Impact of Sarbanes-Oxley compliance costs on small business operations

Regulatory Compliance Costs

What impact does regulatory financial reporting mandates have on a firm's spending on other areas of business operations?

The Sarbanes-Oxley Act of 2002 (SOX) established new standards for accounting practices in order to increase transparency and to restore public confidence in American businesses. The act strengthened corporate accounting controls, but it also adds another level of complexity to an already burdened accounting system. The purpose of this research is to examine academic research related to the affects of these reporting mandated on a firm's expenditures in other areas of the operation.

A review of the relevant literature on this topic reveals many opinions on the impact of Sarbanes-Oxley and the cost of accounting. It was found that the impact was greater for small businesses than for larger businesses. It was also found that the greatest changes occurred as a result of managerial relationships with their accountants. The following will examine the literature found regarding the costs of Sarbanes-Oxley compliance in small businesses and changes on an operational level.

Impact on Small Businesses

Larger corporations are expected to have a larger capacity to absorb shocks than smaller companies. However, for the smaller company, the impact of Sarbanes-Oxley can have a significant impact. According to the U.S. General Accounting Office, smaller public entities experienced a disproportionately higher impact of the costs associated with compliance with the requirements of the Sarbanes-Oxley Act (GAO, 2006). These costs are larger for smaller companies due to the percentage difference in audit fees and the aggregate impact on the operating budget. Larger firms pay smaller accounting fees, based on percentages, than smaller companies. In addition, many smaller firms had to adjust to a system that entailed formal, rather than informal control mechanisms (GAO, 2006).

Sarbanes-Oxley resulted in a rash of mergers and acquisitions as firms found that they could more easily spread the costs of compliance among the two entities (Koehn & DelVecchio, 2006). The typical costs of compliance averages $824,000 for small companies (Koehn & DelVecchio, 2006). Compliance with SOX increased costs for companies by way of increased records-management, salary increases, and increased audit fees (Koehn & DelVecchio, 2006).

Compliance with Sarbanes-Oxley requires a considerable amount of resources. For the small company, this can all but eliminate any profit derived from operations (Edison, 2006). These expenses are passed onto the consumer by way of higher prices (Edison, 2006). No information was found regarding how companies compensate for these losses, other than by raising prices. The impact of raising prices due to Sarbanes-Oxley compliance represents another issue that may be related to the chosen research topic.

In 2003 and 2004, approximately 300 U.S. companies deregistered their common stock (Jacobsen & Scharman, 2007). This technique is termed "going dark" and entails transitioning from a public to a private company. There are many advantages and disadvantages to this technique. Some companies use this as a mean to escape compliance with Sarbanes-Oxley. This typically applies to companies with a capitalization of under $787 million (Daks, 2006). They must also have less than 200 shareholders of record, or less than 500 shareholders of record and less then 10 million in assets for the past three years in order to take advantage of this exemption (Daks, 2006).

When SOX was enacted, 65 publicly traded companies delisted, moving to the pink sheets, while an additional 61 went private (Daks, 2006). The number of companies reporting material weaknesses in their internal controls fell from 15.7% in the first year after the act, to 10.3% in the second year after implementation (Scarborough & Taylor, 2007). This demonstrates an improvement in technique as time went on.

Those in the retail and service industries were more likely to report deficiencies in Internal Controls over Financial Reporting (ICFR) than any other sector (Scarborough & Taylor, 2007). Research demonstrates that small companies who chose to implement Section 404 of the act were less likely to restate their results than companies that did not choose voluntary compliance with the act (Scarborough & Taylor, 2007).

Small, private companies do not have to comply with Sarbanes-Oxley. However, many chose to do so anyway in order to increase public trust in their firm. They may have seen a marketing advantage to compliance as well. Voluntary compliance demonstrates a certain degree of corporate responsibility, which may have led some small companies to participate in voluntary compliance, regardless of the impact on operational costs.

Conclusion

The literature review suggests that compliance with the Sarbanes-Oxley had an impact on both large and small companies. Large companies are generally thought to be able to absorb the expenses associated with compliance more easily than smaller companies. However, larger corporations also have more expense associated with compliance and may have to hire an entire department to meet the requirements of the act.

Regardless of whether the company is large or small, the costs of compliance with the Sarbanes-Oxley act are large and place a great burden on the company. The literature review contains many studies that measured the exact impact of the Sarbanes-Oxley Act. However, only one study addressed how companies absorb these costs. The only suggestion given was that they raise prices to compensate. Raising prices could have an overall negative impact on the revenues, as this could drop demand for their products and services. In addition, this effect was not demonstrated empirically, it was only suggested in the literature as a potential impact.

The purpose of this research is to fill in the gap discovered in the literature review. The impact the Sarbanes-Oxley Act on companies is measurable. However, not much is known about how these companies adjusted in order to absorb the impact of compliance. In order fully to understand the impact of Sarbanes-Oxley on corporations, one must understand how they absorbed the expenses and the impact that it may have had on other departments. This research focuses on the methods used to negate the consequences of compliance with Sarbanes-Oxley.