Sarbanes Oxley and Its Effects on Internal Control - Research Proposal Example

• 1.1 Research Topic

The Sarbanes-Oxley Act (SOX) 2002 was passed and enacted by the US congress on 30th july,2002 to restore investor’s confidence which deflated due to some failures (like Enron, Qwest, Tyco International) in auditing which dissipated investors. The act was named after US senator, Paul Sarbanes and Michael G. Oxley, a representative of U.S (Coates, 2007). This bill contains a total of 6 provisions, in which the primary sections are 302 and 404. Sarbanes-Oxley Act section 302 says that the management is accountable for maintaining the internal controls like reliable accounting and complying with the laws for effective operation. Second one is the section 404, which says all the list of deficiencies in the internal management and employees needs to be listed and focus on the factor that could affect internal controls in a negative way. This act was implemented basically to revise the roles and responsibility of audit committee workers and the corporate officers. This act also established a board known as Public Accounting Oversight Board (PCAOB) which sets the standard for auditing and oversights the audit statement of public trade companies. The incorporation of this act increased the responsibilities of managers for making authentic reports and imposed restrictions on external auditors’ activities. The Sarbanes-Oxley Act 2002 created major change in the regulatory environment by imposing higher penalties for those involved in any fraudulent auditing work. The practical implication of this act on the internal controls can be evaluated further in this research paper.

• 1.2 Research Problem

All the companies who are trading publicly in U.S needs to comply with the provisions of the Sarbanes-Oxley Act. The strict guidelines of the Act forced the companies to adhere to the guided regulations for accounting operation. The major research problem is to analyse the impact on the American organisations after the implementation of Sarbanes Oxley Act, 2002.As discussed above, the most important section were section 302 and section 404, therefore the research will be on how these sections have impacted the internal controls of different companies.

After the huge accounting scandals in U.S like the Enron scandal where the shareholders lost $74 billion by keeping off the debts out from the balance sheet, this act was passed to keep check on the auditing activities of firms (Ghosh & Pawlewicz, 2009). To counter the illegal financial activity the Sarbanes-Oxley Act was formed and this research paper will discuss on whether this act improved the accounting process of the companies or does it have any downside in its implications.

• 2.1 Research Problem Background

Enron, one of the largest companies of U.S until 2001; when it got entangled in a scandal where they devalued themselves by $1.2 billion less than official reported (Ghosh & Pawlewicz, 2009). After this scandal, many other companies like Global crossing, Tyco came under similar scandals. These scandals not only demoralised the investors but also brought in crisis among the whole system of Public ownership firms. To re-establish confidence in the investors and public, U.S congress approved the Sarbanes-Oxley Act.

Different section under this act provides various guidelines for the firm so that their internal controls are within the ethical boundaries. The primary research question is whether this Act restored confidence among investors. The section 404 of this Act says that all the companies needs to incorporate internal controls for the financial reporting and maintain all relevant documents for future references. The following research will put an emphasis on how these sections 302 and 404 impacts different factors of internal control in an organisation.

• 3.1 Theoretical Foundations

The timing of implementing the Sarbanes-Oxley Act was great because an investor was suffering from the uncertainly after the collapse of the Enron in 2001 and then some other companies in 2002. The purpose of SOX implementation was to re-introduce the lost trust among the investors because if investors lose trust in market, they will withdraw from the market. The Sarbanes-Oxley was designed to provide more transparency in disclosure reports and monetary statements. This particular research paper adds different impacts of Sarbanes-Oxley Act, 2002 on the accounting procedure of American companies. This paper primarily focuses on how SOX impact the internal controls of publicly traded companies and what is the cost compliance for implementing the act. Sarbanes-Oxley Act introduced new compliance for auditors and also new regulation for conducting audit but the time when it was launched the cost was on the higher side for the companies which led to extension of compliance deadlines. Later on when the positives of this act got highlighted by more transparent audit statements the cost became justified but for the smaller companies, the cost of maintaining the internal control under SOX Act was still not fare. The main issue that will be discussed in this paper is how an effecting SOX Act is detecting and preventing the fraud activities in preparation of financial statements.

