Table of Contents
- External Auditors: Regulation of the Auditing Profession and Auditing Firms’ Interaction with the Public Companies
- Establishment of the Pubic Company Accounting Board
- Investigative and Disciplinary Authority
- Establishment and Strengthening of Audit Committees in Public Companies
- Restriction and Illegalization of Some Activities
- Internal Auditors
- Does the Act Have the Same Indented Impact across the Board?
- Related Management essays
Since the bankruptcy of WorldCom, Enron, and other companies at the turn of the century, the U.S. business environment has shifted in a significant way. In the business environment, companies have to be audited. Auditing not only provides confidence that investors need for them to continue backing a company, but it also provides a means for an assessment of the business’s worth. The bankruptcy of WorldCom and Enron, among other companies in the late 1990s and early 2000s, had a large impact on the auditing professional due to the passage of the Sarbanes-Oxley Act almost by unanimity in both houses of the Congress. The analysis of the Sarbanes-Oxley Act and its consequences reveals that the Act varied influence on the auditing profession from the increase in supervision of internal auditors to increased spotlight and role of the internal auditors in a company structure.
External Auditors: Regulation of the Auditing Profession and Auditing Firms’ Interaction with the Public Companies
Establishment of the Pubic Company Accounting Board
The Act had a profound effect on the audit profession. Firstly, the Act established the Pubic Company Accounting Board. The Secures and Exchange Commission has a power to appoint this Board, which will be composed of five full-time members (Auerbach, 2010). The Act charges the Board with the authority to oversee and investigate audits, and auditors of all companies that are public. Furthermore, the board has the power to sanction individuals and firms that flout the rules that the Act establishes (Auerbach, 2010). The establishment of this board was not without controversy. Soon, after its establishment, some accounting and audit firms, led by the Free Enterprise Fund, sued the Board. Their grounds were that the Act established the Board as a body whose members had executive powers but whom the president could not remove which was contrary to the constitutional principle of separation of powers (Auerbach, 2010). Consequently, this was a danger to the very existence of not only the Board but the Act as most of the legal experts then enthused that a change in the appointment, dismissal or powers of the Board Members would result in a complete rewriting of the Act. The Free Enterprise Fund freely admitted that this would have allowed them to change other harsh provisions (Auerbach, 2010). However, the Supreme Court held that the drafters need not rewrite the while giving the SEC the power to remove the board members at its discretion. This settled the legal challenges to its existence
With the established Board in law with by the court’s opinion, it took on several important tasks in relating to accounting firms. First of all, the Board took on the role of registration of firms that prepare audits, issue audit reports, or play other unique roles in the audits of public companies (Auerbach, 2010). In fact, there are registration and annual fees for this. Failure to register with the Board exposes the audit firm with strict sanctions meant to ensure compliance with the Act.
The Board as established by the Act and appointed by the SEC also has powers to set standards for the audit firms. The Act mandates the Board to set standards for the auditing profession in the United States (Reiter & Williams, 2013). Moreover, the Act can also adopt measures by other bodies as it deems fit so as to ensure quality in public firms’ audit. The standards include the following: auditing and any attestation related to auditing, ethics and quality control, independence and other standards that in the opinion of the Board help to protect public interest (Reiter & Williams, 2013). Furthermore, the Act gives the Board the powers to set and enforce audit and other quality control standards for public company audits (Reiter & Williams, 2013). This is a drastic change from the time before the Act as the norm for the audit firms was self-regulation.
Investigative and Disciplinary Authority
The Act also set up the Investigative and Disciplinary Authority. The Act has charged the Authority with several powers including the authority to inspect requested audit firms operations and investigate any potential violations of securities laws, proficiency, principles and conduct of individual auditors, accountants or accounting, and audit firms (Auerbach, 2010). The co-operation with this body is mandatory. Any non-compliance will lead to sanctions and so will violations or failure to supervise an employee or a partner during the audit process. The penalties are severe and include suspension of the auditing license, prohibition from working with public firms and the imposition of civil penalties (Auerbach, 2010). In severe cases, the audit firm can even lose its license revoked. The effect of this is that there is little room for audit companies to wriggle as any behavior the Authority punishes severely any abhorrent.
