Section 201 of the Sarbanes-Oxley Act: Impact on the

Brooke Cameron Spring 2015 Honors Thesis

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Introduction:

This thesis attempts to explain the implications of Section 201 of the Sarbanes-Oxley Act of 2002 on the accounting profession, as well as specific points pertaining to the auditing field.

While Sarbanes-Oxley affected many aspects of the industry, this thesis narrows the focus to

Section 201 and effects of prohibiting certain services on the accounting profession.

Background:

On June 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law by President

George W. Bush. This Act was the most expansive law to be passed since the Securities Acts of

1933 and 1934. Under the Act, new mandatory provisions were established for companies to follow. Sarbanes-Oxley was created in an attempt to deter accounting fraud and provide more efficient information for investors to rely upon. The main goal was to restore investor confidence in the industry. such as Enron and Worldcom made investors unwilling to rely on the financial statements of companies because these huge companies were able to fool not only investors but the , as well. If investors are not willing to invest, capital markets will slow down and create problems for companies. With confidence lacking, Sarbanes-Oxley was enacted to attempt to address areas of concern for many investors.

Sarbanes-Oxley has 11 main titles, but some have more implications than others. Each title contains sections addressing specific issues under each title. One of the most important components of the Act was the creation of the Public Company Accounting Oversight Board

(PCAOB). The PCAOB plays an important role in monitoring the profession, an area of concern for many investors. Also, the Act requires mandatory audit partner rotation every five 2 years. Many non-auditing services are now prohibited, which prevents audit firms from providing these services for their audit clients. Prior to the Act, many officers in firms would claim that they were not responsible for inaccuracies in their financial statements because they were unaware of the situation. Now, in an attempt to curtail this response, high ranking officers like the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) are held responsible. They must certify that the financial statements are accurate by signing off on their completeness and accuracy. There are also harshened penalties for individuals within the firm committing fraud. Sarbanes-Oxley also provides protection for whistleblowers. While all provisions of the Act are important, Section 201 of Sarbanes-Oxley greatly impacts the accounting profession and is further discussed below.

Section 1:

Section 201 of the Sarbanes-Oxley Act of 2002 falls under the title of

Independence. Section 201 lists the activities that are outside the scope of the auditor’s responsibilities. This section specifically details the activities that auditors are prohibited from performing. The goal of this section is to protect auditor independence, a major concern for investors. It is believed that performing the prohibited services compromises auditor independence. The following services1 are considered unlawful when performed contemporaneously with an audit:

1. or other services related to the accounting records or

financial statements of the audit client

1 "Prohibited Auditor Activities." Sarbanes-Oxley Act. N.p., n.d. Web. 12 Jan. 2015. . 3

2. financial information systems design and implementation

3. appraisal or valuation services, fairness opinions, or contribution-

in-kind reports

4. actuarial services

5. outsourcing services

6. functions or human resources

7. broker or dealer, investment adviser, or investment banking

services

8. legal services and expert services unrelated to the audit

9. any other service that the Board determines, by regulation, is

impermissible

However, there is an exception to non-audit services. A registered public accounting firm can engage in non-auditing services not listed above for a firm if the audit committee of the issuer firm has pre-approved these services2. For example, if a firm wants to perform tax services for their audit client, the audit committee must approve this service in advance. The exception only applies to services not listed above, and there must be disclosures of the fees paid for these services. Overall, Section 201 of Sarbanes-Oxley tremendously limits the services audit companies can perform for their clients.

2 "Sarbanes Oxley Act Section 201." Sarbanes Oxley Act Section 201. N.p., n.d. Web. 12 Jan. 2015. . 4

Section 2:

Section 201 of the Sarbanes-Oxley Act has impacted the auditing profession as well as the accounting profession as a whole. The effects range from economic impacts to the nature of the profession changing.

Since consulting and auditing performed for the same client is prohibited under the Act, many firms have given up their consulting engagements to other firms and focused on auditing.

