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  1. 1. THE IMPACT OF THE SARBANES OXLEY ACT ON THE FINANCIAL REPORTING PROCESS: EXPERIENCES OF DIRECTORS Jeffrey Cohen Carroll School of Management Boston College Colleen Hayes School of Accounting & Business Information Systems The Australian National University Ganesh Krishnamoorthy Northeastern University Gary S Monroe Australian School of Business The University of New South Wales Arnie Wright Northeastern University 31 January 2009 We thank the participants at the 2008 Asia-Pacific Conference and the 2008 Australian National University ANCAAR Forum for their helpful comments and suggestions. Our special thanks are extended to the directors who participated in the study and therefore made it possible.
  2. 2. THE IMPACT OF THE SARBANES OXLEY ACT ON THE FINANCIAL REPORTING PROCESS: EXPERIENCES OF DIRECTORS ABSTRACT Our study provides insights into the impact of the Sarbanes Oxley Act (2002) on the financial reporting and auditing process from the experiences of US directors. The study involved interviewing 22 directors and, therefore, provides an important perspective on the impact of the legislation on the management –external auditor –audit committee relationship from the experiences of audit committee members and members of the board. The research corroborates and extends that of Cohen et al. (2008), who interviewed auditors, another important party in the financial reporting process, on this issue. Further, this study complements Beasley et al. (2007) who interviewed audit committee members on the audit committee oversight process. Using a semi-structured questionnaire adapted from Cohen et al. (2008) we find overall that directors’ experiences indicate the legislation has had a positive impact on the strength of the relationship between the audit committee and the external auditor, and, similarly, the monitoring role of the board. The strength of this relationship is integral to maintaining a proper balance of power in the management – external auditor relationship. The positive impact is attributable to the enhanced expertise, experience, diligence, commitment to transparency, scepticism and authority of the audit committee (board). The legislation has also led to substantial improvement in the scope and level of responsibility and status of internal auditors. The strengthening of internal controls, the alignment of interests in the management – external auditor – audit committee relationship, and the enhanced effectiveness of the audit committee were identified as having led to improved financial reporting quality. However, the directors report some negative consequences associated with the reforms not identified by auditors in Cohen et al. (2008). Many directors considered that the attention to compliance and the associated growth in bureaucracy that have accompanied the gains in the monitoring role of the audit committee (board) has been excessive and come at a price in terms of less time being dedicated to other responsibilities. The financial cost of compliance was also cited as a burden, and, some respondents called into question whether the legislation has resulted in an excessive focus on compliance to the detriment of other activities of governance. Importantly, directors’ experiences regarding the enhanced expertise, and diligence and power of the audit committee corroborate those reported by auditors in the Cohen et al. study (2008) as well as those in the Beasley et al. (2007) study. Data availability: Contact the authors. Key words: Corporate directors, corporate governance, audit process, Sarbanes-Oxley
  3. 3. THE IMPACT OF THE SARBANES OXLEY ACT ON THE FINANCIAL REPORTING PROCESS: EXPERIENCES OF DIRECTORS 1. INTRODUCTION The objective of this study is twofold. First, our goal is to explore the impact of the Sarbanes Oxley Act (2002) (SOX) on the financial reporting process from the perspective of US corporate directors. Second, to compare the findings of our study with those of Cohen et al. (2008) which examines the experiences of auditors on the same issue. The objective of SOX is to “protect investors by improving the accuracy and reliability of corporate disclosures”(House of Representative, 3763:1). There is considerable debate, however, over the merits or otherwise of the SOX reforms. The negative case is founded on the lack of empirical support for the efficacy of the provisions in the face of significant increased costs including information and agency costs arising out of the altered legal environment (Romano, 2005: Ribstein, 2002). Empirical support for the position is provided, for example, in the direct costs of complying with Section 404 internal control requirements (e.g., Butler and Ribstein, 2006; Galindo-Dorado, 2005) increased audit fees (e.g., Asthana, et al., 2004; Griffin and Lont, 2004) and increased director remuneration and insurance costs (Linck et al., 2006). Further, at the level of the US economy, there has been at least some decline in foreign private issuers listings (e.g., Zhu and Small, 2007; Piotroski and Svirivasan, 2008) and an alleged reduction in the risk appetite of management (Bargeron et al., 2008). Several archival studies, on the other hand, indicate positive SOX effects on the financial reporting process, cost of capital and firm value (e.g., Hoitash et al., 2005; Bedard 2006; Cohen 2005; Ashbaugh-Skaife et al. 2007; Agarwal and Williamson, 2006). However, 3
  4. 4. there is limited research on the direct impact of the legislation on the roles and relationships of the governance parties that are the target of SOX and who are the primary means through which the legislation takes effect, i.e., management, the external auditor, the audit committee and the board of directors. Cohen et al. (2008) examines the impact of SOX through a comparison of the current experiences of external auditors regarding their interactions with various corporate governance mechanisms (e.g., audit committee, the board) to those pre- SOX (Cohen et al. 2002). They report that audit committees have gained considerably greater expertise, diligence, and power in overseeing the financial reporting process in the post SOX era. However, auditors also report that often the party with the greatest influence in hiring the auditor remains with management, and the audit committee frequently avoids involvement in mediating disputes between management and the auditor, preferring instead to be informed of the resolution. Beasley et al. (2007) undertake a detailed examination of audit committee processes associated with the selection of audit committee members, the audit function and financial reporting quality in the post-Sox era, through interviewing 42 US audit committee members. Unlike the present study and that of Cohen et al. (2008), Beasley et al. (2007) is not directly concerned with examining the impact of policy change. However, their findings provide an important benchmark for audit committee behavior in the current era in the areas examined. Therefore, we integrated their findings into our study where relevant in the process of analyzing our results. Our study extends the literature by examining the impact of SOX on the financial reporting process from the perspective of 22 highly experienced US directors, using a semi- structured interview approach. The interview approach allows us to look inside the “corporate box” that is interposed between the input and output relations that are the subject of the positivist association studies (Turley & Zaman, 2004; Gendron et al., 2004). Doing so 4
