The US Federal Law - Sarbanes-Oxley Act 2002 - Research Paper Example

The US Federal Law - Sarbanes-Oxley Act 2002 Introduction The Sarbanes-Oxley Act of 2002 is a U.S. federal law which was enacted and approved on July 30, 2002. It came amidst corporate scandals and economic downturn. It was designed to protect investors and improve their confidence in the market by improving the reliability and accuracy of corporate disclosures that are made in accordance to the securities laws. In addition to other purposes, it also served to increase management’s responsibility for the financial statements that are made in accordance with the securities laws. According to Holt (2008) when President Bush signed the act into law he indicated that it will be used to act against those who have significantly reduced confidence in the US stock market, to expose corruption, punish those who seek to do wrong and protect the rights and interests of workers and investors. President Bush also emphasized not only the message that is being sent to corporate leaders but what it meant for corporate accountants, shareholders, employees and Americans generally (Holt 2008). The Act which is named after Senator Paul Sarbanes from the State of Maryland and Representative Michael Oxley of the Republican Party has faced numerous criticisms from corporate leaders and academics due to the high costs of its implementation and the fact that the same securities and exchange commissions mandate could have been used to bring the necessary changes to book. This paper looks at the motivations for the Sarbanes-Oxley Act of 2002, its requirements, its impact on the audit profession, what it means for accountants, the management of corporations, the perceived benefits and costs of the act, and some criticisms that have been made in response to its implementation. Motivations for Sarbanes-Oxley 2002 The US Congress enacted the Sarbanes-Oxley Act of 2002 as a response to highly publicized failures of businesses (including Enron, Tyco International and World Com), allegations of corporate improprieties and misstatements of financial information (McConnell and Banks 2003). Corporate failures such as these resulted in investors losing their investments in companies. The Act sought to increase certain obligations relating to corporate governance. Hamilton (n.d.) points out that among the major goals of the legislation was the reform of corporate governance and accounting for companies listed on the stock exchange. It also served to increase the responsibility of chief executive officers (CEOs) and Chief Financial Officers (CFOs) by imposing both civil and criminal penalties and extending the statute of limitations relating to suits for securities fraud from two years after its discovery to five years after the actual violation (Hamilton n.d.). Requirements of Sarbanes-Oxley Sarbanes-Oxley Act is separated into sections that falls under various titles. Each tile deals with a particular aspect of the law. The tiles are: i. Public Company Accounting Oversight Board, Auditor Independence; ii. Corporate Responsibility; iii. Enhanced Financial Disclosures; iv. Analyst Conflicts of Interest; v. Commission Resources and Authority; vi. Studies and Reports; vii. Corporate and Criminal Fraud Accountability; viii. White-Collar Crime Penalty Enhancements; ix. Corporate Tax Returns; and Corporate Fraud and Accountability According to the Sarbanes-Oxley Act 2002 the Public Company Accounting Oversight Board was set up to oversee the audit of pubic companies that are subject to the securities laws. The duties of the board include: a. registration of public accounting firms that prepare audit reports for issuers; b. establishing or adopting audit quality control, ethics, independence and other standards relating to the preparation of audit report; c. conducting inspections of registered public accounting firms; d. conducting investigations and carrying out disciplinary proceedings; e. imposing the necessary sanctions as it sees fit; f. performing any other functions deemed necessary; and ensuring compliance with the Act, rules of the board, professional standards and securities laws relating to the preparation and issuance of reports as well as the liabilities and obligations of accountants; g. powers inclusive of the ability to sue and be sued as well as complaining and defending; h. allocating, assessing and collecting accounting and support fees as well as other fees and charges that may be deemed necessary. In order to register with the Board the Sarbanes-Oxley Act makes it mandatory that audit firms submit applications which indicate the names of companies for which the firm has prepared audit reports during the calendar year and the annual fees received for such services as well as to give an indication of other accounting and non-audit services provided. Audit firms are also required to provide financial information for the most recent fiscal year, a quality control statement of the policies of the firm and its accounting and audit practices; a list of the accountants that are associated with the firm; information of actions taken against the firm inclusive of criminal, civil or administrative actions or proceedings that are pending; copies of annual or periodic disclosures and any other information as the rules of the Board specifies. The Sarbanes-Oxley Act has instituted new standards in relation to Auditors Independence where it prohibits audit firms from providing any non-audit service including: a. bookkeeping or other services relating to the accounting records or financials statements of the client