Management 302 – White Paper
Professor Jordi Comas
May 7, 2015
Author: Greg Wasikowski
Do the Benefits of The
Sarbanes-Oxley Act of
2002 Outweigh its Many
Costs?
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Table of Contents
Title Page…………………………………………………………………………………………1
Table of Contents………………………………………………………………………………....2
Executive Summary………………………………………………………………………………3
History and Background of SOX…………………………………………………………………3
What is SOX? ………………………………………………………………………………4
Effectiveness of SOX……………………………………………………………………………4
Section 404………………………………………………………………………………6
Other Consequences of SOX Section 404………………………………………………10
Recommendations…………………………………………………………………………11
Concluding Thoughts…………………………………………………………………………15
References………………………………………………………………………………17
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Executive Summary
There is a general pattern seen in the world of finance: giant corporate fraud or scandal,
resulting government investigation that inevitably is unable to prosecute those responsible, followed
by lengthy governmental legislation attempting to prevent the fraud/scandal from ever happening
again. In the early 2000’s this pattern played out in the form of multiple scandals such as Enron and
WorldCom with resulting legislation in the form of the Sarbanes-Oxley Act of 2002.
SOX is said to be the most sweeping piece of legislature regarding financial reform since
FDR’s Securities Act of 1933 and Securities Exchange Act of 1934. It attempted to restore
confidence and transparency to companies’ financial statements and therefor the market as a whole.
SOX was for the most part able to accomplish this goal, but not without substantial costs to public
companies and the market. Compliance costs were grossly underestimated by Congress and the
regulatory agencies leaving public companies with no choice but to take the hit. Additionally, there
have been substantial declines in the United States’ competitive edge in the global capital markets.
This report is concluded with three suggestions to help accomplish several goals of SOX
that have not yet been achieved as well as an overall answer to the question of whether or not the
costs of SOX outweigh its benefits.
History and Background of SOX
The later years of the 20th century brought an increased amount of fraud to public financial
markets such as the Enron, Tyco, and Adelphia scandals. Congress wanted to respond but was
segregated on the issue between different political parties, lobbyists, interest groups, etc. After
WorldCom went bankrupt, it was clear that despite Congress’ mixed position on the topic,
immediate action against corporate fraud needed to be taken. The Sarbanes-Oxley Act (SOX) was
passed in 2002. SOX is considered by some to be the most widespread piece of legislature regarding
financial reform since FDR was in office during the Great Depression. On the other hand, many
argue SOX was constructed too rapidly and therefor has some unintended negative side effects.
These negative side effects include sizeable compliance costs as well as potential adverse effects on
the capital markets. This report attempts to weigh the effectiveness of SOX in reestablishing trust in
financial markets versus its outlandish compliance costs and opposing effects on the capital markets.
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The report will also look to the future in discussing what could and should be done in order to further
accomplish the goals in which SOX was meant to achieve.
What is SOX?
“[SOX] introduces sweeping changes to corporate governance and corporate responsibility
for financial reporting and financial controls for most corporations that must register with the
Securities and Exchange Commission (SEC),” (Berkowitz). The Act created a regulatory agency for
the accounting industry called the Public Company Accounting Oversight Board (PCAOB). It also
placed requirements for companies’ corporate executives to validate the accuracy and integrity of
financial statements as well as to disclose any fraud within the company, whether it is material or
not. Failure for corporate executives to comply with these requirements could result in criminal
penalty.
The overall encompassing goal of SOX was to reestablish trust in the financial markets. In
order to accomplish this, the legislature set out to accomplish the following: to establish new
corporate accountability and responsibilities, to enhance the accuracy and validity of financial
statements and disclosures, to decrease white-collar corporate fraud, to establish auditor
independence, and to greatly improve internal controls (Berkowitz). There is a great deal of debate
about whether or not SOX has been able to accomplish these goals. Many professionals agree that
SOX has been able to recapture investors’ trust in financial markets, but at an exorbitant cost to
public companies. Section 404 of the Act in particular created a major pushback from public
companies due to its massive compliance costs. A more detailed analysis of Section 404 will come
later in the report. Generally, many professionals question if the benefits of SOX outweigh its costs?
