The Cost of Complying with Sarbanes-Oxley Act - Research Paper Example

The Cost of Complying with Sarbanes-Oxley Act Section 404” “The Cost of Complying with Sarbanes-Oxley Act Section 404” Brandy Swanson College Professor David Medved Financial Analysis, Planning & Control - MSA 602 Abstract Section 404 is the most important section of Title IV of the “Sarbanes-Oxley Act” and has been the most costly part of implementing the latest bill. Under Section 404, board of a company is needed to generate a report on “internal control” that confirms the accountability of the Board for instituting and preserving a required “internal control “setup and processes for “financial reporting”. (Coffee, 2006). However, cost of compliance is said to be relatively high and acts as an additional financial burden to public companies in USA. This research study analyses salient features of section 404, its advantages and defects in detail. “The Cost of Complying with Sarbanes-Oxley Act Section 404” “Sarbanes-Oxley Act”, otherwise known as “SOX”, is the America’s federal law which sets latest or improved standards for all U.S.A based management and public accounting firms. (Coffee, 2006). In 2002, SOX was introduced in retort to frequent occurrence of major accounting and corporate scandals, including scandals such as Tyco International and Enron. (Coffee, 2006). The main purpose of the “Sarbanes-Oxley Act” is to regain the confidence in the capital market by enforcing mandatory standards and rules for companies. The scandal involving Enron Corporation was one of the main drivers behind the enactment of Sarbanes-Oxley Act. CEO, Kenneth L. Lay, was responsible for hiding billions of dollars in debt from failed deals and projects. “Nearly $11 billion were lost by Investors when stock quotes of Enron, which remained at the top of $90 per stock during the middle of 2000, plunged to less than $1 at the close of November 2001.” (Benston, 2006). In December 2001, Enron filed for bankruptcy and Lay was found to be involved in one of the biggest accounting fraud crimes in U.S. history. As a result of scandals like Enron and the public bankruptcy of such well-recognized businesses, US Congress passed the “Sarbanes-Oxley Act of 2002.” (Coffee, 2006). This bill made it mandatory for all public companies to have internal financial auditing controls and an external auditor. Sarbanes-Oxley Act amplified consequences for destructing, changing, or cooking up accounting records during investigations conducted by Federal agencies or for trying to deceive stockholders. The accountability of auditing firms has been increased by SOX so as to make them to remain unprejudiced and autonomous of their clients. (Coffee, 2006). Sarbanes-Oxley Act demands that the “Securities and Exchange Commission (SEC)” to put into practice rulings on needs to adhere with the latest law. (Coffee, 2006). The intent of Sarbanes-Oxley Act was to “protect the integrity of financial reporting by redesigning the network of institutions and intermediaries who served investors in order that the capital markets would not be systematically deceived again,” (Coffee, 2006). What is Section 404? What does SOX require? The Sarbanes-Oxley Act contains eleven titles, which include from criminal penalizations to extra corporate board obligations. Section 404 is the most important section of Title IV of the “Sarbanes-Oxley Act” and has been the most costly part of implementing the new bill. This section established management assessment of internal controls and requires a security management process to protect against unauthorized access. Under Section 404, management is needed to generate a report on “internal control” that confirms the accountability of the Board for instituting and preserving a required “internal control “setup and processes for “financial reporting”. (Coffee, 2006). Section 404 has three main goals, and they are as under. It explains what is needed for a company to maintain enough internal control. It forces auditors and management to formally vouch and certify that enough internal controls are in exercise. It details about the part played by the PCAOB and SEC in accomplishing the main goals of the SOX. (Welytok, 2008, p.182). Further, for the certification of various parts of a public company’s annual report, the top management is now needed to organize a major portion of the report. Thus, auditors and the management have to work in tandem under section 404 to report and evaluate the efficiencies of a corporation’s “internal control” processes. Under “Section 404 of SOX”, the board of a company in its annual report is liable to include an internal control report that includes the following: It elaborates the duty of the management for instituting and preserving satisfactory “internal control” processes and structures for “financial reporting.” It includes an evaluation as of the end of the company’s most latest financial year, of the efficiencies of the internal control and company’s practices for financial dissemination. (Welytok, 2008, p.153). Whom does it affect? Many public companies in USA are of the view that compliance cost of section 404 of too high and have been considered as the drain on their revenues and productivities and this drain actually have placed American public companies at a drawback with their foreign contenders. Public companies in USA that have always functioned in an ethical manner, above-board style in