Regulatory Compliance Costs What Impact

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. Impact on Large Corporate Management Sarbanes-Oxley has meant a reorganization of managerial time and priorities.

Top executives report spending a considerable amount of their time focusing on compliance and attempting to avoid litigation as a result of the Act (Edison, 2006). This reorganization of managerial time means less time to dedicate to reducing operational costs and improving the bottom line. This is a cost that was not considered in previous studies. Section 407 of the Sarbanes-Oxley act requires the formation of an audit committee. The audit committee must include outside members and financial experts (HassabElnaby, 2007).

Committees who have a high percentage of affiliated directors were found to be less likely to issue "going concern" report (HassabElnaby, 2007). In addition, those committees with a higher percentage of affiliated directors were more likely to have a member dismissed as a result of a "going concern" report (HassabElnaby, 2007). The involvement of a third party in the private affairs of the company represented a change in relationships between managers and audit committees. Sarbanes-Oxley changed the relationship between CPA and the companies that employ them (Crosley, 2005).

The act forbids auditors from performing tax provision or goodwill impairment calculations, bookkeeping, designing information systems, or providing internal audit services (Crosley, 2005). The CPA has less control and influence on the internal mechanisms of the company. They act as a true third party, even though they are still employed by the company. The independence of the board of directors and the audit committee are the two most important changes resulting from the act (Carpenter, Fennema, Fretwell, & Hillison, 2004).

One of the key costs of the Sarbanes-Oxley act is the necessity to hire and maintain a fully staffed internal audit department (Carpenter, Fennema, Fretwell, & Hillison, 2004). This department must report to top management on a frequent basis. This represents an additional operational cost that must be absorbed by the company in some manner. Sarbanes-Oxley was a political move initiated by social demands for immediate reform (Zegarowski, 2007).

While large corporations scrambled to find the most cost effective means to compliance, an opportunity presented itself for a new business opportunity specializing in Sarbanes-Oxley compliance (Zegarowski, 2007). Consulting corporations began to spring up as soon as the act went into effect. However, what represents an opportunity for one represents a cost for another. Companies had to find a way to absorb consulting fees, in addition to other expenditures associated with the act.

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.