BUSI 9328: Change Management
Transcript of BUSI 9328: Change Management
BUSI 9328: Change Management
Abhishek Sharma 201089513
[SARBANES-OXLEY ACT AND ITS RAMIFICATIONS ON THE ACCOUNTING PROFESSION]
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Abstract
There are various underlying conditions that affect demand for accounting services by
users of accounting information. Decisions involving the allocation of scarce financial resources
are important from the investor’s perspective because it involves investing not only large dollar
amounts but also significant inputs of time and effort. Needless to say, bad investment decisions
based on incorrect or low quality accounting information can severely reduce the wealth of
investors. Here accountants and auditors act as neutral gatekeepers of financial information.
After the corporate scandals of early 2001-2002, investor confidence in the financial
intermediaries—accountants, auditors and accounting firms—was shaken. The US congress then
passes the Sarbanes-Oxley Act to restore investor confidence and compel the accounting industry
to adequately perform their fiduciary duties. The Sarbanes-Oxley Act is a rule based regime. It
prescribes guidelines for compliance in an often mechanical manner.
The paper attempts to look at the after effects of the Sarbanes-Oxley act on three
variables: culture of Accounting Firms, the effect on the internal control of reporting firms and
the quality of financial information provided in the economy. It was found that the Act
substantially increased the compliance costs and financial burden for firms. This caused the firms
to become risk averse and less innovative. It also attracted less optimal type of executive. The
law had no discernible impact on the internal controls of a reporting company. The cumulative
effect was that the quality of financial signals sent into the economy was not improved because
of conservatism in financial reporting and switching of earning management techniques. The
results of the failure of SOX to bring about improvement in quality of financial information
could be attributed to the misalignment of the various components of the system that make up the
firm, like the informal organization, work, formal organization and people. Finally the paper
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prescribes methods to attaining sustainable compliance which would result in high quality
information. This would be achieved through managing overall cultural change in both the
reporting company and the accounting firm to achieve work processes that are deeply imbedded
into the collective consciousness of the organization.
Introduction and Significance
The demand for financial services is determined by three characteristics of financial
information that affect the end users of financial information. They are: 1) Complexity and 2)
Remoteness of financial information, and 3) Consequences of wrong financial decisions
(Robertson & Smieliauskas, 2010). We could also add a fourth factor: 4) Diffusion of financial
transactions. Firstly, financial information is usually very complex. The simple lay user is ill
equipped to decipher the financial information all by him-herself (Robertson & Smieliauskas,
2010). Secondly, the financial information is removed from the user by distance and time.
Thirdly, there are monetary consequences of basing your decisions on the wrong or incorrect
financial information (Robertson, Smieliauskas, 2005). Intermediaries like accountants, financial
advisors and auditors avail their services by reducing the information asymmetry that exists
between the economic events that occur and the end users of financial information. The
intermediaries do so by recording, classifying, and summarizing the financial information into
concise financial statements so that are easily understood (Arens, 2007). The accountants
compile and summarize the financial information in accordance with the Generally Accepted
Accounting Principles (GAAP) (Robertson & Smieliauskas, 2010). The auditors then approve of
the veracity of the financial information by attesting that they do no not contain substantial
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material misstatements (Dowdell, Kim, Klamm, & Watson 2012) in accordance with the
Generally Accepted Auditing Standards (GAAS).
There are three parties in the relationship who are bound by a relationship of
accountability. The company and the end users are bound by a relationship based on
accountability and full disclosure (Robertson & Smieliauskas, 2010). The end users however,
would be skeptical of the financial statements prepared by the companies. The skepticism is in
large part due to the fact that the financial statements might not reflect the economic substance of
the events which they purport to represent. Also, companies generally tend to overstate their
financial position by rounding up their earnings and rounding down their liabilities in a practice
known as cosmetic earnings management (Aono & Guan, 2008). This is where auditors come in.
The auditors are hired by the company and are bound to the company by the audit engagement.
However, the auditors owe a fiduciary duty to the end user (Arens, 2007). They are supposed to
work as information gatekeepers for the users of financial information.
This tripartite relationship is shown below:
Source: Robertson, J; Smieliauskas, W. Auditing An International Approach (5TH Canadian Edition). Toronto, ON: McGraw-Hill. 2010. Print.
