The Unintended Consequences of the Sarbanes Oxley Act - Term Paper Example

Term Paper Table of Contents Table of Contents 2 Introduction 3 Auditing of a Company 4 Demand and supply of Directors 5 Investors Risk 6 Cost of capital and Earnings Quality 8 Conclusion 10 Works Cited 11 Name of the Student: Name of the Professor: Course Number: Date of the Paper: The unintended Consequences of the Sarbanes Oxley Act Introduction In November 2001, Enron, one of the largest companies of the United States was recognized for overstating their earning by nearly $600 million in federal filling. Within a month Enron was declared bankrupt. The bankruptcy of Enron gained attention due to the size of the company, role of the auditors, financial losses suffered by the investors and the losses met by the employees of Enron. Again in June 2002, WorldCom announced an inflated profit by $3.8 billion over a period of five consecutive quarters. This was regarded to be the largest financial fraud in the commercial history of United States. As soon as the fraud was announced, WorldCom was declared bankrupt. The fraud of WorldCom compelled Congress and President George W. Bush to take stringent action. In the year 2002, Congress with the support of President Bush, acted promptly and passed the legislation known as Sarbanes-Oxley Act (SOX). Sarbanes-Oxley Act was framed to provide a comprehensive solution to the corporate malfeasance that caused the downfall of Enron and WorldCom. The main objectives behind framing this act were firstly to strengthen and provide independence to the auditing firms. Secondly, Sarbanes-Oxley Act intended to implement transparency and quality in the corporate disclosures and financial statement. Thirdly, this act provided an augmentation in the corporate governance by identifying the unchanged rules. Fourthly, it improved the objectivity of research. Lastly, enforcement of the federal security law was strengthened. The study highlights on the unintended consequences caused by Sarbanes-Oxley Act. Auditing of a Company The Sarbanes-Oxley Act has many provisions and far reaching consequences for the Certified Public Accountant (CPA) profession and financial reporting. The section 404 of Sarbanes-Oxley Act requires the companies to implement proper steps to ensure adequate internal controls and procedures for financial reporting. The companies must be capable of assessing the value of financial reporting and internal control. Many of the companies found it difficult to comply with section 404 of the Act. Some of the companies had to either reduce or completely eliminate the department of internal auditing. Some companies lack personnel to tackle the multifaceted accounting issues. The absence of experts to confront the complicated issues itself represents weakness in internal control. Sarbanes Oxley makes it an important point to have adequate internal control and procedures in the companies. The auditor of the financial statements should report on management’s declaration on the effectiveness of internal procedures and controls. The relationship between the company and the external auditor has been changed by the Sarbanes Oxley Act. Before the Act was incorporated the companies used to rely upon the external auditors in order to address the complex accounting issues. This raised a concern of conflict of interest, as the auditors were complete independence in assessing the procedures, controls and reporting of the companies. The Act has not only led the companies to identify that they lack proper personnel who can address the complex accounting issues but also pressurized the external auditors to have proper experienced and trained accounting personnel. This has compelled the auditing firms to reduce the number and types of firm for whom they conduct the auditing (Gibson 8-9). Demand and supply of Directors Sarbanes-Oxley Act has not only raised a profound concern for the action of the auditors and accountants but also for the directors and the Self Regulatory Organization (SRO). Sarbanes-Oxley Act imposed new requirements and has also set directives for the behavior of the directors and the SRO. Due to implementation of Sarbanes-Oxley Act, some changes have been observed in the boards of directors. It has been evident that the number of independent directors in the board has increased. It was suggested by Gordon (2007), that the increase in independent directors was due to the fact that maximization of shareholder’s value was the primary objective of the firm. It has been observed that the Sarbanes-Oxley Act has affected the demand and supply framework of the directors. Due to the mandates related to the composition of the board and workload, the demands for the directors have increased but the supply has decreased. The reason for decrease in supply was due to the fact that there has been an increase in the workload and risk associated with job. When the factors for such a shift were examined it was found that “changes in the workload of directors, the structure of corporate boards, the liability risk faced by directors and the composition of the director pool” (Linck, Netter and Yang 2) were the primary reasons. The directors of the companies are now more viable to increased work load and liability. When a study was conducted in more than 8000 firms during the year 1989 to 2005, it was seen that SOX have dramatically affected not only the activities but also the cost involved in the directors. It was observed that the medium pay of the directors have increased by more than $38,000 from 2001 to 2004. When compared with the pay of the Chief Executive Officer (CEO) for the same period it was seen that the pay of the CEO was increased by only 24% whereas that of the director by 50% . The increase in the pay per director was also coupled with the fact that the there has been a substantial increase