Effectiveness of SOX
There are mixed results with respect to the effectiveness of SOX. A 2008 study looks at the
reactions of stock prices in response to the effects that SOX-related legislative activities had on
earnings management. The authors found that there was a significant positive relationship between
SOX legislation and earnings management and therefor stock returns (Li, H., Pincus, M., & Rego, S.).
This suggests despite the additional costs SOX brings upon companies, the increased accuracy and
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reliability in their financial statements has drastically increased investor sentiment, and thus has had
an overall positive effect on the market.
Another study conducted just a few years after SOX was enacted also suggests the benefits
of the Act greatly outweigh the obligatory compliance costs. This study found that companies with
better pre-SOX corporate governance structures were benefitted much more in the post-SOX era
than companies with weaker pre-SOX corporate governance structures (Rezaee, Zabihollah and Jain,
Pankaj K). This makes sense considering companies with disheveled corporate governance structures
would have to spend more in order to comply with SOX’s standards.
SOX’s establishing of the PCAOB has generally been viewed as a positive addition to the
accounting industry, but there even opposing views on this topic. “Sarbanes-Oxley’s establishment
of the PCAOB, which ended more than 100 years of self-regulation at the federal level by the public
company audit profession, is perhaps the most fundamental change made by SOX,” (EY). It comes
as no surprise that industry-wide self-regulation can lead to conflicts of interests and corporate
fraud. The PCAOB removes this threat.
In a 2005 New York Times article, Jonathan Glater provides opposing views: “Beyond the
costs of assessing their internal controls, executives focused on a few specific concerns. Auditors,
they said, were too conservative - requiring disclosure of everything, testing controls that could not
have a material effect on financial reports,” (Glater). Glater goes on to say that the reasoning behind
this was because the auditors did not want to be bothered by outsiders such as lawyers and
regulators trying to dissect the auditors’ work.
Overall, the general opinions regarding the effectiveness of SOX in accomplishing its goals
are positive; however, there are mixed results in seemingly every aspect of the Act. The complex
nature of the areas of business in which SOX aims to fix make it incredibly difficult and many times
impossible to quantify results and changes directly attributable to SOX. For this reason, the true
effectiveness of SOX comes down to an educated opinion.
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Section 404
One aspect of SOX can be proven: the increase in compliance costs directly attributable to
Section 404 of SOX. Section 404 is brief but overwhelming. It focuses on the internal controls of
the company. Figure 1 seen below displays in full Section 404 of the Sarbanes-Oxley Act.
Figure 1
(SARBANES-OXLEY ACT OF 2002)
In summation, Section 404 requires companies to provide an internal controls report with
their annual financial report. Both management and the external auditing firm must assess the
effectiveness of internal controls by performing a top-down risk assessment. Section 404 essentially
hands responsibility to management for both establishing and maintaining a system of internal
controls concerning their financial statements (SARBANES-OXLEY ACT OF 2002).
It is not much of a surprise to see that these requirements have improved internal controls
within companies. Not only did investors return to the market after these requirements were
enacted, but improvements in company controls are still being seen over ten years after the passing
of the Act. Protiviti released a report in May, 2014 about companies’ abilities to keep pace with SOX
compliance. They asked a group of public companies, “How has internal control over financial
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reporting structures changed since SOX was required for your organization?” The results can be
seen below in Figure 2.
Figure 2
(Protiviti)
The results speak for themselves. 2012 marks the ten year anniversary of the passing of
SOX. 2014 marks the ten year anniversary for when the legislature actually took effect. It is
remarkable that companies are still seeing significant improvement to their internal controls over ten
years later.
While Section 404 of SOX has proven to improve the internal controls of companies, it has
not come without significant cost. “For example, while the SEC initially estimated the cost to
comply with Section 404 to be about $91,000 per company or $1.24 billion in the aggregate, multiple
studies pegged the actual compliance cost at $35 billion, which is, of course, nearly 30 times the
original estimate. But let's put this in perspective: Section 404 is only 168 words long, and if you use
the $35 billion figure, that is almost $21 million per word, and that is just the initial startup cost,”
(THE SARBANES-OXLEY ACT 4 YEARS LATER: WHAT HAVE WE LEARNED?)
