Revisiting the Ripple Effects of the Sarbanes-Oxley Act

CPA Journal, The, May 2006 by Koehn, Jo Lynne, DelVecchio, Stephen C

Almost four years have passed since the Sarbanes-Oxley Act of 2002 (SOX) was legislated and implemented. In "Ripple Effects of the Sarbanes-Oxley Act" (February 2004 CPA Journal), the authors identified and discussed foreseen, and unforeseen consequences of the Act. Now, with the benefit of hindsight, these previously identified effects will be revisited and their status updated. Several additional effects are noted that were not originally identified. (Note: This article presents the "ripple effects" in the same order as the original. The order does not signify the relative importance of the effects.)

Negative Influence on Corporate Mergers and Acquisitions

Merger and acquisition activity in the immediate wake of SOX did not show a decline. The number of deals consummated actually rose, from 7,702 in 2003 to 8,313 in 2004. The dollar value of those deals rose from $570 billion in 2003 to $833 billion in 2004. A portion of the increased activity is likely due to foreign buyers capitalizing on the weaker dollar (R. Weisman, "Merger Activity at Full Tilt, Even Before Gillette," Boston Globe, February 7, 2005).

Some believe that the reason the M&A activity has been the opposite of expectations is that mergers can result in combined entities that can more easily absorb the significant compliance costs associated with SOX. And, while the number of deals after SOX has not declined, SOX has still affected M&A activity by impacting the due diligence required to support merger transactions. Acquiring companies must carefully review financial records, vendors, and key customers of target companies and assume accountability after the merger for those records and relationships. Such increased time and scope for due diligence has increased the transaction costs associated with mergers and acquisitions (R. Ouellette, "Sarbanes-Oxley Sure to Affect Variety of Transactions," Due Diligence, September 26, 2005).

Increased Efforts by Audit Committees

In 1999, the New York Stock Exchange and the National Association of Securities Dealers created the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. The committee established recommendations that audit committee charters require meetings at least four times per year. A survey following the committee's report (W. Read and K. Raghunandan, "The State of Audit Committees," Journal of Accountancy, May 2001) found that, on average, audit committees met less than the recommended four times per year. Since SOX, as anticipated, audit committees are meeting more frequently. The annual Spencer Stuart Board Index study of corporate governance in S&P 500 corporations found that audit committees met, on average, five times per year in 2002. In 2003, the frequency of meetings increased to seven. An alternate survey of governance practices in 200 corporations by Pearl Meyer & Partners reported an average frequency of nine meetings for audit committees in 2005.

Contraction of the Audit Market/Decreased Competitiveness of the Audit Market

In July 2003, the General Accounting Office (GAO, which became the Government Accountability Office in 2004) published a report titled "Public Accounting Firms: Mandated Study on Consolidation and Competition." The SOX-mandated report did not find impaired competition in the audit market for public companies, nor did it find the conditions favorable for any second-tier firms joining the Big Four. The GAO stated: "[L]ack of staff, industry and technical expertise, capital formation, global reach, and reputation" comprise some of the market forces that make it unlikely that any firms will be able to join the Big Four (S. Taub, "Too Few Auditors to Go Around?," cfo.com, July 31, 2003). Size disparity between the top-tier and second-tier firms may just be too large to overcome. If all the revenues of the second-tier firms are added together, they fall short of the revenue of KPMG, the smallest of the top-tier firms ("Report from a General in the SEC's War on Fraud," BusinessWeek, September 26, 2005).

Even though the audit market has not expanded in the sense that second-tier firms have moved to the first tier, nonetheless shifts are occurring in the market. When hiring auditors, many public companies are now considering second-tier firms as viable options. Because the typical audit requires more hours to complete since SOX, the Big Four have shed some clients due to a lack of manpower. Other companies have switched to second-tier firms based on the service they expect to receive if they are among the second-tier firm's highest-profile clients. In 2004, the second-tier firm of BDO Seidman, LLP, gained 109 clients and lost 38. Another firm in the second tier, Grant Thornton, LLP, gained 80 and lost 63 (N. Byrnes, "The Little Guys Doing Large Audits," BusinessWeek Online, August 22,2005). The next year, the 2005 revenues of BDO Seidman showed growth of 13% to $3.3 billion. Comparatively, Ernst & Young's revenues increased 16% to $16.9 billion (J. Ciesielski, "Happy Holidays: Big Revenue Growth at Accounting Firms," www.accountingobserver.com/blog/2005/12/bdo-revenues-up-13/, December 21, 2005).