Financial stake and CPA support for expanding Sarbanes-Oxley to nonpublic entities.

Allen, Paul W. ; Ennis, Kevin L.

INTRODUCTION

In these troubling times of economic and financial crises facing our nation, it is imperative that financial accounting information be fairly presented. Certified Public Accountants (CPAs) must render unbiased judgments toward the financials of corporate America or the whole capitalistic market system can disintegrate. If we ever needed a deep sense of integrity among market participants, it is now.

Following the Enron and WorldCom fiascos at the beginning of this century, the Securities and Exchange Commission (SEC) was empowered by Congress to administer the Sarbanes-Oxley Act of 2002. Its provisions are intended to strengthen corporate governance and the audit function. The provisions of SOX extend to companies which trade equity shares over a public stock exchange overseen by the SEC. SOX does not, at this time, apply to nonpublic companies. However, there is debate over whether SOX should be expanded to nonpublic entities. Nonpublic entities include those that are not currently subject to securities law (i.e. privately owned companies, nonprofit entities, etc.). If stock is available for sale, it is not sold over an open market exchange.

Regardless of whether an entity trades its stock over a public stock exchange regulated by the SEC (therefore "public" in the context of SOX) or not ("nonpublic" in the context of SOX), there are stakeholders who provide the capital to keep those entities going. In other words, regardless of whether the entity is public or nonpublic, a commonality is the need of quality financial information provided to those who have their money invested in that entity. These stakeholders comprise the critical element of the public interest when it comes to maintaining a healthy capital marketplace.

Prior studies (Allen and Ng, 1997; Allen and Ng, 2001) found that a CPA's financial stake bore a significant relationship to the CPA's preferences for ethical changes wrought by the Federal Trade Commission (FTC) in its consent order to the American Institute of CPAs (AICPA) in 1990. The financial stake variable was established in the 1997 study via the FTC's challenge that CPAs included certain ethics bans in their professional conduct code as a means of restraining trade. That is, CPAs were basically accused of banning certain activities in order to increase the size of their pocketbooks.

PROBLEM AND RESEARCH QUESTION

The problem addressed by this paper is that financial stake appears to be a significant variable when related to CPAs' preferences for regulatory changes, specifically, changes aimed at addressing certain ethical issues. SOX is viewed in this paper as a regulatory change, expressly intended to improve the integrity of corporate governance and the audit function of CPAs. There is much debate today over whether SOX should be extended to cover nonpublic entities, better known as the cascading of SOX. The research question then is to address whether the financial stake of CPAs is a significant variable relative to their support for cascading SOX to nonpublic entities. The question is:

 Given a CPA's level of financial stake in the practice of public
 accounting, does she/he support expanding SOX provisions to
 nonpublic entities?

LITERATURE REVIEW

In 1990, the FTC issued a cease and desist order (FTC, 1990) to the AICPA, mandating the profession stop banning certain types of fees and certain types of advertising, bans incorporated within the AICPA Professional Code of Conduct. The FTC alleged that the bans represented restraint of trade violations. The FTC's charges implied that CPAs were financially motivated to retain the bans. Allen and Ng (1997) sought to determine whether the FTC's allegations appeared reasonable. To do so, they studied the relationship between CPAs' financial stake in the practice of public accounting and their support for bans being overturned by the FTC's consent order to the AICPA. The authors' research actually established the proxy for measuring a CPA's financial stake in the practice of public accounting which is used in the current study. Specifically, Allen and Ng's research studied the relationship between CPAs' financial stake and their support of three fee-type AICPA bans challenged by the FTC as restraint of trade violations, namely bans prohibiting CPAs from accepting commissions, referral fees, and contingent fees. Additionally, their study separately studied the relationship between CPAs' financial stake and their support for an AICPA ban against advertising with trade names. This ban was also challenged by the FTC as a restraint of trade violation.

Allen and Ng (1997) reasoned that if the FTC was right about its allegations, which again implied the CPA profession was trying to restrain trade by retaining the subject bans, it would follow that CPAs with a higher financial stake in public practice would support retaining the bans more strongly than would CPAs with lower financial stake. However, they questioned that logic relative to the fee-type bans since relaxing those bans would actually open up new revenue streams to CPAs. Literature is abundant that shows that advertising bans restrain trade by stifling competition, reducing information available to consumers, all leading to higher prices to consumers. Accordingly, Allen and Ng reasoned that the FTC's allegation toward the ban on advertising with trade names was intuitively appealing.