Costs around the industry have increased, but they were primarily fixed costs. This means
that smaller companies were hit much harder than larger ones. “As a percentage of revenue, smaller
issuers in 2004 spent 11 times more on the Sarbanes-Oxley implementation than did larger
companies. Micro-cap companies, with revenues under $100 million, saw an 84 percent increase in
outside audit fees as a result of the law. Small cap companies with revenues between $100 million
and $700 million saw a 92 percent increase in audit fees. And S&P 500 companies saw an increase of
55 percent in their audit fees,” (THE SARBANES-OXLEY ACT 4 YEARS LATER: WHAT HAVE WE
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LEARNED?). The definition of small, medium, and large companies can differ, but the point remains
the same. Smaller companies do not have the resources to keep up with these exorbitant costs.
Additionally, because of the stiff criminal penalty implications, SOX compliance must be a top
priority; especially for smaller companies. SOX compliance ends up monopolizing both costs and
the attention of management.
In 2007, the SEC and PCAOB responded to these criticisms. As a result, they relaxed the
standards so as to reduce the total costs of SOX compliance; especially with respect to Section 404.
They also issued guidance for management for constructing risk-based top-down evaluation of
internal controls over financial reporting. These actions aimed at drastically decreasing costs for
companies with market caps between $75-250 million. A 2011 study performed by the SEC
determined that, with respect to an issuer’s internal control over financial reporting (ICFR), these
actions did decrease compliance costs for targeted companies. The following information was
concluded by the 2011 SEC study: “The costs of Section 404(b) have declined since the
Commission first implemented the requirements of Section 404, particularly in response to the 2007
reforms; Investors generally view the auditor‘s attestation on ICFR as beneficial; Financial reporting
is more reliable when the auditor is involved with ICFR assessments; and There is not conclusive
evidence linking the requirements of Section 404(b) to listing decisions of the studied range of
issuers,” (Study and Recommendations, SEC).
Additional reformation to Section 404 was carried out in 2010 with the Dodd-Frank and
Consumer Protection Acts. These acts were in response to the 2008 financial crisis but they still
made small additional provisions to SOX. These Acts effectively exempted micro-cap companies
(less than $75 million dollar market cap) from Section 404(b). This came into effect even though
these companies technically were never required by the SEC to comply with Section 404(b)
(Nicholls).
In 2012, the Jumpstart Our Business Startups (JOBS) Act exempted all companies defined as
emerging growth companies from Section 404(b). Emerging growth companies are companies with
total gross annual revenue of less than $1 billion (Nicholls). However, Figure 3 from the 2014
Protiviti study shows that SOX compliance costs have increased in recent years. Perhaps even more
worrisome, Figure 4 shows that the rate at which compliance costs are rising is also increasing. This
could be as a result of SEC attention shifting away from the financial crisis and back onto fraud and
corporate governance.
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Figure 3
Figure 4
(Protiviti)
Overall, it is clear that when compliance costs were too high, the SEC and PCAOB took
action in order to decrease costs for targeted companies. It very well be time for these agencies to
step in again because it is also clear that compliance costs are once again on the rise.
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Other Consequences of SOX Section 404
One of the unintended consequences of SOX is the decline in cross-listing from foreign
companies. Cross-listing is when a non-American based public company “goes public” in one of the
major American stock exchanges. The most recent and prominent example was Alibaba. Since the
inception of SOX, there has been a dramatic decline of cross-listings in the American financial
markets. By not cross-listing foreign companies are able to save on massive SOX compliance costs
as well as to avoid the American legal system (Nicholls). “Cross-listing activity in the U.S. by foreign
companies for non-capital raising purposes remained low. Activity through the third quarter of 2014
suggests only 3 foreign companies will cross-list in the U.S. this year for purposes other than capital
raising (such as bonding to US standards), fewer than in any year since 2008, and well below the
historical average of 17 cross-listings per year,” (Scott, H.). This evidence proves cross-listing activity
to be low, and it does not appear that will change any time soon.