adherence with Section 404 may really enjoy a competitive benefit. (Welytok, 2008, p.182). What are the costs of section 404? It is to be noted that implementation of Sarbanes-Oxley Act of 2002 has had a significant and positive effect on investor confidence and protection. Nonetheless, for smaller public companies which have lesser market capitalization or $ 700 million or less, the expenses relating to the adherence has been invariably high as a percentage of revenues as compared with larger public companies, especially with regard to reporting for internal control as stated in section 404 and associated audit fees. Smaller public companies witness challenges in implementing section 404, since there are resource limitation and questions as regards to the relevance of existing internal control by smaller public companies over financial reporting guidance. Increased cost of adherence of section 404 of SOX on the smaller public companies may drive them to become private companies. (Plette, 2008, p viii). As per research survey conducted by Financial Executives International ( FEI) , ninety-four percent of all participants reported that cost of Section 404 of Sox compliance exceed its advantages. (Welytok, 2008, p.182). Though section 404 has initially created major cost expense to public companies, mainly due to pitiable regulatory performance but regrettably had damaged the international repute of SOX seriously. (Lipman, 2008, p.6). SEC (Stock Exchange Commission) has cited the costs as the primary cause for its frequent pushing back its compliance closing dates under Section 404 for smaller public companies. (Welytok, 2008, p.181). What are the impacts of section 404? Section 404 is, in effect, from June 2004 and public companies have to file reports of internal controls and practices vouched and certified by third parties. Company will scuttle mainly to adhere with the section 404 by offering required documentation to statutory and internal auditors. Thus, public companies both small and big are forced to spend heavily on automation of their process and to establish the audit trails and practices into their computer systems. As per AMR research companies spent about $2.5 billion for adherence under SOX alone in 2003. The lion’s share of such expenditure will for consulting fees. As per research study conducted by Financial Executives International ( FEI ) , in the initial year of SOX enactment, each public company in USA spends about $ 3.14 million per company and the lion’s share of initial expenses is associated to costs of the software, consulting and fifty-eight percent increase associated to the fees hike charges by the external auditors. (Welytok, 2008, p.173). Many USA public companies are employing the route of initial public offerings (IPO) with multiple listings on the international level on stock exchanges throughout the globe. The main aim is to assist US based companies by giving an international IPO without having to adhere with registration provisions of SEC and to mainly to escape from the applicability of the some of the most draconian provisos of SOX, especially the high cost attestation report on internal control procedures from the independent auditor as demanded under Section 404 of the SOX. (Lipman, 2008, p.123). What are the benefits? In the initial year of introduction of section 404, public companies both big and small have a higher incidence of restatements and exhibited a strangely large quantum of reported material defects in internal controls. However, over time, due to the existence of efficient internal control backed by the compulsory provision of section 404 has drastically reduced fraudulent activities in American public companies. (Plette, 2008, p.59). As per research survey conducted by Financial Executives International (FEI), about fifty-five percent of public companies of USA are of the view that Section 404 offers investors and other external parties more faith and confidence in the company’s financial reports and eighty-three percent of giant public companies with market capitalization of $ 25 billion or more agrees with the same. (Welytok, 2008, p.182). Some of the Chairpersons of U.S public company audit committee is of the view that Section 404 of Sox had been really offered worthwhile advantages to their companies by compelling the enhancement of internal controls. (Lipman, 2008, p.6). Is it worth it? The regulators of the USA are of the view that the chief advantage derived from Section 404 is that it would offer a greater confidence to investors, creditors and lenders that they could rely on the company’s official financial statements. Further, Section 404 evaluation denotes to the investor, whether the system of internal control is adequately healthy such that perils of material error in the financial statements in the near future are far off or nil. References Benston, George J. (2006). Worldwide Financial Reporting: the Development and the Future. Oxford: Oxford University Press. Coffee, John C. (2006). Gatekeepers: the Professions and Corporate Governance. Oxford: Oxford University Press. Lipman, Frederick D. (2008). International and U.S IPO Planning. A Business Strategy Guide. New York: John Wiley & Sons. Plette, Theodore N. (2008). The Sarbanes –Oxley Act. Implementation, Significance and Impact. New York: Nova Publishers. Welytok, Jill Gilbert. (2008). Sarbanes –Oxley for Dummies. New York: For Dummies. Read More