Sarbanes-Oxley Act of 2002 - Case Study Example

Sarbanes-Oxley Act of 2002 and number submitted Sarbanes-Oxley Act of 2002 Introduction: Sarbanes Oxley Act was signed into law by President George W Bush, which is a revised version of federal securities law for public companies. The law aims to restore and establish investor’s confidence over the information received and disclosures made by the public companies. The Act further put strict regulatory measures for the auditors, regulators, accountants, attorneys and directors and increases the standards of accountability. Key Components and Primary Objectives of the Act: The basic matters identified and revised in the act included the creation of regulatory board to oversee the activities of the public accounting audit firms, revised standards for auditor’s independence and audit committee, requirement of certification of the SEC’s reports by the executives of the public companies, restricts the rules to prevent insider dealings by the directors and executives, increase in the liability for the non-compliance to the federal securities laws and imposes additional responsibility of the attorney to report non compliance and conflict of interests. (Lipman & Lipman. 2006) 1. Establishment of Public Company Oversight Board: Sarbanes Oxley Act established the Public Company Accounting Oversight Board to oversee the audits of the public listed companies. It was established to regulate the activities of the auditing firms including the issues of quality control, ethics and independence of auditors. The aim for its establishment was to increase the confidence of investors and general public. 2. Auditor’s Independence: It focused on strengthening the auditor’s independence by prohibiting the provision of non-audit services (book keeping, internal audit, management, HR functions etc.) to the public companies by the external auditors, mandating the rotation of audit partners on a five year basis and rotation of registered public accounting firms and ensuring no ethical issue arises between the external auditors and the company such as conflict of interest. 3. Enhanced Corporate Governance Requirements: The corporate governance requirements were enhanced in many areas which included the role of audit committee which nave been responsible for the appointment, compensation and oversight of the work of external auditors, who are required to directly report to the audit committee. Further the audit committee should be made up of independent non- executive directors. Sarbanes Oxley Act further prohibits the maintenance of any credit or loan or extension of the same to directors or executives of the public companies. The Act even requires the executives such as CEO and the CFO of every public company to certify in each annual and quarterly report to the SEC that the reports have been reviewed and make the representation of the effectiveness of controls specified. 4. Enhanced Disclosure Requirements: Sarbanes Oxley Act enhances the disclosure requirements for the public companies which included increased reporting on the effectiveness of internal controls and financial reporting procedures, disclosures on codes of ethics and explanations in case of non-compliance and disclosures about the transactions by the directors, management and other stakeholders that can cause security concerns. 5. Commission Resources and Enhanced Authority: In order for the SEC to work effectively, provision of additional funding was ensured. Apart from that more power and authority was given to SEC and federal courts to be exercised on companies and individuals where prohibitions are required. It requires the federal regulatory bodies to conduct researches and make reports about the credit rating agencies, roles of investment banks and financial advisors, consolidation of accounting firms and some other matters etc. 6. Enhanced Accountability: The Act strict the rules and regulations and imposes stricter and larger penalties regarding the breach of law, exercising improper influence on the conduct of audit, temporary freezing of payments to employees and directors and other criminal offences such as altering documents and defrauding shareholders and other law enforcing authorities. It even provided protection to the employees of the companies who revealed fraudulent activities and are involved in whistle blowing. 7. Enhanced White Collar Crime Penalty: It emphasized that the person who attempted to commit white collar crime and mail fraud statues will be held responsible under the law as the person who had committed the crime and the same penalty will be applied. Penalties for mail and wire frauds and ERISA violations increase the prison sentences from 5 to 20 years. Additional penalties are also imposed on CEOs or CFOs for certifying false and misleading reports to SEC. (Hartman. 2002; Lipman & Lipman. 2006) Criticism on Sarbanes Oxley Act 2002: The criticism that mainly surrounded the Sarbanes Oxley Act of 2002 is the compliance cost. Many argued that the cost of implementing the Act weighs much more than the benefits provided by the Act. The costs and benefits associated can be difficult to measure in a single business; therefore much of the research in this aspect has been conducted on the securities market. Increased cost of compliance has affected the companies listed in the US Stock Exchange and also to the companies that are not listed. Firms that are listed on the US Stock Exchange may wish to delist their shares and become a private ltd. Company where SEC’s regulations are not applied or may wish to list on some foreign stock exchange where SEC’s rules are not applicable. The private limited companies may wish to keep their status the same and avoid SEC regulations by seeking funds from private equity providers and not by public securities or can register themselves on the stock exchange of some foreign country. Significant numbers of companies in US may do or did these things to avoid the compliance costs associated with the implementation of the Act. If this happens it would b expected that there would be a decrease in the listed companies on the US Stock Exchange in absolute terms or in relative terms with other foreign exchanges, an increasing trend could be seen in listed companies looking for delisting from the US Stock Exchange which can be negative in many aspects and as the initial public offerings would shrink or will move off shore it would ultimately decrease the number of new listings in the US Stock Exchange too. On the basis of recent researches and studies critics have argued that the US markets have become much less competitive and the reasons mainly identified is the high compliance costs to the regulations that most of the companies can’t afford to incur. (Fletcher & Plette. 