Ethics and Law in Business and Society - Research Paper Example

Research assignment on a public policy: Sarbanes- Oxley Act 17th December Table of Contents Table of Contents 1 Introduction 3 History of Sarbanes- Oxley 4 Tracing Sarbanes- Oxley implementation 7 Sarbanes–Oxley Section 302 7 Sarbanes–Oxley Section 303 7 Sarbanes–Oxley Section 401 8 Sarbanes–Oxley Section 404 8 Sarbanes–Oxley 404 and smaller public firms 9 Sarbanes-Oxley Section 1107 10 Impacts of Sarbanes–Oxley on business and society 11 Compliance costs 11 Benefits to the investor and companies 11 Impact on exchange listing choice for foreign companies 12 Policy analysis 13 How it worked 13 Strengths and weaknesses 14 Recommendations for future policy makers 14 Conclusion 15 References 16 Introduction Sarbanes- Oxley Act of 2002 (SOX) which is also referred to as Public Company Accounting Reform and Investor Protection Act, refers to the US federal law that aims at enhancing performance and standards for all United States public companies boards, accounting firms and managements. The act, which was approved by the house in 2002 after 423votes were in favor and President George Bush signed it into law, aims at curbing the corporate and accounting standards that were experienced in US for example the Worldcom and Enron. After the implementation of SOX, similar regulations were enacted in countries such as Canada, France, Germany, Australia, Japan and India among others. This policy paper will identify the history of the Act; trace its implementation, its impact on business and society as well as its strengths and weaknesses. Additionally, the paper will provide some recommendations for future policy makers. The legislation which came to force in 2002, has 11 major elements. The key provisions that this paper will analyze their implementation include Sarbanes-Oxley Sections 302, 303, 401, 404, 802, 906 and 1106. History of Sarbanes- Oxley Sarbanes- Oxley was named after its sponsors Paul Sarbanes and Michael Oxley who were US Senators and Representative respectively. With the implementation of SOX, it became mandatory for top managements to personally certify the accuracy of the information that is provided by their organizations. Between 2000 and 2002, large corporate frauds occurred in various firms due to variety of complex factors. In addition to Worldcom, and Enron as noted earlier, other frauds included Adelphia, Tyco International, and Peregrine Systems. Apart from the conflict of interest that emanated from the frauds, they also resulted into problems during the incentive compensations practices. Through the analysis of the infamous frauds, the pioneers attained the ground for the introduction of the bill leading to the passage of SOX in 2002. According to Senator Paul Sarbanes, the market had problems that resulted to loss of hundreds and trillions of billions in dollars. Some of the notable issues that led to the mega frauds included lack of independence for the auditors, inadequate accountant’s oversight, conflict of interest on the part of stock analysts, weak corporate government procedures, ineffective disclosure procedures and providing low funds to the Securities and Exchange Commission. Before the introduction of SOX, auditing firms which are noted as watchdogs for the investors did not perform auditing or any consulting from their clients. In addition, the consulting agreement remained beneficial than the auditing engagements (De Kluyver and Cornelis 2009). As a result, conflict of interest emerged. For example, auditors believed that questioning their clients accounting approach and other form of financial practices would result into damaging their relationship with clients. Boardroom failure also resulted to frauds. In US, Audit Committees are responsible for establishing oversight mechanisms that are adopted during financial reporting. The scandals that emerged identified some board members who had no expertise to comprehend the complexities of the firms while others did not exercise their responsibilities. The conflict of interest for the securities analysts was also a major issue that triggered the scandals. Security analyst’s duties include buying and selling recommendations on firms bonds, assisting companies to form mergers and handle acquisitions and guiding investment bankers. Just like auditor conflict, there arose conflict of interest due to the provision of investment banking services and buying and selling recommendations on company bonds. Banking practices also played a notable role in the emergence of scandals. It is worth to note that lending to a company is an indication of the company’s level of risk For example, in Enron; major banks gave loan to the firm by ignoring or not understanding the company risks. As a result, the investors and banks customers were hurt by the bad loans leading to a large settlement payment by the banks. Another issue the led to the emergence of scandals prior to SOX was internet bubbles. The