Sarbanes-Oxley Act of 2002 - Essay Example

Sarbanes-Oxley Act of 2002 of Introduction The effectiveness of capital markets depends significantly on quality, transparency and reliability of financial information that is disseminated by organizations in the primary and secondary market. Heflin, Shaw & Wild (2011) implied that disclosure of high quality enhance degree of market liquidity by minimizing information asymmetries. In this regard, the Congress signed and passed in 2002 the Sarbanes Oxley Act (SOX) as a response to the financial scandals and bankruptcies of companies such as Enron, Xerox, Sunbeam, Worldcom, Tyco and so on (Coates IV, 2007). It was gathered that the list of such default companies was long and their practices eroded investor’s trust and confidence in financial information that are available to general public. It was established from empirical studies and anecdotal evidence that SOX has made significant contribution towards restoring confidence of investors (Jain, Kim & Rezaee, 2008; V Richman & A Richman, 2012). In this paper, the SOX 2002 has been discussed in terms of its key components and their significance, economic consequence of the act on various companies, criticism associated therein and the achievements of the act till date towards its goals and objectives. Key components of SOX 2002 and its objectives According to the Ernst & young (2013), four principle components of the SOX were recognized which are discussed as follows. The SOX established independent monitoring of each of the public firm audits. PCAOB (Public Company Accounting Oversight Board) was established by the act which ended self regulation by public audit firms. This was one of the fundamental changes made by the act. Presently the PCAOB is responsible for establishment of auditing and ethical standards, regulation of audit firms, quality inspection of various audit reports and investigation regarding various allegations against broker-dealers and auditors. The role of PCAOB can be classified in three categories, namely, standard setting, inspection and enforcement. PCAOB is authorized to determine standards regarding ethics and independence of auditors, quality control in audit firm and conducts related to auditing of public firms. PCAOB also assess frequently various auditing areas that require addressing. It inspects various audit firms and present information in a report that is available to public. The inspection is undertaken so that quality in audit is maintained. Lastly, PCAOB enables its enforcement staff to investigate various audit firms as well as individual auditors in context of violation of standards, law and regulations (Ernst & young, 2013). The act was established with an aim to establish corporate governance and strengthen audit committees The SOX has extended responsibilities of various audit committees so that greater degree of corporate governance is imparted. The act required various public companies to establish an independent audit committee comprising only board members. This audit committed was authorized by the SOX for appointing, monitoring and compensating external auditors, who are responsible for assessing and evaluating a firm’s financial statements (Ernst & young, 2013). SOX was accountable for ensuring investor protection, accountability of executives and enhancing transparency The SOX ensured that the audit firms disclose certain information regarding their first time activities such as name of their clients, fees charged and their quality control measures. The act also made it mandatory for CEOs and CFOs of firms to certify the reports they are publishing. SOX also established that for fraudulent activities and unacceptable behavior, executives will face penalties such as fines and imprisonment (Ernst & young, 2013). The Act enhanced independence of auditors According to this component, audit firms have been prohibited from performing activities such as bookkeeping, financial appraisal or valuation, actuarial services, designing of financial information system, investment advising and legal; services irrelevant to auditing. Additionally, SOX made mandatory rotation for lead partner of audit firms every five years so that independence of auditors is enhanced (Ernst & young, 2013). Economic consequences of the SOX 2002 Since its inception, SOX has received mixed reaction. The act is often treated as a haste decision of the Congress for controlling public outrage regarding scandals of public corporations; consequently, a number of literatures focused significantly on benefits and consequences of the act. It was gathered that the section 404 made it mandatory for all firms to create internal control structure as well as provision for the assessment of the system. The control structure was made accountable for controlling financial auditing and reporting. Studies suggest that these mandate resulted in significant rise in overall internal cost of a firm making it relatively more expensive than the assumptions