Increasing audit cost
Sarbanes-Oxley (SOX) Act of 2002 and Increasing Audit Cost
This research study will evaluate secondary literature to determine if compliance to Section 404-Sarbanes-Oxley (SOX) Act of 2002 does or does not increase audit costs. This research study will conduct an investigation to find secondary literary sources containing information about large and small organizations and their compliance to Section 404 of SOX. This research study will also collect information about the dollar amounts paid to auditors to conduct Section 404 audit costs for large and small organizations. This research study will answer the research questions in reference to compliance to Section 404 and the decrease or increase in audit costs.
DEFINITION OF TERMS
Accelerated Filers- Companies that have more than 75 million in stocks, bonds, and debt securities sold to investors.
Attestation- to confirm or certify by signature or oath that something is true or accurate.
Debt Securities- bonds, debentures, and notes offered to the investors for sale.
Debentures: debt not secured by collateral.
(Electronic Data Gathering Analysis and Retrieval)-EDGAR system- a database used by the SEC to collect information concerning publicly traded companies, who sell stocks, bonds, or debt securities.
Insider-Trading- a person who has private information as to whether a stock will increase or decrease based on the private inside information, and the person purchases or trades stocks based on that information.
Internal Control Deficiency (ICD) - companies that have internal control problems in the form of accounting irregularities.
Mutual Funds- a percentage of pooled money invested as a cooperative group into a portfolio.
Non-accelerated Filer- companies with less than 75 million in stocks, bonds, debt securities sold to investors.
Private Company- A company that is restricted to the private investors, who may buy stocks, bonds, and debt securities by contacting the company directly.
Public Company- A company that is limited to the sells stocks, bonds, and debt securities in a publicly traded fashion in the stock market.
Public Company Accounting Oversight Board (PCAOB) – A bureau or organization that makes sure a division remains between accountants and auditors.
Public-float- is part of common stock or preferred stock purchased by management or large shareholders.
Sarbanes-Oxley Act (SOX) of 2002- An regulatory law that contains 11 title sections, and 2 appendices on safeguarding investor's investment and the company's power over publicly traded companies.
Securities- financing stocks, bonds, and debentures purchased and sold in stock market.
Securities Exchange Commission (SEC) - An agency that supervises all the sell of stocks, bonds, and debt securities; and they supervise the individuals who sell stocks, bonds, and debt securities.
This research study will answer the following research questions:
- Is there more or less accountability after Sarbanes-Oxley (SOX) Act of 2002?
- Does compliance to Section 404 of Sarbanes-Oxley (SOX) Act of 2002 increase audit cost?
The first research question is as follows:
(1) Is there more or less accountability after SOX?
- The Null Hypothesis: There is more accountability after Section 404 of SOX is implemented for internal and external controls of companies.
- The Alternative (Research) Hypothesis: There is less accountability after Section 404 is implemented for internal and external controls of companies.
- The Directional Hypothesis: There is a positive correlation between compliance to Section 404 of SOX and more accountability for internal and external controls of companies.
The second research question is as follows:
(2) Does compliance to Section 404 of SOX increase audit cost?
- The Null Hypothesis: Compliance to Section 404 of SOX increases audit costs.
- The Alternative (Research) Hypothesis: Non-compliance to Section 404 of SOX increases audit costs.
- The Directional Hypothesis: There is a positive correlation between compliance to Section 404 of SOX and increase in audit costs.
This research study is interested with compliance to Section 404 of SOX, which is increasing the audit costs for small and big companies to comply with this act. The reason for the increase in audit cost is because one accounting firm must conduct the internal audit on the assessment of internal control for that company and another accounting firm must conduct the external audit on the assessment of external controls of their client's company.