in the pay of the outside directors too. The pay of the directors rose in the smaller firms during the post SOX period. In the year 2004, the smaller firms paid “$3.19 in director fee per $1,000 of net sales” (Linck, Netter and Yang 3), which was $0.84 more than what they paid in 2001 and $1.21 more than what they paid in 1998. As a contrast to this the larger firms paid “$0.32 in director fees per $1,000 of net sales” (Linck, Netter and Yang 3) that was seven cents and ten cents more than what they paid in the year 2001 and 1998 respectively. Therefore, it can be concluded that in the post SOX period the proportion of ‘equity to cash pay’ rose. Investors Risk Sarbanes Oxley Act has impacted the measure of risk, which has become a growing concern for the investors. The investors are concerned about the “upside and downside risk, and firms’ ability to generate returns efficiently” (Vakkur and Vakkur 185). Firm’s Risk-Return Ability Sarbanes Oxley was seen to impact the firm’s risk that was influenced by the managerial decision making. According to Fama and French (1993) managers aim not only to maximize the expected return that is defined by the predicted level, period and extent of cash flow but also to make the best possible use of the firm’s risk per unit of return. This implies that the firms that provide higher return than to risk are more preferred by the investors. The Sarbanes Oxley Act is expected to reduce the “risk-adjusted returns” by preventing the managers from making the best possible use of the correlation between risk and return. Research suggests that the Sarbanes Oxley Act distinctly impacts both risky and efficiently running firms and motivates the behavior of the firms that are supported by the objective of profit making. This reduces the ability of the organization to generate effective returns. In order to comply with the law the managers are forced to provide ‘sub-optimal solutions’ to the strategic troubles. This results into the deterioration of the correlation between the risk and return of the firm, since most of the projects has to comply with the law. Hence there is a decline in the risk adjusted return of the firm, which in turn leads to the incapability of managing risk. Upside Risk of the Firm Upside risk refers to the increase in the value of the security beyond the expected level. According to Simon (1989) the upside risk was also affected by the 1933 Security Act, which improved the disclosure requirements. Sarbanes Oxley Act is regarded to have the same affect on the upside risk. According to Fama and French (1992) upside risk is found to be more pronounced in the small cap firms and they contribute inexplicably to the upside risk of the equity market as a whole. This suggests that since the small firms are forced to divert their resources from the projects that provides high growth, upside risk is expected to decrease. The act is also seen to impact the firms that are inventive and efficiently governed. Investors are seemed to be less concerned about the upside risk rather than the downside. Upside risk is regarded to be the more vital source of investor’s profit as it is the natural desire to gain some excess return. Therefore a reduction in the upside risk is regarded to harm the investors since it decreases their income. Downside Risk of the firm Ang et al (2006) has defined downside risk as the standard deviation of the annualized return from the specific target. In simple terms it is the risk created due to underperformance of the investment and the investors will experience loss comparative to the predestined benchmark. The Sarbanes Oxley Act applies a marginal effect in decreasing the downside risk. The law incorporates stringent rules that results not only to reduce the risk but also decreases the rigidity of the firm. The law exerts tremendous pressure on the firms under which they operate, resulting into the deterioration of managerial decisions due to which the firms suffer from unexpected losses. Sarbanes Oxley ensures that the firms are more vigilant during the market declines and discourages the managers to venture into projects that give rise to the unacceptable risks. Sarbanes Oxley is more likely to reduce expected losses by decreasing the downside volatility that is caused during the market decline. Though the investors perceived that the law caused a very small impact on risk but in reality it helped in preventing and minimizing the downside risk. Cost of capital and Earnings Quality Sarbanes Oxley imposed severe penalties both civil and criminal, if any type of misrepresentation of financial information to the shareholders is found. It also ensures that the company should have independent auditor who are financially literate. It is seen that SOX has resulted into decreasing the unrestricted accruals and increasing the conservatism. By using the ‘four factor market model’ of Fama and French, it was derived that the market is aware of the enhancement in the quality of accrual in post-SOX period. Many of the theoretical and empirical studies showed that there exists a negative correlation between the cost of capital and earning quality. It was observed by Ashbaugh-Skaife et al. (2009) that the weakness in internal control of the firm results in the increase of both risk and cost of capital for the firm. Hence it was perceived that the improvement of the internal control will lead to the improvement in the earning quality, which in turn will lead to enhancing of cost of capital for the firm. Sarbanes Oxley also imposes a significant amount of compliance cost for the firms. After Sarbanes Oxley was incorporated the firms had to increase the fees of the auditor by 25 to 100 percent. On an average the firms had to spend an amount of $4.36 million in order to comply with the requirements specified in the act. Moreover, some of the research