Two-tailed tests were performed by Allen and Ng to ascertain the nature of any potential relationships found between a CPA's financial stake and her/his support for retaining or relaxing the fee-type bans covered by the FTC order. No directional hypothesis was stated since there were opposing angles to take as to how CPAs might gain. That is, the FTC's allegations strongly implied that support for retaining the fee-type bans was consistent with a CPA having a higher financial stake in public accounting practice. Conversely, realizing new revenue streams by removing the bans suggested that CPAs with higher financial stake would favor relaxing the bans relative to CPAs with lower financial stake. The study found that CPAs with higher financial stake, as measured by their position in the public accounting firm, preferred the FTC's position of relaxing fee-based bans more than did CPAs with a lower financial stake, a finding not consistent with the related FTC's allegations.... but consistent with what Allen and Ng expected since it is intuitively appealing that new revenue streams would be favored more by those with a higher financial stake in those revenue streams.

With regard to CPAs' support for retaining an advertising ban on use of trade names, and consistent with the FTC's restraint of trade allegation, Allen and Ng (1997) hypothesized that CPAs with a higher stake would favor retaining the ban relative to CPAs with a lower stake. Again, advertising bans had already been shown to result in restraint of trade activity whereas no priors showed fee-type bans to be restraint of trade activity. Indeed, Allen and Ng determined that CPAs preferred retaining a ban on advertising with trade names, a finding consistent with the related FTC allegations, and consistent with what Allen and Ng expected since stifling competition among CPAs by banning advertising would financially benefit CPAs with a higher financial stake the most.

The net effect of results from the Allen and Ng 1997 study is that it appeared that CPAs would gain financially by an ability to charge previously banned fees, and would also gain by stifling advertising. The financial stake variable used in the Allen and Ng study identified the expected link of a CPA's financial stake in public practice and her/his support of specific ethical regulation.

In another work, Allen and Ennis (2007) concluded that the socialization of CPAs described by Ponemon (1992) whereby CPAs exhibit lower moral reasoning as they move up in rank within the public accounting firm may plausibly be described as socialization toward, or a culture of, self-interest. That is, what is likely taking place is a growing financial stake that comes with a higher rank in the public accounting firm is lending to a compromise of ethical decision-making by the CPA. Since financial stake of a CPA in the practice of public accounting is a relatively new variable, the continuation of studying its relationship to CPAs' preferences in the context of a change in ethics-based regulation is profoundly important. This is because the CPA, in effect, must ultimately render an ethical opinion (decision) as to the fairness of management representations in the financials by way of the most important role played by a CPA, namely, external auditor. Thus, the CPA must remain untarnished by anything that would filter into that decision resulting in a biased judgment.

METHOD

The present study views SOX as bringing significant change to the self-regulatory activity of the CPA profession, especially with regard to the audit role of the CPA toward publicly traded companies. Since the audit role is specifically a function in place to serve the public interest, not to serve the companies being audited, SOX is seen as an attempt at strengthening the integrity of the audit function. It, therefore, is viewed as a change that deals with ethical issues.

Hypothesis

While there is no prior research showing that CPAs have gained financially by SOX, it is intuitively appealing to think that the regulation adds to the workload of the auditor, thereby raising her/his fees. However, an extension of SOX to nonpublic companies might be viewed from opposite perspectives as to whether CPAs would gain financially or not.