Establishment and Strengthening of Audit Committees in Public Companies
Before the Act, auditors were overseen by the management. With the high consultancy fees that audit firms generate from most of the high profile Wall Street firms, the management could always blackmail the audit firms into ignoring unethical accounting methods by the company’s management. This was the case in Enron where the company management thought to have indirectly influenced the audit firm, Arthur Andersen (Reiter & Williams, 2013). This led to the fall of both Enron and Arthur Andersen, which were by then market leaders in both of their industries. To ensure that in future such scandals would not happen, the Act took away the supervision powers of an audit of companies from the management to a specially constituted committee for that purpose (Reiter & Williams, 2013). This committee is a working Committee of the Board of Directors in any public company in the United States. The Act has charged it with not only supervision of external auditors but also financial reporting and the relevant disclosures. To ensure impartiality and avoid potential interference from the management, the committee must constitute of directors who are not part of the managerial team i.e. independent outside directors of which one must be a financial expert (Reiter & Williams, 2013). The removal of the auditors from the grip of management has ensured that they enjoy greater factual independence than before the passage of the Act. As a result, the external auditors can do their jobs better than before the passage of the Act.
The introduction of the audit committees also has meant that auditors must approve all services, including audit services that the auditing firm provides. However, some services are outside the scope of this provision. This is unlike in the past where the management would approve all the consultancy agreements including those that are provided by auditing firms. Additionally, the auditor must report new information to the audit committee (Reiter & Williams, 2013). This was meant to keep the committee abreast with what is happening in the company considering they do not constitute a section of the executive management of the company. An auditor does this through the provision of information on critical accounting policies and practices used in the company. Furthermore, auditors have to discuss any alternative treatments of financial information within Generally Accepted Accounting Principles (GAAP) that the audit firm has disused with the management (Reiter & Williams, 2013). This could help to prevent the situation like the one at Enron, where the management used Special Purpose Entities to misinform investors and the public on the company’s actual financial position, which auditors spotted bit considered legitimate. This added an extra layer of transparency by ensuring that the management of the company will be less likely to use questionable accounting methods without the knowledge of the audit committee.
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Restriction and Illegalization of Some Activities
Moreover, the Act reduced the scope for audit firms in a company. Before the Act, many of the audit firms had involvement in the companies beyond their audit roles as consultants on other roles for some of the companies (Reiter & Williams, 2013). This sometimes produced a conflict of interest as there would be an implied threat to discontinue the other consultancy worked in case the audit firm failed to offer a good audit report. The Act disallowed this practice. The law has now made it illegal for the audit firms to provide their audit clients any other services to audit clients. These include information systems design and the implementation of such a system, appraisals systems, bookkeeping and actuarial systems, investment banking services and legal or expert services that are unrelated to the audit services (Reiter & Williams, 2013). The Board may also set any other activity it determines as not permissible. However, some of the non-audit services can be performed if the Committee preapproves them. While this may seem as restrictive, it has helped to reduce instances of conflict of the audit firm. Consequently, this has ensured the integrity of audit reports that are issued by audit firms.
Before the Act, it was possible for a single partner to do the audits of particular clients for a period spanning more than a decade. This would create an air of familiarity between the company and the lead audit partner. The effect of this is that it would lead the audit partner becoming too familiar with the interest of the management or the company above those of producing an independence and credible audit report (Reiter & Williams, 2013). However, this rotation must be balanced against the need to get a fresh outlook on the audit, and the need to still maintain a body of auditors who are proficient in an audit. The rotation requirement includes any partners who are not technically audit partners, for instance, tax partners, but who served as lead or concurring partners, for instance, relationship partners between the firm and the company. A relationship partner refers to high-level contact in the audit firm who is in touch with the audit client. The rotation of the audit partners should occur every five years, with a five-year timeout. This has served to increase extra costs on the audit firms. Many small such firms struggle to cope with such a requirement and have had to drop audit clients or add more partners they can barely afford (Cernusca, 2010). Thus, while well-meaning, this rule has increased potential costs on audit firms while reducing the market space for small audit firms which do not a significant number of audit partners to enable them to rotate. Closely related to the rotation aspects is an implication of the law on prior employment (Cernusca, 2010). To further enhance the independence of auditors, an accounting firm will not be able to provide services relating to audit, to a company if the firm employed any of the top five officials in the company and previously worked at the companies audit the year before.
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Furthermore, the illegalization of the destruction of papers and the failure to maintain work papers has also affected auditors. During the Enron scandal, there were assertions that the audit firm Arthur Andersen destroyed documents that may have assisted in the investigation, and which helped the company to escape with its fraudulent accounting processes for such a long time. However, the Act made it a felony for failure to maintain work papers for the audit firm for at least five years (Reiter & Williams, 2013). The act has defined these work papers to include the audit or review papers. The five-year aspect has significance as the Act lifted the statute of limitations for three years from the date of discovery to five years (Reiter & Williams, 2013). Thus, the requirement of the time the firm is needed to maintain work papers is in part meant to assist in the case of fraud.
