The Sarbanes-Oxley Act of 2004: Boon or Bane to the US Economy - Case Study Example

The Sarbanes-Oxley Act of 2004: Boon or Bane to the U.S. Economy? Introduction A spate of corporate scandals involving companies like Worldcom, Enron, Tyco, and Arthur Anderson in the beginning of the present century shook the faith of the investors. These companies either tried to hide the actual information or provided partial information to mislead the investors and the general public. As the stocks, triggered by the financial scandals, went on the downward spiral, billions of dollars of shareholders’ wealth vanished into the thin air. Consequently, Sarbanes-Oxley Act of 2002, also called Sarbanes Oxley or simply Sox, relating to corporate governance and internal control over financial reporting, was proposed in the Congress, jointly by Senator Paul Sarbanes and Representative Michael G. Oxley. Passed by the House of Representatives, by a vote of 423:3 and the Senate by 99:0, the Act was promulgated into law by President George Bush on 30 July 2002. The Act is organized into 11 titles and most important of these are 302, 401, 404, 409, 802, and 906. The Act is considered the most sweeping change in the federal securities law ever since the New Deal. The Act also covers the companies who have overseas operations, but are listed on the stock exchanges of the United States. Sarbanes Oxley has been enacted to respond to the weaknesses in the US capital markets that became apparent during bankruptcies of large public corporations (Frantz & Nash, 2003). The law was ostensibly enacted to improve transparency, management accountability, and bring in accuracy in corporate disclosures and restore the confidence of public in the US corporate sector. According to Alderman (2007 , passing of a law, for tightened controls on the corporate world, was kept in abeyance for a long time in the Congress, due to intense lobbying by influential business groups (as cited in Govekar, 2008). Even discounting the occurrence of corporate scandals of this magnitude, popular literature by Michael Porter, Tom Peters, Gary Hamel, C. K. Prahalad and Ken Blanchard suggested that in the information age, we needed control and measures to manage ‘new economy enterprises’ like Cisco, JDS Uniphase, Nortel, EMC Corp., WorldCom, Tyco, Global Crossing, and Enron (Govekar, 2008). Sox seeks to establish corporate responsibility over financial reports (Petra & Loukatos). Besides, setting a code of conduct in corporate governance, the Act also proposed regulatory framework for the US Securities and Exchange Commission (SEC) and other securities exchanges and associations in the country. Sarbanes Oxley Act The Sarbanes Oxley Act seeks to introduce major changes in the regulation of financial practice and corporate governance. Section 301 stipulates that there should be independent directors on the audit committee. Sections 302, 404, and 409 deal with the information technology aspect. Section 404 states that it is the responsibility of the Board to establish, and maintain internal control structures and procedures for financial reporting. Section 402 prohibits the companies to advance loans to their directors and chief executives. Section 407 seeks financial expertise on the audit committees. Section 802 entails that any accountant, who conducts an audit shall maintain audit or review work papers for a periods of five years. The Section 906 mandates that chief executive officers and chief financial officers should sign their companies financial reports after confirming their veracity. There are criminal liabilities for the knowing and intentional false certification. Sarbanes-Oxley Act mandates that the CEO and CFO have the primary responsibility of reporting and ensuring the completeness and accuracy of the reports filed with the SEC and other exchanges. Sarbanes Oxley prohibits sanction of loans to directors or executives of the company. Sox requires that information regarding internal control mechanisms, corrections to past financial statements and material off-balance sheet transactions be disclosed. The management and auditors must conduct a yearly survey of company’s internal controls (Lander, 2002).The Act also stipulates that the companies disclose information on material changes in the operation. Sox implies that the auditing partner of the firm rotate off every five years. The Act establishes processes for electing competent audit committee members and for ensuring that adequate reporting procedures are in place. The audit committee hires, sets compensation, and oversees the work activities of the auditor. The Act prohibits the auditing firm from providing most non-audit services to companies publicly traded on the US exchanges (Nelson, 2008). The audit committee sets rules and processes for complaints concerning accounting and internal control practices. The auditing firm should share all the critical accounting policies and practices with the audit committee. According to Sarbanes Oxley each member of the audit committee should be member of the board and yet be independent. Sarbanes Oxley mandates a capital punishment of 20 years to directors and employees for destroying audit records or falsifying documents and knowing other violations for securities regulations. Auditors of the public company are supposed to preserve the records of audit work or review work for a period of 5 years (Lander, 2002). The Act seeks to lend greater transparency to financial practices, and hold the boards criminally liable for lapses. Sox covers issues such as setting up a Public Company Accounting Oversight Board, establishing auditor independence, corporate responsibility and enhanced financial disclosure. The board, consisting of five members, is to be funded by companies with securities. It is a private non-profit organization that ensures that financial statements are audited according to independent standards. The oversight board is responsible for enforcing standards for the audits of public companies and ensuring transparency in their processes. The board is empowered to oversee the audit of public companies that are subject to securities law. Sarbanes Oxley also calls upon the directors and the officers to ethically handle the situation in case of conflict between personal and professional relationships (Nelson 2008). It is illegal for a corporate entity to punish or discriminate against the whistle blower in any manner. There are criminal penalties for actions taken in retaliation against whistle blowers. As per Sarbanes-Oxley Act, Securities Exchange Commission ensures credibility of the financial statements of the companies. Sarbanes Oxley—A Boon The act is focused on corporate practices and reporting activities of the companies. The heart of Sarbanes-Oxley is integrity of corporate financial data (Stephens, 2005, 102). Beyond the statutory compliance, the Act also helps in creating better internal controls, reliable documentation, and compliance with other statutory regimes, smoother organizational processes, and strengthened internal controls. Sox keeps a tab