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Sarbanes Oxley : Auditing : Thought Leader

What Has SOX Done For Us Lately?

By Deborah Wallace
Deborah Wallace
BrinkPoint Consulting

As a result of Sarbanes–Oxley, we’ve seen business codes of conduct steadily move from a rather loosely defined back-burner element of corporate governance to an element that is now explicit and far more prominent. Now that ethics is at the forefront of corporate concerns, it is important that we take both a short-term and longer-term view of its impact.

In the short-term, for example, we need to continue to assess its reception to date in order to make specific mid-course corrections. An example of a short-term focus would be making changes to the legislation with the objective of making it more “corporate friendly” without compromising its new standards. This is already well underway and is discussed later in this article.

A long-term view would be to consider the legacy of SOX. Is sustained heightened awareness of the surprisingly widespread chicanery and illegal activity in corporate dealings a realistic, albeit modest, goal? Or, are we hoping to institutionalize the principles behind Sarbanes-Oxley’s rigorous and comprehensive laws in our business culture?

What is Sarbanes-Oxley’s track record to date? Is it showing signs of success, and if so, in what ways, to what extent, and for whom? Are corporations making “real” progress toward the goal of preventing unethical conduct and questionable business practices? Has SOX begun to lay the foundation for a cultural shift in how we view, judge, and participate in corporate life? Or, to ask the question in a much broader context and use SOX as a proxy for any legislation intended to improve the ethical standards by which corporate America conducts itself, are our efforts to raise the ethical standards of daily business practices best achieved through legislation?

In the context of its larger purpose of restoring investor confidence in the US capital markets, SOX provides a host of guidelines and mechanisms for elevating and bringing into high relief a set of ethical standards by which every US publicly traded company must operate. From a short-term perspective, how have these guidelines and mechanisms, intended to exert very tight control, been received? What do we know so far about their impact?

While the availability of data is rapidly increasing, three years is too short a timeframe for drawing confident conclusions about a shift, or lack thereof, in the ethical conduct of publicly traded companies. Nor can we draw conclusions about changes in investor confidence, particularly not from the stock market. There is, however, some early data and anecdotal evidence that provides valuable information and insight into the impact of the SOX.

For example, as we know there has been widespread backlash to the auditing standards required by SOX, in particular AS2 and AS5. The initial response from the PCAOB was, appropriately, a wait-and-see response. Recently, though, the PCAOB, supported by the SEC, accepted that the standards were having unintended and detrimental consequences for companies trying to be in full compliance, and has amended both of these very contenscious, internal, control regulations. AS2 was amended by the PCAOB in December 2006, and amendments to the latter will take effect later this year.

In general, investors see this as the PCAOB Board and the SEC deferring too quickly to companies’ complaints of overbearing financial and human capital costs. Management, on the other hand, views it as a necessary capitulation; and for some, it is an insufficient resolution.

The fact is that compliance costs were way beyond what regulators estimated and were especially burdensome for smaller companies. While costs are trending down and most companies are relieved to get back to the business of business rather than the business of compliance, the jury is still out on the fate of these and other audit standards; and the controversy between regulators and business is alive and well.

A more conclusive data point relates to Section 403, which accelerates the deadline for reporting stock option grants to within two business days after the grants are made. According to a 2005 study that looked at the effect of SOX on the manipulation of timing of CEO stock option awards , several positive results emerged with reason to be optimistic.

The study found that the two-day accelerated deadline “deters the opportunistic granting of unscheduled awards after bad news announcements and reduces, but does not eliminate, the opportunistic granting of unscheduled awards before good news announcements,” thereby at least reducing insider windfalls. In addition, the study found that the new deadline requirement discourages the practice of delaying good news after scheduled option awards, and “greatly reduces” the now well-known practice of backdating option grants as a way to lower the options’ strike price.

While each of these previous examples has some positive encouraging news, there is also discouraging data in terms of SOX providing a foundation for rebuilding corporate America’s reputation. The 2005 National Business Ethics Survey conducted between 1994-2005 by the Ethics Resource Center (ERC), asked employees their opinions about ethics and compliance in the workplace. The results were mixed.

For example, formal ethics programs are on the rise nationally but according to this study’s participants, the outcomes of those programs are not expected to be positive, which I think we can assume means that there will be no significant change in the frequency of misconduct. Further, although formal training programs in ethics and compliance do have impact, organizational culture is a more influential factor in determining outcomes. (This should not be surprising to any organization that has been involved in M&A activity where the inability to resolve cultural disparities is central to merger failure.)

One other interesting result is that when employees encounter situations involving unethical or unacceptable behavior there is a “high likelihood” that they will also observe a violation, but are very reluctant to report it to management. In 2005, only 55 percent of employees who did observe misconduct reported it to management, compared to 65 percent in 2003.

Opinions from fraud examiners are not so favorable either. In the positive column, 65 percent of respondents participating in the 2005 Oversight Systems Report on Corporate Fraud reported that SOX has been "somewhat effective" or "very effective" in identifying incidences of financial-statement fraud. Further, only 19 percent believe that SOX is not effective in preventing fraud identification. Despite this encouraging data, however, the CEO of Oversight Systems, Patrick Taylor, is not optimistic. "SOX legislation and the intense focus on corporate scandals have helped battle this type of white-collar crime, but professionals seem to be worried that the C-suite might quickly lose interest in policing corporate fraud."

This concern is born out by other results presented in the same report. Only 17 percent of certified fraud examiners think that there will be any sustained shift toward corporate integrity and fraud prevention among business leaders. More disturbing is that 39 percent of fraud examiners believe that whatever interest exists today for raising the level of corporate integrity and fraud prevention will diminish in the next five years. In addition, nearly one-third, 32 percent, think that the earlier intensely stated commitment to adhere to SOX guidelines has already begun to subside. Finally, 12 percent of the study’s participants report seeing no change among business leaders.

Where To From Here?
While the data presented here gives us a few small windows of perspective into how Sarbanes-Oxley has been received to date, it nonetheless remains a collection of discrete information, too new to show patterns from which we might draw implications about its likelihood for success (more ethical corporate conduct) or failure (regression to careless and misguided corporate conduct).

What it affords, and more importantly what it necessitates, is a refinement and reconsideration of the kind of results that investors, corporate boards and management, and regulators want from such sweeping legislation. If bolstering punishment for egregious behavior succeeds in discouraging such behavior, and if standardizing internal controls results in earlier detection of misconduct even though it may not prevent it, we have at least put a chink in the armor, and in that way, have succeeded. Regaining investor confidence in US capital markets and institutionalizing ethical behavior are qualitatively different results, and require a level of commitment, collaboration, and accommodation among competing interest groups that is not endemic to US business.

If we consider each category of results described above -- those that can be achieved mainly through legal and economic channels and those that can be achieved only through a change in perspective and attitude -- then being very clear about the kind of results we want is lynchpin to answering the question of whether SOX by itself is sufficient to turn the tide of disreputable corporate behavior.

In one case, SOX and other similar legislation may indeed be sufficient to power incremental change. In the other, SOX would be one element in a complex system that would be needed to overhaul the ethical standards that currently support our current corporate business model.

Deborah Wallace
BrinkPoint Consulting
Deborah E. Wallace is the Principal of BrinkPoint Consulting. She has been consulting with Boards of Directors for more than 20 years.

She can be reached at 781-259-0550 or at dwallace@brinkpointconsulting.com

For more information go to www.brinkpointconsulting.com

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