This portion of the Big Four’s practices generated over one third of their before they began to discontinue their consulting practices3. As a result, many accounting firms have lost profits due to losing their consulting engagements. They must now focus their efforts on retaining their audit clients and generating revenues from . While many firms still perform tax services for their audit clients, the majority of revenues consist of audit fees. The focus from a variety of services to mainly auditing has led to financial and structural changes within the firms.

While conducting an audit, auditors may be more wary of what information they share with their clients during the auditing process. They do not want to seem as if they are engaging in consulting, but they also want to ensure the audit is being conducted in a reasonable manner. It is probable that there is loss of information due to less communication occurring during the audit4. Auditors need to ensure that when conducting an audit, they do not unintentionally audit

3 Riesenberg, Thomas L. "Non-Audit Service Restrictions of the Sarbanes-Oxley Act." Non-Audit Service Restrictions of the Sarbanes-Oxley Act Article. The Bureau of National Affairs, Inc., 24 Sept. 2002. Web. 12 Jan. 2015. .

4 Imhoff, Eugene A., Jr. "Accounting Quality, Auditing, and Corporate Governance." Accounting Horizons 17.S-1 (2003): 117-28. Web. 12 Jan. 2015. 5 their own work. Also, they must not cross the line of auditing their own work by providing the client with “information and systems generated and developed during the audit5.” For example, during an audit, potential failings of a client’s systems are discovered. It seems obvious that the auditor is in the best position to offer suggestions and try to correct the internal control issues. However, Section 201 states that this is not allowed, which results in a consulting firm having to perform the work again resulting in higher societal costs6. The Securities and

Exchange Commission (SEC) has addressed the issue of information gathered during an audit that may cross into consulting. They give discretion to the audit committee to pre-approve the auditor to recommend suggestions regarding internal accounting and controls.

However, design and implementation of the controls impairs auditor independence and is prohibited. While the audit committee has the opportunity to pre-approve certain recommendations about internal controls, many audit committees choose not to provide such pre-approval7. The SEC’s discretion grants the audit committee freedom but also gives them a large responsibility if the service begins to take on qualities of a consulting engagement. Without the committee’s pre-approval, auditors have to be very cautious in the behaviors they exhibit.

Since they often choose the side of caution, valuable information that may have been exchanged with clients is not communicated resulting in a loss of information.

5 Alles, Micheal G., Alexander Kogan, and Miklos A. Vasarhelyi. "Implications of Section 201 of the Sarbanes–Oxley Act: The Role of the Audit Committee in Managing the Informational Costs of the Restriction on Auditors Engaging in Consulting." International Journal of Disclosure and Governance 2.1 (2005): 9-26. Web. 12 Jan. 2015.

6 Alles, Micheal G., Alexander Kogan, and Miklos A. Vasarhelyi. "Implications of Section 201 of the Sarbanes–Oxley Act: The Role of the Audit Committee in Managing the Informational Costs of the Restriction on Auditors Engaging in Consulting." International Journal of Disclosure and Governance 2.1 (2005): 9-26. Web. 12 Jan. 2015.

7 Alles, Micheal G., Alexander Kogan, and Miklos A. Vasarhelyi. "Implications of Section 201 of the Sarbanes–Oxley Act: The Role of the Audit Committee in Managing the Informational Costs of the Restriction on Auditors Engaging in Consulting." International Journal of Disclosure and Governance 2.1 (2005): 9-26. Web. 12 Jan. 2015. 6

Along with loss of information, the job functions of auditing and consulting are now completely separate within a firm. This separation leads to further loss of information about the client. When providing consulting services, the firm is developing a deep understanding of the client and aims to provide the best solutions to specific transactions. Auditors are charged with understanding the client as well, but typically not to the same degree as consultants. Auditors are required to develop an understanding of the company and the internal controls. Consultants, in turn, must develop an in-depth understanding of a particular transaction as it relates to the firm or of an area of the firm’s products/services that relates to the engagement. When the consulting and auditing functions can work together, a more complete picture of the client is developed and both auditing and consulting functions are improved. Without the interconnectedness of auditing and consulting, valuable information is being lost and there is less ability to conduct a risk-based audit.

