Research takes a deeper look at effects of legislation

The Sarbanes-Oxley Act, passed in 2002, was the most impactful regulation in terms of accounting and financial reporting since the 1930s. The act, often referred to as SOX, was passed in an effort to diminish the widespread fraud that had gripped the nation for the first part of the decade.

“It was a monumental piece of legislation,” says Nate Sharp, accounting professor and Mays Research Fellow.

SOX tightened the reins on accounting firms that had begun to provide multiple services to their clients beyond auditing, and left them with the ability to perform few services beyond external audits. Although the public was generally pleased with the move toward greater auditor independence, some in the profession argued the additional services offered by auditing firms had led to more thorough and effective audits.

“We tend to call that ‘knowledge spillover,’” says Sharp. “If the audit firm is there doing other services, the argument is that they learn things about the client that then ‘spill over’ and can benefit the audit team when they perform the audit.”

Others argue in favor of the strict regulations put into place by SOX, saying the many services offered by auditing firms had compromised the independence of the auditors; otherwise put, they believe there was enough money at stake to tempt auditors to overlook financial misreporting. In their paper “Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?” Sharp and his colleagues – Douglas Prawitt and David Wood of Brigham Young University – looked into the effects, if there were any, of restricting audit firms from doing internal auditing for their clients, one of the services auditing firms had offered before SOX.

“We said, let’s go back a few years prior to SOX before all of this came into effect to see whether companies that were outsourcing part of their internal audit function to their external auditor had financial statements that were either riskier or less risky,” Sharp says of the idea behind the research. “In other words, if it’s true that allowing the external auditor to participate in the internal audit compromises independence, then companies doing that should have riskier financial statements that appear to be aggressive.”

Gathering information from the Institute of Internal Auditors, the researchers looked at financial statements from 159 firms in the three years leading up to SOX. The firms fit into one of four categories:

– The firm outsourced some of its internal audit function to the same Big Four accounting firm that conducted its external audit
– The firm outsourced some of its internal audit function to a Big Four firm that did not conduct its external audit
– The firm outsourced some of its internal audit function to a non-Big Four firm that did not conduct its external audit
– The firm kept the internal audit function completely in-house

Running the data through a sophisticated model, Sharp and his colleagues were able to determine which firms had riskier financial statements.

“What we found was financial statement risk was lowest when the company outsourced some of its internal audit function to its own external auditor, which is contrary to the assumptions behind the prohibition in SOX,” Sharp says of the results. “Overall financial reporting quality was higher when the external auditor was also providing internal audit services.”

The research was generally well received by both the academic and professional communities. Numerous conferences accepted the paper, and articles in CFO Magazine and Compliance Week cited its findings. Prior to its publication, this paper received the University of Oklahoma Price College of Business 2010 Glen McLaughlin Award for the best, unpublished research paper on accounting and ethics. The paper was later published in Contemporary Accounting Research, a highly respected journal in the field.

“By no means do we think lawmakers should change the law just because we found this,” says Sharp, addressing those who did not receive the research well. “We’re just trying to inform the debate.”

Sharp says he enjoyed working on research that contributed to a debate both within and outside of academics. For Sharp, it is his goal to do relevant research that informs many groups, including experts in the field, practitioners, and students.

“I look for research projects that even people outside of accounting academics can appreciate and understand the importance of the question and the value of what the findings are,” says Sharp of his research philosophy. “I think no matter what field we’re in, we have the opportunity if we look for it to do research with implications that reach far beyond the ivory towers of academics.”

“Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get it Wrong?” was published in Contemporary Accounting Research and is authored by Nate Sharp of Mays, and Douglas F. Prawitt and David A. Wood of Brigham Young University.