  5. 5. provides evidence on whether SOX is having the desired behavioral effects in practice. Further, having used the same set of core questions, we are able to compare the experiences of the directors with those of auditors (Cohen et al. 2008). Our study and those conducted by Cohen et al. (2008) and Beasley et al. (2007) contribute to the growing body of literature that uses qualitative methodology to examine audit committee processes (e.g., Gendron et al., 2004; Gendron and Bedard, 2006; Cohen et al., 2002; Spira, 1999; Turley and Zaman, 2007). Similar to the experiences s of auditors (Cohen et al., 2008) directors experiences reveal that the legislation has had a positive impact on the strength of the relationship between the audit committee and the external auditor, and, similarly, the monitoring role of the board. The legislation has also led to substantial improvement in the scope and level of responsibility and status of the internal auditor. In contrast to the findings reported in Cohen et al., (2008) the directors identified some negative consequences arising out of the legislation including excessive costs and an excessive compliance environment. Like Cohen et al. (2008) and Beasley et al. (2007) we also find some evidence of management dominance of the financial reporting system post-Sox. The remainder of the paper is organised as follows. Section 2 provides the background and the research question, while Section 3 describes the method. Section 4 presents the results of the study. Section 5 concludes with a discussion of the implications and limitations. 2. BACKGROUND AND RESEARCH QUESTIONS Opinion is divided on the impact and merits, or otherwise, of SOX reforms. Challenges to the legislation are founded, for example, on the lack of empirical evidence supporting the efficacy of the mandates relating to independent audit committees, non-audit services, executive loans, and executive certification (Romano, 2005) and the lack of real deterrence associated with the criminal provisions (Perino, 2002). 5
  6. 6. As noted previously, archival studies indicate SOX has positive effects on the financial reporting process, cost of capital and firm value. Hoitash et al. (2005) provide evidence of a significant association between the reduction in non-audit services fees post SOX and lower discretionary accruals. Bedard (2006) finds that the improvement in firms’ internal control systems has led to greater earnings quality. Cohen (2005) reports a significant association between the corporate governance mandates, generally, and a decline in earnings management. Ashbaugh-Skaife et al. (2007) find that the improvement in effective internal controls resulting from SOX lowers information risk, leading to a reduction in the cost of capital, while Agarwal and Williamson (2006, p. 1) report that the regulations are associated with “higher firm value”. However, as stated earlier there is very little evidence on the impact of SOX on corporate behavior in practice. Cox (2006), maintains that a major contribution of the legislation is the clarification it has brought to the roles and relationships of the external auditor –manager – audit committee financial reporting triumvirate than existed previously. The clarification is seated in agency theory, specifically the separation of the decision management (initiation and implementation) and decision control (ratification and monitoring) (Fama & Jensen, 1983) dimensions of the financial reporting decision system. The Section 302 certification provisions consolidate management’ responsibility for s decision management, including the CEO. The responsibility for decision control on the other hand lies with the audit committee and the external auditor. The audit committee has the exclusive authority to appoint, terminate, compensate and oversee the work of the auditor (Section 302). The auditor in turn has the duty of reporting to the audit committee. As a result, the external auditor’ relationship to the firm is now anchored to the “ s audit committee instead of where it was previously, with management” (Cox, 2006, p. 830). The audit committee also has the responsibility of overseeing the role of the auditor in monitoring the 6
  7. 7. discretionary decision making of management regarding the choice of accounting methods, and again the external auditor is accountable to the committee in that respect (Section 204). The specialization of decision control is intended to prevent management dominating the financial reporting decision system i.e., decision control. However, the effectiveness of the strategy ultimately hinges on the effectiveness of the audit committee in exercising control. To that end, SOX mandates audit committee structural attributes, including independent directors, financial expertise and financial resources, intended to facilitate its functional effectiveness. Using an interview approach, Cohen et al. (2002) examined the experiences of auditors in their interactions with audit committees and boards pre-SOX. Auditors at that time reported that audit committees were largely ineffectual in overseeing the financial reporting process with insufficient expertise, authority, power, and diligence. They also reported that auditors often included management as part of the rubric of “corporate governance” in the sense that without management’ support, strong governance in protecting the interests of s shareholders and other stakeholders was not possible. Cohen et al. (2008) extends this earlier study by examining whether auditors’experiences with audit committees and boards have changed significantly post SOX. Importantly, auditors report substantially greater audit committee expertise, power and diligence than in the prior study. One issue of concern, however, is that auditors often note that management still has significant influence in the auditor appointment/termination decision. Further, Cohen et al. (2008) and Beasley et al. (2007) also report that the audit committee frequently does not actively participate in helping to resolve auditor-management accounting disputes, preferring instead to be informed of the outcome on the matter. Cohen et al. (2008) call for additional research capturing the experiences of members of the audit committee and the board as well as management to 7
  8. 8. triangulate the findings in identifying a consensus of the affects of SOX and issues for consideration. A major objective of our study is to gain insight into the impact of the functional and structural provisions on the experiences of the audit committee and the board, including their relationship with the external auditor. Based on the foregoing discussion, our study is guided by the following research question: Research question: What are directors’ experiences with respect to the financial reporting process in the Post-SOX environment? 3. RESEARCH METHOD Consistent with Cohen et al. (2008) a semi-structured interview approach was used to address the research question. The voluntary participation of directors was sought through personal contacts. Twenty two very experienced directors were interviewed in four cities: Boston, Los Angeles, Chicago and New York. Twenty of the directors had served as audit committee members, 16 of those in the SOX era. Eleven of the 22 directors had served as audit committee chair at some point in time. All had experience in serving on at least one or more of the audit and nominations and/or governance committees (see Table 1). The companies represented spanned a broad spectrum of the economy including finance, mining, manufacturing, retail trade, services, information technology, and bio-medical. INSERT TABLE 1 about here The interviews were conducted over a four week period in 2007 by one of the researchers in the offices of the participants, with the exception of one interview that was conducted by telephone. The interviews varied in length from 30 to 60 minutes and were recorded verbatim. As discussed, one of the primary objectives of the current study is to 8