2008) Economic Consequences for Companies That Implemented the Act: The adoption of Sarbanes Oxley Act of 2002 has proved to be costly due to significant reforms introduced for better regulation and compliance. Regarding the economic consequences of the Act the researches have concluded that the economic returns surrounding all the legislative events leading to the passage of the Act is overall negative, the loss amounted to $1.4 trillion in total market value. Many researches had been undertaken to highlight the effect it had brought, according to Financial Executive International (FEI) survey the direct costs associated with the compliance of the Act in a year averages around about $ 4.36 million, 27,000 hours internal working hours, 8,000 external working hours, an increase of 57% in the audit fees, with around 94% people believing that the costs exceeds the benefits obtained from the implementation of the Act. Further the Act imposes greater and stricter penalties on the executive directors which make them take less risk and adopt play safe business strategies which lower down company’s performance and value. (Zhang. 2005; Hoff, Larose & Scaturro. 2002) The accumulated direct and indirect costs of implementing the Act has concluded to be too costly to achieve zero fraud- which can only be achieved by extremely strict measures which eliminates the flexibility of the business which is one of the most important factor to operate fro many companies. With the passage of Sarbanes Oxley Act, the rising concern is the federal regulation and legislation of corporate America has become more rigid and inflexible which is likely to affect and reduce the flexibility of the corporate governance system in America, resulting in changes in business environment and the American economy. A survey conducted by Pricewaterhouse Coopers revealed that 59% of the executives see the over regulation as a hurdle in between the growth of their business. On the other hand the prohibition on non-audit services and the internal control reforms mentioned in Section 404 are all proved to be costly by the analysts. Another point highlighted in the researches about the economic consequences of the Act that public companies with weak corporate governance were not benefiting by the Act that was characterized as an improvement in corporate governance and increasing shareholder’s wealth. (Zhang. 2005) Effectiveness of Sarbanes Oxley Act 2002: Many studies and researches have been conducted about the effectiveness of Sarbanes Oxley Act and to the extent it has been successful and has achieved his goals in the corporate world. There have been mixed opinions regarding its effectiveness and achievement of its goals where some have agreed to the greater transparency, investor’s confidence and better governance the Act has brought, while the others oppose its implementation due to its lacking in cost efficiency. (De & Argosy University. 2006) The most evident area where the Act has not been successful is in the prevention and detection of fraud which is still incurring in the financial statements and the executives and management are continuing to defraud the shareholders. For e.g. in 2003 SEC filed a suit against HealthSouth Corporation including its CEO and chairman who have been alleged in the perpetration of an accounting fraud of $1.4 billion. Another case was seen in 2005 of the ACFE fraud which brought the effectiveness of the Act and its ability to prevent fraudulent activities into question. Another primary objective to be catered by the Act was the restoration of investor’s confidence which according to certain studies have not occurred. Investors seem to be nonplussed by the required disclosures about the internal controls, apparently dismissing the Act themselves. In a research 56% of the companies agreed that their stock prices increases at the end of the day in which any such disclosure is given. However, in opposition few have agreed that the Act accomplished its goal; reassuring that the stock market investors is safe again. (De & Argosy University. 2006) As discussed above many public companies have considered going private or going dark which requires deregistration from SEC. In 2003, 79 companies chose to go private while 127 went dark and many more are to be followed. The reason for incurring such a change in the ownership and capital structure by the company is to avoid the costs associated with the compliance of the Act. If this continued to happen it can impose serious concerns for security armlet and US economy. The other issue to be addressed by the Act was the importance of transparency which was required after the Enron scandal. The former chief accountant of SEC commented that some improvements were seen in the post Enron-scandal years, however there were areas of no improvement and certain areas where things went even worse. The Act was able to complete its goal partially in this area. (De & Argosy University. 2006) The opposing opinions believed that the Act has done well and has brought dramatic changes across and beyond America by reestablishing investor’s confidence in the integrity of financial reporting. Additionally the Sarbanes Oxley Act has created such an impact which has made the European nations consider the adoption of its reforms and revision in the rules for audit of public companies. (De & Argosy University. 2006) Conclusion: The Sarbanes Oxley Act of 2002 was passed after the Enron-Scandal which left the integrity and independence of the external auditors of public listed companies into question. The Act was passed to act as a guardian for the interest of shareholders and investors of the public listed companies and to regain their confidence over the financial reporting and disclosures. Many years have been passed and mixed opinions, reviews and researches have come up over decades regarding the implementation and effectiveness of the Act. The Act has been mainly criticized on the grounds of its compliance costs exceeding its benefits, while many believe the Act has improved the level of corporate governance in America. References Zhang, I. X. (2005). Economic consequences of the Sarbanes-Oxley act of 2002. Hartman, L. P. (2002). Perspectives in business ethics. Boston: McGraw-Hill. De, V. D. L., & Argosy University. (2006). The Effectiveness of the Sarbanes-Oxley Act of 2002 in preventing and detecting fraud in financial statements: A dissertation. Boca Raton, Fla: Dissertation.com. Hoff, J. M., Larose, L. A., & Scaturro, F. J. (2002). Public companies. New York, N.Y: Law Journal Press. Fletcher, W. H., & Plette, T. N. (2008). The Sarbanes-Oxley Act: Implementation, significance, and impact. New York: Nova Science Publishers. Lipman, F. D., & Lipman, L. K. (2006). Corporate governance best practices: Strategies for public, private, and not-for-profit organizations. Hoboken, N.J: Wiley. Read More