Analysis of the Sarbanes-Oxley Act of 2002 - Case Study Example

Sarbanes-Oxley Act The Sarbanes-Oxley Act of 2002 aims at protecting investors by improving the reliability and accuracy of corporate disclosures. The intention of this Act is to protect the integrity of the financial reporting. Other benefits of this Act include the ability of shareholders to fire the board if they can prove that it is not working in the interest of the shareholders and also this increases the independence of the board members. This Act was the government intervention after corporate scandals like WorldCom and Enron and touches on ethical issues such as governance, corporate social responsibility, ethical decision making, and ethical corporate culture. The Act also has a crucial provision, §404 which requires companies to evaluate their internal financial-reporting controls on an annual basis. While the intention of this legislation is clear, the outcome is still debatable in terms of the benefits it brings to the company and the economy as compared to the costs. Some of the provisions that bring this debate include those that cover issues related to insider trading, auditor independence, internal controls, corporate responsibilities, and internal controls. Body After the collapse of Enron and WorldCom that left shockwaves throughout the corporate world and left investors in the biggest accounting scandal in history, the Sarbanes-Oxley Act (SOX) was enforced. This act has become the most significant legislation that embraces corporate governance in the United States since the securities laws of the 1930s. SOX has resulted in a number of changes in the regulatory environment and governance in the United States, including requiring separate analysts of the financial statements from underwriters, requiring senior management to certify their company’s quarterly financial statements, heightened disclosure, and requiring attorneys to report fraud or crimes when detected without delay. While the intention of SOX is clear, there has been a debate about its effects. Proponents of this legislation maintain the fact that it helps investors be more confident in the safety of their investments because it has helped in improving the accuracy of the financial reports and transparency. On the other hand, opponents argue that compliance to this Act results in a greater burden to public firms, especially those which are small because of increased average costs as a result of the new regulations. Studies show that SOX has resulted in a dramatic increase in companies’ compliance costs. Even though this cost has now reduced as compared to when the start of this compliance, the cost is still greater than what many companies had anticipated. Even though many companies have been able to lower their internal compliance costs, the total compliance costs still continue to be high because of an increase in the external compliance costs. Smaller companies have been hit the hardest by high compliance costs. Some public companies have even been forced to take the bold decision of voluntary delisting from the NYSE like the Ohio Art company, which is the maker of Etch-a-Sketch drawing toy. Another company that delisted itself is the car sprays giant Earl Scheib. Adherence to section 404 is considered to be the most problematic because of increased compliance cost. This section required top managers to put in place strict controls on internal financial reporting. Companies are now required to come up with internal control reports that show the company has adequate safeguards in place that protect the financial data and which also show that the financial figures are accurate. This section also demands for end of year reports that have an assessment of the effectiveness of the internal controls which also needs to be looked by an audit team so that it can vouch its accuracy. This law also requires companies to provide protection for whistleblowers, establish independent audit committees, and prohibits companies from giving loans to executives. Moreover, SOX prohibits auditing firms from providing eight categories of non audit services. This is mainly because of the lawmakers’ concerns that this would compromise the independence of auditors. However, the logic of the financial profession, argues that this restriction eliminates the cost-efficiency gained as a result of hiring the auditor as the consultant. Auditors are likely to incur more costs during the audit process through gaining institutional knowledge that they would have gained while performing consultative services for their clients. Generally, all these mean that the compliance costs will be enormous and affects organizations of all sizes. The SOX also has a long term negative economic effect because as a result of increased compliance costs, this makes many companies to lose their competitive advantage. Arguably, companies now prefer to register with the London Stock exchange as opposed to the New York Stock Exchange with the simple aim of avoiding the Sarbanes-Oxley Act that attracts high compliance costs. This in turn makes the Act ineffective in terms of achieving its original intent (Holt, 2008). Apart from the cost and the economic effects of this Act, the SOX takes much of the company’s time. Managers are forced to divert their attention from doing activities that will bring benefits to the company and instead used most of their time in making sure that they are in compliance with the Act. Complying with Section 404 also expects employees from companies to meet with their auditors on a quarterly basis in order to go over the internal controls policies and procedures. Even though this ensures that the company is compliant, it diverts employees’ time and attention from their daily work to administrative tasks. This will eventually reduce the productivity of employees. The SOX requires CEOs and CFOs to certify quarterly and annual reports to the SEC (Section 302) and also for them to raise criminal penalties for white-collar crimes and corporate fraud. Proponents of this Act argue that the requirement has increased accountability of directors and executives to shareholders. It has also reduced the executives’ motivation to commit fraud and has increased the shareholders’ protection. However, this is blamed for discouraging top management from undertaking value-increasing risky investments because it has increased significantly the litigation risks of top management team. This means that if it is proven that there is an intentional accounting restatement, the SOX requires that the CFOs and CEOs to reimburse the company any profits received from the sale of stock or any incentive-based compensation received during the twelve months after misreporting. Executives are also at the risk of facing up to 20 years in prison or a fine of approximately five million dollars. This discouragement in turn, has the highest likelihood of decreasing the growth of companies and deterrence in the economic growth. The SOX has also resulted to tight governance which can be detrimental to companies. For companies that operate in dynamic markets, the intervention of shareholders and outside directors can delay the process of decision making which can in turn result in a loss of investment opportunities. In relation to this, the Act has also led to a reduction in the number of corporate mergers and acquisition which is a hindrance to expansion. The argument here is that the due diligence process required during the acquisition process is likely to lengthen because unlike before where directors were considered to be a simple “rubber stamp” now they are taking their responsibilities more seriously. There is no doubt that SOX is a contentious law that has costly effects on companies. Despite the criticisms of this Act, it is not without its proponents. Proponents of the Act argue that the costs are more obvious than the benefits because the benefits usually appear over time, including, fewer SEC financial reporting cases, fewer restatements, and fewer accounting fraud cases. They also argue that the law helps in restoring the investors’ faith in public companies and the financial markets. The argument is that most of the costs related to Section 404 is as a result of first time implementation (Holt, 2008). However, a company needs to take a number of annual reporting cycles before they can determine if there are benefits. . Conclusion The enactment of the Sarbanes-Oxley Act was as a result of a loss of investors’ wealth as a result of the collapse of Enron and WorldCom. There was also a lot of public criticism about the integrity of the United States markets. It is clear that action had to be taken; however, it should also stand the cost-benefit analysis. Weighing the costs and the benefits of this provision aims at helping the public have a better understanding of an act. In the case of the SOX, compliance with the Act has proven to be costly to companies in terms of professional fees, time, and other resources. The government’s point of view is that the success of the act should not be measured solely by the bottom line, but by looking at the public interest. However, the cost of this Act is likely to negatively affect the public interest. The passage of time in this case will be the true test of the effectiveness of this Act. Bibliography Holt, M. F. (2008). The Sarbanes-Oxley Act: Costs, benefits and business impact. Amsterdam: CIMA. Read More