  9. 9. triangulate the findings with those of Cohen et al. (2008), which examined auditors’ experiences of the impact of SOX. The interview questions were based on those used in that study; however, additional questions were added based on the SOX literature. Importantly, the questions focused on participants’experiences; therefore, questions were prefaced by the phrase “ your experiences” Prior to conducting the interviews, the interview questions in . were reviewed by two experienced directors, resulting in minor changes. A copy of the interview instrument was sent to the participants prior to the interviews being conducted. The participants were advised that we were interested in their individual experiences as a director and that there “ no right or wrong answers” The transcription and the coding are . of the interview data were framed by the interview questions. The coding categories were adapted from the coding scheme used in Cohen et al. (2008). Independent coding by two of the researchers was used to ensure the reliability of the coding (Miles and Huberman, 1994). Differences in coding were discussed between the two coders and, where possible, reconciled by the two coders. Any unreconciled differences in coding were resolved by a third researcher. 4.0 RESULTS The discussion of the results is framed by the following issues: the definition of corporate governance; auditor appointment and termination; audit committee interactions; the expertise and power of the audit committee; the board; the internal auditor; management certification; and, finally, other issues. Quotations taken from the participants’responses are shown in italics. Our results are compared with the findings of Cohen et al. (2008) and Beasley et al. (2007) and analyzed from the perspectives of agency and institutional theory, where applicable. 9
  10. 10. Definition of Corporate Governance The interviews began by asking participants their definition of corporate governance. The primary purpose of the question was to provide a basis for understanding and analyzing the participants’responses to the remaining questions. However, it is important to reflect on the nature of the responses in light of the fact that, using the words of one of the participants, it is one of those terms that is somewhat amorphous, and that it is an evolving term, not least of all as a result of SOX. The definitions were either broad in scope, embracing the relationship between the board, management and shareholders, or were framed from the perspective of the monitoring role of the board. Task specific responsibilities included establishing and maintaining ethical standards, ensuring financial and organizational health and managing risk. Approximately one quarter of the participants indicated that management was part of corporate governance. The definitions of 17 (77%) of the directors were framed from the perspective of the oversight role of the board in discharging its responsibilities as the representatives of shareholders, and in certain cases other stakeholders. The oversight role is generally compatible with an agency view of the role of the board of directors. In comparison, Cohen et al. (2008) reports auditors’ definitions predominately focused on the board (67%) and the management (67%). The percentage of directors including management in their definition of corporate governance is considerably lower than that reported by auditors both pre-SOX and SOX eras (Cohen et al. 2002, 2008). Cohen et al. (2008) suggest that a frequent reference to management may be consistent with management’ continued influence in the corporate governance process. Cohen et al. (2002) s hold that the inclusion of management in the rubric of corporate governance arose in the sense that auditors considered that effective corporate governance was not possible without the co-operation of management. 10
  11. 11. The corporate governance – management co-operation association perspective may also be held by directors. Beasley et al (2007 12) refer to the importance of “management commitment to sound governance” in the willingness of prospective audit committee members to serve on a company and, therein, allowing them to implement a monitoring (agency) role. The directors in the current study also emphasized the need for the audit committee – external auditor – management relationship to be conducted in a co-operative spirit. Importantly, the inclusion of management in the rubric of corporate governance in that sense is positive, i.e., management’ co-operation is a necessary condition for the agency s view of the role of corporate governance to take effect in practice in the Sox era. The lower percentage of directors including management in their definition of corporate governance may indicate that directors now believe that management is not a basic component of corporate governance as SOX vests the power with the board. However, they recognize that co-operation with management is important for successful corporate governance. Auditor Appointment and Termination Participants were asked to identify who, in substance, had the most influence over the appointment of the auditor and to provide the percentage influence of the stakeholders involved. This was the first of a series of questions that are fundamental to evaluating the strength of the relationship between the audit committee and the external auditor, which has as its corollary in the balance of power between management and the external auditor. Most (82%) of the directors identified the audit committee as having the greatest influence, with 64% indicating that management (CEO and/or CFO) has significant influence in appointment and dismissal decisions with respect to auditors. One of the directors who indicated that the power was with the audit committee stated: Well, clearly the audit committee has, the chairman of the audit committee has a great deal of influence. Another 11
  12. 12. with a similar view stated: The audit committee, no question. Now, there are conversations between the chairman of the audit committee and the chief financial officer and the CEO, but I think at the end of the day in most public companies that I’ familiar with, the decision is m the audit committee’ Another director stated: It is at least 90 per cent the audit committee so s. management has some impact. We just changed auditors and it was a discussion that came up among the audit committee, but it was recommended by management. But all the decision rights were the independent directors on the audit committee. One of the participants who identified management as having the most influence over the appointment of the auditor did so in circumstances where the company has a policy of putting the external audit to tender every 5 years, and that process is run by management. So I think they have the most influence because they set up the way it is done. We only get to see two or three of the finalists, probably two, and they will have been screened by management, so they have a lot of influence. Those directors who nominated management as having the greatest influence represented companies that had concentrated equity ownership. A general theme that emerged from the interviews, was that the level of influence of management must be evaluated in the context of the cultural ethos of the organization and how the board (audit committee) perceives its role, i.e., in an agency (monitoring) capacity or otherwise. Returning to the circumstance referred to above where the corporation has a policy of putting its external audit to bid every 5 years, the director concerned allocated 80% to management and 20% to the board with respect to their influence on the appointment of the auditor. However, the participant also emphasised the importance of putting that 20% into context as per the following excerpt of the interview: Boards of directors serve a very ritualistic (role). And if they are good, they alter the way management behaves day-in-day-out. So that by the time they get to the board it looks quite ritualistic . . . But my belief is that if they have done that well and you have often 12
