Public Policy Analysis - Sarbanes-Oxley Act of 2002 - Research Paper Example

Sarbanes-Oxley Act of 2002 Introduction The purpose of this research is to comprehensively and critically examine the public policy measure titled the Sarbanes-Oxley Act of 2002. In order to attain the objectives of this report, the analysis which has been conducted in the paper encompasses several vital areas of considerations with regard to this United States federal law, these components include 1) providing a description of the federal law including its historical background and the present situation 2) examining the rationale for public policy 3) assessing the efficacy and effectiveness of the federal law in achieving its objectives and aims 4) inspecting the implementation of the law’s tenets in the scenario 5) conducting an evaluation of the federal law and 6) providing recommendations for improving the scope of the federal law and enhancing its effectiveness. 2. Description of the Federal Law The Sarbanes-Oxley Act of 2002 or SOX, which is also termed as the ‘Public Company Accounting Reform and Investor Protection Act’ as per the Senate and known as the ‘Corporate and Auditing and Accountability and Responsibility Act’ as per the House is a federal law which was sponsored by United States Senator Paul Sarbanes (D-MD) and United States Representative Michael G. Oxley (R-OH) (Zelizer, 2002). The historical context of the Act is associated with an increase in the incidence of high-profile accounting scandals that marred several corporations across the United States namely Enron, WorldCom and Tyco International amongst several others in the period preceding the inception of the federal law and its tenets (Act, S.O, 2002). The consequences which followed the scandals that targeted key organizations across the nation greatly affected investor’s confidence in securities markets of the country and led to the incurrence of significant loss on the investor’s part which amounted to billions of dollars (Act, S.O, 2002). According to Miller and Bredeson (2009), individuals’ financial trends are characterized by their monthly income and since most individuals within the United States are unable to save on an extensive scale because of minimal salaries or working on legal minimum wage, those who are still able to retain a certain percentage of their income on a monthly basis seek to secure their savings in a reliable source. In the given situation, investing in corporate stocks to benefit from high returns appears to be a viable option that is also secure in comparison with other alternatives (Miller and Bredeson, 2009). The attractiveness of investing in corporate stocks is a critical motivation for investors and this factor explains the extent of the loss that was incurred by individuals that were associated with organizations that were hit by high-profile accounting scandals. As per the regulations of that are outlined in SOX, the federal law aims to secure individuals and investors whose finances are tied up in the corporate stocks of organizations. Therefore, in order to ensure that any malpractice does not occur in financial ventures, the Sarbanes-Oxley Act of 2002, “…sets new or enhanced standards for all U.S public company boards, management, management and public accounting firms” (Act, S.O, 2002, p. 1). In essence, the Sarbanes-Oxley Act of 2002 comprises of eleven core tenets that express particular directives and conditions that must be followed for reporting of financial information, these titles include 1) the establishment of Public Company Accounting Oversight Board (PCAOB) 2) the formation of standard practices to grant independence to external auditor 3) requiring members of the senior management to acknowledge individual accountability with regard to the transparency of financial records 4) the implementation of several measures to improve financial disclosure 5) the adoption of strict codes of conduct and admission of any foreseeable conflicts of interest 6) the outlining of conditions and instances under which dealers, securities analysts, advisors and brokers can be expelled from continuing their practice, if found in violation of specific directives 7) setting a requirement for the Securities and Exchange Commission to conduct research into the realm of public accounting organizations and declare their outcomes 8) highlighting possible criminal action, penalties and probes that may be conducted against individuals who are found guilty of distorting financial records in any manner and declaring safeguarding the status of whistle-blowers 9) highlighting possible criminal action, penalties and probes that may be conducted against individuals who are found guilty of engaging in white-collar crime 10) enforcing a requirement as per which the Chief Operating Officer of the company is expected to sign the tax returns of the organization and 11) recognizing the tampering of financial records as a criminal offence thereby, deeming any individuals who are found guilty of the charges as liable to sentencing or facing possible penalties (Act, S.O, 2002). 