suggests that the “accrual based earning management” (Chang, Fernando and Liao 218) has decreased while there has been no change in the “real earnings management using advertising expenses” (Chang, Fernando and Liao 218). Recent research have highlighted that there exists a close relationship between the cost of capital and the information available to the investors. A multi-asset rational expectations model developed by Easley and O’Hara has shown that the investors demand high return in order to hold the stock in the firm with better information irregularity, which in turn leads to an increase in the cost of capital. The model has also shown that if the quality and quantity of information deteriorate then the cost of capital decreases. It is also seen that the cost of capital is lowered by improving the quality of disclosure and accounting information. Empirical studies have shown that cost of capital has relation with the Earning Quality and disclosure. There exists a negative relation between the disclosures mentioned in the annual report of the firm and the cost of capital. The cost of capital is decreasing with earning quality. An inverse relationship was achieved between the Earning Quality and Cost of Capital when the earning quality was measured which was attained by mapping a relationship between the “current accruals into last-period, current-period, and next-period cash flows” (Chang, Fernando and Liao 219). The standard setters also emphasized on the correlation between reduced cost of capital and improved quality of information. Arthur Levitt, who was the chair of the Securities and Exchange Commission, said that reduction in the cost of capital can be caused by elevating the quality of accounting standards. On investigating the section 404 of Sarbanes Oxley, which mandates the disclosure regarding the effectiveness of the internal control of the firm, it was found that an increase in the cost of capital implies that there exits deficiencies in the internal control. Therefore, it can be summarized that the cost of capital is expected to decrease if the quality and quantity of the information provided by the firm increases. As Sarbanes Oxley Act ensures that the quality and quantity of information provided by the firm should improve so the cost of capital is expected to decrease in the post SOX period. However, the cost of doing business by complying with SOX, may lead to an increase in the cost of capital for the small firms. Hence the impact of SOX on the cost of capital of the firms is a controversial issue. If on one hand the cost of capital decreases when the transparency, quality and quantity of financial reports increases while on the other hand the cost of capital is seen to increase as the compliance cost increases in the post SOX period. It was summarized by Chang et al. (2009) that the Earning Quality has improved after Sarbanes Oxley has been incorporated and at the same time a significant decrease in the cost of equity capital has been marked. Conclusion The Sarbanes Oxley act was passed in the year 2002 after the two corporate scandals of Enron and WorldCom. It was enforced with an expectation that it will restore the confidence of the public on the financial market, which was lost due to these frauds by elevating the quantity and quality of financial information provided to the public. The Act incorporated various steps in order to achieve the target of improving the quality and quantity like it prohibited the auditors from providing non auditing services, which ensured that the management of the company adopts serious initiatives to improve internal control, rendered timely and detailed release of information and imposed penalties if the directions are not followed properly. Nevertheless, there were still some of the criticisms regarding the Act. The study has closely highlighted some of the unintended consequences suffered by the business organization due to the Act. The study has found that the act has lead to an increase in the cost incurred by the firm. It has also lead to an increase in the demand for the directors whereas a decrease in the supply. The Act has also decreased the upside and downside risk. Works Cited Ang, Andrew, Joseph Chen, and Yuhang Xing. “Downside risk”. Review of Financial Studies 19.4 (2006): 1191-239. Print. Ashbaugh-Skaife, Hollis, Daniel W. Collins, William, R. Kinney, Jr., and Ryan LaFond. ‘‘The effect of internal control deficiencies on firm risk and cost of equity capital’’. Journal of Accounting Research 47.1 (2009): 1-43. Print. Chang, Hsihui, Guy D. Fernando and Woody Liao. “Sarbanes-Oxley Act, perceived earnings quality and cost of capital”. Review of Accounting and Finance 8.3 (2009): 216-231. Print. Fama, Eugene F. and Kenneth R. French. “Common risk factors in the returns on stocks and bonds”. Journal of Financial Economics 33.1 (1993): 3-56. Print. Fama, Eugene F. and Kenneth R. French. “The cross-section of expected returns”. Journal of Finance 47 (1992): 427-66. Print. Gibson, Charles H. Financial Reporting and Analysis: Using Financial Accounting Information. Connecticut: Cengage Learning, 2010. Print. Gordon, Jeffrey N. “The rise of independent directors in the United States, 1950-2005: Of shareholder value and stock market prices”. Stanford Law Review 59 (2007): 1465-1568. Print. Linck, James S., Jeffry M. Netter, and Tina Yang. “The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors”. Review of Financial Studies 22.8 (2008): 3287-3328. Pdf. 27 Feb. 2013. . Simon, Carol J. “The effect of the 1933 Securities Act on investor information and the performance of new issues”. American Economic Review 79 (1989): 295-318. Print. Vakkur, N.V. and Zulma J. Herrera-Vakkur. “Ripple effects: Sarbanes Oxley’s impact upon investor risk in a global economy”. Review of Accounting and Finance. 11.2 (2012): 184-205. Print. Read More