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Investors and financial markets need correct and timely information to make efficient
resource allocation decisions. Quality financial information provided by accountants and verified
by auditors act as signals and is essential for the efficient functioning of the capital markets. But
this system of accountability does not always work the way it is supposed to. When a break in
the relationship of accountability occurs, investor confidence in the reliability of financial signals
also starts to erode, shaking the foundation of the capitalist economy. This was made painfully
obvious after the accounting scandals in early 2000s involving some of the biggest names in the
financial and corporate world: Enron, WorldCom, Tyco, Arthur Anderson. Henry Paulson rightly
emphasized that capital markets reply on trust and trust is based on financial information
presumed to be accurate and reflect the economic reality (Cohen et al, 2005).
As a result, in 2002 the US congress passed the Sarbanes Oxley Act (SOX) (Goh, 2013).
President Bush signed the act into legislation and it became effective on July 30, 2002
(Fuerman,2012). The overall purpose of the act was twofold: to improve the quality of financial
information and to restore a thoroughly shaken investor confidence in the reliability of the
information provided by the gatekeepers of financial information (Engel, E., Hayes, R. M., &
Wang, X., 2007). SOX establishes punitive fines and penalties for issuing false statements and/or
failing to certify a financial report up to amounts as much as $5 million and 20 years in prison
(Lobo, 2006). The Act established a quasi-governmental independent regulatory body, the Public
Company Accounting Oversight Board (PCAOB) to oversee and regulate the audit firms and the
audit process.
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Research Question
This paper shall look into the how the quality of financial information changed after the
passage of the Sarbanes-Oxley Act. Consequently, the paper shall also analyze whether the
passage of the act had any remedial effect on the internal controls in a company. Furthermore,
the research will attempt to delve into whether the act had an effect on the organizational culture
of accounting firms. The research question can be summarized as follows:
Has the enactment of the SOX sufficiently changed the culture of Accounting Firms? Has
SOX had a salutary effect on the internal control of reporting firms? Consequently has
the quality of financial information provided in the economy improved?
Literature review
There has been a plethora of studies carried out on the effects of the SOX and I shall
attempt to summarize some of the current themes that exist in the topic. In the view of Brickey
(2003), SOX’s criminal provisions do not amount to sufficient deterrent against corporate
wrongdoing but they are merely a “symbolic political outrage” than a public policy response that
is well thought out and targeted to remedy the corporate malfeasance. Zhang, 2007 argues that
oversight mandated by the SOX could lead to rigid and rule based regulation thereby skewing
the entire economy (Zhang, I. X. 2007). Zhang, 2007 also argues the enactment of the SOX
would convey negative signals in the market and that investors would always factor in
compliance costs when estimating returns. This would increase the cost of capital making capital
more scarce (Zhang, 2007). The act could also signal the likelihood of further anti-business
legislation in the works and significantly hurt investor sentiment (Zhang, 2007). Because the Act
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was crafted specifically keeping the Enron fiasco in focus, it might not universally serve to
remedy all future frauds in all situations (Cullinan,2004). In similar vein, Cohen, Dey & Lys
(2005) point out that in the last 70 years financial regulations have become ever more stringent,
yet financial frauds have continued with regularity and therefore increased regulations may not
necessarily be the answer.
But Coates (2007) disagrees. He argues that investors will face a lower risk of losses
from fraud and theft. Financial reporting would be more reliable, there would be greater
transparency, and accountability (Coates, 2007). The act would also signal a decline in overall
corporate risk taking (Dey, A. 2010) and start the trend of conservatism in financial reporting
(Lobo, 2006) as firms would have a greater incentive to understate their earnings and assets since
courts punish overstatement more than they do understatement.
There have been various studies that have reflected on the cost of supporting Sarbanes-
Oxley related compliance. According to Engel, et al., 76% of all direct costs will stem from
requirements for additional internal resources like development of policy, training of staff,
implementation of tools and technology, need for documentation, legal contingencies, and so on
(Engel, E., Hayes, R. M., & Wang, X. 2007). The new Act, which regulates public companies, is
going to cause a significant number of firms that are already on the public-private borderline to
delist from the public exchange rather than remain a public company (Engel et al., 2007)
increasing the capital market opacity for the investor thereby challenging the purpose of the Act
itself (Dey, 2010).
