Effects of the Sarbanes-Oxley Act and PCAOB on U.S. corporate governance

Sarbanes-Oxley Act and PCAOB

The Sarbanes-Oxley Act (SOX) was implemented in 2002, as a regulating measure to prevent companies from engaging in unethical accounting practices. Specifically, the Act requires CEOs to be financially responsible for accounting restatements when these are required as a result of misconduct. The purpose of the initiative was therefore to ensure public protection by holding companies liable for all their finances and accounting practices. This I also done by means of documented evidence that CEOs are required to provide in evidence for the adequacy of their internal control systems. The Act requires jail time should a CEO fail to do this (Nusbaum, 2003). In addition the public company accounting oversight board was instituted as an insurance measure for the Act, ensuring that its requirements are honored by public companies and their CEOs (PCAOB, 2010). The effect of the legislation has been many-fold. Today, some question the effectiveness of the Act, citing the detrimental effects that it could have on the functioning of public companies.

D'Aquila (2009) notes that there are both direct and indirect costs involved in the Act. In terms of direct costs, financial implications of compliance with the Act are the most significant issue. Accounting and auditing fees have for example risen significantly for companies who had to implement new measures to comply.

In 2003, for example, Nusbaum noted that up to the enactment of the legislation, many CEOs were not typically very concerned with documenting every aspect of their accounting practices internally. Although they might have believed that their control systems were adequate, the proof that this was so was undocumented. Nusbaum suggested the implementation of extra accounting software and personnel to focus specifically upon SOX compliance. This, along with the time and effort of implementation, is the most significant and direct cost of the Act to public companies.

D'Aquila for example states that accounting and audit fees can amount to as much as $2 million during the first year of the company's compliance with section 404. In terms of hours, this cost is supplemented by 12,000 hours of internal work and 3,000 hours of external work. Indeed, some companies have estimated that their compliance costs could add between 20 and 30% to their audit fees. Internal costs are also significant in terms of both working hours and bonuses as well as overtime fees for workers.

Profitability is therefore directly affected, placing significant pressure upon American companies. Companies for example do not have as much to invest in research and development, or in matching the competition in terms of new products and technology. Nusbaum however insists upon the benefit of the Act.

By being more aware of their internal control structures, the effect for CEOs might for example be greater confidence in running their companies. The stronger internal control measures also prevent problems such as overspending, operational failures, as well as unforeseen allegations of fraud and litigation as a result of indiscretion.

However, D'Aquila (2009) maintains that the costs remain significant, while the benefits might not specifically outweigh these. Indirect costs for example could directly affect the way in which companies function. According to D'Aquila, operations such as going public, decision-making and productivity, as well as directorship can be significantly influenced.

In terms of going public, the compliance provisions of the Act has resulted in an increase of almost 100% of fees associated with going public. This has resulted in an increasing number of companies that chose the private rather than public option after the new enactment. The author emphasizes that the cost burden in terms of going public, while higher for large companies, tends to be disproportionately allocated to smaller companies. Young, growing companies may therefore have to seek alternative financing, which will increase their cost of capital.

In terms of decision-making and productivity, the author suggests that companies may become more cautious within the public environment, as the costs of possible missteps are much higher than before the Act. Hence companies tend to take fewer risks, and also take longer to review major decisions. In general, this could affect business decisions in terms of deals, which can in turn affect the economy as a whole -- fewer business deals will mean a lower rate of capital flow.

Productivity is necessarily influenced, as employees are burdened with additional hours on internal control requirements, including evaluating and reevaluating financial reports and compiling information. This leaves less time and energy for other important tasks required for the smooth flow of business within the company. Again, this has an influence upon the economy of the company itself and the business world in general.

The concept of the "independent" director also relates to the indirect costs of the Act. Section 301 of the Act for example stipulates that all audit committee members must be independent. In other words, they are not to receive any compensation other than for their service on the board. They should also not be affiliated with the company in question or its associates. The majority of the board of directors must also be independent.

An advantage of this is that there is a higher rate of objectivity in terms of general company oversight. This results in a lower likelihood of non-compliance or indiscretion. On the other hand, this very independence also results in limited knowledge of the company to the senior executives, most directly overseen by the board of directors. Furthermore, the independent director also lacks direct access to financial information. This in itself could defeat the purpose of the Act itself. Financial information can only be obtained from management. This could result in further costs, as audit committees at times choose to hire individuals to more fully understand the dealings of the company being assessed.

The greatest cost are to small and mid-sized companies, where there is often a lack of internal audit departments or in-house counsel that could help to handle the responsibility of compliance with the Act. Smaller companies will therefore be disproportionately burdened by the need to hire more staff or outsource audit services.

Hence, Nusbaum (2003) admits that being a CEO for a public company is no longer as desirable as it once was. In order to comply with the Act, the author recommends that companies begin by reviewing their internal financial controls, assess potential auditing risks, and diminish these. By focusing on specific risks, smaller companies could mitigate the costs associated with internal and external audits. This assessment in itself will also increase a CEO's sense of confidence in his or her ability to not only comply with the law, but also to handle the financial and other risks within the company by means of internal control.

D'Aquila emphasizes that costs and benefits should be carefully considered when implementing internal controls. An excessive amount of internal controls for example will result in excessive costs with only limited benefits. Smaller companies should for example mitigate costs by means of a thorough risk and needs analysis. This will then indicate the best risk as opposed to benefit ratio.

Despite criticism against the rigors of the Act, many, like Nusbaum, believe that the benefits do indeed outweigh the costs. Many analysts also believe that the changes were important, particularly where large companies are concerned, where there is a greater risk of financial wrongdoing. And indeed, exercising internal as well as external control prevents serious risks to the public, which is after all served by the companies in question.