The Effect of Sarbanes-Oxley Act to Cost accounting and Ethics - Research Paper Example

The Effect of Sarbanes-Oxley Act to Cost accounting and Ethics TABLE OF CONTENTS PAGE NO Introduction 2 2. ment of the problem 2 3. Methodology 2 4. Discussion and analysis 2 An overview of the Sarbanes-Oxley Act 3 Effect of the SOX to public companies and to investors 5 Impact of the SOX to investors 5 Effect to all firms 6 Effect to small and medium sized firms 7 Impact to global trade 7 Over all effect 9 Heightened importance of auditors 9 5. Conclusion 11 6. Work cited 12 The Effect of Sarbanes-Oxley Act to Cost accounting and Ethics Introduction The Sarbanes-Oxley Act was enacted on July 30, 2002 to restore the confidence of investors and to make managers and directors of corporations more accountable to shareholders. The law was created to respond to a number of scandals that affected the public’s confidence in the securities markets. The law was named after Senator Paul Sarbanes and U.S. Representative Michael G. Oxley who were the sponsors of the Act. However, while the intention of this Act is to benefit public companies, Section 404 proves to be controversial. The reportorial requirement and compliance has been the subject of too many complaints coming from affected companies. Statement of the problem The law has been in effect for eight years already. At this time, costs and benefits can already be identified and effects of SOX implementation to the investors and public companies can be found out. The purpose of the study is to answer the question “What is the impact of the law to public companies? Methodology Secondary data from internet sources and journals is gathered to form opinion and valid answers to the problem. The situation of compliance today is compared with 2002, the initial year of SOX implementation. A conclusion is drawn if SOX has achieved its basic objectives of bringing transparency to reporting Discussions and analysis An overview of the Sarbanes-Oxley Act (SOX) SOX Act has been enacted to create transparency in reporting to raise investors’ confidence in the company they may buy. (The U.S. Congress) The SOX ACT has 11 sections ranging from additional board responsibilities to criminal liabilities. SOX Act has commissioned the Securities and Exchange Commission to enforce regulations of this Act. First section of the SOX created the Public Company Accounting Oversight Board (PCAOB) “ to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports”(PCAOB Our Mission). Section two specifies the functions of the auditors and imposes their independence from their clients. Section 201 sets the prohibited services of an audit firm to the same client to avoid conflicts of interests. Scope of Section 2 covers auditor’s independence in order to limit conflicts of interests. The provision specifies new auditor approval requirements, audit partner rotation, and auditor reporting requirements. The prohibited services include bookkeeping, financial information system, valuation and actuarial services, human resources management and investment services. Exceptions are subject to the approval of the Board. Other relevant issues on this section are audit partner rotations, accounting firm reporting procedures and executive officer independences Section 3 has eight subsections that define corporate responsibility. A public company audit committee is created consisting of board members who are not allowed to receive payments outside of service on the boards. This section also defines the corporate responsibility of executive officers for the financial reports. The senior executives certify for the accuracy of the statement, and they will be liable for intentional failure to include this in the audit report. The section also provides for the authority of the federal court to penalize executives who may attempt to manipulate the financial statements for the benefit of investors. Section four pertains to the details of financial disclosure and internal audit procedures. It has sections that prohibit granting of personal loans to executives and giving a timeline for disclosure of executive/owner transaction. The internal control procedures of this section impacts the operation of the public company, and will be discussed in Part 2 of this report. Section four requires submission of annual report that must be done according to the required control structure and procedures for financial reporting. Report should also contain an assessment at the end of the fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. In addition, each firm is required to disclose if its senior financial officers have or have not adopted a code of ethics and to present the contents of this code. The code of ethics is defined as “such standards as are reasonably