regarding the same. During 2004, it was estimated in a study that the costs or expenses of SOX increased by 62% in four months and in 2005, a follow up survey revealed that about 217 companies experienced around 40% rise in their external and internal cost. The main reason of increase in external cost was increase of fee of external auditors and consultation charges. It was further gathered by the SEC (Securities Exchange Commission) that companies spent about 5.4 million staff hours while complying with regulations of the SOX. Other research added that estimated cost of consulting services, IT and manpower was around $6.1 billion. It was also gathered that most of the cost related to Section 404 can be accounted as sunk cost (Zhang, 2007). A number of discrepancies were noticed while implementation of the SOX in terms of high cost. It was ascertained that compliance of SOX was mandatory for public companies and resources needed to be allocated accordingly. It resulted in shift of resources from profitable ventures causing unproductive investment which can further be explained in terms of loss of profit or innovation of the firm. Compliance of SOX also resulted in allocation of manpower to internal control instead of profitable activities. It was observed that a number of CEOs diverted their resources from strategic management division to control management. Additionally, due to implementation of SOX, many financial resources could not be taken in account for calculation of returns on investment for a firm. Large firms observed implementation of SOX as an opportunity but the process was significantly cost intensive for small and midsized public companies. Since managerial time and professional charges varied negligibly with size of company, these companies observed allocation of a significant amount of their revenue to the compliance of the act. Consequently, delisting of the public companies tripled between 2002 and 2003 and it was gathered that delisting was adopted only to avoid high expenses associated with SOX compliance. Elimination of a number of auditing firms resulted in limited number of companies charging inflated fees for various auditing services to audited companies (Bergen, 2005; Zhang, 2007). Benefits of SOX, 2012 The unexpected benefits of SOX are discussed as follows: Reinforcement of the control environment A control environment is defined in terms of strong governance, ethical values, appropriate behavior and adoption of proper procedures and these components form the foundation base of internal control. PCAOB empowers auditors to evaluate internal control under the section 404. It was further gathered that organizations that adopt strong control environment, are capable of minimizing the scope of evaluation of internal control (Wagner & Dittmar, 2006). Improvement in documentation It was observed that during the first year of SOX implementation a large number of resources were consumed for documentation activities. Companies had to update operation manuals, record controls processes and revise management policies. Additionally, sections such as 302 and 404 ensured that CFOs and CEOs personally attest various reports regarding firm’s financial condition and practices. It was gathered that extensive documentation resulted in better information and resource management (Wagner & Dittmar, 2006). Increase in involvement of audit committee It was gathered that prior to the SOX, board member of various corporations had limited responsibility and greater amount of financial rewards. However, implementation of act increased their responsibility and involvement in the organizational decision making. It was also found that independent members of the audit committee exhibited greater engagement in the organization (Wagner & Dittmar, 2006). Exploiting convergence opportunities SOX presented significant convergence opportunities to organizations as they could either meet the requirements at minimum cost using limited resources or they could leverage more resources for gaining better return. Many organizations combined both these strategies along with other regulatory measures to achieve efficiency and minimize cost in this regard. Various areas of convergence in this context include record keeping, resource maintenance, training and consumer relationship (Wagner & Dittmar, 2006). Standardization of processes Standardization of process resulted in minimization of complexity and recognition of weak links in the organization. The act also ensured that operational discrepancies are addressed at their basic level and that degree of human error is minimized (Wagner & Dittmar, 2006). Criticism regarding Sarbanes Oxley Act, 2002 The SOX, 2012 came into existence as a result of collapse of several high profile firms in 2001. The act was responsible for restoring public confidence and enhancing corporate governance. Despite its potential benefits, the act and its related measures were often regarded as political product. According to certain study, it