Ethics and Law in Business and Society - Research Paper Example

?Running Head: ETHICS AND LAW IN BUSINESS AND SOCIETY Topic: Ethics and Law in Business and Society Introduction: With the coming into effect of the Public Company Accounting Reform and Investor Protection Act, the so-called Sarbanes Oxley Act (SOX) in the year 2002, the US corporate world was meant to radically change. SOX has extensively been labeled as the broadest sweeping legislation to radically change corporations and the way public accounting is conducted since the 1933 and 1934 when securities acts started seeing the light of day (Roberts, & Mahoney, 2004). Precipitated by a slew of corporate scandals that included the Enron, WorldCom and Global Crossing scandals to name but a few of the corporate misdeed that informed its enactment, SOX has lived to expectation although at a price. However, there are those who say that the price is not commensurate to the benefits that the law appears to be bringing to the corporate world and especially when it comes to the high compliance costs. History and Implementation of SOX: Following several high profile accounting scandals in the 1990s and particularly the infamous Enron and WorldCom scandals, the ensuing intense soul-searching in the US corporate world concluded that effective safeguards needed to put in place if a repeat of the two scandals was to be completely obviated and if the investor confidence was to be restored. This is how the Public Company Accounting Reform Protection Act, the so-called Sarbanes-Oxley Act was conceived. Enacted in July of 2002, the Sarbanes Oxley Act was informed by need to put an end to corporate scandals and particularly to restore the public confidence in the capital markets (Roberts, & Mahoney, 2004). According to Section 404(a) of this Act, the management ought to not only assess but also report on the effectiveness of the business internal controls over financial reporting (Roberts, & Mahoney, 2004). This section also demands that independent auditors confirm the management assessment of the effectiveness of these internal controls. Sarbanes Oxley Act has three main primary authoritative bodies. The first of these bodies is the Securities Exchange Commission (SEC), which is mandated by this Act to police the trading (buying and selling) of securities (Heath, & Norman, 2004). There are a number of laws governing SEC, however and after the 1940’s Investment Adviser Act, SOX is arguably SEC’s most recent law that it is charged to oversee. Other than SEC, SOX has implementation power that it exercises through the US Department of Justice whose primary function is to prosecute the federal crimes that are associated with acts like; conspiring or even attempting to commit fraud, verifying false financial statements, destroying or tampering with documents, and retaliating against whistleblowers (Heath, & Norman, 2004). In corroboration with the office of the Attorney General, the FBI (Federal Bureau of Investigation) is charged with the responsibility of investigating crime related with corporate fraud while still retaining its mandate as the only detective agency that can investigate and apprehend those accused of committing corporate bad behavior (Heath, & Norman, 2004). SOX immense power can be looked from its Titles that include; acting as a Public Company Accounting Oversight Body; enforcing the independence of auditors; policing corporate responsibility; improving financial disclosures; analyzing conflict of interest; upholding the accountability of corporate and criminal fraud; and enhancing penalties on white collar crimes (Brannick, & Roche, 1887). According to Section 404 of the Sarbanes-Oxley Act, SEC was to adopt rules requiring the management of all companies with publicly traded securities (apart from registered investment companies) to annually report their assessment of the effectiveness of their internal controls as well as an auditor’s independent confirmation of the effectiveness of the said internal controls. Adopted on 27th March 2003, these rules laid out the elements that were expected of each annual report and any material weakness in the internal control that might have been discovered in course of that year, information that was to be disclosed by the management as part of that annual report (Brannick, & Roche, 1887). The initial recommendation on compliance called upon accelerated filers to start complying in their report for the year ending 15th June 2004 onwards. Foreign private issuers and non-accelerated filers on the other hand were required to comply in their report beginning with the year ending 15th April 2005 onwards. However, this was not to be because the commission subsequently postponed the compliance deadlines for foreign private issuers and non-accelerated filers several times citing inevitable reasons (Brannick, & Roche, 1887). In course of this period the practitioners revised their views to reflect the current realities on the best practices while the Smaller Public Companies’ Advisory Committee forwarded recommendation to the commission concerning the way to structure Section 404 of this law (Brannick, & Roche, 1887). At the time of adoption of these rules under section 404, the expressed objectives of this law was to improve the quality of financial reporting and restore investor confidence not only in the financial statements but also in the capital markets. Among the feature of this release from the commission was the declaration of the benefits that investors stood to enjoy following the disclosure of the scope of the responsibility that the management bore on the company’s internal control and financial statements (Gile, & Teubner, 2006). In the commission wisdom, this was an important feature of the financial reporting especially bearing in mind that weaknesses in internal control more often than not creates opportunities for deliberate earning management and unintended accounting assessment and reporting mistakes. In fact, the release proceeded to hail these rules proclaiming that with these rules “investors will be empowered to better assess the performance and stewardship of the management and also the reliability of its financial statements together with other unaudited financial information (Gile, & Teubner, 2006).” This, they reasoned was going to greatly improve the detection of any fraudulent financial reporting in good time and possibly deter financial fraud or even minimize their adverse effects. Concerns on the cost of compliance with the requirements of Section 404 surfaced latter on and persisted