  13. 13. enough interacted that ritualistic meaning, management will do a better job in the day to day work. So when I say 80/20, the 20 is really important, because it frames the way management will look at the problem the next time it comes around. This response highlights the fact that the strength of the monitoring role of the board ultimately relies on the extent to which it provides an effective check and balance to management (Lipton and Lorsch, 1992, citing the Cadbury Committee). Auditors’experiences, as reported by Cohen et al. (2008), in some ways mirror those of directors but in other ways differ. Although the auditors in that study agreed that both management and the audit committee had considerable influence over the appointment and termination of auditors, the respondents perceived that management had more influence over the process than the audit committee. In contrast, the directors in our study perceived that the audit committee had the dominant influence. The directors’ responses in our study are consistent with Section 301 (2) of SOX, which vests the audit committee with the responsibility of appointing the external auditor. Overall, higher levels of management influence on the auditor appointment/termination decision in both instances is attributed to firm specific characteristics –in the case where the CEO is also the chair of the board, and in the case of the directors, where equity ownership is concentrated. Management has the capacity to affect the role of audit committee (board) through its power to select and compensate its members (Baysinger and Hokinson, 1990). Therefore, the directors were asked what influence if any the CEO had on the selection of board members who serve on the audit committee. The overwhelming sentiment was that the overriding authority was exercised by the nominations committee, with several directors identifying that situation as being different to the way things were in the past. However, nearly all acknowledged that the CEO had a role to play in the selection of the audit committee. As mentioned earlier, the need to consult with the CEO was emphasised in the context of the 13
  14. 14. need for the ongoing audit committee – external auditor – management relationship to be conducted in a co-operative spirit, reflected in the following response: The answer is that it’ a shared decision. . . . In the end it’ the board processes that s s count, but when I recruit a new board member… I have as part of the interview process that they interview the CEO and the CFO. And if they are not comfortable, I need to stop and say well do I really want to drive somebody in they’ not comfortable with. re Audit Committee Interactions The next set of questions concerned the interaction between the audit committee and the external auditor. The questions provide insight not only into the strength of the relationship between the auditor and the audit committee but also into contemporary audit processes. The first question asked the participants what specific changes, if any, had occurred with respect to the effectiveness of the typical audit committee of a public company in fulfilling its fiduciary responsibilities in the financial reporting process post-SOX. An overwhelming majority of the directors stated that there had been a major change in the effectiveness of the audit committee because the bar has been raised on several dimensions reflected in the following excerpts drawn from a broad cross-section of respondents, all of which are indicative of a heightened agency approach to financial reporting: the meetings are longer. They are more frequent; more expertise; a stronger sense of ownership on the part of the audit committee; a stronger desire for transparency; better and more frequent communication with the internal and external auditors; more skepticism; the chairman of the audit committee has much more of a direct relationship with the outside auditors; deeper questioning . . . more rigour; the advanced materials are more fulsome; and more accountability. I think there has been an improvement. I think that the audit committees are asking more questions. They are asking for a paper trail and documentation. One director stated: I think the effectiveness in terms of financial reporting has probably gone up. I think we are paying a lot more attention to quote “how we report things”. One of the directors stated: 14
  15. 15. There has been actually quite a bit of change because the requirements for financial expertise has had a marked change in the way audit committees function, because I think audit committees in general did not necessarily have particular experts on them. They should have, but some boards didn’ have much financial expertise. So the requirement of financial t expert has had an important impact. The whole SOX 404 controls has had . . . an impact and then there has been a kind of increased emphasis on . . . risk analysis I think if you go back five years ago the audit committee was narrowly looking at financial things. Now the audit committee is looking at the financial audit, it is looking at the control compliance audit. This statement is consistent with Beasley et al. (2007) as many of the audit committee members they interviewed identified “willingness to ask probing questions” (p. 31) as the most important trait an audit committee member can possess. The source of change was attributed by one participant to the fact that the relationship with the independent auditor now belongs to the audit committee. That didn’ happen before. t It was with the CFO. Another director also attributed the rigour of the relationship to the change in attitude of the audit firms, and the role of SOX in that respect: The relationship of the audit committee to the outside auditing firm has changed substantially because of the way the auditing firms . . . view their responsibilities and the changes that have occurred in how they conduct themselves in the client’ office, the questions they s answer, the multitude of government checks and balances Sarbanes-Oxley has put in. Both of the foregoing responses emphasise the cultural dimension of corporate governance, i.e., that “corporate governance is affected by the relationships among participants in the governance system”(OECD, 2004, p. 12). However, three participants stated that there had been no change in the effectiveness of the committee because, in the words of one of the participants, the audit committee was extremely effective before hand and is no more effective today. The same participant went on to state, however, that the exception today is the fact that the committee now takes three times as long to be as effective as it used to. The sense of over-kill was echoed by many other participants, and in one instance not only in relation to the audit committee but also management and the auditing firms. 15