Other than external auditors, internal auditors also got an impetus from the Act mandated many changes not only in the external auditing of companies but also internal audits. This is in spite of the fact that the Act seldom mentions internal audit. However, as a result of changes in the structure of public companies brought up by the Act and the increased scrutiny public companies find themselves after the passage of the Act, the internal audit department is likely to play a larger role in the management and running of public companies than was the case before (Abbott, Parker, Peters, & Rama, 2007). This is evident in several instances.
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First, the Act required businesses to review, modify, evaluate and in cases where this is appropriate, develop internal control systems in time for compliance with section 404. Thus, the internal audit and control increasingly received higher profile than before. Management and Boards of Directors have thus started looking towards internal audit with a sense of urgency (Abbott et al., 2007). This is because the law has increased the level of independence of external auditors, who are onlooker answerable to the management but the audit committees. While this does not imply that the internal auditors should not be independence, they are usually the first line of defense for the corporations in that they are likely to note unsavory things in the company before the external auditors have come to the fore (Abbott et al., 2007). In this respect, it is apparent that internal auditors have gained a more prominent role in the company with the passage of the Act. Management will rely on them much more than was the case to note any issues that may be of concern before the external auditors draw attention to them to the Board of Directors through the Audit Committee.
The increased prominence of the role of internal auditors has meant that they have to review the businesses from top down. Thus, many companies are likely to increase the staff in their audit departments as well as give them more power. This is in despite their increased exposure and chances of buy-in from the management as unlike their external counterparts, as they are usually employees of the company (Abbott et al., 2007). The events that led to the bankruptcy of Enron, WorldCom, and other firms at the turn of the century would not have happened with active, independent, powerful and well-staffed internal audit departments as they would have noted many of the irregulars and either warned the management about it or the Board of Directors.
While every one of those companies had an internal audit department, the management continued committing fraud while the internal audit concentrated on the various transactions within departments at the business units. Their role will thus require looking at the bigger picture (Abbott et al., 2007). This will unquestionably result in an increase in the types and extent of reviews at the company offices covering daily operations, monthly, quarterly and yearly processes that have any significant effect on the balance sheet.
The internal audit will further be expected to engage in the company-wide risk management. This means that in the first place, the internal audit department will be charged with producing reports that can be used to tame unnecessary (Abbott et al., 2007). While attitudes towards risk taking in an organization can vary, the responsibility to advise a company’s management on unnecessary risks that can have an adverse impact on the company will be the role of internal auditors. Thus, internal auditors will no longer be sideshows in an organization as the Act ensures that they take a central in an organization.
Does the Act Have the Same Indented Impact across the Board?
In spite of all these measures, there are questions about whether the SOX is having its intended consequences in the audit profession. The PCAOB has taken around 50 enforcement actions that result from the audits that are faulty and even conflicts of interest. These, according to PCAOB chair include several big four firms (Sikka, 2009). There have been assertions that there was an increase in the number of deficiencies in audits of public companies. This calls for the improvement in the audit process and audit model itself (Sikka, 2009). This further shows that, in spite of the bankruptcy of the Enron and its effect on the economy, including the decline of a Big Five audit firm Arthur Anderson, some audit firms are not compliant with the act yet. A name-and-shame mechanism would assist in this regard.
Moreover, there the case of Lehmann Brothers, which was similar to the Enron debacle because of the two firm's use of aggressive accounting techniques to mask losses, makes one question the impact of the Act on the accounting profession. Auditors either missed the Controversial Repo 105 scheme at the Bank or chose to ignore it while earning over 31 million dollars in the process. The fact that, unlike in the case of Arthur Andersen and Enron where both the company and the accounting firm took the blame for the debacle, in the case of Lehmann Brothers and the Ernest and Young the bank and the regulators took the blame.
It is apparent that the Sarbanes-Oxley Act had a varied impact on the auditing profession. In the first place, the Act led to more regulation of auditors and audit firms and their professional interaction with their public client companies. This is apparent through the establishment of the Pubic Company Accounting Board (PCAOB) whose duties are to oversee and investigate auditors and audit firms of all public companies. The board will do this though the Investigative and Disciplinary Authority. Furthermore, while the external auditors used to be accountable to the management and thus the management could coerce them, the Act established and strengthened existing Audit Committees in all public companies. Furthermore, the act restricted some activities that are likely to lead to the compromise of the external auditors. These include a number of consultancies another auditing the firms could do for public companies, the restricting the period a lead partner could spend on the audit of one company to five years and illegalization of destruction of materials and failure to keep work papers for more at least five years. Internal auditors are also in the spotlight more due to their increased role in a company.