurs have used clear (if overstated) evidence on direct costs to deride the act as a symbol of regulatory overreach, despite the view among informed observers that the costs and benefits of the law as implemented have been at worst roughly equivalent and possibly net positive,” observe Coates and Srinivasan.

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