Overview of Historical and Theoretical Perspectives
This research study will examine both small and big organizations as they comply with Section 404 of SOX, and how that compliance to Section 404 drives the cost of audit prices up. This research study will introduce the historical overview of laws that existed prior to the implementation of prior to Sarbanes-Oxley (SOX) Act of 2002. Those laws are as follows:
The Securities Act of 1933 created to protect investors by having companies to inform investors of a company's financial status and all pertinent information concerning the public sale of stocks for that company. The act also prevents the company and individual's selling stocks from participating in deceit, the misrepresentation of company financial information, or participating in fraud in the sale of stocks. All public companies that trade and sell stocks to the general public must register with the SEC, and file a 10k (financial statements) thru the SEC website located in an EDGAR (the Electronic Data Gathering, Analysis, and Retrieval system).
The Securities Act of 1933 is vague, because it allows companies to file their financial statements called a 10k; but that financial information cannot be verified as being accurate. The SEC cannot guarantee that the investor will not lose money thru the purchase of that company's stock. Whereas the company is the responsible party for financial and criminal loss, and the corporate executives are not.
The next following year, the Securities Act of 1934 passed and this legislation created an agency called the creation of the Securities Exchange Commission (SEC). The Securities Exchange Commission (SEC) makes the final ruling on any discrepancies with the sale of stocks; they oversee all financial transactions concerning the sale of stocks. The SEC also controls agencies, organizations, and stock exchanges that sell stocks.
This Act also prohibits insider trading, which can affect when and if stocks, being sold for huge profits or normal profits. It is illegal for a person who has inside information from a company or person selling stocks to profit from this information as to whether these securities will increase or decrease in price before the general public obtains that same information. This information also cannot benefit the persons who own the stock by giving them huge profits and minimum losses; otherwise that person can be accused of insider trading. This Securities Act of 1934 also controls the professional conduct of all organizations and individuals selling stocks.
The Trust Indenture Act of 1939 controls the sell and purchase of bonds, debentures, and notes. This act means the seller and purchaser of bonds, debentures, and notes must have a formal agreement called a trust debenture. This means that the purchase price is set, and the amount of bonds, debentures, and notes are set as how many are purchased.
The Investment Company Act of 1940 has company's disclose their financial status upon initial stock sale, subsequent stock sale, and on daily basis. This Act prevents the SEC from consulting or advising on investment decisions or the activities of any company. This act did provide a little accountability on behalf of the company, but the problem is that it requires no accountability of the individual's in charge of the actual decisions affecting investor's holdings.
This act does require those who consult or advise in securities transaction be registered with the SEC.
After numerous accounting scandals from 2002 to 2004, the Sarbanes-Oxley (SOX) Act of 2002 was implemented. This paper will address Section 404 of SOX only.
Section 404 of Sarbanes-Oxley Act of 2002 is the Management's Assessment of Internal Control, which requires management to establish and maintain good internal control systems, which can provide accurate financial reports or financial statements. Section 404 stipulates that a Management's Report on the Assessment of Internal Control be incorporated with a company's 10k for each financial year the company is operating the business.
Previous laws held companies financially and criminally liable to investors, but Section 302 of Sarbanes-Oxley Act 2002 requires the corporate executives making the decisions be held financially and criminally liable to investors. This accountability would mean that corporate executives would exhibit better decision-making abilities, and practice making better decisions.
Significance of the Research
The importance of this research is to indicate the level of conformity to Section 404 of SOX for publicly traded corporations, and the escalation audit costs remunerated by firms today to be in compliance to Section 404.
Relevance of Research
The importance of this research is to relate that Section 404 of SOX indirectly affects the general public because of their individual retirement plan like 401 (k) plan or pension plan. These retirement plans or pension plans are comprised of stocks, bonds, and debt securities, and these stocks, bonds, and debt securities will increase in the value or the decrease in value. The value of a person's retirement plan or pension plan will determine how well each individual will live after age 65. If too many losses are incurred in their retirement plan or pension plan, these individual's will have to work in their retirement years.