3. Rationale for the Federal Law According to Bauer (2009), Enron’s ‘fall from grace’ emerged as one of the most crucial events in the nation’s history in terms of the gravity and scale of the corporate dishonor that was conducted by the company which ultimately filed for bankruptcy. Eventually, the Sarbanes-Oxley Act of 2002 surfaced as a key legislative reaction to the malpractice and financial deception of Enron and other public companies that operate within the United States. However, the preceding reason cannot be outlined as the sole motivation for the implementation of the legislation. As suggested by Romano (2005), many of the tenets that are presented in SOX do not intend to fulfill the objectives of eliminating the weaknesses and limitations that prevail in the corporate scenario where major corporations such as WorldCom and Enron proved to be unsuccessful. Romano (2005) asserts that the rationale for SOX can therefore, not be deemed as the integration of regulatory advancements within the wider framework of corporate governance, in fact, SOX eventually puts into practice the proposals and initiatives that have been championed by entrepreneurs of corporate governance for a significant period of time. Given the determinants of SOX which are rooted in the need to advance corporate governance procedures in U.S public companies that were essentially forwarded in corporate law reforms prior to their incorporation in realm of federal law, it can be suggested that the rationale for the directive was also based in the progress of political and cultural scenarios that existed in the nation from the period between 2000 and 2002. With regard to this observation, Kingdon and Thurber (1984) postulate that even though, political science research does not utilize a concrete theory to describe the phenomenon of how proposed policies experience a shift to the top priority of legislative programs, possible reasons for this trend can be identified as the transition in public mood and the turnover of designated public representatives in addition with a chain of focusing incidents. Applying the proposals of Kingdon and Thurber (1984) to examine the rationale for the implementation of SOX, Romano (2005) identifies that a change in public opinion of high-profile corporations which was marked by negative perception prompted the execution of the Act, also as this shift in public opinion corresponded with a rise in reports of corporate scandals and poor performance within the stock market, the rise in such focusing incidents is what it took to propel the need of SOX into the scope of prioritized legislative agenda. Therefore, the collapse of Enron and WorldCom as focusing incidents can be termed as contributing factors to combat an undesirable situation that had already escalated (Farrell, 2005). 4. Analysis of Policy’s Efficacy and Implementation The crux of the analysis that aims to explore the efficacy of Sarbanes-Oxley Act of 2002 lies in conducting a comparison of whether market responses and regulatory responses have the potential to counter the problem of corporate fraud by evaluating if one response can be labeled as more effective than the other. According to Ribstein (2002), the corporate scandals that emerged at Enron and other public companies could not be resolved successfully despite of the implementation of numerous forms of market devices and measures to limit the incidence of such issues that can gravely harm investors and trigger billions of dollars of financial loss for several individuals. Given this observation Ribstein (2002) comments that for analysts who advocate the execution of regulatory responses in such circumstances, the primary argument which favors the rejection of market responses to corporate scandals claims that securities markets cannot be relied upon to operate singlehandedly without the aid of regulatory frameworks to assist their functioning. Thus, this statement essentially stipulates that in order to regain the trust of investors, it is important to abide by the recommendations of regulatory frameworks to address legitimate concerns regarding the possibility of corporate fraud and the financial loss that is produced by it (Ribstein, 2002). Despite of the arguments which favor the implementation of regulatory responses over those which are generated by the market, Ribstein (2002) concludes that the case for regulation is rather weak. This notion is based upon the premise that SOX’s proposals experienced a significant breach by external forces or outsiders since their implementation that appeared to be willing to expose themselves to strict criminal liability and penalties under the Act (Ribstein, 2002). The implications of the preceding identification are that the placement of autonomous supervisors who are expected to be motivated to fulfill their duty of inspecting the actions of such individuals who have comprehensive knowledge of extremely private and confidential matters of the organization and that too with the provision of minimum incentivizing factors is improbable and cannot be deemed as an action that can resolve the current issue (Ribstein, 2002). Another factor that harms the efficacy of regulation for effectively tackling corporate fraud is associated with the costs of further legislations that have proven to be ineffective in deterring defrauders in the past. Moreover, markets hold the capacity to address the root causes of corporate fraud in a precise and effective manner, which regulation could ultimately fail to achieve, Ribstein (2002) therefore suggests that the merits of market response to corporate fraud are much greater in comparison with regulatory frameworks as the latter is not supported by cost-benefit analysis. While, this view contends that any regulation for enhancing corporate governance is bound to be less effective than market responses, it is important to establish the reservations of Ribstein (2002) and several other critics have been applicable in the case of SOX. The efficacy of SOX can be examined by critically evaluating the implications of the legislation’s titles and whether their implementation has been able to promote positive outcomes. According to the assessment of Cullinan (2004), the efficacy of SOX can be assessed by outlining the implications of the auditors’ role in the corporate scandals that hit various companies including Enron and WorldCom and linking these outcomes with the provisions of the Act. Cullinan (2004) postulates that the even though misstatement recognition is classified as a key role of the auditor, the auditor model comprises of five fundamentals of immense significance, thus, when