Additionally, United States global share of IPO’s sits at just 9% compared to its historical
average of 26.8% from 1996-2007 (Scott, H.). This is further evidence that foreign companies are
avoiding U.S. equity markets. The significant drop-off in the years following SOX are no
coincidence. Instead, “Foreign companies that did raise equity capital in the United States through
the third quarter of 2014 did so overwhelmingly via private rather than public markets.
Approximately 84% of initial offerings of foreign equity in the United States were conducted
through private Rule 144A offerings rather than public offerings. This measure of aversion to U.S.
public equity markets stands significantly higher than the historical average of 66.1% (1996-2007),”
(Scott, H.). Foreign company aversion from American equity markets makes them uncompetitive
and weak.
Another unintended consequence of SOX is the increased number of “going-private”
transactions. A study performed a few years after SOX was enacted attempted to prove SOX was
the cause of the increased going-private transactions. The study sampled 470 going-private
transactions from 1998 to 2005. The data shows a notable increase in firms performing goingprivate transactions after the enactment of SOX. For example, 243 firms went private in the 33
months after SOX was implemented compared to 159 in the 34 months before SOX. Furthermore
the study goes on to determine that the majority of firms that decided to go private after the
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installation of SOX were relatively small (Engel, E., Hayes, R., & Wang, X.). This makes sense when
considering the arguments made earlier about smaller companies being more affected by SOX
compliant costs. Even though the years following SOX were favorable in the equity markets,
because of the outlandish costs of SOX compliance, many companies still decided going-private was
the best business decision.
These negative side effects of SOX drastically decrease the competitiveness of American
equity markets. This brings up the question of should regulators relax standards in order to bring
back foreign investment and decrease going-private transactions? The United States has lost much
of its edge in the global market, and this is largely due to the enactment of SOX; especially Section
404. However it is also clear that SOX and Section 404 in particular have greatly benefitted the
market in the form of better internal controls and more reliable and transparent financial statements.
Perhaps the best long-term approach is to secure a steadfast market in which investors from all
countries can have confidence investing their money.
Recommendations
After digesting the information provided in this report, I have three recommendations that
would benefit investors, companies, auditing firms, regulators, and the overall market as a whole. 1)
There should be a higher concentration of catching fraud at the upper management level; something
SOX does not necessarily protect against. 2) Simultaneously promote and protect whistleblowing. 3)
Require a firm’s auditor to provide solely auditing business as to avoid conflicts of interest.
In today’s market, there is an incredible amount of pressure for short-term results. Managers
are pressured to make decisions that benefit the short-term bottom line rather than preserve longterm sustainable growth. In extreme cases, these same pressures can motivate managers to commit
fraud. The majority of fraud stems from unethical management rather than poor internal controls.
Neither SOX nor other reform can prevent unethical, greedy behavior of managers. The only
possible solution is to place a higher concentration on “snuffing out” corporate misconduct at the
managerial level. Improvements to internal controls are beneficial for the company’s operations as
well as its financial statements, but it barely inhibits fraud in the slightest. Figure 5 shows that in
recent years only 1% of fraud was initially detected as a result of internal controls. Improvements to
internal controls contribute to the validity of a company’s financial statements, but if there is still
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fraud in the market, even perfect internal controls would not make a difference. There needs to be a
higher concentration on stopping fraud at the upper management level.
Figure 5
(Detection)
My second recommendation is to both promote and protect whistleblowing. Figure 5 shows
that the most prominent way fraud is initially detected is by “tips.” Tips substantially outweigh other
categories when it comes to stopping fraud. Whistleblowing is difficult because it often comes with
the possibility of personal career damage. In her article, Courtenay Thompson explains, “The
likelihood of career damage varies depending on the perpetrator and the nature of the fraud. For
example, career damage is rare when the fraud is perpetrated by clerical employees. It is most likely
to occur to auditors who surface fraud by executives and top performers, fraud for the benefit of the
organization, and fraudulent financial reporting,” (Thompson, C.).