audited; financial information systems design and implementation; b. appraisal or valuation services, fairness opinions, or contribution in kind reports; c. actuarial services; internal audit outsourcing services; d. management functions or human resources; e. broker or dealer, investment adviser or investment banking services; and f. legal services and reporting. The Act also indicates that any audit service not specified including the provision of tax services may be allowed if preapproved by the audit committee of the issuer. In addition, the Act requires rotation of partners after five years of preparing services to an issuer. In terms of corporate (management) responsibility Section 302 and 404 of the Act, the principal financial officer has been charged with ensuring that the responsibilities that has been undertaken in acceptance of that position is properly discharged by ensuring that both the quarterly and annual reports are reviewed and do not contain any untrue statement or omit to indicate any material facts. This regulation will ensure that the report is not misleading. The Act makes clear that one of the CFO’s roles is to establish and maintain internal controls. The effectiveness of these controls the act states should be evaluated for their effectiveness within 90 days prior to the issuance of the report. The act also requires that the effectiveness of the controls be reported. Section 404 of the Act cannot be delegated to anyone external to the company it is the sole responsibility of the company and the persons charged with responsibility to carry out those functions. Therefore, the auditors are now somewhat free from some of the blames that they have been used to receiving when things go bad as management seeks to ‘pass the buck’. This however, does not mean that they have no responsibility. Their work load has increased as the ways in which they are used to carry out their roles have been intensified. They have to make sure that they do not take on management responsibility but ensure that the necessary checks are done to determine whether the internal controls are in place and are working. The Impact of Sarbanes Oxley on the Audit Profession According to PricewaterhouseCoopers (2005), since the enactment of Sarbanes-Oxley the demand for internal audit services are at an all time high as they often play a key role in compliance and risk management by providing support to management and audit committee stakeholders. In response to strong review mandates from the Institute of Internal Auditors (IIA) internal auditors have placed strong emphasis on quality assurance. In a survey carried out by PricewaterhouseCoopers more than 70% of reporting companies indicate that in the first year of Sarbanes-Oxley compliance required over 50% of their internal audit resources. In year two internal audit groups continued their focus on the requirements of the Act. PricewaterhouseCoopers (2005) indicates that because the responsibilities of management cannot be delegated to anyone else they often turn to internal audit to support compliance with the requirements of the Act. This reliance on internal audit, PricewaterhouseCoopers (2005) suggests, is a direct result of their proven skills in managing very large and complicated projects. Rittenberg and Miller (2005) also suggested that there is some uncertainty regarding the work of internal auditors in relation to Section 404 of Sarbanes-Oxley regulations. Most internal practitioners would like to maintain a strong presence in the risk and control arena and have seen the need to carry out more operational auditing that will continue to add value to organizations. Benefits of Sarbanes-Oxley Compliance According to Rittenberg and Miller (2005) companies have struggled to put in place the internal controls required by the Sarbanes-Oxley Act 2002, the cost has been high but only a few studies have really looked at the benefits that have been and can be derived from its implementation. Rittenberg and Miller (2005) in their survey of 171 chief audit executives (CAE’s) and internal audit managers sought to determine the specific benefits associated with Section 404. Among the major themes emerging from their study is the fact that there are some significant benefits that are associated with control identification, documentation, and the testing process. The process of evaluation has facilitated improvements in basic internal controls such as reconciliations and segregation of duties (Rittenberg and Miller 2005). Substantial improvements in the control environments are a direct result of the process. A number of companies have recognized that they have weaknesses in the information technology (IT) area of their businesses and have looked at the possibility of devoting more resources in order to both improve and evaluate IT controls as the time goes by. Additionally, companies are now more confident in their control structure and are now evaluating accounting risks which will allow investors to have more confidence in the reliability of both audited and audited information that have been made available to the securities market (Rittenberg and Miller 2005). Another of the major themes arising from Rittenberg and Miller’s work is the prognosis that future costs associated with the implementation of Section 404 will decrease after the first three years. Rittenberg and Miller (2005) found that much of the initial cost was due to the fact that internal controls were not properly documented or evaluated prior to Sarbanes-Oxley regulations. It is expected that companies will see a significant reduction in costs as soon as