Regulation and Unintended Consequences: Thoughts on Sarbanes-Oxley

By Richard H. Gifford and Harry Howe

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Designed to improve the existing procedures for creating and reviewing financial disclosure, the act targets information risk, but contains provisions with effects that may increase a variety of business risks and costs. The Sarbanes-Oxley Act will change the balance of business and information risk for many firms, with the predictable and undesirable result that many businesspeople will forgo promising opportunities. A brief review of the possible negative consequences of this well-intentioned legislation suggests that the Sarbanes-Oxley Act may lower the quality of some accounting services and adversely affect the development of new standards.

Social Engineering and Financial Regulation

Congress faced substantial pressure to “do something” in the wake of the unusual problem created by the scandals at Enron and WorldCom. Consider the combination of legal scholar John Coffee’s observation that “the problem with viewing Enron as an indication of any systematic governance failure is that its core facts are maddeningly unique,” and the comment of former FASB chairman Dennis Beresford: “It’s probably the major story in the accounting profession in the time I’ve been involved, which is a little over 40 years now. It’s hard for me to believe that anything else has had as much impact on the profession.” Pressured by a host of constituencies and scrutinized by the media, lawmakers may have been pushed to act before they were prepared.

Some past legislative negative impacts have been modest, such as the several thousand middle-class jobs lost by the predictable effects of the January 1991 luxury tax on consumer items: The wealthy bought fewer pleasure boats, and boatbuilders had to lay off personnel.

Other effects have been more severe, as in the savings-and-loan crisis, where Congress, intent on “rescuing” the S&L industry in the face of virtually insuperable market forces, suspended GAAP reporting and continued to guarantee deposits with taxpayer funds. This created an environment that fostered everything from aggressive overinvestment in high-risk commercial real estate all the way to basic fraud. Estimates of the eventual cleanup under the 1989 FIRREA range from $500 billion to $1 trillion, taking into account direct payments made by the FDIC, the lost equity of S&L investors, and administrative and other costs.

Another example is more directly related to the current environment. In response to public concern at the growth of executive salaries in the early 1990s, Congress set out to encourage companies to link salaries to performance by eliminating the deductibility of executive payments over $1 million that were not tied to performance. Expanded use of stock options linked to stock performance was an obvious solution to the new constraints. In many instances, inflated nine-figure option-fueled compensation awards resulted from legislation originally intended to flatten compensation. This increased the incentives for earnings management, which contributed in part to the 1990s’ “irrational exuberance,” and the related disinclination to critically analyze financial reports, which was part of the groundwork for Enron.

Congress intended to restore confidence in the capital markets through a combination of rules and oversight that addressed conflicts of interest on the assurance side and a lack of accountability on the corporate side. These provisions include limitations on the scope and quantity of nonaudit services that auditors can provide to clients, new regulatory oversight for auditors [the Public Company Accounting Oversight Board (PCAOB)], rules that increase the scope and independence of corporate audit committees, and an apparently dramatic increase in the legal accountability of CEOs and CFOs.

The Auditor’s Knowledge Base

Section 201 of the Sarbanes-Oxley Act imposes strict limitations on the nonaudit services that audit firms can provide to their clients, leading to the likelihood of gun-shy audit committees balking at proposals to provide any kind of nonaudit service. While the intent was to ensure the independence of the public accountant, the prohibition will reduce the amount of company-specific knowledge available to the accounting firm, decreasing audit quality while increasing audit fees. Auditors must understand all aspects of a company’s strategy and operations in order to effectively audit it, and consulting work helped an audit firm acquire deep insight into a company. Going forward, the lowered knowledge base and reduced level of broad, business-process understanding will hamper accountants’ ability to conduct risk-based audits. Similar problems arise from the audit partner rotation provision found in section 203.

Independence and Duplicated Costs

Sarbanes-Oxley implicitly assumes that the social benefits of removing a possible conflict of interest outweigh the costs to an audited company of providing duplicate services, which is the effective result of audit partner rotation, and Sarbanes-Oxley mandates this duplication as a premier remedy. Many professions have similar potential conflicts of interest (e.g., architects who design and supervise construction, and set fees as a percentage of cost; doctors who diagnose and operate; law firms whose clients may at one time or another engage in adversarial proceedings against each other; and real estate listing agents who work with potential buyers), and settled procedures in these professions include the client’s option to seek duplicated services (e.g., use a construction manager; obtain a second opinion; hire a new law firm for a special project; engage a buyer’s broker). The Sarbanes-Oxley Act effectively requires all audit-and-consulting-services clients to obtain some level of duplicated service, and forecloses the development of other solutions to the conflict-of-interest problem.

Critics of the “old model,” in which audit firms provided now-prohibited consulting services, observe that this relationship provides the company with a “low-visibility sanction” that could be wielded in the event of a dispute over accounting standards. Terminating a lucrative consulting contract does not expose a company to the same kind of reputation costs as firing an auditor. One counterargument is that expanding required 8-K disclosures to include any change in the level of services provided to a company would address this concern.