decline in the overall market and sharp declines in technology affected the investor in 2000. It was noted that some mutual fund managers were quietly selling certain technology stock while they supported their purchase (Weber, 1991). As a result, investors incurred high losses that created general anger among themselves. Despite its positive implication in terms of curbing the accounting frauds, SOX has been termed as a government failure by some congressmen such as Ron Paul and certain governors. According to the critics, SOX was costly for the government in its effort to intrude US corporate management. They also criticized the Act due to its role of driving businesses out of US. The views by the critics can be supported by a research done by Wharton Business School which indicated that the number of US companies pulling out of New York Stock Exchange tripled in 2003, just after SOX became a law. Korn Ferry International, the US largest executive search firm indicates that Fortune 500 companies incur an average of $5.1 million in 2004 in their efforts to comply with Sarbanes-Oxley law. Another criticism for SOX occurred in 2007-2010 financial year. This was due to the reduced number of Initial Public Offerings (IPO) on US stock exchange in 2008. National Venture Capital Association indicated that in 208, only six companies have gone public. This was contrary to the high number of IPOs that occurred prior to SOX. For example, in 1996, 272 companies went public, 269 in 1999 and 365 in 1986. Other critics indicate that US economy is not generating adequate employment opportunities due to lack of creation of enough employers. It has been noted that Hong Kong has been leading for the last three years in the new stock offering surpassing New York. However, Act has enjoyed the support of significant federal officers such as Alan Greenspan who indicates that SOX has made corporate managers and shareholders to allocate company resources to their optimum. Tracing Sarbanes- Oxley implementation Sarbanes–Oxley Section 302 During the implementation of Sarbanes–Oxley, there emerged two notable sections. These include 15 U.S.C. § 7241 (section 302) and al. 18 U.S.C. § 1350 (section 906) which represented the civil provision and criminal provision respectively. Section 302 of SOX, provides various internal procedures that are designed with an objective of producing accurate financial disclosure. It indicates that officers who are responsible for signing the statements must indicate that they are responsible for maintaining internal controls. Additionally, the section indicates that during the period when the financial statements are made, other officers in consolidated subsidiaries must be aware of the materials information that has been provided by the officers in the parent company. Prior to the final report and within duration of 90 days, section 302 also depict that the officers must evaluate the effectiveness of the internal controls and produce a report of their evaluation (Kuschnik, 2006). One of the major aspects that enforced the provision of the Act as indicated in Section 302 and Section 404 was the direction by Congress to SEC requiring it to interpret the sections in Final rule 33-8124. Another major aspect of Section 302 was that external auditors were supposed to issue an opinion as to whether all the material respects of the managements had effective internal controls on the matters of financial reporting. Additionally, auditors were mandated to issue an opinion on the matters relating to the accuracy of the financial statements. Sarbanes–Oxley Section 303 According to Section 303 of SOX, it is illegal for any officer to intentionally fraudulently influence or mislead any certified or public accountant who is engaged in undertaking his or her duties. On the matters of enforcement, Section 303 indicates that the commission will have powers to enforce this section as well as any rule issued under this section during a civil proceeding. Sarbanes–Oxley Section 401 This section which provides for disclosures in periodic reports was based on the bankruptcy of Enron that was significantly due to fraudulently use of off-balance sheet instruments. In addition, the instruments attracted the attention of the government due to the Lehman Brothers bankruptcy which Lehman used to indicate a favorable financial position to lure investors. With the introduction of Section 401, companies were now required to disclose all material off-balance sheet items. In addition, the Act required that SEC to ensure that stakeholders in the field of accounting and auditing better understand the usage of the instruments and whether they have been adequately addressed by the accounting principles (Porter and Kramer, 2011). However, according to critics, SEC did not put efforts to monitor and regulate the usage of the instruments leading to ineffective financial report. Sarbanes–Oxley Section 404 Sarbanes–Oxley Section 404 is one of the most controversial