Toward the perspective that the CPA might not gain, there are two notions proffered. First, if the profession is overly occupied with its big publicly-traded corporate clients, it might not be that interested in investigating adherence to SOX by nonpublic companies. That is, extending SOX to nonpublic entities might interrupt the ability of CPAs to enjoy the higher fees derived by monitoring for compliance their "big fish" publicly-traded audit clients. This would be due to the "necessity" of CPAs taking on the additional work mandated by SOX expansion to nonpublic entities. It is likely that CPA firms would all have to share in taking on the work imposed by an expansion of SOX to nonpublic companies. Second, and to be taken independent of the first, CPAs might think that many nonpublic entities would be hard-pressed to afford compliance with SOX. This would likely translate to a loss of fees should adherence to SOX contribute to nonpublic entities failing at a greater rate than can be offset by the ability of CPAs to charge higher fees for SOX compliance. Since SOX was implemented, for example, there are numerous small-cap publicly-traded companies that have intentionally delisted their stock from public stock exchanges for the express reason of getting out of the huge relative expense of compliance with SOX. Given either of the foregoing notions toward the perspective that the CPA might not gain financially should SOX be expanded to nonpublic entities, one would expect CPAs with a higher financial stake in the practice of public accounting to be more opposed to expanding SOX toward nonpublic entities than CPAs with a lower stake.

Toward the perspective that the CPA might gain, CPAs might see an expansion of SOX to nonpublic entities as additional revenue streams and thereby favor the opportunity to gain financially. Given this thinking, one would expect CPAs with greater financial stake to be more supportive of expanding SOX to nonpublic entities than CPAs with a lower stake.

Thus, in the absence of a clear directional expectation, the following non-directional hypothesis in the alternative form is established:

 The financial stake of a CPA in the practice of public accounting
 is related to her/his preference for expanding SOX to nonpublic
 entities.

Data Collection

A mail survey collected the data for this study during late 2004 and early 2005. Data was collected from a random sample of the AICPA membership. A 32.4 percent response rate resulted from gaining 305 usable responses out of 941 CPAs solicited. Based on comparing responses of late respondents from a follow-up mailing to the responses of early respondents from the initial mailing, nonresponse bias was not evidenced. A questionnaire was included in the survey which collected the data for testing the hypothesis in this study. CPA's were asked to indicate their financial stake by choosing an answer descriptive of their position in the public accounting firm. They were also asked to indicate whether they supported expanding SOX to nonpublic entities.

Data Coding

Allen and Ng (1997) measured financial stake by combining the type and position of CPAs. Type dichotomizes CPAs into those not in public accounting and those in public accounting. CPAs not in public accounting practice proxy for those with no (or nil) direct financial stake and, as such, represent those CPAs with the least potential financial bias toward a regulatory change aimed specifically at public accounting practice. Position reflects the employment rank of those CPAs in the practice of public accounting. Thus, the continuum for the financial stake variable ascends from CPAs not in public accounting, to staff members in the public accounting firm, to managers in the firm, and finally to partners or proprietors in the firm, coded as 1, 2, 3 and 4, respectively. Given this proxy, established by the Allen and Ng 1997 study and strengthened later by the Allen and Ennis 2007 work, the current study measured the financial stake of a CPA in public practice in the same manner as already described.

Support for expanding SOX to nonpublic entities was measured by coding CPAs into two groups, either for or against. This was accomplished by capturing CPAs' responses to a question which elicited respondents to indicate support by selecting "yes" (coded 1) or to indicate opposition by choosing "no" (coded 0).

Importance of Analysis

Analyzing the relationship of a CPA's financial stake in the practice of public accounting to her/his support for expanding SOX to nonpublic entities offers the opportunity to determine whether financial stake is an important variable relative to CPAs' preferences toward ethical issues. That is, given that it has been found to be an important variable in prior research settings, a finding of significance in a new setting, that being an expansion of SOX to nonpublic entities, would strengthen the notion that financial stake may be an important factor relative to CPAs' ethical decision-making. Given the growing level of accounting and auditing scandals reported on over recent years, any study which adds to the notion that financial stake of CPAs in public practice significantly impacts their ethically-based decisions builds the case that self-interest may be afflicting the profession. This would pose a gargantuan problem since capital formation, in large measure, depends upon the confidence of the public to invest in companies. The audit role serves as a critical monitoring mechanism in sustaining that confidence among investors. An investor wants to know whether the financial representations of company management are fair. Clearly, if the CPA is significantly influenced by any type of monetary self-interest when passing a "fairness" judgment on management representations in the financials, the public interest is greatly endangered and confidence in investing could collapse. Given the fragility of the current state of the U.S economy, and for that matter, the world economy, it's incumbent on the CPA profession to quickly face and address any ethical conflicts of interest it has invited upon itself by allowing money to become more important than the public interest.