on the internal processes and information disclosure guidelines of the company. The Act provides adequate protection for the whistle blowers. Retaliation against whistle blowers or informants is punishable by a fine and imprisonment up to 20 years (Lander, 2002). Sarbanes-Oxley empowers the external auditors and corporate directors to make public disclosures as per the US securities regulations. In general, Sarbanes Oxley tries to improve the independence of the external auditors and diligence of directors and officers so that they are better able to prepare the disclosures with form or substance required by the securities regulations. Though apparently the Sarbanes Oxley regulations may seem a financial burden on an organization, but in the longer run, these very changes will strengthen the financial and the ethical foundations of the company. The valuable insights attained into operations by compliance are translated into improved productivity, efficiency, and cost savings. The implementation of the Act is costly and difficult in the first year, but there is sizeable decrease in costs and difficulties associated with compliance in the second year. Sox has gone a long way in restoring investor confidence in the stock markets of the United States. The Act not only protects the interests of the investor but also tries to deliver more share holder value. Sarbanes Oxley—A Boon A large segment of industry insiders are of the view that Sarbanes Oxley is full of red tape, is time consuming, and a drain on resources and productivity. An increasingly large number of executives believe that the law will not have positive impacts on the US economy. The larger the company, the more are its internal controls. Large global corporations have hundreds of controls. The large companies are required to monitor these controls to find out that they are effective. Further, they need to be checked for effectiveness by an external auditor. Confusion over what the law requires has left the companies vulnerable to experts and consultants. Consultants and audit experts can coerce companies into incurring unnecessary expenditure. The biggest demerit of Sarbanes Oxley is its compliance costs. The US companies spent a large sum of $ 5.5 Billion on Sarbanes Oxley compliance in 2004 (Green, 2005). According to Foley and Lardner, a Chicago, IL based law firm, the cost of being a public company has increased 171 percent for companies with revenues less than $ 1 billion with most of cost being attributable to compliance with Section 404 (Petra & Loukatos, 2008). Sox tends to increase the indirect costs over and above the direct costs. Due to rise in compliance costs, one in four of the respondent public companies were actively considering going private (Petra & Loukatos, 2008). Though the Act has gone a long way in restoring the investor confidence, but it is increasingly acting as a facilitator for companies to look for operational markets with low compliance costs. According to the Act certain data and types of records need to be retained for minimum periods and the failure to archive information can be a serious offence. The data retention service is a drain on resources in both financial and in terms of staff hours. Since email is an accepted form of communication, its records must be retained to meet the provisions of the Act. However, the Act is silent upon what kind of messages and communication need to be retained. In the absence of guidelines, the company need to retain all messages from the expert and company officials regarding preparation of financial results, audits, which is not only a cumbersome process but is also a drain on time and resources. Rather than punitive action for non-compliance, the most worrying aspect of Sarbanes-Oxley for chief executives is the effort, staff time, and consulting fees involved in ensuring compliance (Meyer, 2003). As a result foreign firms are also shying away from listing their stocks on the US exchanges. Chief executives of companies contend that they spend more time in avoiding liabilities, under than Act, than focusing on improving the fiscal health of the company. Sarbanes Oxley Act seems to be hurting the interests of small and medium business enterprises the most. The Sarbanes-Oxley Act is acting as deterrent for small private organizations to go public. Small companies may not have the required capital to hire team of external and internal auditors to check their financial statements. High compliance costs are acting as deterrents for small companies to go public, expand and widen their horizons. As a result, the number of companies going public since enforcement of Sarbanes Act in 2002 is on the decline. The costs related with going public are simply prohibitive for small scale companies. Sarbanes-Oxley only pertains to disclosure requirements for directors and chief executives under US security regulations. However, with some exceptions, it is ignores the broader obligations of the corporate directors or officers to their corporations or standards applicable to the performance of the companies (Nelson, 2008) Conclusion Though full implications of Sarbanes-Oxley will only be realized with the passage of time, it is certain that the fear of legal backlash, amongst the managements, is sure to check corporate melt downs and related problems. Weighing the pros and cons, it is clear those compliance difficulties notwithstanding, the Act shall go a long way in holding intact the public confidence in the stock markets of the US. Besides, the Act shall improve the overall financial functionality of the companies. Sarbanes Oxley shall lead to development of systems and processes that shall stand the senior managements of the companies in good stead in the longer run. References Frantz, M.A., & Miller, N. (2003) Corporate Governance redefined: The Sarbanes-Oxley Act of 2002 and related rulemaking. Retrieved July 14, 2009, from http://library.findlaw.com/2003/Oct/31/133131.html Govekar, P, L., (2008). An historical perspective on the Sarbanes-Oxley Act. Journal of Management History (14) 3, 284-293 Retrieved July 10, 2009, from Emeraldinsight database. Green, S. (2005) Sarbanes Oxley and the board of directors New York: Wiley Publishers Lander, Guy, P. (2002) The Sarbanes Oxley Act of 2002, Journal of Investment Compliance 44-52 Retrieved July 11, 2009, from Emeraldinsight database. Meyer, M. (2003). Corporate real estate and Sarbanes-Oxley: Web-based tools for ensuring compliance and improving financial management. Journal of Corporate Real Estate (6) 1. Retrieved July 12, 2009, from Emeraldinsight database. Nelson, B, L. (2008). The American national system of corporate governance. (Narciri.A., Ed.) Routledge, Taylor and Francis Group. Petra, S, T. & Loukatos, G. (2008) The Sarbanes-Oxley Act of 2002: a five-year retrospective. Corporate Governance (9)2. Retrieved July 13, 2009, from Emeraldinsight database. Stephens, D, O., (2005). The Sarbanes-Oxley Act record management implications. Records Management Journal (15)2, 98-103 Retrieved July 11, 2009, from Emeraldinsight database. Read More