Checking Corporate Fraud With The Sarbanes-Oxley Corporate Reform Act 2002 - Case Study Example

This paper is a discussion on the Sarbanes-Oxley Corporate Reform Act of 2002 with a special emphasis on the financial structure of the American organization. The Act is described with reference to the changes it has instituted in the corporate culture. The international impact of the new legislation is further touched on. Checking Corporate Fraud With The Sarbanes-Oxley Corporate Reform Act 2002 The Sarbanes-Oxley Corporate Reform legislation was passed by the Congress in the year 2002 before the midterm elections, the principal goal of the Act being to rebuild investor confidence and to protect capital markets at a time when huge corporate governance debacles plagued America. The front page headlines around the nation at that time were reading that firms such as Worldcom, Enron, Global Crossing and Arthur Anderson had failed to meet the American expectations of straightforward transparency in financial affairs (Whalen 2003; Spiro 1996). The Sarbanes-Oxley Act specifically empowered the Securities Exchange Commission, IRS, and the Public Company Accounting Oversight Board to handle the problem. It is a different matter altogether that these authorities were placed by the Act in a position to not only oversee financial management practices in the American companies, but also to overstep their boundaries to the point where they were almost running the organizations around the nation. Yet, this was a typical move on the part of the Bush administration seeing as the Patriot Act, too, is known as a very intrusive measure to combat ‘evil.’ In the case of the Sarbanes-Oxley Corporate Reform Act of 2002, the regulations punish both the corrupt and the honest executives and accountants. The latter are punished as their roles in the firm have now been transformed and they have had to deal with the discomfort of organizational change. Everyone in the organization is responsible for detecting fraud at present, and the cost to organizations for compliance with the Act are quite high (Longnecker 2004). To counter fraudulent accounting practices and executives’ self-dealing transactions the dramatic likes of which were discovered in the cases of Enron and Worldcom, the Sarbanes-Oxley Act was an important or perhaps necessary step taken by the government. The substantive corporate governance provisions in the Act were recycled ideas that had been advocated for a long time by corporate governance entrepreneurs. In fact, all successful national law reforms usually involve a recombination of older elements that had been advanced in policy circles for some time. The Sarbanes-Oxley Corporate Reform Act, in particular, was intended to increase the reliability and accurateness of corporate reporting, accounting, and auditing practices. The law holds chief executive officers and chief financial officers directly accountable for mismanagement in financial matters. The validity of an organization’s financial statements is the responsibility of these chiefs. In effect, the Act makes them legally accountable for their firm’s financial practices. This means that there are no grounds any longer for excuse-making or claiming ignorance when disaster strikes, as in the circumstances of Enron and Worldcom that entered bankruptcy proceedings (Romano 2005; Longnecker). The new corporate governance regulations were meant to be of immense benefit, even a blessing, to organizations that are determined about fair dealing to begin with. The Sarbanes-Oxley Act of 2002 further introduced regulations for accounting firms that perform audits on the financial statements of publicly held companies. These regulations were established in the form of the Public Company Accounting Oversight Board with a mission to tighten accounting standards and reinstate confidence in the accounting profession (Whalen). One of the most significant regulations through the new Board was the prohibition of accounting firms’ provision of consulting services to auditing clients (Romano). The effect of this law was observed as far as in the United Kingdom when Ernst & Young, one of the key accounting firms in the monarchy, decided that it would no longer work on internal financial controls for clients for whom it already acted as an external auditor. Alan McGuinness, the head of internal audit services at Ernst & Young, stated: “As a result of the Enron situation, boards and non-executive directors are putting a lot of scrutiny on what their internal and external auditors are doing.” The alteration of accounting policy at Ernst & Young led to other accounting firms in the UK to begin reviewing their practices as well as policies (Armitage 2002). In the United States, organizations had to deal with ever-mounting costs and the need to make internal changes as they labored to comply with the new Corporate Reform Act of 2002. The law required every publicly traded company to supply documentation for each transaction so that external auditors could track any dubious numbers. The amount of documentation needed for most companies was both extensive and expensive. The CEO of W. W. Grainger Inc. in Mettawa said that his company had spent millions of dollars on compliance. A consulting firm by the name of Korn/Ferry International Inc. found that the average organization spent more than five million dollars on compliance in the year 2004, with a total cost of more than five billion to U.S. firms for the year! The CEO of W. W. Grainger added that certain public companies were contemplating pursuing private financing instead of seeking funding on the public markets “to avoid all the costs and hassles of compliance.” Moreover, he had noticed reluctance in public companies to take risks especially at the end of the year when officials had to devote time and resources to ensuring that their numbers were correct. “I