Fees and Audit Quality

Partly because of the need to perform additional audit work in order to gain the necessary knowledge, and partly because of the loss of income from higher-margin consulting work, audit fees will rise. Higher costs will ultimately be borne not just by the relatively few companies that were involved in the accounting frauds, but by all companies and consumers. A March 25, 2004, article on CFO.com cited an average 23% audit fee hike in a sample of North and South Carolina firms, with one Charlotte-based manufacturer incurring a 127% increase. A recent Financial Executives International (FEI) survey reported first-year compliance costs ranging from $2 million to $5 million. The financial consulting firm The Johnsson Group has estimated total 2004 costs to run upwards of $15 billion, with many large companies seeing thousands of hours diverted from staff support and research activities to compliance work.

Another provision that may significantly increase audit fees lies in the Sarbanes-Oxley Act’s far-reaching authority. The act applies to any firm that audits a publicly traded U.S. company. As such, foreign subsidiaries or affiliates of public accounting firms may determine that they do not want to become involved with a client’s operations in its home country because of U.S. regulations. As a result, U.S. firms would have to audit the foreign subsidiaries of the client, at a significant increase in time and cost to the client. In addition, the move by U.S. regulators to review the work of foreign accounting firms could prompt retaliation by other countries in the form of reviewing the work of U.S. firms that audit U.S. subsidiaries of foreign multinationals.

The auditor must also report on the effectiveness of internal controls over financial reporting and management’s assessment of it, as part of the audit. Although Sarbanes-Oxley “does not intend that the auditor’s evaluation (of management controls) … be the basis for increased charges or fees,” given the increased political costs and potential legal liability associated with such an assertion, audit firms and management will probably need to spend significantly more time evaluating controls, particularly for engagements or audit areas with low reliance on controls. The expectation that audit firms would accept additional risk without doing additional work, and that they would perform the additional work without increased compensation, is akin to an unfunded mandate. Of course, virtually all public companies have experienced significant increases in audit-related fees.

Reduced Competition

While CPAs have a monopoly on the provision of audit services, the ability of firms to offer a combination of audit and nonaudit services created opportunities for competition along dimensions beyond price. One likely result of Sarbanes-Oxley will be a reduction in the number of firms that offer audit services to public companies. Without the ability to use audit services as a “loss leader” to initiate a client relationship that holds the prospect of higher-margin consulting business, many firms will find it desirable to concentrate on consulting and exit the audit field altogether. While the problems and potential for conflicts of interest in the old model were real, strengthening an oligopoly for audit services cannot have a completely benign effect. Section 701 of the Sarbanes-Oxley Act addresses this issue by directing the General Accounting Office (GAO) to conduct a study of the reasons for consolidation in the accounting industry since 1989, and to present its findings to Congress within a year of the act’s effective date. Ironically, this section stipulates that the report address several specific problems exacerbated by limited competition, including higher costs, lower quality, and lack of choice—exactly the kinds of problems that Sarbanes-Oxley may unintentionally contribute to.

Ability of Companies to Obtain Audit Services

As accounting firms reassess their business strategies, some companies may experience difficulty in securing audit services, while others may find the audit bill to be unaffordable. As they did in the 1990s during the profession’s litigation crises, accounting firms may walk away from high-risk clients. Some firms have threatened to drop audit clients that refuse to pay fees that offset these higher costs. Accordingly, a number of companies may choose not to go public because of the reporting and compliance costs associated with Sarbanes-Oxley. Tellingly, some public companies are currently opting to go private. Foreign firms may decide—as did Porsche—not to list shares in U.S. markets. Any of these decisions will limit access to the capital markets and, ultimately, restrict economic growth.

A more extreme negative effect of the auditor restriction could be a reduction in the number of audit firms that are willing to provide audit services to listed companies. Although it is unlikely that any of the Big Four would decide to exit the audit market, firms that currently audit a relatively small number of listed firms may make the strategic decision to do so. Such decisions will force smaller publicly companies either to pay the Big Four’s higher fees or to delist.

Given the vivid catastrophe provided by the demise of Andersen, along with the more routine legal risks of nine-figure tort suits, it seems all but certain that some audit firms, reviewing their risk assessments, will demand audit fees that some companies may find beyond their ability to pay. Firms may decline to provide audit services to some companies under any circumstances. What would then happen? Would the SEC or the PCAOB have a responsibility to provide audit services? Could one or the other of these agencies force an accounting firm to provide services? What exposure would there be in the event of an audit failure?

Disincentive to Take on Business Risk

One way to combat potential lawsuits is to avoid complex or ambiguous accounting issues. New ventures present high levels of business uncertainty and often raise such accounting issues. One way to avoid controversial but supportable accounting treatments would be to avoid such ventures. According to Alan Reynolds, a senior fellow with the Cato Institute, “The most serious effect will be to discourage risk … executives will naturally become ultra-cautious, even timid. Bold new [ventures] will be shunned … By penalizing risk, certification threatens chronic economic paralysis.” Forbes publisher Rich Karlgaard commented, “[The Sarbanes-Oxley Act] may well succeed in stopping the next Enron—but it could crib-kill the next Cisco, Microsoft and Starbucks … Cash-starved startups may have to dump three engineers for one lawyer.” The 2004 Global CEO survey of 1,400 CEOs conducted by PricewaterhouseCoopers reports 11% and 46% of respondents stating that the current business climate is making companies excessively or somewhat risk-averse.