necessary to promote honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships” Sections five to eleven are SEC’s responsibilities, monetary resources and authority for the implementation of the Act; the requisites for studies and reports, definition of corporate and criminal accountability. Section nine points to the enhancement of white-collar ten crime penalty report; section ten discusses corporate tax returns and section details corporate fraud and accountability The effect of SOX ACT to public companies and to investors Impact of the SOX for investors A belief that SOX Act will reinstate investors’ confidence to the securities market is held by Rep. Michael Oxley, the co-creator of the ACT. He said that ”the average investor now feels that they are being treated more fairly and that the bad guys are being punished for wrecking their faith in those public traded corporations”. (Bergen, L. 2005). Right after the scandals are known, share prices in 2001 to 2002, declined in Enron (99.9%), Global Crossings (99.7%) and WorldCom (93.8%). The outrage of investors had a contagion effect to the U.S. public traded companies that led to financial losses. What has SOX implementation done today? The effects cannot be monitored overnight, but recent reports from the NYSE indicate confidence of investors is slowly coming back. News Releases in NYSE (Brackman, 2009) reported that the NYSE had raised $2.2 billion in proceeds during first half of 2009 that far exceeds other major exchanges in Europe. Chart at left shows comparison of capital raised by major exchanges showing NYSE leading by a wide margin. Effects to all firms 1. Compliance cost. After almost eight years of implementation, the impact to firms is shown in several studies and almost simultaneously describes cost as primary effect. One of these studies is the FEI Survey in 2007 that showed decrease in compliance cost as compared with the initial years of implementation. Survey result showed that in 2007, SOX compliance had cost $1.7 million. Survey also showed a slight increase in Audit fees to $3.6 million, and that more companies see benefit and showed positive changes to audit In contrast to 2004 survey by same firm, SOX compliance showed cost was estimated at $4.6 for large companies and $2 million each for small and medium sized companies. (Madison, N.) 2. Increased confidence on Section 404 The 2007 survey of FEI conducted among 168 big companies indicated that confidence of respondents on the importance of Section 404 has improved as compared with previous year’s respondents. In brief, results of survey are quoted below: 50.3% agreed that financial reports are more accurate; up from 46% in 2006. 56.0% agreed that financial reports are more reliable, up from 48% in 2006. 43.6% agreed that compliance with Section 404 has helped prevent or detect fraud; up from 34% in 2006. 69.1% agreed that compliance with Section 404 has resulted in more investor confidence in their financial reports, up from 60% in 2006. SOURCE: Madison, N. Financial Executives International Improvements in Audit reports. FEI survey revealed improvements in the 2007 audit reports. For instance, financial statements Audit and SOX audit requirements are now more integrated; more auditors use a risk-based approach; less key controls identified; and more auditors use judgment, and reliance on other auditors’ work is enhanced. Effect to small and medium sized public corporations The small and medium sized sectors are affected by SOX as the professional fees of auditors remain the same regardless of the size of the companies. Thus, they are required to allocate resources for this purpose that could rather be used for productive use. (Bergen, L. 2005). The smaller companies, according to Bergen have considered shrinking the company to a size exempted from SOX or delisting the company from the Exchange. Bergen cites the study of Wharton School wherein she noted the number of delisted companies have a triple increase from 2002 to 2003. This may be construed as trying to save money on cost or to avoid scrutiny thru the SOX Act. Bergen suspected that there might be other reasons such that “firms were not being managed in the most efficient manner or the company is hiding information such as excessive compensation. However, public companies turning to private are not really exempted from SOX as they will have to report to the Securities & Exchange Commission which is also allied with SOX. These companies will also use high-debt interest leverage for their operations which in effect is more risky and disadvantageous for smaller companies. but staying. (Bartlet, R. 2009) Impact to global trade. Foreign investors have questioned SOX and are not in favor because of too much regulations required. For instance, SOX