Correlation analysis was used to test the hypothesis in this study. Both Pearson's R and Spearman Rank were calculated to determine whether the proposed relationship may exist.

RESULTS

Two tables are presented to reveal the relevant results for this study. Table 1 shows the frequency of CPA responses relative to both financial stake and to support for expanding SOX to nonpublic entities. Of the 305 CPA respondents, 98 were not in public accounting (had no financial stake), 33 were staff members in a public accounting firm, 95 were managers and 79 were partners.

Of the 305 respondents, 218 indicated they did not support the expansion of SOX to nonpublic entities while 87 did support its expansion. Clearly, the majority of CPA respondents did not support the expansion of SOX to nonpublic entities

Table 2 reveals the correlation results from testing the hypothesis in this study. Pearson's R analysis resulted in a coefficient of -.130, significant at the .05 level. Applying Spearman Rank analysis resulted in a coefficient of -.133, also significant at the .05 level. Based on these results, the hypothesis may be accepted. That is, the financial stake of CPAs is significantly related to their support for expanding SOX to nonpublic entities. The direction of the relationship found, which, by the way was not included in the non-directional hypothesis developed for the study, was negative. Therefore, the results indicate that as CPAs move to a higher financial stake in the practice of public accounting, they tend to support an expansion of SOX to nonpublic entities less.

CONCLUSIONS AND SUGGESTED FUTURE RESEARCH

Allen and Ng (1997) discovered that financial stake of CPAs was an important variable relative to their support for the ethical regulatory changes made by the FTC's consent order to the AICPA. The current study found that financial stake is, again, an important variable relative to a CPA's support for expanding ethical regulatory change, in the form of SOX, to nonpublic entities. Specifically, the higher a CPA's financial stake in the practice of public accounting, the lesser her/his support for expanding SOX becomes. One possible explanation may be that CPAs with a higher financial stake in public practice are not that interested in expanding SOX to nonpublic entities because their plates are full servicing their publicly traded American behemoths. Additionally, it may be that the costs of SOX compliance by nonpublic entities would be prohibitive such that many of the entities might be unable to stay afloat financially. Regardless of the reason behind the relationship found herein, it remains that a relationship between the financial stake of CPAs in the practice of public accounting and their support of an ethical regulatory change is concerning.

While it may be reasonable outside of the domain of public accounting to expect that a person will be financially motivated toward many aspects of doing business, the CPA profession is different. The profession must serve the public over self. It has been said that the CPA auditor's client is not really the company being audited, albeit that company pays the auditor, but rather the users of the financials of that company. Of course, that auditor fee ultimately comes out of the equity holder's pocket. The point is that the CPA must look out for the markets which are putting up the capital to permit the companies to function. The integrity of financial information is of paramount import.

Future research should continue to look at the role financial stake plays relative to ethics-based decisions CPAs make. The profession must address any self-interest among its membership or the public interest can become seriously compromised. Our world today is already standing on shaky ground, financially speaking.

REFERENCES

Allen, P. W., & C. K. Ng (1997). Financial stake and support for banning trade names, commissions, referral fees and contingent fees. Accounting Horizons, 11, 1-6.

Allen, P. W. & C. K. Ng (2001). Self interest among CPAs may influence their moral reasoning. Journal of Business Ethics, 33, 29-35.

Allen, P. W. & K. L. Ennis (2007). Do CPAs with a higher financial stake in public accounting exhibit levels of moral reasoning? The Southern Business & Economic Journal, 30, 1-9.

Federal Trade Commission (FTC) (1990). In the matter of the AICPA. Decision and Order, Docket No. C-3297. Washington, D.C.: FTC.

Ponemon, L. (1992). Ethical reasoning and selection-socialization in accounting. Organizations and Society, April/May, 239-258.

Paul W. Allen, Mississippi State University, Meridian

Kevin L. Ennis, Mississippi State University, Meridian

Table 1: Frequency of CPA Responses

Financial Stake No to Expansion Yes to Expansion Totals

Not in Public Accounting 64 34 98
Staff 22 11 33
Manager 68 27 95
Partner 64 15 79
Totals 218 87 305

Table 2: Correlation Results of Testing Hypothesis

 Coefficient Value Significance

Pearson's R -.130 .023
Spearman Rank -.133 .021