  16. 16. The tenor of the relationship between the audit committee and the external auditor was also addressed by a number of the participants in responding to an additional question eliciting the directors’observations of the changes in the relationship in the past 5 years. The responses varied. The perception of one of the directors was of a greater sensitivity of the audit firm to the needs of the client. Others, however, described the relationship as being more formal, less interactive, more technical, more adversarial, and as having a greater focus on compliance. The focus on compliance was often cited as coming at the expense of efficiency. This situation is typified by the following response referring to the role of the audit committee: I think the effectiveness in terms of financial reporting has probably gone up. I think the effectiveness of being a good audit committee has gone down. One participant described the relationship as a double edged sword, going on to say: on the one hand there is much more communication going on between the auditors and the audit committee. But there is also, you know, managements are frustrated with the way auditors are treating them in the last 4 or 5 years because . . . the work that auditors have has increased dramatically because of SOX 404 certification. And so the frustrations that management have, one the timeliness with which things are getting done and the staff quality . . . there is more variance I think with this. Number two, costs have escalated dramatically. Auditors’ experiences (Cohen et al., 2008) indicate that audit committees have become stronger since SOX in terms of greater financial expertise, power, authority, and diligence. Further, their interactions with the audit committee have gone from infrequent meetings (two per year) that were passive to frequent meetings (average 5.6 per year) where there is an active dialogue occurring. With respect to audit committee - auditor interactions, one director responded that: They have gone way up. We used to have an audit committee meeting for about two hours on the day of a board meeting. But the audit committee now meets for probably about 8 hours the day before the board meeting. And that time is spent mainly with the outside auditors are always there. And the chairman of the audit committee chair probably talks with the lead guy on the accounting firm, I would guess, for 5 or 10 hours between meetings. And that was never much the case. 16
  17. 17. Beasley et al. (2007) also report enhanced audit committee diligence in their interactions with the external auditor in the SOX era. Cohen et al. (2008) report that many auditors indicated that the increased interaction has resulted in a greater focus by the audit committee on matters related to the audit process. One of the directors in our study commented: So we are always discussing with them what they have been doing and what the management internal auditing group has been doing to assist them. Another director stated: One of the major things that gets discussed is tone at the top, especially when you’ dealing re with this 404 compliance. The participants were also asked whether the audit committee played a role in helping resolve contentious accounting and financial reporting issues between the auditor and the management. A majority of the directors (58%) believed that the audit committee did play a role in resolving these issues. First, one of the participants stated that it was not so much that (we have) disagreed around an issue, saying instead that the contentions have been more about whether (the auditor) had the right people or . . . enough people really able to legitimately audit what goes on with some of the financial practices, etcetera. The participant attributed the latter to the SOX era, and the collapse of Arthur Andersen. A small number of the remaining 21 participants demonstrated sensitivity to the use of the word contentious, but at the same time all stated that the audit committee helped to resolve important accounting issues. One of the respondents indicated that the role of the audit committee was very slight, going on to say that the truth is there rarely are contentious accounting issues anymore because everybody is scared to object to anything. However, other participants disagreed as exemplified in the following response: The answer is they are right up to their eyeballs. I mean mostly the contentious issues are trying to figure out what the hell the issue is and what the facts are that the issues – I mean if management is too conservative or too aggressive and that is flagged by the audit committee or by the auditor, the audit committee will be all over the issue and they may be over it anyway because if there is substantial disagreement between the auditor and 17
  18. 18. management or the audit report that is an issue that has to be properly disclosed. I mean you work hard to get those things squared away. One participant also attributed the increased role of the audit committee in that respect to the fact that in many cases it now has the skills to be an active participant in the discussion of these problems. And it has the experience to recommend solutions it may have seen in similar cases. The directors were also asked about their experiences with the role that the audit committee played with respect to establishing and maintaining effective internal controls under Section 404. The unanimous response was that the audit committee played a major role in that respect, and in most instances that was different to the way things were pre-SOX. This finding is consistent with the experiences of auditors (Cohen et al., 2008) where 88 percent of the auditors concurred that the audit committee was playing a major role with respect to controls. Expertise and Power of the Audit Committee On the specific attributes of the audit committee arising out of SOX, the directors were asked whether they considered that the audit committee had sufficient financial expertise to effectively deal with financial reporting, auditing and internal control related issues. Twenty one (95%) of the participants answered ‘ . Some participants were of the yes’ opinion that smaller firms may be disadvantaged in that respect in responding to a second part of the question which asked specifically whether size, industry or other factors had a role to play. The reasons given were the lack of availability of financial experts and the financial resources needed to purchase the expertise. Eight-five percent of the participants also indicated that an audit committee financial expertise could vary along industry lines. One of the participants added that when you are 18