requires companies involved in international trade to establish controls for import-export operations and global supply chains to be published in the annual reports to investors. These reports are in addition to the requirements of the Customs and Border Protection, the Department of Commerce and the Food and Drug Administration. The company faces stiff legal penalty for a wrongful declaration under the Act. Another implication is the provision that requires disclosure of all-balance sheet transactions, obligations and managements, with failure to comply resulting in delisting by the SEC or barring of international trade” This provision make it hard for international trade to comply as many small firms have low international trade volumes and have very little knowledge about customs compliance Compliance with too much regulatory controls caused many issuers to get out from the U.S. Stock Exchanges and go to the London Stock Exchange. Formaini (2005), reported that the foreign listings have gone down as 198 foreign firms have chosen to be delisted. This number has increased three times over the previous years. Many foreign issuers think SOX regulation is too costly to implement, and believe their corporate executives are more open to personal reliability. (Koehn, J. and DelVecchio, S. 2006) Moreover, foreign issuers claimed that they are already complying with the equivalent International Financial Standards and are reluctant to follow the SOX. Overall Effect The 2007 FEI survey has marked improvements over the past years’ apprehension on the compliance of SOX from companies. These anxieties are based on expenses on the internal control measures on reporting and auditing. Surveys done in 2004 and 2005 (Bergen L. 2005) proved complaints come from implementation cost of audit and software. Bergen’s study reports of an SEC estimate saying U.S companies needs 5.4 million staff hours each year and about $6.1 billion for manpower, IT, and counseling services needed to support SOX requirement Companies will have to allocate a one-time big expense called “sunk cost” whose benefits cannot be measured in the short run analysis. However, it is a process that supports trailing system better Heightened importance of auditors The SOX provisions have emphasized the heightened importance of the role of auditors in compliance. It bans several activities that established conflicts of interests particularly with client-auditor relationship. For instance, auditors cannot perform bookkeeping services for same clients as auditors are supposed to render independent service. Auditors in this sense cannot evaluate independently financial reports that he himself has prepared. An auditor is required to evaluate efficiency of accounting design and information system; hence an auditor is prohibited from designing one for the client he is auditing. An auditor is not allowed to provide actuarial or valuation services as this will create conflict of interest. An auditor can only assist client in understanding the assumptions and models used. An auditor cannot perform management functions nor be involved in the hiring process of audit personnel as it is against SOX provisions of conflicts of interest. He cannot be a broker, dealer, investment adviser, a legal adviser and a provider of expert service adviser in litigation process. Services of Audit firms As a result of SOX, services of audit firms are needed to perform the required reportorial requirements. In 2002 survey (Koehn, J. and DelVecchio, S) showed 38% of companies surveyed do not have an internal audit department and in the process of hiring personnel to do the work. Salary Increases Hiring of accounting personnel is guided by the 2005 Salary Guide (Bergen, L. (2005) that provides a double digit increases in internal audit and managerial positions identified below: Internal auditors at large corporations: 12.5% Internal auditors at mid-size corporations: 16.8% Managers at large public accounting firms: 10.2% Senior accountants at large public accounting firms: 11.7% Entry-level professionals at small public accounting firms: 11.4%. Source: Bergen, L. (2005). Increase in Audit Fees The increase cost of audit fees has been anticipated because of the amount of time needed for implementation. D’Aquila (2004) estimated audit fees to increase by 38% during the first year. This was confirmed by result of Financial Executives International survey in January 2004, saying that multinationals with revenues of over $5 million could incur $4.6 million while small and medium sized companies could incur $2 million each. The amount of time to be devoted by auditors in SOX compliance ranges from 1,150 to 35,000 hours internal work and 846 to 6,197 hours external work. (D’Aquila) D’Aquila puts the equivalent