Enactment of Sarbanes-Oxley Act - Case Study Example

Introduction

Several complex factors resulted in enactment of Sarbanes-Oxley Act, for example, the conditions and even cultures surrounding business activities where a lot of corporate frauds took place. More profoundly, activities like public frauds especially at WorldCom, Tyco among other areas greatly exposed a lot of problems characterized by a lot of conflicts of interests together with other practices towards business incentive compensation. About these complex fraudulent activities had a direct bearing on the passage of the Sarbanes-Oxley Act. The act required that those individuals are sitting on the Senate Banking Committee to carry out hearings on market issues that resulted in the loss of large sums of money. This Senate hearing was meant to set out and lay a firm foundation for proper legislation to come up with a remarkable consensus on the type and nature of the problem resulting in loss of market value. Among the problems that vividly featured during the hearing included but not limited to inadequate oversight of the financial accountants, lack of independence in the auditoria work, a lot of weaknesses when it comes to corporate governance, conflict of interest among the stock analysts among many other challenges.

Before the enactment of the SOX, auditing companies served as the key financial watchdogs for most of the investors in the banking industry, and they were in most cases self-regulated. The auditing firms also took part in other non-audit operations for the business organizations the audited. A lot of these consulting contracts were very lucrative than the general auditing works and therefore resulted in the rise of conflict of interest among the company auditors. In such a situation, for example, any action aimed at challenging the accounting approach adopted by the company may result in damage to the relationships that exist among the company's clients, and most importantly, it may place a good number of consulting arrangements at risk. Secondly, failure of the board of directors for example audit committees who were bestowed with the responsibility of creating an oversight mechanisms particularly for financial reporting on behalf of the investors. A lot of these scandals exposed negatively most of the Boards members who in one way or the other failed to exercise their duties effectively or lacked the required expertise to properly understand the complexities of running a business. In several instances, most members of the audit committee became highly dependent on the company's management and therefore could not discharge their duties effectively and efficiently.

A third factors in the conflict of interest among the security analysts regarding executing their duties, for example, they were discharged with the responsibilities of purchasing and selling recommendations of the company's stocks and bonds. Secondly, the security analysis was also discharged with the responsibility of helping to hand issues touching on the mergers and acquisitions and even issues relating to loans of the companies which again resulted in rising of conflict of interest. Next issue is lending practices of the banks which in most cases sent signals to the business investors about the risks involved in most business investments. Enron for example; a lot of banks offered loans to Enron without proper understanding the risks involved in carrying out business with such an organization. Most of the investors of such banks like Enron together with their clients were deeply hurt by those many cases of such bad loans thus resulting in high settlement payments to be made by the banks. Lastly, stock options in conjunction with the bonus practices and the volatility of the stock prices created a lot of pressures to the management of the earnings made by most banks. In this case, several stock option were hardly treated by the company as the compensation expense thus exposing the stock-based bonus at a higher risk as the company's managers put under great pressure to meet achieve their targets.

Return on equity

Return on equity is seen as a ratio of net income received by a business entity during a particular time of the years about the equity of the stockholders during that particular period of the year. Return on equity ratio measures the rate of profitability of the business enterprise as a measure of the stockholder's investments. The ratio is commonly known as the return on capital, and it indicates the net income of the business organization as a percentage of the equity investment of the stockholders. Return on equity is determined using the formula outline below:

ROE = 

Annual Net Income

Average Stockholders' Equity

Net income used in the calculation of the return on equity of the business is usual an income after tax while the average equity of the shareholders is determined by dividing the total number of the shareholders' equity at the start and the end of the year by two. The net income value is usually obtained from the income statement of the business while the shareholder's equity is usually extracted from the balance sheet of the business. To get the average shareholders' equity, one will need to have the ending balances of the two consecutive financial periods to determine the average equity investments of the shareholders.

Return on equity is a good measure of the levels of the company profitability within a certain period, and in most cases, a higher value is more favorable to the business as it implies that the business is effective and efficient in generating cash on its investments. A lot of investors compares the return on equity of different business organizations and also looks at the trend over a certain period to determine whether to invest in a certain business or not. However, it is important to note that solely depending on the return on equity for the analysis of the type of investment to venture into may not be sometimes safe because the return on equity may sometimes be influenced by the business management. A good example when the management can influence return on equity to favor the business is when debt financing is used to cut down the amount of share capital; in such a case there will be a rise in the return on equity even if the income does not change.