worry about that in a competitive world,” he remarked (“Companies Find” 2005). Whalen writes on compliance with the Sarbanes-Oxley Corporate Reform Act: More than a year since Congress passed the legislation known as Sarbanes-Oxley, inhabitants of Wall Street and Main Street are still trying to figure out how to comply with the law. As Washington’s latest foray into market intervention, the law attempts to make lawyers, directors, and accountants police corporate behavior. The legislation mandates specific rules for officials of public companies and the professionals who work for them, and sets tough criminal penalties for violations. But like all attempts to regulate market behavior, Sarbanes-Oxley is very long on promises but short on practical implementation. Later in this discussion we shall be better able to grasp how the Act is short on practical implementation. The Sarbanes-Oxley Corporate Reform Act covers many areas of the business environment, yet it is most significant for our current discussion to focus on how the Act has managed to revolutionize the American corporate culture. The Sarbanes-Oxley Act of 2002 called for new practices and technology to track internal activities. Organizational change was set into motion as companies were forced to retrain employees from the factory floor right up to the boardroom. The upper management of every firm knew that it bore the responsibility for any infractions, major or minor. Thus, the assistant corporate comptroller for Baxter International Inc. in Deerfield stated: “Everybody’s name is on the line” (“Companies Find”). Employees had to be watched and extra precautions had to be taken to prevent the sickness of fraud at all levels of the organizational hierarchy. All the same, the American organization understands that the Sarbanes-Oxley Corporate Reform Act was launched in good faith, and its stipulations – once adjusted to – entail raised degrees of competitiveness and productivity in the long run. The legislation for good practices that was essentially meant to stop corporate abuses at large scale business ventures such as Worldcom and Enron did hurt the small entrepreneurial public companies a lot. New entrants were particularly displeased with the mounds of complicated and pricey red tape. Jack Wynn, president of the National Small Public Company Leadership Council, stated that small businesses have been financially hammered by the introduction of Sarbanes-Oxley Corporate Reform. Besides, these businesses create approximately seventy three percent of new jobs in the economy, and new employment in the United States had definitely lessened following the institution of Sarbanes-Oxley Act. “You’re not going to have job growth without small businesses,” spoke Wynn. “If small businesses are overburdened by regulation, it’s no surprise they’re not creating jobs” (Berlau 2004). Also after the passage of the Sarbanes-Oxley Corporate Reform Act, the American economy experienced a stock market boom. The new law had at least succeeded on an immediate basis in restoring investor confidence. Given that the nation had lost a massive amount of $7 trillion in market capitalization prior to the stock market boom, the confidence of the supporters of the Act was further renewed. Economic recovery swiftly following the establishment of the Sarbanes-Oxley Corporate Reform was a favorable sign, proving in part that the new regulations will lead to greater gains in the days to come (Berlau). Scott Green (2005) wrote: “Poorly designed corporate legislation can retard innovation and warp economic growth while good policy can create confidence in the capitalist system, encourage prudent risk-taking, and foster growth.” According to Green’s description of good and bad regulations, the Sarbanes-Oxley Act has already indicated its competence to assist the U.S. economy. “However,” adds Green, “whether the Act actually will protect financial markets by efficiently providing long-term deterrents to fraud at public companies is a valid topic of debate.” The author attributes his doubts to the fact that legislations concerning the business environment in the past have not always yielded desired results in the long-run despite Federal oversight. Market pressures get the government to initiate structural changes, and this has happened since the stock market crash of 1929. Nonetheless, legislations cannot be expected to be of benefit at all times. The Sarbanes-Oxley Corporate Reform Act has already disappointed the nation by not being able to prevent the certification of HealthSouth Corporation’s fraudulent financial statements. Green describes this worthy of note situation as we speak of Sarbanes-Oxley as a fraud check: ….One of the first major cases utilizing the deterrents built into the Sarbanes-Oxley Act is the much-anticipated prosecution of Richard Scrushy, the former chairman and CEO of HealthSouth Corporation, among the nation’s largest health care providers. In the original 85-count indictment brought by the Department of Justice is the prosecution’s allegation that Scrushy personally certified financial statements filed with the SEC that he knew to be false. This count, made available by the Sarbanes- Oxley Act, together with the other counts, means that, if convicted of all of the current charges, Scrushy could have been sentenced to up to 650 years in jail, been required to pay $36,000,000 in fines, and have had to forfeit over $275,000,000 of real estate, airplanes, yachts, and other property. Interestingly, false certification under the Sarbanes-Oxley Act only counts for about 20 of the 650 possible years of jail time. As this case goes to trial, prosecutors have refined their charges by focusing on 45 of the strongest counts, including false certification of financial statements under Sarbanes- Oxley. So what did Scrushy do to run so afoul of the government? Prosecutors contend that he devised