  19. 19. dealing with derivatives and hedging, nobody will say that they’ an expert in that. Another re participant stated that whether an audit committee had sufficient expertise was a function of how complicated your business model is rather than size or industry. Two participants also raised the issue of whether, in the words of one of them, the pendulum has swung too far on the matter of financial expertise possibly adversely affecting audit committee effectiveness and therefore the quality of financial reporting with respect to the exercise of judgement. A problem with respect to the skills and mindset of those most likely to meet the definition of a financial expert was identified by some of the directors. In the words of one of the directors, the problem with CFOs and auditor are they are rules-based people, they aren’ judgement t based people. The implications for financial reporting are evident in the following response of one of the directors: ...the real value in financial reporting oversight of audit comes from connecting business issues with financial reporting issues. Because technical financial reporting issues are going to be handled correctly by the management and the auditors . . . the audit committee can bring no competitive advantage in that respect. But where you have judgment . . . in a clause, in a case clause or in policy choices and that judgement centres on knowing something about the business, board members can bring it, add value. Now if you have too many people that are ex directors and ex CFOs they usually try to replicate what the management or the auditors have done rather than bring a new perspective, which is a business perspective that says that given what I see is going on in the industry or . . . that I make of this business, should we be . . . putting more reserves or should we be following this capitalisation policy . . . the kinds of questions . . . you need less technical knowledge for it, but more business savviness and then connecting the business savviness with financial reporting . . . so there are still issues there. The same sentiment was expressed by another director who stated that the problem with CFOs and auditors are they are rules-based people, they aren’ judgement-based people. t On the matter of whether the audit committee has sufficient power and authority from the board to confront management in dealing with contentious financial reporting, auditing and internal control related issues, 20 of the 22 directors answered yes. One participant stated that in his experience the audit committee did not have sufficient independence from the board in that respect, i.e., that it would go to the board before approaching management. 19
  20. 20. As noted previously, auditors also reported overwhelmingly that SOX era audit committees have sufficient expertise and power to accomplish their responsibilities (Cohen et al., 2008). Further, auditors note audit committees are considerably more diligent and aware of the role they play in the financial reporting process. The current study explores audit committee appointments in more depth than Cohen et al. (2008), in that participants were also asked how board members are specifically selected to serve on the audit committee. Consistent with Beasley et al. (2007) the most frequently cited selection criterion was financial expertise. To that end, one of the participants in our study stated that he considered the question ought to be the other way around . . . I think it’ s, now let’ get somebody to serve on the audit committee and we will nail them to the board, s despite the fact that the financial expertise criterion is framed as a disclosure requirement only. Another director stated: Most companies actually have a little difficulty and need somebody who satisfies the letter of the law to be the financial expert. So first it is “ you are legally a financial expert” Another stated”We have to meet our interpretation of what the ? financially sophisticated criteria are. So you look for former CEOs, they meet it, or former CFOs meet it, or CPAs meet it. The participant also stated that he considered that the negative of all this is we usually have rotation of the board members, of the committee membership. That I think is diminishing because to get somebody on the audit committee who is qualified you don’ want him to go anywhere else. So that is changing the picture a little bit. t The negative impact of the financial expertise criterion on the skills set of the board as a whole is also reflected in the fact that two of the directors stated that in the companies they are associated with, post-SOX, new board members, who do not possess the requisites skills, are no longer appointed to the audit committee. Consistent with Beasley et al. (2007), other attributes identified as important selection criteria were independence and time to serve. The participants in our study also acknowledged the need to establish a balanced portfolio of 20
  21. 21. skills on the audit committee. Here, one of the directors, while acknowledging the need for the depth of the skills set of an audit committee to match the size and complexity of the organization, stated that beyond the need for financial expertise, in his experience there was also a need for legal expertise with respect to the issue of compliance and, in addition, people who have a good understanding of financial markets. The participant stated that on the audit committees he serves on they had more expertise in relation to all three areas than they had pre-SOX, and that they also have a CEO who has more the big picture expertise. The Board The next set of questions asked what specific changes, if any had occurred with respect to the effectiveness of the board in fulfilling its fiduciary responsibilities relating to the financial reporting process. While 50 percent of the auditors in Cohen et al. (2008) identified a significantly greater role for the board, in our study, 91 percent of the directors in our study were of the opinion that the board has taken a more proactive role over the last five years. The nature of the positive changes identified by the participants essentially mirrored those factors identified earlier, in relation to the same question dealing with the audit committee, and are reflected in the following cross-section of excerpts from the responses: I think they pay a lot more attention than they used to; I would say directors are more aware; The boards are very interested in listening to the audit committee’ report and s making sure that the audit committee has appropriate resources, appropriate expertise and all that stuff; There is much more awareness; Today they are very much more engaged . . . they’ more independent . . . they’ experienced, they’ more expert and they’ more re re re re diligent; Hell it is much more inquisitive than it was before. It has heightened the sense of responsibility. The responses are consistent with the factors that prior literature identifies as the determinants of audit committee (board) effectiveness e.g., composition, authority, resources and diligence (e.g., DeZoort et al., 2002; Cohen et al. 2004). One of the participants stated that boards are also focused on their own effectiveness. They’ doing a lot of internal re 21