for an extended period causing the postponement of the compliance deadlines several times. By 2007 several companies had published information concerning the compliance costs of this law and particularly Section 404. The compliance cost from this information ranged from as low as $860,000 to as high as $5.4 million per company (Williams, 2006). In addressing this concern, the commission issued in July 2007 the Management Guideline which approved the new PCAOB’s AS5 audit standards that were to be applied by auditors of public companies (Weil, & Ross, 2004). In order to meet the demands of Section 404, these Management Guidelines proposed a top-down, risk-based strategy. The reasoning behind this proposal was that it made sense to reduce cost by first “permitting the management to focus first on the internal controls that would sufficiently address the risk posed by material misstatement of a company’s financial statement (Weil, & Ross, 2004).” The second reasoning was that permitting the management to align both the nature and the scope of its evaluation process with the areas of financial reporting posing the greatest danger to reliable and truthful financial reporting (Williams, 2006). By insisting that the management had to bring both its experience and judgment to bear in this process of Internal Control and Financial Reporting, this release encouraged more discretion and flexibility on the part of the management in complying with this section (Section 404). The release also noted that the management Guidance ought to assist the management in avoiding the costs emanating from excessive testing and documentation while still enabling small public companies to scale and design their evaluation procedures and methods to align with their size and circumstances. However, this release (2007) was quick to categorically reiterate that reliance on the commission’s Management Guidance was purely voluntary. All these reforms were informed by the need to increase the effectiveness and efficiency of the implementation of Section 404. Additionally, on July the same year (2007), effective for internal control’s audits for fiscal year ending on 15th November of that year onwards, the commission approved PCAOB’s AS5, which ushered in a new standard for an independent audit of Internal Control Financial Reporting (ICFR) as demanded under Section 404(b) (Williams, 2006). The anticipated benefit of this AS5 comprised of; permitting auditors to apply their judgment, scaling the scope of internal control testing to a level that matches the company’s size, eliminating unnecessary procedure for audit while permitting auditors to focus on matters that they consider to be of the greatest importance to the company’s internal control, and lastly, permitting auditors to apply a principle-based technique in deciding the extent to which they can agree with other people’s work as far as Internal Control and Financial Reporting (ICFR) is concerned (Weil, & Ross, 2004). SOX Impact on Business and Society: Just after the Enron and WorldCom scandals, the corporate environment was characterized by a lot of suspicion and mistrust. It is the revelation of improper financial reporting in connivance with outside auditors forced Congress to pass the Sarbanes-Oxley Act (SOX). SOX enactment was informed by the need to restore the lost investor confidence in the corporate America and especially its capital markets. It intended to among others, bring radically change the management while inculcating responsible financial reporting (Barias, et al, 2005). Being a recent reality in the corporate world, SOX just like majority of the forceful regulatory mandates in the past has been criticized right, left and center. There are those who criticize how it came into force, other castigate the implication of why and how it was enacted, however one thing remain true – that corporate fraud together with its public policy constituent of information asymmetry and market failure requires social institutions that should endeavor to cure this malady (Barias, et al, 2005). Every time market fails, the society looks up at the government due to its ability to make laws and allocate resources both on a national and global scale. No one can dispute that an Act of Congress is no doubt democracy at work to the best of its ability to respond to crises such as market failure. This therefore put SOX into equal standing with the likes of 1930s executive persuasion to have the society bailed out of economic depression of the time (Barias, et al, 2005). One of the things that SOX demand from CEO and CFO of public companies is that they sign-off the financial statement of their company as a sign of total faith and knowledge of whatever is contained in those statements (Barias, et al, 2005). This puts to an end the passing of buck like was witnessed in both Enron and WorldCom scandals. This coupled with the threats of a 20 years jail term, penalties running into $5million in fines or both was enough to greatly reduce the temptation of engaging incorporate bad behaviors on the part of CEO and CFO or any other person occupying an executive position in a corporate body (Barias, et al, 2005). This is a requirement that has been reported to have tremendously deterred any corporate bad behavior that CEO and CFO might be tempted to do for their private interest. By establishing a body to enforce a standard accounting procedure in all companies, SOX has enhanced transparency in the financial reporting. This transparency has been further reinforced by the requirement that all companies retain independent audit committees whose mandate is to oversee the company’s relationship with their auditors (Keep, 2003). Another avenue of corporate fraud that was closed by SOX was the personal loans to executive officers and directors of a company, not to mention the stiff penalties that it recommends to any contravention of securities laws (Keep, 2003). So far, SOX has recorded some positive effects. Just a few years ago, only a mere one percent of analysts could advise investors sell (Kane, 1994). Today, that number as grown many times over, if Turner’s, an accounting professor at the prestigious Colorado State University, report is anything to go by. The number of shareholders wining what can only be referred as “proxy wars” has increased tremendously. It has also been reported that annual general meetings are witnessing more motions that are aimed at limiting excessive compensations on CEO and CFO than any other time (Kane, 1994). SOX can also be credited with the restructuring in the