sections of SOX. This section mandates the external auditors as well as managers to report on the effectiveness and adequacy of internal control on financial reporting. Just like the critics of the Act indicated on its cost, Section 404 is a costly aspect of the Act for organization to implement. This is based on the fact that documenting and doing teats on financial manual as well as automated controls is a process that calls for enormous efforts. Under this section, the Act indicates that during each and every Exchange Act report provided, managers must ensure that it has an internal control report. In addition, the report must contain assessment of the internal controls of the past fiscal years of the companies. In order to address the costs associated with this section, managers have continued to be guided as a way of making them to comply with the legislation. Some of the guidance that has been approved by the Public Company Accounting Oversight Board (PCAOB) includes Auditing Standard No. 5 and Auditing standard No. 2. On its part, SEC established the interpretive guidance which aimed at providing guidance to the management. External auditors and management are required to undertake top down risk assessment (TDRA) as required by the SEC and PCAOB. This assessment, which is used to determine the needed evidence of the internal control testing, is used by auditors to issue opinions of the financial performance of the companies as well as the effectiveness of the internal controls. Auditing Standard No. 5 and Auditing standard No. 2 requires management to undertake various issues including assessing the effectiveness of internal controls, understanding the IT aspect of the companies, understanding the adequacy of the financial reporting, assessing fraud risk and evaluating controls put in place to detect fraud among others. Section 404 requires managers to automate their financial systems, an aspect that increases the compliance costs. For instance, in 2007 a research by Financial Executives International indicates that compliance costs for organizations that are decentralized in nature stood at $1.9 million while those of centralized firms were $1.3 million. Sarbanes–Oxley 404 and smaller public firms Just like the costs implication of big companies, Section 404 has significant impact on smaller companies. This is based on the fixed costs that are involved during the process of complying with the legislation. For instance, in 2004, US firms that generated revenue of $5 billion and above, spent approximately 0.06% of that revenue on SOX compliance while smaller companies with less than $100 billion spent 2.55%. The cost disparity that exists has now become a point of concern for SEC and PCAOB (Norris and Liptak, 2010). To deal with this challenge, SEC provided various extensions to smaller companies such as that of outside auditor assessment until the end of fiscal year 2010. Sarbanes–Oxley Section 802 This section indicates the criminal penalties that will emerge once an individual is caught influencing US investigators. The legislation indicates that anyone who intentionally mutilates or make untrue information in the accounting records, influence investigators, destroys document and covers up among other illegal actions, is liable for a fine or 20 years in prison or both. Sarbanes-Oxley Section 1107 This section of the SOX provides the penalties against the individuals who retaliate against the whistleblowers. It indicates that any person who internationally takes harmful action against whistleblowers or a person who informs law enforcement officers on any kind of federal offense shall be fined or be imprisoned for 10 years or both (Stephen et al, 2004). Sarbanes–Oxley Section 906 Sarbanes–Oxley Section 906 indicates the criminal penalties that the Chief Executive Officers and the Chief Financial Officers will face due to their failure certify financial reports. For example, the section indicates that periodic reports with financial statements must be accompanied by a statement from the CEO and CFO that indicates that they have certified the statements. In addition, the section indicates that the issuer must fairly indicate all material aspects that are supposed to be in the financial statements (Sandel and Michael, 2010). In order to deal with any case of non-compliance, this section indicates that any officer who does not certify the reports is liable for a fine of $1 million or be imprisoned for 10 years or both. In addition, the section indicates that officers who intentionally certify periodic reports that are not providing true information is liable for a fine of not more than $5 million, or be imprisoned for 20 years or both. Impacts of Sarbanes–Oxley on business and society Compliance costs Based on the difficulties in making a distinction between SOX and other variables that impact on corporate earnings and stock market, SOX produce results that are viewed differently. As noted earlier, the legislation