a scheme to ensure that HealthSouth would make sufficient net income to meet the expectations of Wall Street analysts without regard to true operating performance. Their indictment charges that management created $2,700,000,000 of fictitious income between 1996 and 2003 specifically to “fill the gap” between reality and Wall Street targets. As a part of the fraud, the prosecutors allege that Scrushy obtained large compensation packages for those helping him manipulate the financial statements. Additionally, he personally accumulated in excess of $250,000,000 over the fraud period. The situation at HealthSouth began to unravel in August of 2002 when accounting staff advised management that they no longer would make false entries. According to the indictment, a senior officer also refused to sign a financial report until Scrushy agreed to a plan to correct accounting problems and promote the senior officer to CFO of a HealthSouth spinoff. Finally, on or about November 13, 2002, Scrushy and other co-conspirators certified and filed a doctored quarterly financial statement with the SEC. This is the event that allowed prosecutors to indict Scrushy under provisions of the Sarbanes-Oxley Act. The ability of HealthSouth to “make its numbers” and the resulting impression of profitability drove the company’s stock price up to $30 a share; the ensuing disclosure of fraud saw it collapse to pennies. The stock has since recovered to about six dollars a share. This is of little solace to those who bought at $30. The Federal overseers are not proficient at detecting fraud continually. In spite of that, the Sarbanes-Oxley Corporate Reform Act is a deterrent in itself when it comes to organizations that would like to indulge in corruption without paying its legal costs. The Securities Exchange Commission and the Department of Justice are rigorously pursuing wayward managers since 2001. And, the Sarbanes-Oxley Act has most certainly raised the stakes for board members, executives, and employees. Following the passage of the Act, companies had to get their financial houses in order. Restatement of financial statements was at a record high, as organizations corrected past accounting and disclosure errors and adjusted to refined accounting guidance. Furthermore, financial analysts reported improvements in the quality of earnings and financial disclosures (Green). The Sarbanes-Oxley Corporate Reform Act additionally witnessed as an almost instant outcome of itself an increase in independence on public boards of directors. The American Society of Corporate Secretaries reported that sixty two percent of the corporate boards of its membership presently have an independent chairperson, lead director, or presiding outside director. The figure rose up from twenty six percent prior to the introduction of Sarbanes-Oxley. Today, the corporate directors are more active, and “independent audit committees have been strengthened with real oversight authority, including the ability to retain their own independent counsel.” What is more, the PricewaterhouseCoopers has said that seventy two percent of the U.S. multinational companies have recently established a whistleblower complaint process because it makes the identification of managerial fraud more likely (Green). Another important advantage of the Sarbanes-Oxley Corporate Reform Act is described by Green thus: Most of the early initiatives of Sarbanes-Oxley produced significant structural benefits to shareholders at reasonable costs, which is the hallmark of excellent legislation. The most expensive and far-reaching component appears to be Section 404 requiring public companies to certify their system of internal control over financial reporting. It is not enough that the CEO and CFO must certify their financials; they also must document, test, and certify their system of internal control for processes that produce the company’s financial statements. Yet, even a robust control structure will wilt in the presence of widespread executive collusion. There simply are too many vulnerable positions to protect economically when the organization is rotten at the top. Nevertheless, it would seem that Congress did not want to take any chances, so it took a belts and suspenders approach to financial reporting. There are many areas of the economy, both inside and outside America, impacted by the Sarbanes-Oxley Act. Changing organizational structure and instilling fear in the would-be corrupt officials in the business environment is an enormous accomplishment in itself. We have also gathered evidence that the new Act can sometimes fail to prevent corporate fraud. Nevertheless, its presence is a sigh of relief for the law-abiding American corporation. References 1. Armitage, Jim. “Ernst & Young to Ditch Dual-Audit Role in UK.” The Evening Standard (London, England), 22 February 2002. 2. Berlau, John. “Sarbanes-Oxley Is Business Disaster: Passage of the Sarbanes-Oxley Corporate Reform Act Was Supposed to Stop Corporate Abuses, but Instead It Has Strangled Small Business and Slowed Job Growth.” Insight on the News, 2 February 2004, pp. 24. 3. “Companies Find New Audit Rules To Be Daunting.” Daily Herald, 20 January 2005, pp. 3. 4. Green, Scott. “The Limitations Of The Sarbanes-Oxley Act.” USA Today, Vol. 133, Issue 2718, March 2005, pp. 66+ 5. Longnecker, Brent M. “The Sarbanes-Oxley Act: Altering The Fabric Of American Business.” USA Today, Vol. 132, Issue 2708, May 2004, pp. 28+. 6. Romano, Roberta. “The Sarbanes-Oxley Act And The Making Of Quack Corporate Goernance.” Yale Law Journal, Vol. 114, Issue 7, 2005, pp. 1521+. 7. Spiro, Herbert T. Finance for the Nonfinancial Manager. 4th ed. New York: John Wiley & Sons Inc, 1996. 8. Whalen, Christopher. “Revisiting Sarbanes-Oxley: Was The Well-Intentioned Landmark Legislation Slapped Together Too Quickly?” The International Economy, Vol. 17, Issue 4, 2003, pp. 40+. Read More