audit fees for this amount of time at $590,000 to $1.5 million. The Pricewaterhouse Coopers survey June 2003, cited by Dr. D’Aquila confirmed that SOX has doubled expenses of companies from 32% to 60% The audit market The audit market is composed of the 4 big audit firms and the second tier audit companies. The market did not contract or expand as the loss of clients of big firms due to high costs and lack of manpower is the gain of smaller audit firms. (Koehn and DelVecchio, 2006) A Reuters report, (Chasan, 2008) said the large companies in the U.S. feel that they are limited in their choices of the “Big four” audit firms. However, Chasan cited Government Accountability Office (GAO) that said “large companies do not experience bad effects with limited choices”. Chasan said GAO found out that large companies do not prefer auditors outside of the “Big Four” but suggested having more than four. The Big four dominance, according to GAO report becomes a barrier to entry of other auditing firms. These firms are PricewaterhouseCoopers [PWC.UL], KPMG [KPMG.UL], Ernst & Young [ERNY.UL] and Deloitte & Touche [DLTE.UL] -- audit 98 percent of U.S. companies with annual revenues over $1 billion. Conclusion Based on the data reviewed the effect of Sarbanes-Oxley Act to cost accounting and ethics are cost of implementation and ethical role of auditors in preparation of internal control and financial statements. Impact to public companies is the responsibilities of compliance that is tied up to stiff penalties under the law. When the Sarbanes-Oxley Act was implemented, most public companies view it as detrimental to growth and costly. They have perhaps forgotten the feeling of investors who suffered financial loses in their investments. Apparently, investors have lost their trust in the security of investments as well as confidence on the financial reports presented by companies. SOX Act is created to regain confidence of people and it is the responsibility of companies to submit trust worthy financial reports to stockholders. The scandals in 2002 can be repeated if the government did not intervene and impose strict regulations. By virtue of SOX, US trading have reinforced its leadership position which was affected by Enron scandals in 2002. In the course of its implementation, public companies responded accordingly as they have perhaps understood the long term benefits for the companies as well as to the investors. The activity in the trading exchanges attest to renewed confidence of investors. Does the cost outweigh benefits? The study done is limited as few studies are done about benefits, and more about costs. The Act may be considered to be in its infant stage, so that revisions and amendments may be done to address complaints that are focused mostly on costs of compliance. Works Cited Bartlett, R. Going Private but Staying Public: Reexamining the Effect of Sarbanes- Oxley on Firms’ Going-private Decisions. The University of Chicago Law Review. Retrieved September 6, 2009 from http://www. Lawreview.uchicago.edu-issues-archives-v76… Bergen, L. (2005). The Sarbanes-Oakley Act of 2002 and its Effects on American Business. Retrieved September 6, 2009 from http://www.financialforum.umb.edu/documents/Sarbanes-Oxley.pdf Brakman, C. 2009) NYSE Euronext Continues to Lead U.S. IPO Market as NYSE IPOs Raise $2.2 Bln in 1H . NYSE Euronext. Retrieved September 6, 2009 from http://www.nyse.com/press/1246875732166.html Chasan, E. (2008) U.S. WatchDogs says “Big Four” Audit Firms enough for now.. Reuters. Retrieved September 6, 2009 from http://www.reuters.com/article/governmentFilingsNews/idUSN10485198200 80111 D’Aquila, J. (Nov. 4, 2004). Tallying the Cost of Sarbanes-Oxley Act. CPA Journal Retrieved September 5, 2009 from http://www.nysscpa.org/cpajournal/2004/1104/perspectives/p6.htm Formaini, R. L. Sarbanes-Oxley: Corporate transparency or cost trap? The Capco Journal of Financial Information. Retrieved September 6, 2009from www.capco.com/.../02_Sarbanes%20Oxley%20Corporate%20transpare ncy%20or%20cost Koehn, J. L. & Delvecchio S. C. (2006) Revisiting the Ripple Effects of Sorbanes- Oxley Act. The CPA Journal, May 2006. Retrieved September 5, 2009 from http://www.nysscpa.org/cpajournal/2006/506/essentials/p32. Madison, N. FEI Surveys. Financial Executives Internationa. Retreved September 5, 2009 from Web site: http://www.financialexecutives.org/ PCAOB -Public Company Accounting Board. Our Mission. Retrieved September 6, 2009 fromhttp://www.pcaobus.org/ SOX Online. Section 201 of the Sarbanes-Oxley Act:Prohibited Auditor Activities. The Vendor-Neutral Sarbanes-Oxley Site Retrieved September 5, 2009 from http://www.sox-online.com/act_section_201.html The U.S. Congress. 2002. Sarbanes-Oxley Act. H.R. 3763. Retrieved September 6, 2009 from . Read More