resulted to high costs of compliance especially for smaller companies. According to a survey by Finance Executives International in 2007, 168 organizations incurred an average revenue of $4.7 billion while in 2006, companies compliance costs averaged at $6.8 billion. Foley and Lardner survey of 2007 indicates that US public companies have negatively been affected by SOX cots that emerge in the form of auditors fees, board compensation, legal costs, director and officers insurance and lost productivity among others. On their research in 2006, Butler and Ribstein indicate that SOX should be totally overhauled due to high costs. Their argument was that despite frauds or competition, investors can still diversify their stock investment while still managing the risks associated with their investments. However, on its part SEC study indicates that after the establishment of 2007 accounting guidance, compliance costs have continued to decline. Benefits to the investor and companies Despite the high compliance costs that critics have associated SOX with, different organizations and individual studies have established quite a number of benefits. For example, a research paper by Arping and Saunter in 2010 indicates that SOX has resulted to corporate transparency. Following the introduction of SOX, managers and auditors in cross-listed US companies have become more responsible making the investors to have higher trust on the public companies. Another benefit is that SOX has reduced the borrowing costs for companies that have maintained effective internal control that is regularly evaluated. This is due to the proper usage of available funds and certified assessment. According to Lord & Benoit report in 2006, the share prices of companies that had few weaknesses in their internal controls were much higher than that of the firms with no internal control mechanisms. As a result, more investors were attracted by companies that had higher market share resulting to increased capital and profits for the firms. Through the accountability and transparency that has emerged since the establishment of Sarbanes–Oxley, companies have now improved their internal controls thus making the financial statements to be more reliable. Additionally, investor fraternities as well as the general public are able to make proper investment decisions. Impact on exchange listing choice for foreign companies It has been argued by some individuals that SOX has displaced business from New York to London due to the lighter regulation of companies by the Financial Services Authority. To the companies that are non-US but cross-listed in the US market, SOX has different impact from companies from less developed countries. Once the foreign companies from poorly regulated countries adopt the US regulations, they experience higher credit rating. As a result, they value the benefits attained rather than complaining of high costs of compliance. On their part, non-US companies from strictly regulated and developed countries who follow transparency only incur costs. Companies whose credit rating is high have a higher chance of participating in stock exchange markets. Policy analysis How it worked Based on the need to make the US public companies to be competitive globally, Federal Reserve under the chairmanship of Alan Greenspan ensured that each and every company followed the provisions of Sarbanes–Oxley Act. The policy worked since it reinforced the principle of owing the US corporations by shareholders. Not only the Federal Reserve officers that have praised the Act, but also financial expert in the industry, have indicated that SOX has enhanced investor confidence, allowed for the provision of more accurate financial reports and preparation of reliable financial statements. Before the implementation of SOX, CEO and CFO were not taking the ownership of their financial reports. But with the introduction of SOX, they have been made to be responsible thus attaining higher level of transparency in financial dealings. SOX, through Section 201, has also prohibited auditors from having consulting agreements with their clients (Shakespeare, 2008). In this way, conflict of interest that was a major source of the accounting scandals has significantly been avoided. Studies done by SEC, Financial Executives International and IIA among other organizations indicate that SOX has resulted into accountability, independent audit, speedy reporting, improvement in board and improved controls in companies. Glass, Lewis & Company, a US based firm indicated that there has been an increase in financial restatements since the introduction of SOX. For example, in 2004, the number of financial restatements stood at approximate 650. This figure increased to 1,295 in 2005 (Paul et al, 2011). Another issue that Sarbanes-Oxley Act has covered is nurturing of ethical value. This is through forcing the managers to be transparent, protection of whistleblowers and making the employees to be responsible