Coates (2007) cautions against overspending on internal controls without actually
remedying the underlying problems that give rise to internal control deficiencies. Reliance on
overcomplicated IT based internal control can also fail because: the internal control assumptions
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have been invalidated with time, the new internal control regulations mandated by Sarbox are
impossible to design, implement and document, or in cases where they can be implemented,
internal control systems are too complicated to audit (Rockness & Rockness, 2005). Dowdell,
Kim, Klamm, & Watson (2012) use market liquidity as a proxy for quality of financial
information in their study. They conclude that breakdown in internal control has no significant
effect in market liquidity and hence the entire premise on which SOX is based—that disclosure
and regulation of internal controls in financial reporting results in higher quality financial
information—is fundamentally flawed. Another interesting study by Linck, Netter, & Yang
(2009) showed that the enactment of the SOX caused unanticipated increase in the pay of
directors which would have to be ultimately borne by the investors. These types of unintended
costs of the changed regulatory regime could well far exceed the obvious costs of SOX
compliance in the form of additional audit staff or procedures.
In the view of Kumar, Pollanen, & Maheshwari (2008), compliance to SOX regulations
would require cultural changes in addition to technical and process related changes. The
technical, process and information system aspect of compliance would not be nearly as difficult
as effecting change in culture, notably resistance to change. Firms with cultures of self reporting
of errors would benefit from changes in SOX related compliance procedures than would firms
that are unwillingly forced to make the disclosure of risks (Akhigbe, & Martin, 2006). The
culture set at the top very often percolates to the lower levels as in the case of Enron where the
climate for breaking the rules were deliberately set by its CEO Jeff Skilling (Rockness &
Rockness, 2005). There were some silver linings in the literature on SOX though. Regarding the
effect of Sarbanes Oxley on financial reporting, Aono & Guan (2008) suggest that aggressive
accounting practices actually fell and the quality of earnings increased after the legislation was
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enforced. Similarly Aono & Guan (2008) also propose that cosmetic earning management
decreased in the years that followed.
There are some gaps in the extant literature which this paper will attempt to address.
Although there have been some research done on the effect of the new regulatory regime on the
internal control within a reporting firm, there seems to be no study done specifically to address
the effect of SOX on the quality of financial information that have resulted from the additional
internal control requirements. There are also substantial gaps in the literature on the changed end
user perception of the financial information following the Act. The efficacy of the financial
signals from the perspective of end user in the changed regulatory context has not been
sufficiently studied. There is a dearth of literature on the effect of the changed regulatory
environment on the prevailing cultural practices of accounting firms. This paper shall attempt to
bridge some of the gaps in literature by building on existing studies.
Research Design, Methodology and Limitations
A dynamic methodology of research will be employed in this paper. The dynamic
methodology will go further than the static view of research which merely aims gathering
information, arranging the information, creating intelligible patterns out of the information and
adding to the existing body of knowledge. Our research will not only encompass adding to the
existing body of knowledge to arrive at new ideas, it will also aim to provide prescriptive
solutions to existing problems in conjunction with the body of knowledge in the discipline of
Change Management. The research methodology will go through the requisite processes of
scientific enquiry. The steps that will be followed in our research methodology will be as
follows:
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1. Problem Identification
2. Problem Definition
3. Analysis of the findings
4. Deductions and Conclusions based on the analysis
5. Recommendations and plans for Implementation where applicable
The structure of the paper will follow the above processes. The research will use inductive
pattern of reasoning. An extensive literature review was conducted in the beginning. This was
followed by observing patterns in the information and arriving at tentative deductions and
prescriptive measures using the models of Change Management which would be applicable in
the particular context.
The research entailed the use of secondary sources, namely journal articles, peer-reviewed
papers, books, newspaper articles, trade and industry publications, websites and company
financial reports. Primary research methodologies like interviews, and data collection by
administering survey and questionnaires were not conducted since they require prior ethical
approval from the university. Neither did the research entail conducting of quantitative statistical
analysis. Instead the research derived statistical inferences from the data contained in studies in
secondary source literature that already exists. These data will be referred to throughout the
paper.
There are various limitations to the study. Because primary research was not carried out, the
study will reflect the limitations of the sources they derive from. The research is also limited in
time and space. The research is limited to a study of practices within the boundaries of the US
financial and corporate environment. This paper will not address the implications of the changes
in the Canadian or international context. Since some of information used in the study derives
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from sources that are a little dated, the accuracy of the findings and applicability of the proposed
recommendations for managing change may be limited in the present context.