the information, communication and monitoring concepts that are embedded in COSO’s Internal Control – Integrated Framework has been fully implemented (Rittenberg and Miller 2005). Rittenberg and Miller (2005) have also identified some lessons that were learned that can assist in improving the efficiency and effectiveness of control evaluations in the future. Henry and Borrus (2005) have also indicated that some companies have realized that their focus on internal controls have unearthed a number of problems. This has led to some of these companies firing employees because of the number of errors which were being made prior to their implementation of the provisions of Sarbanes-Oxley. It must be emphasized that some of these requirements were in place before and the implementation of the Sarbanes-Oxley Act 2002. The Act now serves to enforce them because they were being disregarded as immaterial. It therefore means that there are definite benefits that can be derived from its implementation as it focuses on the importance of making sure that management, external auditors and the internal auditors perform their functions in keeping with the standards required by their profession. In relation to the improvements in internal controls Rittenberg and Miller (2005) have prepared what they describe as a “Top 10” list of the control improvements which have been brought about by the implementation of Sarbanes-Oxley. They are: i. A more engaged control environment with the board, audit committee and management actively participating in the process. ii. More thoughtful analysis of monitoring controls, in addition to the recognition that monitoring is an integral aspect of the whole control process or processes. iii. More structure to the year end closing process and recording of journal entries, and therefore the recognition of the extent to which these areas have increased in complexity. iv. Implementation of activities designed to prevent fraud with well defined processes including the assignment of the responsibility of follow-up to the relevant parties, and the approaches that will be used to resolve related issues. v. Better understanding of the risks associated with general computer controls, and the need to improve both control and audit procedures to gain assurances that the risks that are associated with computer systems are mitigated. vi. Improved documentation of both the control and control processes that provide a basis for training, practical guidance on a day to day basis, as well as management evaluation. vii. Improved definition of controls and the relationship between controls and risk across the organization. viii. Control concepts being embedded in the organization with a broader understanding of operating personnel as well as management of their responsibility for controls. ix. Improvements in the adequacy of audit trail as a basis of providing support for operations as well as audit assessment of control adequacy and financial reporting. x. Re-implementation of some basic controls like segregation of duties, periodic reconciliation of accounts and authorization processes that were no longer being practiced as organizations downsized or consolidated their operations. The Cost of Sarbanes-Oxley Compliance The cost of complying with the Sarbanes-Oxley of 2002 is no doubt very high and according to Henry and Borrus (2005) the cost is upwards of $35 million on average for large companies. Reynolds (2005) also indicates that it cost GE $30 million and this does not include the increased expense of insuring officers and directors. Reynolds (2005) also indicate that this expense has resulted in the delisting of common shares by a number of companies. According to Reynolds (2005) these delistings tripled in 2003 and this was caused partially by the regulations required by Sarbanes-Oxley. Reynolds (2005) further indicates that it has increased the cost of doing business as a publicly traded US corporation because the cost of compensating outside directors has also increased by 150% from $40,000 to $100,000 in some cases, as revealed in a study done by Foley & Lardner. Criticisms of the Sarbanes-Oxley Act Reynolds (2005) suggests that the Sarbanes Oxley Act of 2002 was too hastily enacted and therefore follows from the well known proverb – “haste makes waste”, the remedies adopted have no bearing on and were not connected to the causes of the financial crisis. The Act was simply related to the enforcement of the latest generally accepted accounting standards (GAAPs) at the time (Reynolds (2005). Bankruptcies, Reynolds (2005) points out have absolutely nothing to do with how records are kept; they are real events and accounting that sets out to deceive was not the real cause of the financial crisis but only a consequence of it. Reynolds (2005) also gave examples of companies that failed because of bankruptcies like Bethlehem Steel, K-Mart, PSI, Net and W.R. Grace and those that failed because of accounting scandals like Tyco, Xerox, Rite Aid and AOL. Additionally, Reynolds (2005) indicates that Sarbanes-Oxley is obsessed with bookkeeping which although helpful to stockholders but investors were aware that both Enron and WorldCom’s earnings were overstated and that they had undisclosed debts well in advance of either the accountants or federal regulators becoming aware of this. It was this knowledge by investors that led to Enron’s stock declining below $1 and WorldCom’s stock declining by approximately 61% (Reynolds 2005). In relation to the creation of the Public Company Accounting Oversight Board (PCAOB) Reynolds (2005) indicates that almost half of