Limitation and Delimitation
The delimitation of this research study is to isolate just Section 404 of SOX as it pertains to publicly traded organizations and firms with 75 million of stocks, bonds, and debt securities sold to investors. The limitation of this research study will isolate just the audit costs within the scope of accounting as it relates to Section 404 of SOX and the publicly traded organizations and firms.
The research study will use a mixed methodology to answer both research questions. The qualitative method will use secondary literary sources to answer the first and second research question: (1) is there more or less accountability after SOX implementation? (2) Does compliance to Section 404 of SOX increase audit cost?
This investigation will accumulate the latest facts to convey the outcome to the following:
- the assumption concerning compliance to Section 404 of SOX, and whether Section 404 adds more or less responsibility or liability on the part of individuals that run these companies.
- the assumption concerning whether Section 404 of SOX increases audit costs.
A random stratified sample collected by (Hartmann, 2006) of the S & P 500, S & P Mid-Cap 400, and S & P Small-Cap 600 indices will be used to reflect the overall population of publicly traded companies who report the amount they pay in audit fees to auditors, and the dollar amount in increases paid for audit fees
This research study will use the information obtain from (Hartmann, 2006) in which data is collected from a random sample of 850 publicly traded companies registered with the S & P, the sample size will be randomly selected from the S & P 500, S & P Mid-Cap 400, and S & P Small-Cap 600 indices.
The research methodology procedures will examine all secondary literary sources on the topic of Section 404 of SOX that provides the audit costs prices before the implementation of Sarbanes-Oxley Act of 2002-Section 404 versus the audit costs prices after the implementation of Sarbanes-Oxley Act of 2002-Section 404. The research study will examine these secondary sources to evaluate the reasons for the increase in audit prices have increased. This research study will provide the result of this information by comparison of these companies with each other to the general public.
Action research is used in many setting, for example in businesses by corporate executives, in colleges and universities by professors and students, and in schools by educators to conduct research to identify why a problem currently occurring. These professionals identify what the problem is, and then they plan different courses of action that they plan to take. They chose a course of action that they believe will correct the problem, and monitor if that course of action will solve the problem. If not, then these professionals choose another course of action until the problem is solved. Next, these professionals document the problem, course of action taken, and the results to solve the problems. Lastly, they will identify things to learn from the problem and solution to the problem.
GOALS OF ACTION RESEARCH
This goal of this action research is to make improvements to a problem by finding a solution. Sometimes this may involve taking an old process, and developing ways to improve on that process. The result is that the problem should not occur again.
THE VALIDILITY OF ACTION RESEARCH
The validity of this action research is to evaluate Section 404 of SOX for ways of improving on the current law or regulation to improve compliance procedures and help reduce audit costs. Since the implementation of Section 404 of SOX, companies complain that compliance to this Act increases audit cost.
Accounting and business professionals alike both have debates about Section 404 and its overall regulation to publicly traded firms with 75 million in stocks, bonds, and debt securities, because of the accounting scandals from 2002 to 2004 like Enron, WorldCom, Adelphia, Bristol Meyers, and various other companies. Sarbanes-Oxley (SOX) Act of 2002 provides control and regulation of all publicly traded firms big and small. No longer could corporate executives' conduct accounting fraud or conduct shady business practices and the organization or firm be held liable only. SOX held corporate executives' responsible for financial statements and shady business practices, and they would be arrested and their personal assets used to compensate investors who lost money through the purchase of company stock.
Publicly-traded companies are companies with 75 million in stocks, bonds, and debt securities outstanding of the company's stock holdings. These companies must register with the Securities Exchange Commission (SEC) and make sure a company's 10k, and a Management's Report assessing the internal controls of their company is available to the general public and investors. Privately-owned companies, which are personally owned, do not have to complete a registration form with SEC, and Section 404 of SOX does not apply to privately owned companies.