Theoretical Framework
In this paper two primary models of Change Management will used for analysis:
1) Nadler and Tushman’s Congruence Model (Cameron & Green, 2009, p 120), and
2) The Guidelines to Cultural Change (Cameron & Green, 2009, p 259)
Nadler and Tushman’s congruence model can be used to explain the success and failures of any
attempt at changing a corporate organization and accounting firms. This model views the change
entity as composed of various subsystems which react to changes in the external environment
(Cameron & Green, 2009). This fits perfectly with the financial industry which reacts to the
change in the environment, in our instance, the change being legislative in nature. The system is
also viewed as an organism which learns from the environment (Cameron & Green, 2009).
Various players in the financial market also take information signals and learn to try to quickly
respond to them. Similarly, the financial system is also composed of various subsystems—
accountants, users, auditors, accounting firms, public companies, regulatory bodies that interact
with each other. This model will be used to explain the congruence/incongruence of the
subsystems in the successes and failures of the legislative attempt viz a viz the Sarbanes-Oxley
Act to change accounting practices and standards. Primarily, Nadler and Tushman’s congruence
model will be used in a descriptive capacity in our paper.
On the other hand the Guidelines for Cultural Change are broader and provide generic
prescriptive methods of attaining significant and lasting cultural change. I will be using the
model of cultural change because I am of the view that there are ethical dimensions to
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accounting and that any meaningful change can only be attained through cultural transformation.
Some of my inclinations towards using this guideline is also rooted in the fact that there exists an
inherent tension in the duality of roles that Public Accounting Firms have to perform. On the one
hand, there is a need to balance the professional, legal, ethical requirements as well as social
obligations to act as gatekeepers and filters of useful financial information. On the other hand
Public Accounting Firms conduct their business in an extremely competitive environment. The
firms have to ensure profitability of current operations. They also have to secure future
engagements with their clients by ensuring that the professional engagements are satisfactory not
only to themselves but also to the client. In order for the accountant, or any other financial
professional, to balance the duality of roles and also to develop practices which are ethical and
adhere to the highest professional standards, they have to be rooted in a culture that promotes
high ethical standards. The Guidelines for Cultural Change will be used in prescriptive capacity
in that regard.
There are also other competing theorier that could be employed: Lewin’s Three Step
Model (Cameron & Green, 2009, p 111), the Strategic Change Process (Cameron & Green,
2009, p 183), and Kotter’s Eight Step Model (Change Book, Pg 115). However, despite their
applicability we shall not use these models in our paper for brevity’s sake.
Findings
According to President George W Bush, Sarbanes Oxley Act constitutes, “some of the
most far reaching reforms of American Business practices since the time President Franklin D.
Roosevelt” (Cohen et al; 2005). In similar vein, the head of the American Institute of Certified
Public Accountants (AICPA) had at that time commented that SOX “contains some of the most
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far reaching changes that Congress has ever introduced to the business world” (Cohen et al,
2005). Congressmen Donaldson in 2003 also remarked that, “the Act represents the most
important securities legislation since the original federal securities laws of the 1930s”
(Linck et al, 2009). However, the study found that the results of the Sarbanes Oxley Act have
achieved some mixed results. Brief explanations of the findings of the research on the effects of
the SOX are discussed:
i)
One of the glaring implications of SOX has been that it has imposed substantial financial
costs on public companies. According to one study the compliance costs for American
Corporations in 2002 was a staggering $35 Billion (Clark, 2005). In a sample of 1000 listed
companies of all sizes the average cost of confirming to SOX amounted to $7.8 million out of
which $1.9 million extra compliance expenses related to cost of external auditors and $5.9
million to internal control costs (Clark, 2005). Other studies have shown that internal staffing
costs can amount as much as 31 percent of the total costs of compliance for the average energy
trading company (Dunn, 2007). Particularly small firms were found to be more badly affected by
the compliance costs, because of the non-discretionary fixed cost involved (Engel et al., 2007).
Increased Compliance Costs
Other costs incurred by firms were more indirect. SOX places provisions for punitive
measures against managers that fail to comply with Section 302 of the Act (Sabanes-Oxley Act,
2003). Therefore, managers are likely to seek to lessen the risks associated with non-compliance
and managerial uncertainty over financial reporting (Vakkur, N. V., McAfee, R. P., &
Kipperman, F., 2010). According to the “sub optimal hypothesis” (Vakkur et al., 2010), an
unyielding rule based regime where executives are unconditionally held liable and punished for
failure to assess and report internal control leads to executive flight. The optimal risk minded
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executive may prefer to work in a less regulated environment and in the process, public
companies governed by the Sarbox regime end up attracting the suboptimal type of executive
(Vakkur et al., 2010) which could in the long run lead to the erosion of investor wealth. The
increased workload and liability faced by executives post-SOX has reduced the supply of
directors (Linck et al, 2009). As a result, the median pay per director increased by 50% from
2001 to 2004, which in a dollar amount was an increase of $38,000 (Linck et al, 2009), further
adding to the financial burden of the public companies and eroding shareholder wealth. Smaller
listed companies were hit harder by increasing executive compensation levels. From 2001 to
2004 the director fees per $1,000 of net sales for small firms have slowly crept up to $3.19 which
is an increase of $0.84 from 2000 compensation levels (Linck et al, 2009). The increased
compensation costs are attributable to the compliance regime established by the Sarbox.