the pages is devoted to this area, just to do what the Securities and Exchange Commission (SEC) has the mandate to do, the only difference being that the PCAOB is dominated by persons with no accounting expertise. This according to Reynolds (2005) has led to mid-sized accounting firms no longer performing audits for public companies. In terms of the requirements for independent directors on the audit committee of every corporate board the majority of whom should have no expertise and one with expert knowledge, eye brows have been raised as there are examples of companies that have failed that already have this in place. Reynolds (2005) indicates that Enron’s Board was 86% independent and chaired by an Accounting Professor at Stanford who was highly rated as one of America’s best by Chief Executive Magazine. The requirements relating to the rotation of auditors have been criticized by Bumgardner (2003) who indicates that this last provision that allows the auditors to do additional work appears to swallow the rule as it allows for consultancy services and the oversight broad has the authority to grant exemptions which allow an auditor to provide any of the prohibited services. It makes provisions for conflict of interest requiring that if an auditor who took part in the audit of an issuer’s records and financial statements is subsequently employed in a key role such as chief accounting officer (CFO) then the audit by the same firm to which the CFO was employed within the last two years would constitute a conflict of interest. Pollock (2009) suggests that in addition to being a great cost and financial bureaucracy Sarbanes-Oxley has succeeded in creating a bonanza for the partners of accounting firms. This effort did not prevent the financial bubble which started in 2008 resulting in the Great Recession that appears not to have ended but to be heading for a double dip. Pollock (2009) indicates that in discussions with industry players it was revealed that the melt-down proved that Sarbanes-Oxley has had no impact on corporate behavior. This would appear so since the Sarbanes Oxley Act of 2002 speaks specifically to off-balance sheet transactions which include derivatives such as credit default swaps. These derivatives were not properly understood by even the institutions that were engaged in their use and the result was the fall of several companies and bailouts for some that had not fully complied with the provisions of the Act. Conclusion The Sarbanes-Oxley Act of 2002 has brought about a number of changes in the way companies are managed. It has set new and enhanced standards for all boards of public companies in the U.S. as well as the management and public accounting sponsors. The Act has not so much increased the responsibilities of management as it has made them more aware of some of the key aspects of their role. It has prevented them from delegating key aspects of their responsibilities to outside parties and seeks to ensure that they focus on making the control environment reliable so that investors’ confidence in information provided in annual reports can be improved. Control improvements have been facilitated as a direct result of Sarbanes Oxley provisions relating to corporate responsibility and auditor independence. In the past auditors would perform certain aspects of their work on a rotational basis. The act has resulted in unnecessary cost for some companies that can least afford to implement it. The increased requirements for companies that are publicly traded have resulted in an increased level of delisting, never experienced before. It has also resulted in smaller audit firms not having the continued experience of auditing publicly listed companies. It is be extremely difficult to determine whether the benefits outweigh the costs in some cases as the recent episode of failures indicate that there are some aspects of the Sarbanes-Oxley Act of 2002 that was not implemented in a number of public companies. So far there have been few penalties or imprisonments associated with blatant fraudulent actions. Investors have continued to lose out because of non-disclosures, fraud and conflict of interest on the part of credit rating agencies even though there is a section in the Act relating to the analyst conflict of interest. References Bumgardner, L. (2003). Reforming Corporate America: How does the Sarbanes-Oxley Act impact American business? Graziadio Business Review: 6(1). Retrieved from: http://gbr.pepperdine.edu/2010/08/reforming-corporate-america/ Henry, D. and Borrus, A. (2005). No Escaping Sarbanes-Oxley. Retrieved from: http://www.businessweek.com/bwdaily/dnflash/jan2005/nf2005016_5163_db016.htm. Last accessed 19th Aug 2011 Pollock, A.J. (2009). Sarbanes-Oxley in the Light of the Financial Crisis. Retrieved from: http://www.aei.org/outlook/100090. Last accessed 10th Aug 2011 PricewaterhouseCoopers (2005) PricewaterhouseCoopers’ State of the internal audit profession study: Internal audit post Sarbanes-Oxley. Retrieved from: http://www.pwc.com/en_US/us/internal-audit/assets/state_internal_audit_profession_study_05.pdf. Last accessed 13th Aug 2011 Reynolds, A. (2005). The Sarbanes Oxley Tax. Retrieved from: http://www.cato.org/pub_display.php?pub_id=4240. Last accessed 11th Aug 2011 Rittenberg, L.E. and Miller, P.K. (2005). Sarbanes-Oxley Section 404 Work Looking at the Benefits. Florida: The Institute of Internal Auditors Research Foundation U.S. Government Printing Office (2002). PUBLIC LAW 107–204—JULY 30, 2002. Retrieved from: http://www.gpo.gov/fdsys/pkg/PLAW-107publ204/pdf/PLAW-107publ204.pdf. Last accessed 10th Aug 2011 Read More