“IIiev reports that testifying before the Small Business Committee of the U. S. House of Representatives, Micheal J. Ryan Jr., Executive Director and Senior Vice President of the Center of Capital Markets Competitiveness at the U. S. Chamber of Commerce, concluded (based on the evidence from the center survey) that Section 404 costs and regulatory burden are “far beyond what Congress intended and well in excess of the benefits to shareholders and management” (Manickeravasagam, 2007).
Management and Accountability
The accounting scandals like the following companies: WorldCom (2002), Enron (2004), Adelphia (2002) , HealthSouth Corporation (2003), AOL (2002), and countless others like Kmart (2002), Halliburton (2002) , Freddie Mac (2002) , and AIG (2004) for falsifying financial statements, inflated sales or revenues, and misleading accounting practices, represented poor management and a lack of accountability. Big accounting firms went out of business like Arthur Anderson who audited the financial statements of some of these companies, and other accounting firms who performed audits for these companies listed above and are responsible for these companies fraudulent misstatements are Deloitte & Touché, Ernst & Young, Pricewaterhouse Coopers, and KPMG. The WorldCom and Enron scandal was the breaking point for investors who lost money in these companies.
The Public Company Accounting Oversight Board (PCAOB) formed by the Sarbanes-Oxley (SOX) Act of 2002 is accountable for dividing the Accountant's duties from the Auditor's duties to make sure no other accounting scandals will occur. This means that accounting firms cannot provide both consulting or accounting services and conduct audit services to the same company that it has as a client.
Coates reports that” the goals and promises of Sarbanes-Oxley Act are long-term benefits like the investors facing lower risk of losses from fraud and theft, and more reliable financial reporting, greater transparency, and accountability of companies and corporate executives.” (Coates, 2007) Most people invest in companies directly by purchasing stocks and mutual funds or indirectly by investing in a 401k plan which invests in various organizations stock..
Coates reports that “with Sarbanes-Oxley Act in place, fraudulent cases are down because Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and Accounting firms are financially and criminally liable for falsify financial statements.” (Coates, 2007)
Brown reports that “SOX resulted in increased out-of-pocket expenses for public companies and the amounts overstate the continuing costs of SOX, in which if SOX is trying to correct the market and corporations, when the market should correct itself.” (Brown, 2007)
Estimation of Audit Cost
The estimation of the audit cost is a two part process involving the auditor planning the audit and the auditor estimating the price to charge the company. The cost of an audit is an estimation based on:
- the customer's business size,
- the quantity of sections the examiner must look at,
- the volume of inventory and accounts receivables,
- and the auditor's judgment in regards to the customer's internal controls and financial reports.
Another factor is the overall experience that an auditor has to learn how to determine the appropriate price for an audit. Typically, auditors need 15 years of experience to be competent in estimating and conducting an audit.
(Dickins, Higgs, & Skantz) “interviewed audit practitioners and their structured interviews were conducted in the summer 2006 and included 27 partner and senior manager auditors responsible for the estimation of audit fees. The authors report that the participants were members of five different accounting firms, from seven different U.S. cities, and had an average of 15 years of auditing experience.”(Dickins, Higgs, & Skantz, 2008)
(Dickins, Higgs, & Skantz, 2008) “report that all participants reported that, consistent with the pre-SOX period, audit pricing is a function of three factors: (1) the estimated effort to perform the audit; (2) the rank of personnel required to execute the audit; and (3) the audit firm's perceived risk and rewards. The operational definitions are the many variables related to the audit process and the interview of the audit practitioners which are both valid and reliable.” ((Dickins, Higgs, & Skantz, 2008)
The results of the authors findings were that the estimated effort and level of personnel are the primary drivers of the arranged audit fee that are initially estimated by senior and manager personnel based on a account by account analysis of a client's financial statements.