ii)
The internal controls in an organization are a set of processes, practices and technologies that
provide reasonable assurances that financial statements are free of material errors (Coates 2007).
Although Sarbanes-Oxley does not authorize the regulatory authorities to design and correct any
internal control deficiencies that may be present in an organization or in an audit firm (Coates,
2007), it certainly seems to provide incentives to do so for the complying public companies.
Checking for internal control deficiencies in the post SOX environment could be one of the
measures of the improvement in the quality of financial information put out by companies. In the
research, it was found that only 2 percent of the firms with market capitalization in excess of $1
billion disclosed any material weakness in 2005 (Coates, 2007). The total number of firms
disclosing material weakness has steadily declined since then (Coates, 2007) which is perhaps
indicative of conservatism in reporting internal control deficiencies caused by the regulatory
Mixed Internal Control Indicators
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scare following the passage of SOX. Akhigbe, & Martin (2006) suggest that firms which already
have sufficient control and monitoring in place benefit little from the added disclosure
requirements as mandated by the regulatory change. Therefore, firms that are already well
governed were not expected to receive significant SOX related benefits by overspending on
internal controls (Engel et al., 2007). It could be concluded on this basis that the quality of
financial information that was put out by firms after SOX went into force was not markedly
improved than before.
On the other hand, there are various arguments that propose that the internal control
disclosures that are mandated by the Act are valued by the investors (Coates, 2007). However
some of the effects are nebulous and cannot be ascertained definitely. According to Dowdell et
al., (2012) when Sections 302 an 404 of the Act became law, an analysis of the pre and post
liquidity of stock prices (which was used as a proxy for information quality) found that liquidity
was not significantly affected. This signalled that there was no immediate improvement in the
quality of financial reporting. However, Dowdell et al., (2012) also make the point that on the
long term there were positive liquidity effects on the trading of stocks of the companies that
immediately complied with Sections 302 and 404 of SOX. On the whole, the disclosure
requirements pertaining to internal controls that were mandated by Sections 404 in particular
seemed to have no great effect on reducing perceived end user information asymmetry as
evidenced by the liquidity of stocks (Dowdell et al., 2012). Zhang, 2007 also states that share
prices for complying companies declined during the period of application of Sarbox which could
be a signal that investors perceived weak internal controls in companies that complied with the
act (Zhang, 2007).
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i)
Centralization in management decision making seems to be another malevolent effect of the
regulatory change. Because the risk of increased liability post SOX, managers were more wont to
centralize control and reporting (Vakkur et al., 2010). This has in turn led to the centralization of
the key organizational processes through a whip lash effect and resulted in increased rigidity in
financial reporting processes (Vakkur et al., 2010). Sarbox has failed to compel firms to reduce
their earning management. The firms have simply switched to different earning management
techniques (Vakkur et al., 2010).
Increase in the Opacity of Financial Information
The extensive disclosures which are made not with the purpose to inform but to parry off any
potential management liability have resulted in further confusing the user of financial
information (Vakkur et al., 2010). The end users are not equipped to distinguish between the
useful disclosures from the compliance related disclosures. They interpret the disclosures as
compliance and reduce their monitoring activity, further increasing the likelihood of fraud
(Povel, Singh and Winton, 2007). Engel et al., explain that optimal levels of disclosure that are
chosen by consumers of financial information may differ from the mandated level of disclosures.
Therefore, it cannot be concluded that mere compliance to Sarbox is guarantee of transparency in
financial reporting. This was made painfully obvious by the failure of companies like Bear
Sterns, AIG and Lehman brothers all of which were Sarbanes-Oxley compliant (Vakkur et al.,
2010). Smith, (2007) even goes so far as to propose an effective ban on selective disclosures and
to make any financial disclosures “simple, cheap and internally consistent” (Smith, 2007). He
argues that such a ban will reduce the speed at which security prices fully reflect relevant
information.