was a plan to overthrow the Bush Administration for taking the corporate scandals lightly by democrats while republicans aimed at punishing the corporate using the act. Besides the political connections, the act was also criticized in terms of its high implementation cost. It was further gathered that the cost was not constant and continued rising with passage of time (Zhang, 2005). The act was also criticized in the lights of innovation. It was considered as a deterrent of innovation and creativity in the business front. As observed by many authors, SOX prevented owners and business managers from making risky decisions as the consequences involved heavy penalties. Facts suggest that the total of direct and indirect costs related to SOX was observed to be greater than its benefits. In addition, a PWC survey revealed that CEOs feared of overregulation risk as a result of SOX compliance (Zhang, 2005). A number of commentators in this regard complained that corporate governance measures of SOX failed to address the issues that actually lead to the corporate scandal of 2001-02. They claimed that the act focused only on minor issues and may not protect investors from corporate fraud in long run. It was also observed that specific sections under the SOX were found to be unreasonable. For instance, section 201 prohibited audit firms from providing non-audit services citing concern for audit quality as the reason. However, authors such as Romano researched and found that there is no relation between non-audit services and audit quality. In the similar context, questions were raised against section 402 (a) and section 302 (Wade, 2008). Reutter (2004) underlined that the SOX failed to address various core corporate accounting conflicts. The author also quoted various lobbying groups who expressed their concern that foreign companies may feel disinterested in making investment in the United States. In addition to that, criticism in context to SOX include role of the act in minimizing the competitiveness of the publicly listed companies (Wade, 2008). Conclusion SOX, 2002 was passed as a result of corporate scandals of 2001 where prominent firms such as Enron and Xerox embezzled investors’ fund and lost public confidence. The act is primarily responsible for ensuring corporate governance and gaining public confidence. In this paper, key components of SOX, 2002 has been discussed in an elaborate manner. The study revealed that the act established PCAOB which is responsible for monitoring various audit firms. The act also required independence of auditors and established auditors’ committee from board members of a firm. There are a number of benefits that were recognized as a result of implementation of this act but the act is prone to certain drawbacks as well which has been discussed in detail in the paper. The paper highlighted economic consequences of the act as well where it was observed that the act costs significant amount of sunk cost for the complying firms. Overall, the paper discussed costs and benefits associated with implementation of the act. References Bergen, L. (2005). The Sarbanes-Oxley Act of 2002 and its Effects on American Business. Retrieved from http://scholarworks.umb.edu/cgi/viewcontent.cgi?article=1015&context=financialforum_pubs. Coates, J. C. (2007). The goals and promise of the Sarbanes-Oxley Act. The Journal of Economic Perspectives, 91-116. Ernst & young. (2013). The Sarbanes-Oxley Act at 10. Retrieved from http://www.ey.com/Publication/vwLUAssets/The_Sarbanes-Oxley_Act_at_10_-_Enhancing_the_reliability_of_financial_reporting_and_audit_quality/$FILE/JJ0003.pdf. Heflin, F., Shaw, K. W., & Wild, J. J. (2011). Credit ratings and disclosure channels.  Research in Accounting Regulation, 23(1), 20-33. Jain, P. K., Kim, J. C., & Rezaee, Z. (2008). The Sarbanes‐Oxley Act of 2002 and Market Liquidity. Financial Review, 43(3), 361-382. Reutter, M. (2004). Sarbanes-Oxley Act Fails To Address Corporate Accounting Flaws, Scholar Says. Retrieved from http://news.illinois.edu/news/04/0628oxley.html. Richman, V. & Richman, A. (2012). A Tale of Two Perspectives: Regulation Versus Self-Regulation. A Financial Reporting Approach (from Sarbanes–Oxley) for Research Ethics. Science and engineering ethics, 18(2), 241-246. Wade, C.L. (2008). Sarbanes-Oxley Five Years Later: Will Criticism of SOX Undermine Its Benefits? Retrieved from http://luc.edu/media/lucedu/law/students/publications/llj/pdfs/wade.pdf. Wagner, S. & Dittmar, L. (2006). The unexpected benefits of Sarbanes-Oxley. Harvard business review, 84(4), 133-143. Zhang, I. X. (2007). Economic consequences of the Sarbanes–Oxley Act of 2002.  Journal of Accounting and Economics, 44(1), 74-115. Bibliography Bardos, K. S. (2011). Quality of financial information and liquidity. Review of Financial Economics, 20(2), 49-62. Dowdell, T. D., Kim, J. C., Klamm, B. K., & Watson, M. W. (2013). Internal control reporting and market liquidity. Research in Accounting Regulation, 25(1), 30-40. Read More