Quittner (2006) conveys that accounting firms are relating that billable rate for accounting services have increased to $160 dollars an hour since the implementation of Sarbanes-Oxley (SOX) Act of 2002, especially since organizations must comply with Section 404-Sarbanes-Oxley (SOX) Act of 2002. “He also reports that audit fees have tripled from $1.7 billion dollars to $5.3 billion dollars since 2001 to 2005 at the largest accounting firms.” (Quittner, 2006)
The Costs of Section 404 of SOX
Hartmann (2006) describes “the total cost of being public for companies with under $1 billion dollars in annual revenue dropped by 16%.” Hartmann (2006) “He testifies that companies with over $1 billion in annual revenue, the total costs dropped by 6%. The following table reports the auditor's fees from 2001 to 2005.” (Hartmann, 2006)
Audit Fees Source: Hartmann, T. (2006)
“Hartmann (2006) obtained his information from S & P database which represents a random sample of public companies included in the S & P 500, S & P Mid-Cap 400, and S & P Small-Cap 600 indices.”( Hartmann, 2006)
“The following table reports the fees paid to auditors by S & P companies.” (Hartmann, 2006)
Fees Paid to Auditors Source: Hartmann, T. (2006)
Quittner (2006) states that “the reason is largely because SOX stipulates that the same firm cannot perform both the external auditing of financial statements and internal audit, known as Section 404.” (Quittner, 2006) Most business use larger accounting firms like the Big 4 to complete the internal audits, while other accounting firms are used to complete the external audits.
Internal Control of Audit Cost
The result of internal controls have a bearing on the audit costs, and also have a bearing on the accuracy of the accuracy of the financial statements. Investors rely on those financial statements before investing, and lending institutions determine whether they will lend to companies based on their annual report (10) and the Manager's Report assessment of internal controls. Internal controls are discussed in the following article below and the significance of internal controls within an organization, as well as the lending institutions reactions to internal control issue.
Gottlieb (2006) introduces and defines the term called Internal Control Deficiencies (ICDs) as organization with more accounting irregularities. He reports that these organizations pay a higher cost to borrow money and their stock prices are listed lower on the stock exchange. “The author introduces ICD as the variable. He defines the fact that companies with accounting irregularities will treated badly by banks, while companies with good internal controls will be treated good by banks.” (Gottlieb, 2006)
Section 404 mainly assesses the internal controls of a company, but what occurs when a company has weak internal controls or a deficiency. The article below discusses how internal controls affect a company's overall business practices.
“Gottlieb uses stock prices in support of ICD concept by stating that companies reporting no problems in 2004 or 2005 showed an average share-price gain of 27.7% and companies that reported ICDs in both 2004 and 2005 saw an average decline of 5.7% and this is the operational definition. The author conveys his point very well when he uses a measure instrument like stock prices to illustrate his point that Internal Control Deficiencies (ICD) that are weak are rewarded with adverse actions against their company. He also points out the audit prices have increased because of compliance to Section 404 of Sarbanes-Oxley Act of 2002.” (Gottlieb, 2006)
FINDINGS AND CONCLUSION OF RESEARCH
The conclusion to this research study is that Section 404 of SOX has created more accountability than the previous laws. Coates reports that” the goals and promises of Sarbanes-Oxley Act are long-term benefits like the investors facing lower risk of losses from fraud and theft, and more reliable financial reporting, greater transparency, and accountability of companies and corporate executives.” (Coates, 2007) This research has answered the first question: Is there more or less accountability after Sarbanes-Oxley (SOX) Act of 2002?