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The opacity of financial information in the capital markets have further increased as firms
increasingly chose to de-list and go private rather than stay public comply with Sarbox (Engel et
al., 2007). This could be part of the avoidance strategy employed by firms in light of the new
compliance regime (Dey, 2010). Private companies are not required to make their financial
reporting public. And this beats the purpose of the Act which aimed to improve corporate
financial transparency (Dey, 2010). This is not to say that there have not been contrary opinions
on the matter of financial transparency traceable to the SOX regime. For instance, Fuerman
(2012) state that audit and financial reporting quality improved after SOX became law (Fuerman,
2012). He further states that because the severity and frequency of auditor litigation and auditor
liability risk reduced post SOX, the financial reporting quality and audit quality must have
improved. But extreme caution must be exercised in attributing this piece of legislation to any
perceived effect on the quality of financial information since market expectations are largely
unobservable and any alternative explanation in the environment to the reduced litigation and
risk cannot be ruled out (Zhang, 2007).
Conservatism in financial reporting for fear of legal liabilities has also increased after
Sarbanes-Oxley. CEO/CFOs have exhibited a greater propensity to avoid overstating their
earnings and assets and to quickly recognize their expenses and liabilities (Zhang, 2007).
Although conservatism is one of the defining principles of accounting (Porter, 2008), excessive
conservatism in reporting earnings can also decrease the quality of financial reporting.
According to Lobo (2006), provisions of heightened legal liability to curb misstatements have
paradoxically resulted in understatement of financial information as policies become more
weighted towards conservatism in accounting as a result of regulatory change brought in by
Sarbox (Lobo, 2006). It would be fair to say that the investing public can suffer losses not only
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because of overstatements, but also in terms of lost opportunity to allocate financial resources
into profitable financial instruments because of conservatism in reporting earnings and assets.
Discussion and Conclusion
Several years after its enactment is obvious that enactment Sarbanes-Oxley Act has
yielded a mixed scorecard. Despite mandating substantive corporate governance, more rigorous
oversight, and even imposing far greater penalties for managerial misconduct, SOX has not been
very successful at strengthening internal controls, increasing the quality of financial reporting,
improving reporting transparency and removing information asymmetry because of its excessive
reliance on fixed criteria, benchmarks, thresholds and strict implementation guidelines. The
prescriptive nature of Sarbox means that Accountants and audit firms are not left with much
room improvising in their attainment of the desired objectives of transparent financial reporting.
Evidence suggests that it has increased the costs associated with compliance and has hindered the
way accounting professionals perform their roles because of misguided focus (Vakkur et al.,
2010). Where in the past accountants used to depend on their knowledge of the economic
substance of business transactions, they are now focused on a mechanistic application of the law
without understanding the underlying economic gist. There may be other non quantifiable costs
that have been imposed on the accounting profession because of an emphasis on an inflexible
rule based regulatory system. Not only that, Sarbox has failed to deter further accounting fraud
and corporate misconduct since 2002. It has to be realized that the economic recession of 2008
and the string of financial failures is not totally independent of the Act.
Even when accounting misconduct has been unearthed and directors have been fired from
firms for failing to perform due diligence and effectively monitor internal controls, it cannot be
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ascertained that more effective directors replace them and bring about real reform of the
corporate governance structure within these firms. On the other side of coin, shareholders in
firms that were well governed even prior to Sarbox were found to receive equal quality
information even after the enactment of the legislation (Engel et al., 2007).
The failure of the Sarbanes-Oxley Act to achieve its desired results can be explained
using Nader and Tushman’s model of congruence (Cameron & Green, 2009). Change in the
regulatory environment following the passage of the act and the establishment of the Public
Company Accounting Oversight Board (PCOAB) was the external input factor that initially
misaligned the various subsystems in the financial industry: the existing Informal Organization,
the Formal Organization, the People and the Work. There was also a dearth of input of financial
resources because injections of financial resources into compliance related activities, significant
as they were, were not commensurate with the changes mandated by SOX (Multiple impacts of
Sarbanes-Oxley, 2005). Also, companies realigned their strategy becoming more risk averse and
infected with adverse selection in light of the strong punitive measures (Vakkur et al., 2010). We
can see that even before the input factors effected a change in the subsystem, the input factors
themselves were conflicted with each other to begin with.