for their activities while undertaking their duties. Strengths and weaknesses One of the notable strengths of Sarbanes–Oxley as indicated earlier is that it resulted into production of reliable investment and business information. Notwithstanding the costs of the legislation, markets have been able to utilize the information derived from the companies. Additionally, it has led to improved internal processes and over time internal control testing has turned to be cost effective. SOX has also increased investor confidence while at the same time it has reduced the cases of frauds. For example, in 2005, Financial Executives Research Foundation found that 83% of big companies in US agreed that SOX has created a stronger investors confidence while 33% indicated that it has effectively addressed cases of fraud in companies (Carroll and Archie, 1991). The legislation has also established internal control provisions that have addressed the weaknesses that existed in the internal controls prior to the Act. Despite the strengths of Sarbanes–Oxley, it has been noted that it has resulted to high costs of doing business. For example, Apart from being mandated to obtain independent audit to evaluate their internal controls, public companies were needed to improve their IT in order to detect any deviation during their day to day activities. Such requirements have resulted to high costs for the companies. Another notable weakness as indicated by critics is that it has resulted to moving of smaller firm from US to UK due to lack of strictness in UK business operations. As a result, the number of job opportunities has gone down in US. As the result of the legislation, critics indicated that in 2007 to 2010 financial crisis, there was low Initial Public Offer in US stock exchange leading to limited investment opportunities. Recommendations for future policy makers With the increasing need to diversify their operations, companies should not overlook the provisions of Sarbanes–Oxley. In developing countries, where cases of frauds are still rampant, it is vital to employ the same regulation. However, an extensive research should be conducted to in order to ensure that the weaknesses that are associated with the Act do not hurt the economy of developing countries where investment is extensively needed. In US, it is vital to undertake some amendment especially that affects smaller companies forcing them to deregister or move to the UK market. As more countries face the challenge of high level of scandals just like the one that occurred in US, it is vital that countries collaborate as a way of ensuring that the resources that are hidden by the corrupt in other states are returned to the owners. Additionally, stiffer penalty should be provided for the company officials who hire auditors with an intention to fraud yet they know there is a conflict of interest. Conclusion Based on the above discussion, it is clear that US has taken strategic steps to curb frauds in the era where many countries in the world are wasting huge amount of funds to corrupt company officials. Through the optimistic view of improving the US economy, Paul Sarbanes and Michael Oxley came up with Sarbanes–Oxley. The legislation has effectively changed the way companies have maintained their internal control. Through various sections such as Sarbanes–Oxley Section 302, Sarbanes–Oxley Section 401and Sarbanes–Oxley 404 and smaller public firms among others, Sarbanes–Oxley has clearly indicated how managers and auditors should behave during the performance of their duties. As a result, Sarbanes–Oxley has generated various benefits for US companies. These includes improved speed of doing things, transparency, improved relationship between managers and shareholders, increased investor confidence and reduced cases of fraud by managers. However, Sarbanes–Oxley has also generated criticism due to various reasons. First, it is noted by critics to be costly due to the adjustment that it mandates in the internal control. It is also taken as a legislation that has reduced the number of investor in US with smaller companies moving to UK. Despite the criticism, Sarbanes–Oxley has effectively reduced frauds and scandals in US. It is a strategy that other countries in the world should adopt. References Carroll, Archie B. (1991). The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders. Business Horizons (July-August), pp. 39-48. De Kluyver, Cornelis A. (2009). A Primer on Corporate Governance. New York: Business Expert Press. Kuschnik, B. (2006). The Sarbanes Oxley Act: Big Brother is watching you or Adequate Measures of Corporate Governance Regulation? 5 Rutgers Business Law Journal [2008], 64–95; available at http://businesslaw.newark.rutgers.edu Norris, F and Liptak, A. (2010). Supreme Court Upholds Accounting Board. The New York Times. Paul, D et al. (2011). Financial Accounting, 6th Edition. London: Wiley. Porter, M and Kramer, M. 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