Return on equity of 20 banks

Bank

Return on equity before enactment of Sox

Return on equity after enactment of Sox

First Horizon National Corporation

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Net annual income =$1,763,000

Average Shareholders' Equity = ( $14,587,000 + $14,502,000 ) / 2 = $14,544,500Return On Equity =$1,763,000 / $14,544,500= 0.12 or 12%

Alley Financial (MI)

Net annual income =$1,164,000

Average Shareholders' Equity = ( $22,587,000 + $12,332,000 ) / 2 = $17,495,500Return On Equity = $1,164,000 / $17,495,500= 0.06 or 6%

Net annual income =$1,345,000

Average Shareholders' Equity = ( $10,587,000 + $18,332,000 ) / 2 = $14,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.09 or 9%

Barclays Bank (Del)

Net annual income =$1,763,000

Average Shareholders' Equity = ( $14,587,000 + $14,502,000 ) / 2 = $14,544,500Return On Equity =$1,763,000 / $14,544,500= 0.12 or 12%

Union Bank of California

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Net annual income =$1,977,000

Average Shareholders' Equity = ( $12,587,500 + $13,332,000 ) / 2 = $12,959,750Return On Equity = $1,977,000/ $12,959,750= 0.15 or 15%

Chemical bank Corp.

Net annual income =$1,164,000

Average Shareholders' Equity = ( $22,587,000 + $12,332,000 ) / 2 = $17,495,500Return On Equity = $1,164,000 / $17,495,500= 0.06 or 6%

Net annual income =$1320,000

Average Shareholders' Equity = ( $14,587,000 + $17002,000 ) / 2 = $15,794,500Return On Equity = $1,722,000 / $15,459,500 = 0.08 or 8%

City Group

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Net annual income =$2,000,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $2,000,000 / $15,459,500 = 0.13 or 13%

Bank of America

Net annual income =$1320,000

Average Shareholders' Equity = ( $14,587,000 + $17002,000 ) / 2 = $15,794,500Return On Equity = $1,722,000 / $15,459,500 = 0.08 or 8%

Net annual income =$1,345,000

Average Shareholders' Equity = ( $10,587,000 + $18,332,000 ) / 2 = $14,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.09 or 9%

Manufacturers Hanover Corp

Net annual income =$1,345,000

Average Shareholders' Equity = ( $10,587,000 + $18,332,000 ) / 2 = $14,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.09 or 9%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Corporate Trust business of Bank of Tokyo-Mitsubishi

Net annual income =$1,823,000

Average Shareholders' Equity = ( $14,000,000 + $16,000,000 ) / 2 = $15,00,000Return On Equity = $1,823,000 / $15,000,000 = 0.12 or 12%

Net annual income =$1,977,000

Average Shareholders' Equity = ( $12,587,500 + $13,332,000 ) / 2 = $12,959,750Return On Equity = $1,977,000/ $12,959,750= 0.15 or 15%

Sino Pac financial holding

Net annual income =$2,000,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $2,000,000 / $15,459,500 = 0.13 or 13%

Net annual income =$1,977,000

Average Shareholders' Equity = ( $12,587,500 + $13,332,000 ) / 2 = $12,959,750Return On Equity = $1,977,000/ $12,959,750= 0.15 or 15%

International Bank of Taipei

Net annual income =$1,555,000

Average Shareholders' Equity = ( $14,778,000 + $16,244,000 ) / 2 = $15,511,000Return On Equity = $1,555,000 / $15,511,000 = 0.10 or 10%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

NBD Bancorp

Net annual income =$1,122,000

Average Shareholders' Equity = ( $14,000,000 + $16,444,000 ) / 2 = $15,222,000Return On Equity = $1,122,000 / $15,222,000 = 0.07 or 7%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

First Chicago Corp.

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Net annual income =$1,922,000

Average Shareholders' Equity = ( $14,324,000 + $16,453,000 ) / 2 = $15,388,500Return On Equity = $1,922,000 / $15,459,500 = 0.12 or 12%

Banc One Corp

Net annual income =$1,555,000

Average Shareholders' Equity = ( $14,778,000 + $16,244,000 ) / 2 = $15,511,000Return On Equity = $1,555,000 / $15,511,000 = 0.10 or 10%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Wells Fargo Advantage Funds

Net annual income =$1,333,000

Average Shareholders' Equity = ( $12,587,000 + $14,332,000 ) / 2 = $13,459,500Return On Equity = $1,333,000 / $13,459,500 = 0.09 or 19%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Bear Stearns Companies Inc.