accounting industry that has been going on for some time now. A case in point is the PricewaterhouseCoopers restructuring that has seen it separate it’s auditing function from its consulting function (Kane, 1994). Policy Analysis: Signed into law by President Bush in 2002 in an effort to restore public confidence in the US capital markets, the Sarbanes Oxley has come under serious scrutiny and especially its effectiveness in inculcating transparency and ethical practices in the conduct of business. The American public has likewise been very keen in auditing the effectiveness of this piece of legislation. The American public has expressed disquiet on the accuracy of the financial statements and even the integrity of those auditing them in complying with this law (Hoffman, 2004). For instance, in a Gallup poll of at least a thousand participants, 75% of those polled indicated that a financial audit conducted in compliance of the Sarbanes Oxley hides negative information on a corporation (Hoffman, 2004). Profit maximization, which is one of the most criticize element of commerce is not always evil as many would like to point out. If anything, profitability is an important measure of a business entity’s sustainability and growth potential (Creress, 1998). Noteworthy also, is the fact that growth enhances overall demand, while still bringing wealth opportunities that are needed in the development of communities. However, the criticism that this attribute of commerce (profit maximization) receive have merit in majority of the instances. For instance, at the heart of the Enron, WorldCom and a number of other infamous scandals, was the uncontrolled desire to maximize profits while hiding underperformance (Creress, 1998). Profit maximization is also the major factors that informed the enactment of Sarbanes Oxley Act. Many will agree that market failure was at the heart of not only Enron but similar scandals that have come to share headlines with Enron and WorldCom scandals. Market failure in this case refers to the pursuit of selfish private interest at the expenses of the public good (Creress, 1998). Majority of scholar have connected market failure to the theory of externalities that permeate the relationship between consumers and providers. In our case, we are mostly interested in information deficits, which is one of the externalities. Normally, information deficits create a situation where competition between and among business entities is not fair (Bozeman, 2002). In corporate fraud, information deficit basically refer to cheating, stealing, and lying. According to Weimer & Vining (1991), information deficits or information asymmetry is one of the major deficiencies in the market that Sarbanes-Oxley attempted to address. The domain of information asymmetry and market failure is the foundation for understanding Sarbanes Oxley in almost all aspects of the investment world. Sarbanes Oxley Act (SOX) has been accused ostensibly for being unfair, an assault on profitability and too costly an adventure. In fact, since its enactment the debate on this law has oscillated around its cost rather than its benefits. Since its passing there has been uproar from the US corporate world to the effect that the cost of complying with this piece of legislation, and especially Section 404(a) and 404(b), is disproportional to the mischief that its tries to heal (Bozeman, 2002. While the resource borne in complying with Section 404(a) are basically associated with increased internal labor and external vendor expenses, those borne through the compliance of section 404(b) are primarily through increased cost of contracting an independent-auditor that the section requires (Bozeman, 2002). Nobody is denying the fact that the relationship of a firm’s costs to its profitability is important to its financial health, however it is not proper to dismiss SOX on account of its compliance cost, especially considering the bill’s co-author, Michael Oxley’s, assertion to the effect that the first year compliance costs barely exceed one percent of a firm’s total revenue (Burn, 2004, pp. 2). Critic of the bill have rubbished Oxley’s assertion claiming that his arguments are highlighted on the “less than,” without considering that any marginal cost has a diminishing benefit over time. In this regard, his detractors have pointed out at Wal-Mart in exposing the significant impact that SOX has on the firm’s bottom line. According to them, Wal-Mart stood to lose over $250,000, which constituted one percent of its total revenue during the year when this law became operational. However, considered in the context of its size and corporate social responsibility, there is no doubt that Wal-Mart would enjoy an opportunity presented by this law to spend a mere one percent of its annual revenue on the redistribution of wealth. Just like all other regulatory mandates, - laws implemented to reduce or eliminate pollution as is the case with Clean Air and Water Act, these laws are at best a cost to the business firm fashioned as permit or taxes. SOX, with it clear mandate to inculcate corporate ethical behavior, is a tax-free-cost, that just like pollution control, is planned to assist the greater good by enhancing investor confidence via stronger transparency benchmarks together with severe sanctions for executive fraudulent actions (Borrus, 2002). In fact, it is incumbent upon corporations to innovate their processes and systems in a way that enables them to stay competitive, something that is not confined to SOX but all other regulations. The intrinsic value being that the business firm together with its stakeholders inculcates ethics and also corporate social responsibility to the firm’s culture and the overarching strategy (Borrus, 2002). If anything, just like pollution control, ethics control is a new reality in this and subsequent generations. Of course, SOX is just as rule just like many others that are scattered in our rule book. It is impossible for legislators and their rules to mandate integrity. Just as they have been unable to stop crooks from peddling dope or even robbing bank, they cannot as well stop fraudster from ripping off investors in the capital markets. But they can set up repercussions while requiring for the doubling-up of effort just as they are doing in the enactment of this (SOX) law. Bibliography: Barias, S, Bollinger, M., & Williams, K. (2005). Does SOX 404 Compliance? Strategic Finance, Vol. 87 Issue No.5 Borrus, A., (2002). Learning to Love Sarbanes-Oxley, Business Week. 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