  22. 22. reviews, doing evaluations of their own processes and other individuals. Beasley et al. (2007) also provide evidence of audit committees benchmarking their performance against best practices in the post-SOX era. However, as with the audit committee, several participants in our study stated that the enhanced monitoring role of the board, with respect to financial reporting, had come at the expense of board efficiency with respect to other responsibilities, as reflected in the following response: So I think they pay a lot more attention than they used to. But that means they are paying less attention to what they used to. If you are a kind of cynic, you might think they used not to do anything, and so now they are paying attention to it. I think a lot of good boards used to worry about the future of the company, and now they’ spending a lot of time re talking about how we’ reporting what happened. It (SOX) has shortened the time horizon re people have. It’ got them into details that they never used to get into. s Another director stated: If you have only got a finite period of time, that means you are spending less time doing what you used to do, which I thought was ... looking at how management was actually running the business and I think that’ a downside of Sarbanes Oxley. Before I leave that s completely, I think the net result of Sarbanes Oxley has been very good. There are a lot of people more conscious of things. But we are now at the point where we are spending a lot of time on window dressing. Internal Auditors The directors were asked whether in their experiences the role of internal auditors had changed in the last 5 years, and, if so, how. Almost all (95 percent) of the participants stated that the role of the internal audit had increased in terms of its scope, level of responsibility and status. The responses taken as a whole demonstrated various ways in which the role had changed and they are reflected, in part, in the following excerpts taken from a cross section of the interviews: Yes, it has changed. I think that the internal audit function is taken more seriously. I think at times in the past it was kind of like a necessary evil. You checked the box to say you have it. But, in our particular case it has been much 22
  23. 23. upgraded. We have substantially higher quality people. More disciplined. More professional. Much, much better. You wouldn’ even recognize them as the two t groups. Yes. I think the internal audit role has become more powerful. I think that the stature of the internal audit manager has been raised. They have been elevated to effectively a higher level of management than they were before. There are two things to me. One, it has gained in importance so much. The second thing is it has gained some separation that it didn’ have before . . . in t many ways it was looked at as an adjunct to the audit functions of the company or the executive function. . . . And now what’ happened in the past 5 years is s the audit committee has separated themselves, and set themselves up as an independent entity much more than they were. These results are similar to the responses Cohen et al. (2008) had with auditors where 83 percent perceived that there had been a greater role for internal auditors The final question on the impact of SOX on internal audit asked the directors whether the nature of the relationship between the internal and external auditor had changed over the past 5 years and, if so, how. Of the 19 participants who had experience with this issue, 17 considered it had changed, but in varying degrees, directions, and in nature, as reflected in the following excerpts from separate interviews: It is less collegial. Because the internal auditor is really nervous about being tricked. I believe they are more arms length. I mean they used to be pretty co- operative and they world share each other. So the internal guys are now a little more nervous about initially telling the outside guys. They go through the audit committee more than they used to. There’ just much more reliance being placed by the independent auditors on s the internal auditors and . . . part of that’ because of what’ happened with s s Sarbanes-Oxley, it’ also just because other things have happened. I mean, the s whole thing has been ratcheted up. I think they see themselves much more as equals now . . . I think, because we have beefed up our internal capabilities, in many cases our people are as experienced and degreed, if you know what I mean, as those they are meeting, with the external auditor. So they see one another much more as equals. 23
  24. 24. Cohen et al. (2008) also found auditors overwhelmingly reported (85%) that the role of the internal audit function has changed over the past five years and reliance on the internal auditors has increased considerably. In particular, auditors note internal audit has played a significant role in overseeing and testing internal controls as required by SOX section 404. Beasley et al. (2007, p. 26) also report that “audit committee interactions with internal audit has increased”in the post-SOX era. Management Certification The next set of questions concerned participant experiences of the impact of the CEO (CFO) certification on, first, the integrity of the financial reporting and, second the audit process. Sixty-four percent of respondents felt that the requirement had a positive influence on the integrity of financial reporting. However, the responses taken as a whole were polarised, as reflected in the following quotations, beginning with the case for the negative So here I think none. I think all of us to the best of our ability before looked at the financial reports of our companies and said “ that’ fairly presented” As s . things have become more sophisticated, as we were just saying, obviously we have had to become somewhat more sophisticated too. We have had to ask a few more questions, What’ the basis for this number? What underlies, and what s model did you value that on? So, it’ become more complicated. But none-the- s less I think we all looked at those numbers and signed off on them as the right numbers, in good faith. So, I think it has created a lot of pressure and a lot of headlines, and, again, I think it’ added the government’ case in marginal s s cases. But, I don’ think, in general, that it’ had a difference in the majority of t s cases. At the other end of the spectrum a second participant stated that he considered the legislative provision to be perhaps one of the most important changes that has taken place in aligning the incentives of all parties in the audit process. The participant went on to say: So, now the CEO also wants a good audit and previously it used to be like, you know, passing the buck kind of mentality, whereas now in a sense, you know, I’ on the hook, you’ on the hook and the audit committee is on the hook. So, m re all three of us have to coordinate and kind of make sure that, you know, we do 24
  25. 25. this right. So, in that sense I think it has been a very positive thing because it’ s created more a team mentality between the management, external auditors and the audit committee. The latter response may be contrasted with the assertion by another participant that from my own experience the people that I have worked with before and no, I do not doubt their integrity or honesty and so signing a piece of paper is superfluous. The responses of all participants to the questions are framed by their own experiences, and in that respect may be viewed, in part, from the perspective that the impact of the certification, would depend on the company and how closely they complied with some of the requirements of Sarbanes Oxley prior to Sarbanes Oxley. A common theme that emerged from the question was that fact that CEO (CFO) certification had, in the words of one the participants, been pushed . . . down through the organization so you’ got every level sort of doing their due diligence. The participant also ve added that he considered that aspect to be a fine part of Sarbanes Oxley. The participant also attributed the dramatic cost of Section 404 to the failure to take a risk-based approach to its implementation –a consequence that Langevoort (2007) identifies as an example of the social construction of SOX. Finally, one of the participants who had substantial direct experience with non-US stock exchanges stated that the CEO certification was particularly unpopular with non-US CEOs. On the question of the impact of CEO certification on the audit, the majority (65 %) of the participants considered that it had not had any impact in that respect. Others, however, considered that the impact lay in the heightened interest of the CEO in the audit and the fact that it had the effect of bringing more people into the process. Again, it is pushing the ownership down in the organization. The experiences of auditors (Cohen et al. 2008) on the impact of CEO/CFO certification appear to closely mirror those of directors. About two-thirds indicated certification 25