Fries wick says that auditors need to focus more on how to detect the frauds in the accounting which is the demand of the investors and public. The negligence of the auditors is bringing a question on their credibility on conducting proper analysis of reports. Initial the regulation appeared to be strict as small companies were electing themselves to become private so that they can avoid the laws and the cost related to it. Since its incorporation the percent of companies getting privatized increased to 30% (Ge & McVay, 2005).

According to Clayton and Mackintosh (2002) SOX can affect officers of any organisation either public or private sector and impose heavy penalties for fraudulent activities. Albrecht (2003) said that a healthy economy is about hiding companies’ problem by changing the books of account. Albrecht also observed that auditors are getting deeply involved in practicing unethical means to please the clients; the client Anderson did the same with Enron (Ge & McVay, 2005). Normally the certified accounting firms avoid to take responsibility for detection of fraud that is, the SOX Act put more emphasis on involvement of auditors in the fraud detection system.

Kwechansky says that fraud is happening since the time trading of money started for exchange of goods and services. Kwechansky divided frauds into three categories such as, investment fraud by corrupt people or investors, second one being the employee fraud where employees do fraud with company taking companies’ money, thirdly corporate fraud which became very evident before the SOX Act was passed, under this fraud the management itself cheats the employees, investors and even their customers. The corporate fraud which came into the limelight recently for the accounting scandal of Enron, WorldCom and other companies involved in similar scandals (Zhang, 2007).

• 3.2 Contributions to Theory

The ultimate objective of this paper is to draw an analysis that whether Sarbanes-Oxley Act was the right tool to protect investors from the corporate fraud as mentioned above by Kwechansky in the theoretical foundation. There are several theoretical framework on SOX, some of them are:

• • 3.2.1 Public Policy Theory of SOX

In case of Enron the trading was not with retail products but investment banking, stock investing, accounts of money management and capitalisation and others. For all the trading in these products range requires transparent information flow between investors and the management. In the case of corporate fraud that happened in between 1990s to 2002, these assumptions were avoided resulting into the collapse of market, organisations funds, livelihood and most importantly loss of confidence among the investors. The scandals shattered their trust that American market is a safe place to invest.

• • 3.2.2 Public Implementation Theory

Analysis the theoretical outlay of public policy of market failure, SOX can be considered as a policy tool. SOX consist of Securities Exchange Commission (SEC) and together their objective is to protect the trading of securities. The second one is implementation power to act against fraudulent activities.

The best theoretical framework provided in case of SOX is by Sabatier who says that the process of policy needs an involvement of intergovernmental community composed of interest groups, expertise reporter’s legislative personnel. Elmore says the earlier one is the source of the crisis, the superior is one's capacity to control it; and the analytic ability of composite systems do not rely on hierarchical control but maximizing judgment where the problem is in need of attention. Both the scholars provided enough theoretical assumptions for the successful action of government policy.

• 3.3 Theoretical Implications

Sarbanes-Oxley Act is one of the most successful legislation passed since the initial regulation passed in 1930s.Most agreed that the Act benefitted the accounting industry and brought significant changes like:

Sarbanes-Oxley created a board called Public Company Accounting Oversight Board (PCAOB) to safeguard the rights of investors and prepare a transparent financial report for public. The PCAOB works together with Securities and Exchange Commission to have an overall control over all the financial statement of public companies.

• • 3.3.1 Different sections of Sarbanes-Oxley Act

SOX have several sections to control different financial activity. The theoretical implications of these sections are as follows:-

Section 201 says the board must pre approve all audits. Section 203 requires that managing partner of auditing firms must be rotated at the minimum of 5 years. While the section 204 mandates that reporting of accounting firm must be directly to independent committee of firm (Coates, 2007).