As profits begin to shrink, more competition arises between the Big 4 accounting firms

(Ernst & Young, KPMG, Deloitte, and PricewaterhouseCoopers). Although many accounting firms exited the auditing profession to focus on consulting services, the Big 4 firms have increased competition with each other to obtain and hold on to audit clients. With this increased competition, auditors must lower their audit fees and be able to compete based on price. While competition improves quality, it is also hurting audit firm profits. Auditors are forced to perform audits at lower costs and with less profits generated from their services.

Furthermore, audit firms are less likely to be involved in internal audit functions. Due to the prohibition of external auditors performing internal audit work, firms are extremely cautious to not cross the line into a prohibited service. “There is some concerns that external auditors will respond to Section 201 by being much more cautious in how they interact with internal auditors, 7 because of concerns that suggesting to them what controls are needed would be tantamount to taking responsibility for those controls in a way that would violate the prohibitions on consulting and/or internal audit outsourcing8.” Section 201 requirements cause auditors to be more cautious when auditing internal controls in compliance with Section 404. This caution can lead to a loss of information between the auditor and the client regarding internal controls preventing a greater understanding by the auditor. However, if auditors are not careful enough, they will be in violation of Section 201. Therefore, there is a very fine line that auditors need to walk when auditing internal controls. Yet another consequence of Section 201 of the Sarbanes-Oxley Act of

2002.

Section 3:

Due to the implications of Section 201 of the Act, there are several important ideas to take away. As mentioned above, because of lower profits due to loss of consulting engagements, auditors are forced to retain as many audit clients as possible. There is increased emphasis on audits, so auditors feel pressured to please their clients in order to retain their business. For example, “when auditors accept drastically discounted fees, they are likely to be highly motivated to retain the client for several years9.” Therefore, auditor independence continues to be at risk. Auditors may turn a blind eye to certain questionable and subjective accounting practices that comply with the client’s requests in order to maintain the client’s business. Alternatively, it is possible that the client would choose to hire a different auditor in subsequent years who would

8 Alles, Micheal G., Alexander Kogan, and Miklos A. Vasarhelyi. "Implications of Section 201 of the Sarbanes–Oxley Act: The Role of the Audit Committee in Managing the Informational Costs of the Restriction on Auditors Engaging in Consulting." International Journal of Disclosure and Governance 2.1 (2005): 9-26. Web. 12 Jan. 2015.

9 Bazerman, Max H., Kimberly P. Morgan, and George F. Loewenstein. "The Impossibility of Auditor Independence." SLOAN MANAGEMENT REVIEW (1997): n. pag. Web. 12 Jan. 2015. 8 agree with their method of accounting. If this sort of practice were to occur, there would be less independence, which creates another realm of issues to address regarding auditor independence.

There should be consideration of this possible effect on auditor independence when evaluating the effectiveness of the Sarbanes-Oxley Act of 2002.

While there are reasons to keep the audit and consulting functions separate, there should be times when consulting is allowed. If valuable information is available that could improve the audit, the consulting firm should be allowed to provide that information to the auditor. Internal audit outsourcing can improve audit quality because the auditor can provide advice on internal controls that will benefit the company. If controls are functioning in accordance with the auditor’s standards, there is less chance of misstatements occurring. Appraisal services could potentially increase audit quality, as well. If the auditor was allowed to perform this service, their expertise in this area would likely increase, improving their ability to audit the many estimates of developed by management. Fair market value disclosures have been increasing in recent years, so appraisal experts could help and improve audit quality. However, certain aspects of Section 201 should be seen as necessary. External auditors should not be involved in any management functions of the firm because this would clearly require them to take on the role of management, inhibiting their ability to be independent. Any bookkeeping services should also remain exclusively the client’s responsibility since auditors should not audit their own work.