Impacts on Managers and Directors

The corporate governance and certification requirements of Sarbanes-Oxley could potentially create even more adverse effects than the auditor restrictions. The act places authority for the audit process and nonaudit services provided by the auditor with the audit committee, one member of which must be designated as a “financial expert.” The certification provisions require that the CEO and CFO certify the accuracy of the financial statements. Although some writers suggest that certification will have no substantive effect absent other proof demonstrating criminal charges, some members of the public will undoubtedly interpret certification as a guarantee extending to business results. One wonders what section 302, “Corporate Responsibility for Financial Reports,” accomplishes that is not already extant in management or audit scope letters currently found in annual reports, except to provide another rationale for a shareholder lawsuit.

The market for directors and officers (D&O) insurance has hardened considerably over the last year, with effective limits on coverage (e.g., “entity coverage” caps) that in some cases are well below the level of possible damages. Heightened political and legal risks associated with service as a CEO, CFO, or board member have already begun to translate into higher compensation for these professionals—costs ultimately borne by shareholders and customers. All of these circumstances portend a decrease in the talent pool, and a decrease in willingness to accept any kind of risk.

At the same time that the Sarbanes-Oxley Act has made it more difficult for firms to attract the required “independent” board members, there is a growing awareness that staffing a board with outsiders may not be a panacea for the perceived ills besetting corporate governance. Analyzing survey data from officers and directors working at Forbes 500 companies, researcher James Westphal found that board independence lowered board effectiveness by reducing the level of cooperative interaction. This result accords with the intuition that managers are likely to be more cautious and less open with outsiders than with individuals with whom they’ve developed working relationships. Fortune editorial director Geoffrey Colvin (Fortune, December 30, 2002) noted the irony that the tightly framed definition of a “financial expert” would appear to eliminate eminently capable professionals (e.g., Warren Buffet or Alan Greenspan) from serving as the audit committee financial expert because these individuals had not served as an “accountant, auditor or CFO.”

Other Unanticipated Business Effects

It will be interesting to see what other kinds of anomalous consequences materialize as a result of the Sarbanes-Oxley Act:

• Will there be abuses of the section 1109 “whistle-blower” provision, which may provide underperforming employees with a chance to stave off dismissal by posing as whistle-blowers?
• How many “litigation minefields” await discovery?
• What does the future hold for purchasers of untested section 404 compliance software packages from startup vendors?
• Will there be a “section 404 burnout” effect?
• How will the impact on foreign companies affect the creation of “insourced” U.S. jobs, which some economists claim outnumber the U.S. jobs lost to outsourcing?
• Section 404 will probably create incentives for some companies to adopt a compliance strategy of outsourcing or even offshoring noncore finance and accounting functions to vendors that can provide the requisite expertise. Will Sarbanes-Oxley drain jobs from the U.S. economy?
• While perhaps not in itself a cause for public companies to go private, Sarbanes-Oxley has been cited as an important factor in some of these decisions. Recent reports show an increase in going-private decisions, and similar concerns will affect companies contemplating an IPO. What costs will this trend impose on the economy?

Alternative Cures?

An open question remains as to whether a combination of vigorous enforcement of existing laws and a renewed dedication to the critical evaluation of financial reporting would have addressed the problem. As G. Peter Wilson observed in his White Paper on Enron Implications, “[M]arkets are powerful disciplining mechanisms. If individuals who create, audit, and disseminate information did not already comprehend the devastating consequences of losing their credibility with the capital markets, the Enron debacle has punctuated this lesson.” (Interestingly, European countries seem to have taken a far more gradual, market-based approach.) We should not ignore the reality that a great deal of usable information was available before Sarbanes-Oxley; for example, the January 28, 2002, Barron’s profile of hedge fund short-seller James Chanos vividly demonstrates the good use to which even flawed disclosure may be put if the user possesses courage and common sense.

The financial markets in the United States have thrived because of the availability of capital in a society that values the business risk-and-return relationship. The market declines in 2002 brought about by the accounting frauds demonstrate the importance of controlling information risk. As a country we are learning about the direct costs of Sarbanes-Oxley compliance, and we should also begin to consider the new opportunity costs and business risks imposed by this legislation. The Sarbanes-Oxley Act has certainly created high expectations for fraud prevention, but many years will pass before we know whether these are justified. Some writers have argued that “compliance is free” because the benefits of exhaustively documenting and fully understanding internal processes will outweigh the associated costs. This may be true, but it bears noting that relatively few companies elected to pursue these benefits prior to Sarbanes-Oxley. It also bears observing that we have as yet no way of measuring the costs of Sarbanes-Oxley–spawned litigation.

Does current market sentiment anticipate that companies will absorb significantly higher information costs and be less willing to assume business risk in an attempt to avoid the associated information risk? If so, failure to respect the law of unintended consequences may have administered a “cure” to thousands of companies that may be worse than the original disease.