A First Look at Sarbanes-Oxley in Operation

The Sarbanes-Oxley Act of 2002, the shotgun wedding offspring of Enron/WorldCom scandals, et. al., is now in operation. The legislation was designed to improve the governance performance of boards of directors of public companies and to regulate the activities of the accounting profession. It’s a bit early for a true evaluation of the effectiveness of the new legislation, but here are some preliminary views based on my experiences as a board member of five public banks and other companies.

1. The legislation focuses on the audit committee of the board as the principal tool for improving governance. This somewhat backwater and non-elite group of directors is suddenly required to hire the CPAs, understand and evaluate their work, ensure independent judgment, and generally be ready to stand behind the published numbers. Further, they must assure the public that nothing relevant has been omitted.

This is, in fact, a near-impossible job, since the audit committee only works with information provided by others. While the law provides for the right to hire professional assistance, this is really only useful in cases where the issues are already before the committee.

In practice, so far, audit committees are on “information overload” and are bogged down with an increasing number of time-consuming meetings. Clearly, audit committees will be more effective than they were, but even their best performance can’t provide bulletproof protection against another WorldCom, Adelphia, or Global Crossing. In the end, they must rely on the information provided by management and auditorsu00e2u20ac”they can’t perform audits.

2. My view is that the basic failure of the previous oversight system that led to Sarbanes-Oxley came about largely because of the accounting profession’s loss of independence. This weakness grew from pressure to cut corners and side with their employeru00e2u20ac”the managementu00e2u20ac”rather than maintain objectivity. Sarbanes-Oxley provides new regulation and supervision of CPAs through an accounting board created as a subsidiary of the SEC. Essentially, this board will audit the auditors. Self-regulation, once so proudly a part of the CPA profession, is a thing of the past. Here, also, it is too early to know how this will play out.

But one thing we can count on is, if past experience is a guide, audit operations will become much more costly, inflexible, and slow. No doubt they will also become more independent of management pressure. Yet, just how their independence will be affected by the current practice of bidding wars for audits will undoubtedly be a subject for the future. We should watch to see whether the accounting supervisory board will try to set bidding standards, for example.

3. Sarbanes-Oxley requires management to sign off on all published statements. Executives are subjected to criminal penalties and exposure to the plaintiff’s bar as a result of this provision. Some say this will change managements’ behavior, making directors and officers more cautious and less willing to take legitimate business risks. I haven’t seen any such result to date. This provision has, however, created some tension between auditors and financial officers as to who is relying on whom for final approval.

4. In well-run companies, the act doesn’t seem to create much in the way of change. Directors were already independent, auditors were reporting to audit committees, and so on. Perhaps the biggest change has been the requirement that boards now have a “financial expert” as a member or else explain why they don’t. This provision was drafted so narrowly that few could actually qualify, so in reality it has been interpreted so that anybody with an MBA ought to qualify.

My early appraisal of Sarbanes-Oxley is that it won’t change much at the best companies and will be a pain for those who played the Enron games. The real change will be in the CPA profession where government regulation and supervision will transform accounting from a profession to a new government bureaucracy. But I guess that’s progress.