When evaluating the potential impacts on audit quality improvement, it seems clear that, in addition to monetary costs, audit firms are incurring significant informational costs as a result of

Section 201.

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Section 4:

There has been a lot of research done since the implementation of the Sarbanes-Oxley

Act of 2002. More specifically, there has been research done on Section 201 of Sarbanes-Oxley.

The research has been conducted to determine whether non-audit services actually hinder independence. Also, there is discussion on how effective Sarbanes-Oxley has been since it was first implemented.

Significant research has been conducted regarding non-audit services prohibited under

Section 201 of Sarbanes-Oxley. Many experts have stated that the prohibited services affect independence in appearance as well as independence in fact. Some argue that when auditors engage in these services, they not only become less independent in appearance but also reduce audit quality10. However, since implementation of Section 201, research has shown that there is little effect on audit quality from performing non-audit services. Others suggest independence in fact may be compromised by economic pressures to retain clients for non-audit services.

However, research has shown that even while prohibiting services, economic pressures still remain. Auditors are still receiving payments for their services from their audit clients.

Essentially, the auditor’s paycheck is relying on their audit clients. For example, “contemporary auditing firms expect partners to generate significant , and failure to meet these expectations frequently leads to retirement11.” An auditor cannot possibly be completely independent when they are still being paid for their services from their clients. Regardless of

10 Nelson, Mark W. "Ameliorating Conflicts Of Interest In Auditing: Effects Of Recent Reforms On Auditors And Their Clients." Academy of Management Review 31.1 (2006): 30-42. Web. 12 Jan. 2015.

11 Bazerman, Max H., Kimberly P. Morgan, and George F. Loewenstein. "The Impossibility of Auditor Independence." SLOAN MANAGEMENT REVIEW (1997): n. pag. Web. 12 Jan. 2015. 10 independence provisions put into place, payments from clients remain. It can be argued that economic pressures are the biggest issue to auditor independence. Also, independence in fact is hindered if an auditor becomes an advocate for the client. It is argued that, when performing non- audit services, public cannot separate the role of auditor from that of client advocate and therefore cannot possibly be independent when conducting an audit. Yet, evidence shows that non-audit services do not diminish auditor independence12. There is also no relationship between performing non-audit services and accounting restatements. Finally, a negative relationship exists between tax services and restatements, which implies that tax services improve audit quality13. Therefore, it appears that many researchers inaccurately assume that non-audit services impede auditor independence.

During one research study, the effectiveness of the Sarbanes-Oxley Act was investigated for the 10 year period since implementation. Overall, the Act has been successful. All portions of the Act have remained, unlike previous laws in the past. There have been drastic increases in costs associated with compliance with the Act, but experts believe the benefits outweigh the costs. The main increase in costs was due to compliance of Section 404 of the Act regarding an opinion on internal controls. It is also expected that costs due to implementation from the Act would be high during the early stages of implementation and continue to decrease in the future.

There has been increased accounting quality since the Act was enacted most likely due to the increased quality of audits14. The Public Company Accounting Oversight Board (PCAOB) is

12 Nelson, Mark W. "Ameliorating Conflicts Of Interest In Auditing: Effects Of Recent Reforms On Auditors And Their Clients." Academy of Management Review 31.1 (2006): 30-42. Web. 12 Jan. 2015.

13 Nelson, Mark W. "Ameliorating Conflicts Of Interest In Auditing: Effects Of Recent Reforms On Auditors And Their Clients." Academy of Management Review 31.1 (2006): 30-42. Web. 12 Jan. 2015.