Net annual income =$1,822,000

Average Shareholders' Equity = ( $14,687,000 + $16,932,000 ) / 2 = $15,809,500Return On Equity = $1,822,000 / $15,809,500 = 0.12 or 12%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Washington Mutual's banking operations

Net annual income =$2,222,000

Average Shareholders' Equity = ( $15,587,000 + $17,332,000 ) / 2 = $16,459,500Return On Equity = $2,222,000 / $16,459,500 = 0.13 or 13%

Net annual income =$1,562,000

Average Shareholders' Equity = ( $8,597,000 + $12,702,000 ) / 2 = $10,649,500Return On Equity = $1,562,000 / $10,649,500 = 0.15 or 15%

Nikko Cordial

Net annual income =$1,842,000

Average Shareholders' Equity = ( $14,666,000 + $16,777,000 ) / 2 = $15,721,500Return On Equity = $1,842,000 / $15,459,500 = 0.12 or 12%

Net annual income =$2,222,000

Average Shareholders' Equity = ( $15,587,000 + $17,332,000 ) / 2 = $16,459,500Return On Equity = $2,222,000 / $16,459,500 = 0.13 or 13%

Barclays Global

Net annual income =$2,222,000

Average Shareholders' Equity = ( $15,587,000 + $17,332,000 ) / 2 = $16,459,500Return On Equity = $2,222,000 / $16,459,500 = 0.13 or 13%

Net annual income =$1,562,000

Average Shareholders' Equity = ( $8,597,000 + $12,702,000 ) / 2 = $10,649,500Return On Equity = $1,562,000 / $10,649,500 = 0.15 or 15%

Nara Bank N.A.

Net annual income =$1,522,000

Average Shareholders' Equity = ( $14,387,000 + $16,432,000 ) / 2 = $15,409,500Return On Equity = $1,522,000 / $15,409,500 = 0.10 or 10%

Net annual income =$1,722,000

Average Shareholders' Equity = ( $14,587,000 + $16,332,000 ) / 2 = $15,459,500Return On Equity = $1,722,000 / $15,459,500 = 0.11 or 11%

Analysis

After enactment of the SOX, the return on equity of the banks appeared to be higher than before partly because, before the enactment, there were a lot of accounting issues relating to overstated operation costs for the companies. SOX played a greater role in trying to enhance most of the business corporate transparency which is measured regarding the rate of dispersion and accuracy of the forecasts of the analysts' earnings of the business. After enactment of SOX, the borrowing costs for most business firms reduced significantly especially for business firms that made an effort to improve their internal operations (Daniel, 2002). With the help of the act, most companies that had no material weaknesses especially in their internal controls or those business organizations that controlled their internal weaknesses in some good time experienced a greater increase in their share prices.

For example, when looking at the foreign companies that are cross-listed in the United States and comparing them with those companies that are not subjected to SOX policies; cross-listed companies are significantly more transparent in undertaking their duties following SOX. Business transparency is measured regarding the dispersion and accuracy of the security analyst's earnings forecast, and this explains why returns on equity are higher after enactment of SOX than before.

Hypothesis testing

Null hypothesis

Enactment of the Sarbanes-Oxley Act has no significant impact on the banks return on equity and that the average current ratio is below 0.15

Alternative hypothesis

Enactment of the Sarbanes-Oxley Act has significant impact on the banks return on equity and that the average current ratio is above 0.15

Ho: µ ≤ 0.15

H1: µ ≥ 0.15

At 0.05 significance level, when we employ the critical approach to hypothesis testing, is there a good reason or evidence to believe that the return on equity is greater than 2.0?

Assuming that α=10; n=20 and π=2

Using a z-test

=2-0.15/10/ /20

=0.83

Given that 0.83 is greater than 0.15 then we reject the null hypothesis that states that enactment of SOX does not affect the returns on equity this, therefore, leaves us with the alternative hypothesis. An error type I (false positive) occur in a test analysis only if the null hypothesis is rejected/ not accepted that is actual sense is very true while error II (False negative) takes place only if the researcher fails to reject the null hypothesis that is not true in the population sample. In the above example error, I type does not occur since the null hypothesis is rejected on the basis that enactment of SOX has a significant effect on the company's return on equity. Error II type equally does not occur because the null hypothesis is rejected on the account that it is not true that implementation of SOX policies not affect the return on equity of the business.

Conclusion

Hypothesis testing is the basic background in which empirical research is anchored, and it appears to be the most growing technique that most researchers use in the works. Despite the use of hypothesis testing in most of the research works, hypothesis testing may also have limits in which it operates. It is important to appreciate that it is almost impossible to eliminate uncertainties and this is the reason why hypothesis testing is used to help in qualifying the uncertainties. The most common types of uncertainties that may arise when testing your hypothesis are of two types for example type I error which is falsely rejecting the null hypothesis while it is very true and the type II error which means falsely accepting the null hypothesis while it is not true. It is relatively very hard to prove or even disapprove something only through hypothesis testing or even through statistical tests; it is only possible to reject the null hypothesis, and by rejecting the null hypothesis then it implies that by default we have accepted the alternative hypothesis.

Reference

Daniel, W. (2002). Biostatistics in Hypothesis testing (7 ed.). New York: John Wiley and Sons, Inc.