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Sarbanes-Oxley act: impact on the audit and effects of adoption

Larissa Ryabokuchka
CIPA, auditor


After a series of corporate scandals in the U.S. involving violations in corporate governance and financial reporting in companies Enron, Tyco International, Adelphia, Peregrine Systems and World-Com, which led to multimillion losses of investors of these corporations, in 2002, the Sarbanes-Oxley Act was adopted. The Act is the largest in the U.S. piece of legislation on securities adopted after the Securities Exchange Act 1934. The law changed the procedure for reporting by companies-issuers of securities, new requirements for companies were imposed on a much larger amount of information disclosed in the financial statements. In general the legislative act embraced corporate governance, assessment of internal controls over financial reporting and auditor independence.

Effect of the Sarbanes-Oxley Act extended not only to U.S. companies, but also to all enterprises (established in the United States and any other country), the securities of which are registered with the U.S. Securities and Exchange Commission (SEC). The requirements of the law did not affect the family companies, and companies whose securities were not listed on U.S. stock exchanges.

In accordance with the Sarbanes-Oxley Act, in each public company an Audit Committee should be established, whose members are independent and are part of the Board of Directors. To ensure the independence of the members of the audit committee may not accept a reward for advice from the company, and to have any relationship with the underlying company or its subsidiaries, except for the performance of the functions of the Board members. If the audit committee is not formed, the Board of Directors in full may be considered in its capacity, and in this case also, the principle of the independence of each of its members is required. As part of the audit committee there should be at least one financial expert with knowledge of generally accepted accounting practices (GAAP) and financial reporting, as well as the experience of an audit of financial statements. Responsibilities of the audit committee include the appointment, supervision, payment of the internal auditors, who report directly to the Committee, as well approval of all audit and other services provided by the external auditors.

Financial filings with the U.S. Securities and Exchange Commission should be signed by CEO and CFO. To reports of the issuer certified the CEO and the CFO confirmation also is attached that the information in financial statements, in all material aspects, gives a fair presentation of the financial position and results of operations. In the case of re-issue of the financial statements due to non-compliance to its drafting, the CEO and CFO lose their bonus and incentive payments, as well as income from the sale of securities of the company in their property within 12 months after the publication of the financial statements containing inaccurate data.

The Sarbanes-Oxley Act also forbids issuing companies to provide loans to management personnel other than those that are offered on the market conditions and available in the open market.

The annual accounts of companies include a report on internal controls, assessing the effectiveness of internal controls, as well as management's statement of responsibility for the establishment and performance of the system of internal control.

Requirements for auditors

The provisions of the Sarbanes-Oxley Act and the SEC regulations relating to audit companies aim to ensure the independence of the external auditors of the companies whose financial statements they inspect, and the elimination of potential conflicts of interest. For this purpose, the law introduced a number of amendments that prohibit audit firms, which carry out assurance of financial statements of public companies, to provide these companies services on bookkeeping and financial reporting, financial consulting, development and implementation of financial information systems, implementation services of the internal audit, management, personnel, brokerage, legal and other services not directly related to the audit.

In connection with this requirement, some accounting firms put out of their composition divisions providing services other than auditing.

 The auditor is required to test the system of internal control of the issuer, during which to establish:

- how detailed, accurately and reliably the accounting records transactions and asset management of the issuer;

- receipt and expenditure of the issuer is solely under the authority of its management;

- whether the transactions properly in accordance with generally accepted accounting principles are accounted for;

- whether there are significant deficiencies in internal controls and significant non-compliance with established rules.

The results are represented by the auditor in the audit report or as a separate document, and all the working papers of such audits should be kept in the audit company for at least seven years. Also audit firms carrying out audits of public companies are required to annually disclose the remuneration received from such clients.

To gain control over the activities of audit firms, the development of auditing standards, monitoring the independence of the audit and investigation under surveillance by SEC Oversight Board auditing and accounting of public companies (Public Company Accounting Oversight Board) was established. In 2003, SEC determined that foreign auditors, checking statements of subsidiaries of U.S. public companies must register with the Board during the year.

The provisions of the Sarbanes-Oxley Act in respect of audit firms are not confined to the U.S. auditors, but also on the international and national accounting firms: any audit firm is subject to the Act if it gives an audit report to a company registered in the SEC.

Audit opinion or any significant services of non-audit nature by a foreign auditor can be used by the audit firm registered with the SEC in connection with the preparation of the audit report or its part or separate opinions in the audit report. In this case, it is considered that a foreign audit firm automatically gives consent to working documentation for audit to the Council or the SEC when they undertake any investigation in respect of such audit report. In this case the firm falls within the jurisdiction U.S. courts in part of the enforcement of any demand to provide this documentation.