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Section 806 of SOX is commonly referred to as the whistleblower provision. “[Section 806]
provides protection to employees against retaliation by certain persons covered under the Act for
engaging in specified protected activity…The whistleblower provision is intended to protect
employees who report fraudulent activity and violations of Securities Exchange Commission (SEC)
rules and regulations that can harm innocent investors in publicly traded companies,” (OSHA). The
Dodd—Frank Act went on to reform Section 806 of SOX to increase awareness for specific
whistleblower protocol.
“Sarbanes-Oxley's whistleblower provision, as amended by Dodd-Frank, includes
procedures that allow a covered employee to file a complaint with the Secretary of Labor not later
than 180 days after the alleged retaliation or after the employee learns of the alleged
retaliation…Accordingly, upon receipt of the complaint, the Secretary must provide written notice
to the person or persons named in the complaint alleged to have violated the Act (respondent) of
the filing of the complaint, the allegations contained in the complaint, the substance of the evidence
supporting the complaint, and the rights afforded the respondent throughout the investigation. The
Secretary must then, within 60 days of receipt of the complaint, afford the respondent an
opportunity to submit a response and meet with the investigator to present statements from
witnesses, and conduct an investigation,” (OSHA).
The reforms made by the Dodd-Frank Act are consistent with whistleblowing policies in
many other areas of appropriate legislature. I recommend that the SEC, PCAOB, and any other
pertinent regulating agencies should place an even higher concentration on whistleblowing. Nearly
half of all fraud is initially detected from tips. This information should be embraced by regulatory
agencies. It is very possible that even more fraud could be detected if additional protections were
offered to whistleblowers. I am not simply promoting a “tattle-tale”, but it is very clear that this is an
important way to uncover fraud and therefor establish more trust and reliability in the financial
markets.
My third suggestion is to require auditing firms to provide solely auditing business to their
clients. One of the main goals of SOX is to establish auditor independence, yet it does not require
CPA firms to stop providing non-audit-related business to clients. For example, hypothetical
accounting firm, ABC Incorporated, provides both audit-related and non-audit related business to
retail firm, XYZ Co. XYZ pays ABC to help them with their internal controls; typical consulting
work that is very popular in the accounting industry. ABC implements their most effective internal
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controls system in XYZ. XYZ is so satisfied with ABC’s work that they then hire ABC to help them
with their tax matters. Again, ABC is paid to give advice to and help XYZ. XYZ’s fiscal year ends so
it is time to hire an auditing company to review their financial statements and to initiate a top-down
risk-assessment of internal controls with regard to financial statements in order to comply with
Section 404 of SOX. XYZ hires ABC. When ABC performs the internal controls assessment, they
are essentially grading their own work. Why would ABC find any problems with internal controls
when they installed them in the first place? Why would ABC criticize XYZ’s tax framework when
ABC was paid to install it into XYZ’s business? Unfortunately, it is not difficult to imagine how
conflicts of interest arise in these types of situations. This was a hypothetical example but it
represents very real, and in some cases common state of affairs.
Those who oppose the claims of conflicts of interest argue that as long as managers make
the final decision, which they do, then a conflict does not arise; thus auditing companies should not
be prohibited from selling their non-auditing services to audit clients. A New York Times article
quotes an anonymous executive at a Big 4 accounting firm in saying, “You can go in and you can
make an assessment as part of your audit, which is what auditors do, and you can make
recommendations for changes, which is typically what auditors do, but you can't go in and step into
management's shoes and decide what to adopt and then implement it,'' (Glater) Essentially this
representative is saying it is not auditor independence that matters, rather management
independence is what prevents conflicts of interest.
On the other hand, many companies and audit firms are not comfortable with the idea of
CPA firms selling their non-audit business to audit firms. For example, Apple has a policy to review
their auditing firm every five years. In 2009, they hired Ernst & Young in place of KPMG who had
been their auditor for the previous 12 years. The decision reportedly came in the absence of any
disagreements between Apple and KMPG over Apple’s financial statements (Beattie, E.). In other
words, it was just time. Another example is Grant Thornton, the sixth largest CPA firm in America,
said, “it will not help clients design internal controls, put them in place or provide internal control
software to companies it audits,” (Glater).
