Overview of the Sarbanes-Oxley Act
The Sarbanes-Oxley Act of 2002 (SOX) was enacted in response to management fraud in Corporate America. Fraud at such premier companies as Enron, WorldCom and Tyco, resulted in misleading financial statements which caused huge losses to investors when the fraud was unraveled. Currently, SOX only applies to public companies; private companies, not-for-profit organizations and governmental entities are specifically exempt.
Some of the key provisions of SOX specifically Sections 301 (audit committee's oversight of issuers accounting, internal controls and auditing procedures), 302 (annual certification of the financials by the CEO and CFO) and 404 (management's assessment of the effectiveness of internal controls over financial reporting) have increased the role of the board of directors and management in the oversight and reporting process within organizations (Lander, 2004). This has resulted in an increase in accountability and transparency within public corporations so that the ultimate owners (i.e., shareholders) have a better understanding of the business practices and financial transactions within such organizations.
For example, Deloitte & Touche chief executive noted that as a result of SOX, audit committees are more involved and have deepened their understanding of the financial reporting process and accounting policies within their organizations. The executive also noted that SOX has enhanced transparency and reduced the risk of corporate fraud in many organizations (Martin, 2003). In addition, an audit committee chair noted that audit committees have doubled the time spent on audit related matters and that boards are more deeply involved in controls and are better informed of the organization's performance as a result of SOX (Stainburn, 2006).
In terms of financial reporting, one study found that 1,118 US companies and 90 foreign companies--one in every 12 companies with US listed securities--filed a total of 1,342 material weaknesses disclosures in 2006 (Zhang & Pang, 2008). Arlinghaus (2007) reported that twenty seven of the 201 respondents in its study of SOX compliance reported material weaknesses in internal control in the tax area in their annual report on management's assessment of internal control. A material weakness in internal control is a combination or combination of deficiencies that results in a reasonable possibility that a material misstatement in the financial statements would not be prevented or detected on a timely basis (Louwers, Ramsey, Sinason & Strawser, 2008).
Gullapalli (2005) noted that the Heron Consulting Group identified 414 companies with error driven financial restatements in 2004. This was a sharp increase from the 323 in 2003 (Gullapalli, 2005) 330 in 2002 and 270 in 2001 (Farrell, 2005). The 28% increase from 2003 to 2004 was primarily attributed to the significant amounts of time and money spent by public companies to comply with the requirements of SOX, and the accounting mistakes caught in the process (Bryan, Lilien, Ruland & Sinnett, 2005). The number of companies reporting earnings restatements ballooned to approximately 1,200 in 2005 primarily due to the implementation of SOX Section 404 (Farrell, 2005). Section 404 requires the outside auditor and the company's top brass to annually certify the soundness of internal financial-reporting controls (Gullapalli, 2005). However, 56% of the accounting mistakes identified was simply the result of human errors (Plourd, 2008).
Montana (2007) noted that most corporate commentators concede benefits of various kinds from SOX especially in the financial controls and reporting areas. This led private companies and not-for-profit organizations to recognize the effectiveness of various SOX provisions and have applied certain requirements (such as an audit committee and independent internal control assessments) as best practices (Elson, O'Callaghan & Walker, 2007)
The Sarbanes-Oxley Act and Local Governments
Most local governments are not as proactive and instead rely on existing structures and controls to ensure accountability and transparency in the management of taxpayers' resources. General purpose local governments rely on taxes levied upon their citizens as their primary revenue source. Too often the assumption is that if taxpayers do not face tax increases then the local government is exercising its fiduciary responsibilities. However, this assumption is flawed as local government faces tremendous pressures to identify and control the financial abuse and political pressures faced by elected and appointed officials.
Local governments may not have adequate internal controls over financial accounting and reporting in such areas as the awarding of contracts and access to cash and sensitive data. The lack of adequate controls has led to scandals and corruptions in local government which in turn has reduced taxpayers' confidence in their elected officials. It is important to remember that citizens invest in governments through taxes and receive dividends in the form of a well run government (J. Fretti, personal communication, July 19, 2007).
Another frequently overlooked stakeholder is the municipal bond holder. Many local governments issue municipal bonds as part of the approximately $2.4 trillion municipal bond market (Greenhouse, 2008). These bonds are purchased by individual investors who are relying on the integrity of the financial accounting and reporting controls in the governmental entity. Therefore, it is critical for local governments to have adequate controls in place to ensure accountability and transparency of financial information.
Perhaps the solution resides in SOX. We believe that certain requirements in SOX could be adapted by local governments without any significant cost increase to taxpayers. The benefits are tremendous: an increase in oversight, accountability and transparency in the operations of a local governmental entity.
Other researchers notably Czaja (2005) and George (2005) explored extending SOX reforms to nonpublic companies. However, the researchers addressed establishing audit committees and the impact of SOX on the nonpublic organizations' independent accountants and not the themes explored in this paper.
This paper discusses some of the recent scandals within local government and current practices that are in place to ensure accountability and transparency. Since these practices are not always effective, we offer an alternative approach based on SOX to improve oversight and accountability. These are establishing an audit committee, obtaining the CEO/CFO certification of financial reports, management's assessment of internal controls, and adopting a comprehensive code of conduct policy.
LOCAL GOVERNMENT SCANDALS
Scandals and local government seems to coexist in harmony and seem to thrive in some cities. For purpose of this paper, scandals refer to the different types of corruption found in local government--bribery, extortion, embezzlement (misappropriation of assets), nepotism and patronage systems. Atlantic City New Jersey, with its glistening casinos, poor constituents and on going political scandals is one example of the challenges faced by local governments. New Orleans, Louisiana, is another major city with public …