10 years later

In July 2012 turned 10 years since the adoption of the Sarbanes-Oxley Act, which was the occasion to discuss its implications, and assess whether it managed to achieve the goals set at the adoption of the legislative act.

The Sarbanes-Oxley Act has changed ways of doing business. When it was first implemented in 2002, almost every company's finance and accounting related projects were delayed. Why? Tons of new paperwork was generated, and IT projects designed to track everything required by the Sarbanes Oxley Act had to be implemented as quickly as possible.

In 2004, a study conducted by the International Organization of CFOs found that the initial cost of compliance with the law for the largest firms was about $ 4.6 million. Proponents of the legislation argue that the law was necessary to prevent financial turmoil due to the bankruptcy of companies that have taken place during 2000-2002.

But the exorbitant costs of compliance with the law called into question its benefits.

Negative influence factor of the Sarbanes-Oxley Act may be called significant increase in firms' cost on auditor services. From this point of view, the most controversial aspect of the law, according to the researchers, is Section 404.

Section 404 of the Sarbanes-Oxley Act requires that when filing reports with the SEC executives provided confirmation of the effectiveness of internal controls over preparation of financial reporting. In this case the units, whose task is the implementation of internal controls, should include in the annual report of the company their own assessment of management performance in accordance with accepted standards. This section presents the greatest difficulty in the implementation, as most public companies do not use detailed reports for managing their finances. Responsibility of companies is the implementation of internal control systems, testing their effectiveness, assessment of their vulnerability.

At observance of Section 404 of the companies have difficulties in lack of qualified and experienced staff, the inefficiency of the system of internal control, the lack of reliable methodology for the preparation of financial statements, a lack of human, technological and financial resources. All this led to the need to engage the services of outside consultants and auditors.

 The need for the audit of the Company's internal controls, as required by Section 404, has led to an increase in the cost of the audit by an average of 30 percent.

During the studies of the effect of the Sarbanes-Oxley Act on the cost of equity results showed that the cost of equity of the companies researched decreased after the entry into force of the law. However, when small and large firms are considered separately, it was found that the decrease in the cost of capital is typical for small firms. Opponents of the law say that the cost of compliance with it is too cumbersome for these small businesses and this prevents implementation of benefits of the application. Supporters, on the contrary, are of the opinion that the law increased the efficiency of small firms by reducing the overall riskiness of their activities and increasing transparency.

The Sarbanes-Oxley Act has caused for many companies the need to completely change the way they prepare the reporting. These changes do not come without cost, but the benefits outweigh the costs manyfold already. Many companies have benefited from the change; accounting standards in general become stricter; during the action of the law the U.S. economy could avoid a lot of corporate crises. But there were also a lot of companies that have failed to meet the requirements of the law. Many of them are no longer market participants or were forced to carry out placement of their shares outside the U.S.

Currently, according to the estimates by corporate executives, the costs of internal audit gradually decrease and are 30-40% less than when the system of internal financial audit was just being introduced. Reduced costs are due to the fact that the employees of the companies execute a constant activity on the collection and control of financial information. When U.S. corporations faced the need to adapt to the requirements of the new law, they had to engage consulting firms and external auditors to assess the flows of financial information collection. To date, all the procedures were spelled out and a number of challenges of internal audit the companies can already resolve on their own, which reduces costs of external consultants.

In relation to the observance of the rules of Section 404 companies split into two categories. Some have focused on a simple compliance with the rules, but it contributed to a more effective work due to the fact that the improvement of controls has led to more accurate data, which, in turn, contributed to better decision-making. Other companies have chosen to modernize the management and processes as a result got higher production efficiency and cost savings. In any case, for enterprises the strengthening of internal controls led to positive results.

In economic periodicals there are different and even opposing views on the need of the Sarbanes-Oxley Act, from high praise of the law as the main factor of stability in global financial markets to a complete disproval due to exorbitant cost of resources on its compliance and its inefficiency in combating the global financial crisis.

Overall, despite the difficulties and the high cost of the initial application of the requirements of the Sarbanes-Oxley Act, the creation of an effective system of internal control of enterprises, strict requirements for the preparation and audit of financial statements led to transparency of companies for investors and supervising authorities and therefore to increased stability of the stock market . The positive aspect herewith was a significant increase in the role of internal audit in companies.

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