auditor role is applied to corporate fraud the conclusion suggests that there are several areas of failure throughout the auditing process which should be handled effectively. Despite of such important considerations on the audit model, the actions which have been implemented under the Sarbanes-Oxley Act of 2002 to address concerns has only attended to two aspects of the audit process, which are that of misstatement recognition and the procedure of financial reporting for public companies (Cullinan, 2004). According to Cullinan (2004) such limitations of SOX only intend to enhance auditor independence but fail to take into account the various considerations that led to high-profile corporate frauds in the first place. Thus, what the Act merely does is that it recognizes warning signs of Enron collapse, while, failing to provide important solutions to the issue by not understanding fully the scope of the entire audit process (Cullinan, 2004). The ultimate deciding factor that can define the efficacy of SOX is linked with conducting a cost-benefit analysis of the Act’s implications and whether the policy holds more advantages than alternative options such as market responses. The succeeding section of the discussion focuses on evaluating the effectiveness of SOX by examining the legislation from the perspective of a cost-benefit analysis. 5. Evaluation of The Sarbanes-Oxley Act of 2002 Engel, Hayes and Wang (2007) argue that SOX holds the capability of benefiting investors, increase accountability and transparency in corporations and promoting corporate governance in public companies however, it is important identify the impact that the passing of this legislation has had on the state of firms and their decision-making procedures, specially the decisions which are based upon deregistering from the stock exchange and managing operations as private firms in the wake of the imposition of stricter financial reporting and auditing regulations. While, the theoretical or desired benefits of SOX are undeniable for they intend to eliminate the possibility of the occurrence of Enron-like corporate scandals that can gravely affect investor confidence, the practical implications pose critical concerns. As concluded by the research of Engel, Haye and Wang (2007), firms’ decision to deregister as a public company is dependent upon the presence of SOX-related benefits and SOX-related costs such that an excess of SOX-related costs over SOX-related benefits would motivate firms to opt for going private while, an opposite scenario would favor their decision to not do so. Data suggests that SOX is indeed a critical component in company’s decision to change to the status of a private firm and the number of firms who have opted for this selection has risen in the period succeeding the passing of the Act (Engel, Haye and Wang, 2007). Consequently, SOX has also been able to impact the financial management procedures and managerial decision making within organizations specifically through its tenet which requires the Chief Executive Officer and Chief Financial Officer of the company to attest the accuracy of financial records and statements (Lobo and Zhou, 2006). As per the title of the Act, the penalties which are to be levied for presenting overstated figures in financial records is more than the fine which have to be incurred for declaring understatements. Lobo and Zhou (2006) conclude that this factor has greatly impacted companies’ financial practices by enhancing the scale of accounting conservatism. According to the research of Lara, Osma and Penalva (2009), firms that demonstrate strong corporate governance are characterized by the presence of accounting conservatism, however, the relationship between these two factors is not such where good corporate governance can be identified as the cause of conservatism yet there is a positive correlation between these two variables that has also been prompted by the implementation of SOX. This aspect can be recognized as a positive consequence of the Act because it suggests that since its execution, companies have began to demonstrate caution in their handling of financial records by reporting objective and accurate data to remain secured from penalties and criminal liabilities under the Sarbanes-Oxley Act of 2002. 6. Recommendations Romano’s (2005) conclusion of SOX coincides with the assessment of Cullinan (2004) as the researcher postulates that the directives of the Act have been inadequately conceived because they fail to prove through objective sources that the implementation of the legislation can yield successful results nor do they offer a realistic basis for proposing the same. As stated by Romano (2005) this aspect leads to the development of “…a disconnect between means and ends” that essentially renders the efficacy of the legislation as inexistent. These concerns were also voiced by Cullinan (2005) in the course of his research as the author suggested that the mandate of the Act only addresses the symptoms of the problem rather than delving into the root of the problem to grasp and correct the issue. This notion is primarily shown by the tenet of auditor independence in SOX which only focuses on Andersen’s failure approach Enron’s management regarding the matter rather than assessing the significance of other factors of the auditing process (Cullinan, 2005). Thus, the recommendations for enhancing the scope of SOX are rooted in redefining the Act’s mandates to bridge the gap between reality and expectations. This aspect is related with revising directives, broadening the scope of monitoring of financial records from outsiders and establishing a research-based framework by incorporating evidence and using factual basis to establish the efficacy of SOX in comparison with alternatives such as market responses and devices. 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