The most obvious result of the change in input described above was in changing the
Formal Organization viz the structure, systems and policies inherent to companies and audit
firms. New systems to annually evaluate of internal control were mandated. Policies related to
conflict reducing roles, limits on multiple roles and services, certification of financial reports and
the audit committee were enacted by accounting firms and companies (Clark, 2005). Accordingly
elements of the Work Subsystem were also affected. The work process design became more
centralized as we have already discussed (Vakkur et al., 2010). But the work system basically
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remained unchanged. For instance in a survey of credit professionals only 14.5% indicated some
change in their formal work processes, while 52% reported no change in their formal work
(IOMA, 2003). The subsystem that consists of People also seems to have been greatly
misaligned. The high risk of being sued for corporate negligence resulted in corporate flight and
attracted the sub-optimal type of executive as we have previously discussed (Vakkur et al.,
2010). These newly hired executives were perhaps not equipped with the requisite skills to
enforce any meaningful change either in the company or in the accounting firm. The changes in
the legislative environment also wrecked tremendous pressure on accountants and skewed the
reward element of work (Multiple impacts of Sarbanes-Oxley, 2005). Auditors felt they were
stretched too thin in having to meet the new policy requirements (Multiple impacts of Sarbanes-
Oxley, 2005), and the morale among the Chief Financial Officers was low due to perceived high
pressure of the job and low rewards, leading to a decline in confidence and work performance
and resistance to change (Multiple impacts of Sarbanes-Oxley, 2005).
Yet, the most crucial misalignment seems to have occurred in the Informal Organization
component of the system consisting of power, influence, and more crucially, values and norms.
Despite the stricture against working as a business consultant for audit clients for avoiding any
conflict of interest, accounting firms seem eager to skirt around the rule by forming alliance with
other big firms to assist the audit clients of their alliance partners in advisory capacity (Partner's
Report, 2003). In fact, the big accounting firms like PriceWaterhouseCoopers and Deloitte have
almost retained their pre-SOX revenue levels in advising which had dropped off after 2002 when
the Act was passed (Hahn, 2004). Although adhering to SOX in the letter, the wink and nod
system of values and norms would have created considerable resistance to real organizational
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change in the Informal Organization component of the overall system. We shall further discuss
the relevance of values and norms through change in organizational culture shortly.
According to Nader and Tushman’s model of congruence (Cameron & Green, 2009)
when there is a misalignment among the various components of the financial system, it will
result in a reversion into the old status quo. This is what seemed to have happened in the
accounting industry even after change was initiated in external environment through the
Sarbanes-Oxley Act. There was clearly a lack of alignment among the Work, People, Formal
Organization and Informal Organization components of the system, which typically comprises
firms in the financial sector. As a result, a state of homeostasis occurred and this caused the
accounting firms and reporting corporations reverting back to their old practices. My study has
also shown that resistance to change developed in the form of fear of the unknown: anxiety in
accountants, auditors and corporate executives about the implications of Sarbanes Oxley Act,
conservatism in financial reporting, adverse selections and risk minimization strategies.
Resistance also manifested themselves in the form of power problems: many accounting firms
became more centralized. Gradually, the impetus for change ran out of steam. The end result was
decreased firm performance because of which the efficacy of internal control system retuned to
pre-SOX era and the quality of the financial information put out in the market was lowered.
It is patently obvious that unless firms manage the change process through a holistic
approach the change, even if backed up by the force of legislation like the Sarbanes-Oxley Act,
the change will remain temporary and only superficial. Strict adherence to a check in the box
type of directive accounting rule will never yield the perfect and desired change. There are
always moments of judgement when a directive rulebook will be inapplicable. Principles by
themselves will never restrain rent seeking behavior on the part of managers and accountants
22
(Bratton, 2003). Sarbanes Oxley does not require the accounting firms and reporting corporations
to enact reform of the work culture. It is up to the organizations themselves to become better
managed and sustain the change through a change in their culture.