This research study proves through careful examination that a positive correlation exist between Section 404 compliance and increase in audit cost. Quittner (2006) conveys that accounting firms are relating that billable rate for accounting services have increased to $160 dollars an hour since the implementation of Sarbanes-Oxley (SOX) Act of 2002, especially since organizations must comply with Section 404-Sarbanes-Oxley (SOX) Act of 2002. “He also reports that audit fees have tripled from $1.7 billion dollars to $5.3 billion dollars since 2001 to 2005 at the largest accounting firms.” (Quittner, 2006)
This research study also finds that Section 404 of Sarbanes-Oxley Act of 2002 does increase audit costs, the reason for this is that one accounting firm must perform the internal audit and a different accounting firm must conduct the external audit. Another factor that increases audit costs is the auditors must also attest to managements ascertain that their company have good internal controls and that the financial statements reflect true and accurate information, and the auditor must determine if the risk of auditing particular companies is worth it. Most of the research study shows that small companies had the biggest burden in costs to comply with Section 404. This research has proved the null hypothesis for both research questions and the directional hypothesis for both research questions.
“(Cosgrove & Niederjohn state that some companies in 2003, 20.6 percent switched from the Big 4 auditors to middle tier auditors and 22.9 percent switched from the Big 4 auditors to the small tier auditors.” (Cosgrove & Niederjohn, 2008)
Small companies were bearing the biggest cost of audit costs to be in compliance to Section 404, so the SEC conduct an investigation to determine how to minimize the costs to them. Hartmann (2006) reports in the following table below shows how much of the cost burden each companies bears in regards to audit costs.
Audit Costs in Dollars and Percentage
Source: Hartmann (2006)
“Hartmann (2006) reports in the Fiscal Year (FY) 2005, the percentage increase in average audit fees was significantly higher for small-cap companies (22%) than mid-cap (6%) and S & P 500 companies (4%).” (Hartmann, 2006)
LATEST AMENDMENTS TO SECTION 404 OF SARBANES-OXLEY ACT
The SEC has granted to extension to small business owners (non-accelerated filers) previously, and now the SEC has issued another ruling giving small business another extension until June 15, 2020 instead of December 15, 2009 to include the Section 404-Management's Report on the Assessment of Internal Controls with their financial statements. The reason for the extension is that the SEC conducted its own investigation on the impact of Section 404 on business and founded that small businesses are burden the most with compliance to Section 404.
- (2009) How the SEC protects investors, maintains market integrity. Retrieved from http://www.sec.gov/about/laws.shtml. 1-4.
- (2009) Defining Issues: SEC grants six-month extensions for non-accelerated filers to begin complying with final stage of Sarbanes-Oxley. KPMG. 1-2.
- Brown Jr., J. (2007) Criticizing the critics: Sarbanes-Oxley and quack corporate governance. Marquette Law Review, 309-335.
- Cosgrove, S. & Niederjohn, M. (2008) The effects if the Sarbanes-Oxley Act of 2002 on audit fees. Journal of Business Strategies, 25(1), 31-52.
- Coates, J. (2007) The goals and promise of the Sarbanes-Oxley Act. Journal of Economic Perspectives. 21(1), 91-116.
- Dickins, D., Higgs, J. & Skantz, T. (2008) Estimating audit fees post-SOX. Current Issues in Auditing. 2., A9-A18.
- Gottlieb, O. (2006) Paying the price for internal control deficiencies: Weak internal controls lead to higher cost of capital, lower stock price according to new studies. Audit Integrity News. 1-5.
- Hartmann, T. (2006) The cost of being public in the era of Sarbanes-Oxley. Foley & Lardner LLP. 1-19.
- Iliev, P. (2009) The effects of SOX section 404: Costs, earnings quality, and stock prices. 1-73.
- Manickasavagam, M. (2007) SEC plans to propose further delay for small company section 404 compliance. Corporate Accountability & Fraud Daily.
- Morgan, J. (2008) Fund execs on how to share information with directors. American Banker. Retrieved from Encyclopedia Britannica Online: Academic Edition, 1-5.
- Quittner, J. (2006) Sarbanes-Oxley projects add up for smaller firms. Crain's New York Business. Retrieved from Encyclopedia Britannica Online: Academic Edition, 1-4.
- Wagner, S., & Dittmar, L. (2006) The unexpected benefits of Sarbanes-Oxley. Harvard Business Review. 1-10.