Ripple Effects of the Sarbanes-Oxley Act

CPA Journal, The, Feb 2004 by Koehn, Jo Lynne, Vecchio, Stephen C Del

auditing

The Sarbanes-Oxley Act is the most significant change to U.S. securities law since 1934. The act's congressional sponsors-Representative Michael G. Oxley (R-Ohio) and Senator Paul Sarbanes (D-Md.)-both believe that the legislation is helping to restore investor confidence and deter fraud. The two are divided, however, in their assessments of other consequences of the act.

Oxley is concerned that the legislation might be motivating undue risk aversion arising from fear of violating provisions of the act and incurring stiff penalties. Sarbanes thinks that the rules are forcing companies "to clean up their acts." Although it is too soon to tell the overall impact of the act, the popular and financial press has identified certain intended and unforeseen consequences.

Negative influence on Corporate Mergers and Acquisitions

Oxley's concern about the act's potentially chilling effect on risk taking is supported by a slowdown in merger and acquisition activity. Acquirers may be wary of the financial liability they could assume for the private companies they acquire. Public company executives question whether they may be held accountable for an acquired private company's history. Understandably, the due diligence process is taking longer and deals are now being consummated more slowly.

Increased Efforts by Audit Committees

A Deloitte & Touche LLP survey found that audit committee meetings are more frequent and longer. Before the Sarbanes-Oxley Act, 11 of the 66 companies surveyed met more than six times per year. Since the act, 39 companies have met that frequently. Before the act, half of the companies surveyed met for one hour or less. Since the act, only 10% have met for such a short time. Evidence suggests that committee members are also working longer hours outside of audit committee meetings.

Contraction of the Audit Market

Accounting firms providing services to public companies faced an October 22, 2003, deadline for registering with the Public Company Accounting Oversight Board (PCOAB). Non-U.S. firms have an additional six months to register. Formerly, over 850 accounting firms audited public companies, and 250 more retained the training and credentials to do so. As of October 23, 2003, the actual number of firms registering with PCOAB by the deadline was only 598. Small firms must not only weigh the PCAOB registration costs but also consider the accompanying operating costs, such as increased liability insurance costs, staff training costs, and increased liability risk.

Decreased Competitiveness of the Audit Market

A recent report from the General Accounting Office (GAO) found that the Big Four audit around 78% of U.S. public companies. The GAO characterizes the audit providers as an oligopoly of a few businesses, with risks of becoming even more concentrated. Ernst & Young LLP recently endured a six-month prohibition from accepting new public-company clients. Other large firms may receive similar sanctions in the future. Additionally, none of the Big Four have expertise in every industry, so some market segments are actually dominated by just one or two firms.

Increase in Accounting Costs

For some registrants, one of the most costly provisions is compliance with section 404 of the act. Section 404 requires management to organize and assess internal control systems and the independent auditor to assess their effectiveness. Some companies estimate that section 404 compliance alone may cost 1% of earnings. Total compliance costs for listed companies have been estimated at $7 billion a year. As the estimate implies, the costs are not one-time, but recurring: internal control systems must be tested each year. Some larger registrants, on the other hand, may have minimal out-of-pocket costs in complying with section 404 because adequate systems and talent are already in place.

The cost of recruiting appropriate board members has also increased. A financially literate audit committee is now required to have a designated "financial expert." Some registrants may have difficulty finding qualified board members under the stricter board composition requirements. Additionally, 5,200 public companies and 3,300 mutual funds will pay fees based on average monthly market capitalization to support the PCAOB's operations.

PricewaterhouseCoopers estimates that 81 % of public companies predict that the costs of complying with the act will rise in the future. Exhibit 1 presents the findings of a survey by the law firm Foley & Lardner of 32 mid-size companies regarding the costs of Sarbanes-Oxley compliance.

Increased Records Management Requirements

Before the Sarbanes-Oxley Act, the government had the burden of proof to show that an individual destroyed evidence with knowledge that the evidence was sought in an official proceeding. After the act, an individual can be charged with obstruction of justice (carrying 20 years imprisonment) for destroying evidence if the person should have known to preserve the document for any possible future government inquiries. The act also creates potential criminal liability for the destruction of records, even when conforming with an otherwise applicable records management policy and even if no federal investigation was in process at the time the records were destroyed.