A potential solution to this problem that has been proposed is a rotational program among
major auditing firms. This would require companies to rotate their auditors every few years. This
would definitely decrease the chances of conflicts of interest, but this proposed solution has been
criticized for being too conservative. The problem with this idea is that it drastically reduces auditing
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firms’ access to information. It inhibits external auditors from detecting fraud. Auditing, assessing,
and learning a new company is an incredibly daunting and information-heavy task. This is a main
reason why many major companies keep their auditors for long periods of time. Once the auditors
“know” their clients, business operations are conducted much more smoothly, and auditors are
better able to detect problems and fraud within their companies.
For these reasons I believe my suggestion of disallowing CPA firms from selling non-audit
services to audit clients is the better solution. Not only would my suggestion lower the chances of
conflicts of interest, but CPA firms would most likely not even see a decrease in their non-auditing
services. The demand for non-audit services would not be changing; it would merely be rearranging
the layout of the market.
Concluding Thoughts
The beginning of the 21st century called for major reform. Series of fraud caused investors to
lose faith in the validity of financial statements and the market as a whole. The Sarbanes-Oxley Act
of 2002 was that major reform. The authors of SOX ultimately sought to reinstall confidence and
transparency in the market by establishing new corporate accountability and responsibilities,
enhancing the accuracy and validity of financial statements, decreasing white-collar corporate fraud,
establishing auditor independence, and improving internal controls.
While this report proves that in many cases, the effectiveness of SOX is a matter of opinion,
the general perception is that SOX succeeded in establishing new corporate accountability and
responsibility, enhancing the accuracy and validity of financial statements, and improving internal
controls. Unfortunately these great steps in financial reform came at substantial costs to public
companies; especially smaller companies. Eventual reform to SOX lessened the burden placed on
smaller companies when complying with SOX Section 404 regulations, but as the data from this
report shows, SOX compliance costs are once again on the rise.
This report also shows that there are many unintended negative consequences of SOX.
Cross-listing from foreign companies has declined significantly since its inception. Foreign
companies do not want to actively expose themselves to the outrageous Section 404 compliance
costs. In addition, there has been an increase in domestic companies deciding to go private and
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remove themselves from major American Exchanges. The combination of these two residual effects
leave the American capital markets at a weaker and less competitive position than in the pre-SOX
era.
The goals of decreasing white-collar fraud and establishing auditor independence have not
yet been accomplished. I believe the three recommendations I provided in this report would
significantly contribute towards achieving those goals. Fraud will always exist in the corporate world,
but there are better ways to attack it than SOX provides. There should be a higher concentration on
catching unethical behavior at the upper management level. Over 40% of fraud is initially detected
from tips. This fact needs to be embraced and encouraged by regulators. Further protection and
concentration needs to be placed on whistleblowing.
SOX claims to establish auditor independence, but this is not possible when CPA firms can
sell non-audit services to their audit clients. This undoubtedly presents many instances of conflicts
of interest. A commonly proposed solution of installing a rotational program among audit firms
does establish auditor independence; however, it also drastically reduces auditors’ access to
information. My suggestion is to disallow audit companies from selling non-audit services to audit
clients; not to disallow non-audit services altogether.
Do the benefits of SOX outweigh its costs? While the costs of SOX compliance are
excessive, especially Section 404 compliance, the restoration of confidence and trust in the market
coupled with improvements to companies’ internal controls justify them. Capital markets cannot
operate without public trust. Sweeping legislation was not only necessary but most likely overdue.
With respect to the U.S. equity market, increased corporate costs and losses in global competitive
edge were necessary steps towards restoring investor confidence; although there is still work to be
done. Auditor independence is currently more of an idea than a legitimate result of SOX. I challenge
regulators to fix this problem before an inevitable conflict of interest arises at the expense of innocent
investors. With that being said, fraud cannot be exterminated, but improvements in catching
fraudulent behavior are definitely possible. The Sarbanes-Oxley Act of 2002 was a necessary and
beneficial piece of legislation, but there are additional actions that need to be taken in order to fully
accomplish its goals.
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