14 Coates, John C., and Suraj Srinivasan. "SOX after Ten Years: A Multidisciplinary Review." Accounting Horizons 28.3 (2014): 627-71. Web. 12 Jan. 2015. 11 credited with helping improve audit quality with their inspections. It is important to note that the ban of non-audit services is not credited with improving audit quality. There is no evidence to support the assertion that these non-audit services affect the quality of financial reporting. If there is no improvement in quality, the ban of these services seems to be unfair to accounting firms who relied on providing these services to their clients. Multiple studies “all find no effect of non-audit fees on financial reporting quality15.” Due to the implementation of Sarbanes-Oxley, it is more difficult to perform research on audit quality due to non-audit services because these are now banned. However, research is mounting that these prohibited services do not negatively affect an audit but merely impede the public’s perception of auditor independence.

Section 5:

Moving forward from the Sarbanes-Oxley Act of 2002, there have to be some changes made in the accounting profession to address Section 201. While there have been positives to the implementation of the Act, no research has shown that non-audit services actually impair independence or impair audit quality. These questionable services need to be addressed further in order to obtain the highest quality audit available.

In order to improve audit quality, there should be updated terms to Section 201 of

Sarbanes-Oxley that address when it is allowed for the prohibited services to be performed in collaboration with an audit. For example, there should be specific instances when consulting with an audit client is allowed. If there is an improvement in the quality of the audit, there should be no ban on this issue. As mentioned earlier, if possible, a firm could document when

15 Coates, John C., and Suraj Srinivasan. "SOX after Ten Years: A Multidisciplinary Review." Accounting Horizons 28.3 (2014): 627-71. Web. 12 Jan. 2015. 12 consulting was performed and submit the report to the SEC in case questioning were to occur.

There should not be regular ongoing consulting because that would be too drastic of a change for the SEC to adopt. However, slight modifications to this portion could greatly improve audit quality. For example, as mentioned previously, the SEC has given discretion to audit committees regarding approval of recommendations on internal controls but many are wary of granting approval. The SEC should provide further guidance that encourages audit committees to make the change if they feel it is appropriate. Firms would not have to be so wary of communicating with their clients if they did not feel like they would be punished for wrongly consulting with them. There would be a greater flow of information between the firm and the client creating a higher quality audit without jeopardizing independence.

Since companies are constantly trying to receive the lowest cost audit, there is likely not enough focus on the quality of the audit. Some companies are now more focused on complying with regulations rather than demonstrating to their investors that their company is fairly presenting financial statements. The mindset of these companies needs to be changed. The focus needs to be on quality rather than costs. Fixed fee audits would probably not be the answer because there are too many differences between clients and the amount of work needed to be done. However, there should be some consideration to cost of audit fees and structuring them so there is less focus on cost. At this time, there is not enough focus on the quality of the audit because attention is on complying with regulations.

Since the main reason Section 201 was implemented was to address investors’ concerns with independence, there should be more focus on the independence guidelines rather than on the strict rules under Section 201. While independence guidelines do exist already, more guidelines could be created to address what is expected of auditors regarding Section 201. It would make 13 implementation of this Section more understandable if auditors know how to apply the rules.

There should be guidelines addressing when there are exceptions to the prohibited services as addressed previously. The guidelines should also explain what constitutes consulting and violates

Section 201, so auditors do not need to be skeptical of communicating certain items with their clients. These new guidelines would clarify Section 201 and improve audit quality.

Conclusion:

Overall, the Sarbanes-Oxley Act of 2002 has drastically improved the accounting environment as a whole. However, Section 201 of the Act fails to address improved accounting or audit quality. While audit quality has increased, it is due to other factors and not the prohibited services under Section 201. Research has shown that non-audit services do not hamper independence or decrease the quality of the audit. There have been many negative effects of the

Section for accounting firms including the loss of their consulting engagements and internal audit functions with their clients. Complete separation of these activities from the audit lead to decreased quality of the audit because there is a loss of information being transferred between the auditor and the client. Section 201 of the Sarbanes-Oxley Act of 2002 has failed to increase auditor independence but has instead created more complications that firms must address when auditing their clients.