Other sections like, Section 302 now requires the CEO and the CFO to personally verifying the annual and quarterly financial statements. Major scandals happen due to the negligence or direct intention of fraud by CEO and CFO. Section 401 of SOX says the companies must include items which are off-balance sheet in the annual and quarterly financial statements (Coates, 2007).

To avoid any discrepancy through delay Section 403 was incorporated which says any monetary transaction which involves stockholders and management need to reveal in the second dealing day of transaction.

Most important section of the SOX Act is its Section 404, which requires a firm to present an annual statement for the evaluation of company’s internal control and the value of applying the controls. This section is widely accepted to improve the internal controls of business but some exception who thinks its way to expensive for its benefits (Chan, Farrell & Lee, 2008).

• 3.4 Practical Implications

Number of surveys indicated that the implications of SOX are on the positive side and helped improving the reliability of reporting and reduced frauds.

• • 3.4.1 Reliability of Financial Information

One of the prime objectives of SOX is to maintain internal control in an effective way is by producing trustworthy information. Li, Pincus and Rego said SOX was successful in restoring the confidence of public and re-establish the integrity of capital market (Rockness & Rockness, 2005).

• • 3.4.2 Strengthen Corporate Governance

Incorporation of Corporate Governance brings discipline among the members of organisation. In a study Government Metrics International (2005) analysed about 2500 companies and found that there was an increase of 10% performance in their governance activity in comparison to non American companies (Li, Pincus & Rego, 2008).

• • 3.4.3 Reduction of Financial Statement Fraud

The major intention of implementing this act was to reduce fraudulent especially when big companies are involved in such frauds and makes investor suffer from huge monetary loss and ultimately the whole market gets affected by loss in sense of trust. Since the incorporation of this act there has not been any major financial scandal except the scandal of options back-dating in 2002.

• • 3.4.4 Model for Private and Non-Profit companies

In a survey Price Waterhouse Coopers found that 30% of the companies surveyed accepted that they are or will be impacted by the SOX Act. Most private companies consider this act as maintenance and not as problem solving. Public companies accepted that this strengthens ethics and conducts, improved the procedure of documentation (Hammersley, Myers, & Shakespeare, 2008).

• • 3.4.5 Improved Liquidity

Bushee and leuz (2005) found that SOX implementation increased liquidity of market by reduction asymmetry of information. It was found that the liquidity improved by reducing the selection constituent of trading cost which ultimately reduced irregularity of information (Rockness & Rockness, 2005).

• 4.3 Ethical Considerations

Sarbanes-Oxley was the act passed to stop unethical activities in the internal controls of company. The Act was enacted in response to huge failure of ethical governance, it primarily emphasised on improving the quality of corporate’ financial disclosure and put stern constraint on the auditing procedures. Sarbanes-Oxley ethical guidelines are:

• The responsibility of senior mangers got increased for the content of financial statement.
• To increase the liberty of auditing committee created separated board to mange auditing activity.

Corporate governance got stronger because before the implementation of the SOX Act the selection and evaluation of auditors was done by management, but after SOX auditors play a big role in managing statements independently.

A study in November 2009 by Audit Analytics found that 46% of companies did restatements that did not adhere to SOX guidelines. Thus, SOX helps in avoiding restatements of financial disclosures (Ghosh & Pawlewicz, 2009).

The quality of audit also improved through the inspection process of PCAOB, as of Dec, 2011 over 2000 auditing firms from over 80 countries registered with PCAOB.

The concept of independent auditors brought a huge revolution in accounting industry. Sarbanes-Oxley Act totally support the ethical way in conducting financial audits, as discussed above all its sections guides a firm to do accounting within the ethical boundaries so that any further frauds like Enron can be completely avoided. This act helped in creating an ethical ambience in the American market and foreign markets as an investor now feel more secure investing their money into public traded companies. The strict guidelines of SOX Act infused fear among the board members of firms, the fear feel keep the management away from using any unethical means to conduct audit reports.