  26. 26. has had a positive impact on the integrity of the financial reports. In contrast, only 20% believed that the requirement ultimately had an effect on the audit process. Other Issues The remaining interview questions went beyond those posed by Cohen et al. (2008) to address cost - benefit related issues of SOX and whether SOX had affected corporate risk taking. The first question asked the directors whether they considered the awareness of the board regarding their responsibilities and exposure to liability surrounding the financial reporting process had changed in the last 5 years. Consistent with the findings of prior studies (e.g., Linck et al 2008) almost all of the participants (91%) said yes. The participant who answered “ stated that he did not consider that the awareness of the board regarding their no” responsibilities and exposure had increased for the following reason: I remember discussions 10 and 15 years ago where we were paranoid about our own exposure and our responsibility and the risk of shareholder suites and what it would do to our reputations. If anything has changes it is the fear of going to jail. It is not the legal responsibility, exposure, personal reputation, we have always worried about those things. Two other questions asked whether, irrespective of cost, they thought that SOX has led to an improvement in the quality of financial reporting and to rate the cost-benefit associated with implementation of the legislation on a ten-point scale (described below). There was overwhelming agreement (84%) that SOX had positively affected the quality of financial reporting. However, there was considerable variation in the perceived strength of the impact as reflected in the following cross section of responses: Yes. Absolutely. No question about it; Yes. But not as much as people think; maybe; and possibly. The factors identified as the source of improvement in financial reporting mirrored responses to earlier questions including the alignment of interests in the management – external auditor – audit committee relationship;, the strengthening of internal controls;, and 26
  27. 27. the enhanced effectiveness in the monitoring role of the audit committee and the board. However, at the same time all acknowledged the financial burden of complying with SOX. In relation to the second (rating) question, the number 1 on the scale was anchored by the descriptor “costs far exceed benefits” 5 “ , benefits equal costs” and 10 “ , benefits far exceed costs” The mean response on the scale was 5.81 which suggests a slightly favourable . opinion on the part of the directors that the benefits exceeded the costs. A small number of participants were not willing to provide an assessment, considering the jury to be still out on the issue and that the benefits were difficult to quantify. Another question asked the directors whether SOX had impacted corporate risk-taking. Half of the directors indicated that, yes, SOX had affected corporate risk-taking. However, they didn’ necessarily believe this was a negative consequence as reflected in the following t comments: In a minor way that there now in most companies is a risk analysis, a broader risk analysis than pure financial risk and that probably has been improved indirectly by SOX. I think accounting risks and being conservative about accounting and reporting and there are less, you know, there are less risks rather than there used to be. . . . The risks that companies aren’ taking any more are the sort of risks related to potential fraud and that sort of stuff. t Which are risks that they didn’ want to take before, it just wasn’ on the radar. I mean, but t t do companies take thoughtful business risk in the same way they did before? Sure, but there’ more, if you’ looking at an acquisition, you would spend a lot more time looking at s re the Sarbanes-Oxley issues in the other company than you did before. So you try to reduce that risk. Some directors, however, thought that reduced risk-taking was a negative consequence of SOX, for example, one director stating, It has caused corporations to be more cautious and that is not all a good thing. 5. CONCLUSION The primary purpose of this study was to extend the Cohen et al. (2008) study conducted with auditors by providing evidence of US directors’experiences of the impact of the Sarbanes Oxley Act on the financial reporting process, specifically the audit committee 27
  28. 28. (board) – management – external auditor relationship, internal audit, and CEO (CFO) certification. The results provide substantial evidence of enhanced improvement in audit committee (board) effectiveness that is attributable to both the functional and structural provisions of SOX and the institutionalisation of the relevant SOX mandates. The magnitude of the change is, however, subject to the extent to which there was a gap between rhetoric and reality pre-SOX. The enhanced improvement in the monitoring role of the audit committee (board) with respect to financial reporting was cited by some respondents as being at the expense of time being spent on other responsibilities as well as a substantial financial burden. Comparing the responses of the directors to that of the auditors in Cohen et al. (2008), we see significant convergence but also some noteworthy differences. Importantly, directors’ experiences regarding the enhanced expertise and diligence of the audit committee corroborate those reported by auditors in Cohen et al. (2008). However, in contrast to Cohen et al. (2008), the directors’ experiences indicate that audit committees played a more important role in the resolution of accounting disputes than indicated by auditors. Further, the directors were much less likely than the auditors to include management as part of their definition of corporate governance. Finally, some directors perceived that the cost of compliance was a burden and that the reforms may have had the unintended consequence of creating an overly bureaucratic monitoring role for the audit committee and the board to the detriment of some of their other roles and responsibilities. The strength of the qualitative method employed in the study is its ability to capture the experiences of insiders on the impact of Sarbanes Oxley. The data obtained provided depth of response but cannot be said to be statistically representative. However, while the number of participants is relatively small in number, they represent a broad spectrum of the economy and collectively provide both depth and breadth of information in relation to the research question addressed. 28
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  32. 32. TABLE 1: DEMOGRAPHIC DATA Committee Membership Years Companies Audit in Nominations (N), DIRECTOR Experience served the 5 years Compensation (C) post-SOX or Other (O) 1 13 21 No N, C 2 19 6 Yes N, C, O 3 35 12 Yes N, C, O 4 5 6 No N, O 5 20 4 No N, C 6 32 3 Yes N 7 15 14 Yes N, C 8 21 10 No N, C 9 5 3 Yes Nil 10 11 2 Yes N, C 11 12 8 Yes N, C 12 17 5 Yes N, C 13 40 20 No N, C 14 40 20 Yes N 15 5 1 Yes Nil 16 23 14 Yes Nil 17 20 12 Yes N, C 18 20 6 No N, C, O 19 18 5 Yes N, C, O 20 36 5 Yes N, C 21 35 11 Yes N, C 22 10 1 Yes Nil Mean (total) 20.55 8.59 (16) 32
  34. 34. TABLE 2: RESPONSES FROM DIRECTORS (continued) 34
  35. 35. TABLE 2: RESPONSES FROM DIRECTORS (continued) 35