Now we shall briefly provide some prescriptive measures for managing change in the
regulatory environment using the Guidelines for Cultural Change (Cameron & Green, 2009):
i)
Always Link Change to Organizational Vision, Mission and Objectives
Culture change, suspended of a context and in and of itself, is often viewed by auditors and
accountants as devoid of context. Luckily, the need for change in the aftermath of Sarbanes-
Oxley was immediate and mandatory. Therefore firms should not find themselves searching for
an overarching objective on which to hinge the need for change. There is hardly any need for
organizations and firms to sell the idea of change and organizational compliance to their
workers. However, the firms and managers should communicate a vision of an organization
committed to quality control, ethics, independence and other standards related to financial audit
reports.
ii)
Create a Sense of Urgency and Continually Reinforce the Need to Change
Because the Act came in existence almost overnight, it seems to have created some sense of
urgency in the business and accounting communities to the need for immediate change. Without
timely reminders, accounting professionals would be more prone to slipping back into the
familiar old habits. For instance in some firms, the audit board was subject to lobbying by their
own clients and therefore undertook reform at an agonizingly slow speed (Aronson, 2002).
Therefore, firms could also hire an external change-agent to expedite the sense of urgency for the
need for change in the norms, values and work culture.
23
iii)
Attend to Stakeholder Issues
Firms, professionals and managers need to change their views about doing things right, not
just for meeting their own compliance needs, but also doing the right thing on behalf of their
constituents, including but not limited to shareholders, suppliers, employees, creditors,
customers, and the end users of financial information. The accounting firms should always view
themselves as information gatekeepers who owe a duty of care toward their stakeholders
(Rockness & Rockness, 2005).
iv)
Remember the How is as Important as the What
Organizational cultural, its beliefs, values and norms are especially hard to change because
they evolve slowly and employees generally resist any form of change. If a cultural change plan
is not laid out in writing and communicated carefully the forces of resistance result in ad-hoc
systems, inappropriate measurement systems and rewards (Zhang, 2007). To have a practicable
use firms must plan the hows of the supporting structures and processes that reinforce the
desirable behaviours in accountants until the desired compliance behavior becomes a basic part
of the way firms conduct their operations, a part of their cultural fabric, and a part of the
collective consciousness of the overall firm including the audit professionals.
v)
Build on the Old, and Step Into the New
There was a robust system of self-regulation in the accounting profession prior to SOX
(Coates, 2007). Federal regulation was not extensive (Coates, 2007) and the public oversight
board was dominated by the industry practitioners i.e. accountants (Coates, 2007). Therefore
SOX is not the only impetus for a culture of improved corporate governance. In addition to SOX,
24
firms and reporting companies can also build on existing culture of accountability and high
standards by creating their own corporate governance guidelines.
vi)
Generate Enabling Mechanisms
The punitive one size fits all system of compliance mandated by SOX should not reflect in
reduced learning in a firm for fear of punishment. If there isn’t a correct system of reward in
place, cultural learning and innovation in the new rigid regulatory environment could suffer,
paradoxically resulting in low compliance. Compliance with laws, internal control and must be
built on the new cultural norms. There should be predictable rewards for the right behavior and
well as swift delivery of significant sanctions for inappropriate behavior (Rockness & Rockness,
2005).
vii)
Act as Role Models
There is an ancient Chinese proverb that says, “The fish starts to rot from the head.”
Likewise, low quality financial reporting and financial fraud happens because of the precedent
set at the very top tiers of a firm or an organization. Gradually the malevolent infection of the
culture spreads like a virus. An analysis of the culture at Enron revealed that the atmosphere of
deliberate rule breaking was established by the former CEO, Jeff Skilling (Rockness &
Rockness, 2005). Conversely, if companies and accounting firms want to establish a culture
which promotes good quality reporting and financial transparency, the top executives will have
to be the living embodiment of the new culture in the way they conduct themselves.
viii)
Insist on Collective Ownership of the Changes
Financial frauds involve not just one guilty party but collusion of several parties. In a study
of Korean auditors 75% of the auditors were found to be acting on behalf of the management and
25
only 25% were publicly oriented (Cullinan,2004). Likewise, one cannot imagine the high quality
reporting or a successful audit to be the result of the efforts of just a singular party. Everyone
from the accountants representing their client, to the internal auditors, the junior auditors, to the
team leader, firms and managers has to shoulder the ownership of the successes as well as take
stock of failures. Without everyone taking collective ownership, the change initiative is bound to
fail.
Suggestions for Further Research
This paper does not address several possible topics that could be the subject of further
research. The effect of the Sarbanes-Oxley Act on regulatory agencies outside the United States,
particularly in Canada could be one such topic. Other interesting topics for research could be the
emergence of trends in accounting profession set off by Sarbox, or the impact of the legislation
on companies that are cross listed in the US exchange. The enforcement of Sarbox on US
companies listed on foreign exchanges could also be a topic for further research.
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