Should Provisions of the Sarbanes-Oxley Act of 2002 Apply to Local Governments in Order to Improve Accountability and Transparency?

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INTRODUCTION

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. …