A Primer on Sarbanes-Oxley Essay
A Primer on Sarbanes-Oxley
This paper identifies issues, activities and practices, in financial reporting by public companies that were sanctioned by the Sarbanes-Oxley legislation Act of 2002 (SOX). This act was passed with the intent to restore public confidence and increase transparency in financial reports of publicly held companies, due to the aftermath of the financial scandals that plagued companies such as Enron and Worldcom (Jennings, 2012).
The problem to be investigated is the ethical issues that were legislated by SOX, the cost associated with the implementation of the new act on different stakeholders, and new governance practices required of public companies to insure compliance with the new act. Introduction SOX was implemented in 2002 as “an act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes” (Jennings, 2012, p. 212).
This act focused primarily on the independence of auditors who are responsible for auditing public companies, the corporate responsibilities of Chief Executive Officer(CEO) and Chief Financial Officer(CFO), the proper disclosure of financial statements, the conflict of interest between the parties involved, criminal fraud accountability of those involved, and the imposition of the penalty in case of violations. The Public Accounting oversight Board (PAOB) was then created to enforce all the issues identified under the above act (Jennings, 2012).
This legislation was imposed on employees of public companies who are responsible for disclosing financial statements. Although this legislation seemed new, it can be argued that all the issues addressed could have been covered by enforcing already existing code of ethics within any of these organizations. Violations in the SOX legislation that could have been voluntarily resolved as ethic issues In order to reduce the incidences of fraud in financial reporting of publicly held company, the PAOB was given the authority to regulate activities of CEO, CFO and auditors who are responsible in preparing and certifying financial records.
The new legislation requires public accounting auditors to be independent from the operations of the company they are auditing. This requirement is not new as it is a basic requirement from all accounting firms to be independent of all activities of the corporation they are auditing. This concept of independence is the foundation of the profession of public accounting. It is based on the belief that auditors should be independent in facts and appearance in order to minimize outside pressure that may be imposed by clients who hired them. Lack of independence can impair their judgment on the accuracy of the financial statements being audited.
This concept also inspires confidence in the quality of the financial statements audited by the public who have interest in them (Previts & Merino, 1998). It can be easily concluded that there is a potential conflict of interest if a work is performed and then audited by the same party. In this case, the stakeholders cannot be assured of the validity of the report. The legislation by PCAOB applicable to the auditor’s independence was not necessary if the public accounting firms and the companies involved had adhered to the auditors’ professional requirements.
The legislation with the issues of corporate responsibility, financial disclosures, and conflicts of interest in general could have been prevented if the leadership of the companies involved exercised their moral responsibility in their role as managers. Moral responsibilities include honesty, transparency, respect and fairness. It may also include factors such as excellence in the conduct of business, profitability and others. Davis, Schoorman, & Donaldson (1997) define stewardship as a higher level of duty of governance in which the motivations of managers are based on pro-organizational rather than self-interest behavior (p. 27).
Ethical stewardship can be defined as a “morally established duty and a fiduciary obligation” (Caldwell, Hayes & Long, 2010, p. 501). Honesty and ethical conduct include the handling of both personal and professional conflict of interest, the ability to fairly, accurately and timely report and disclose all the information that are the representation of the company one is entrusted in his or her fiduciary responsibilities. This means that the certification and disclosure of financial statements by CEO and CFO should be their binding words as to their truthfulness of the financial condition of the company they are responsible for.
Finally, an organization that wants to portray itself as trustworthy should not have boards of directors who have personal interest in its daily operation. The organization is better served if the directors are viewed as autonomous, and impartial to the one who make daily decisions. This will ensure that they have the ability to review the operation of the managers and make decisions that are independent and to the best interest of the organization. Any organization should have rules and regulations in place that reward or penalized bad behaviors. These rules should be in plain view and enforceable.
It is a moral responsibility for all organizations to comply with all applicable governmental laws and regulations. Any violation of these laws should be reported and corrected. Therefore, companies should already have laws in existence that should screen prior violators and current offenders to insure the integrity of the company and increase public trust. This shows that SOX legislations on criminal fraud and white collar crimes were not necessary if the companies had followed their internal rules and regulations. Additional costs as a result of the SOX requirements
The costs of implementing SOX can be characterized as direct or indirect. Direct costs are the obvious financial expenditures such as increase fees through the hiring of external auditors, boards of directors, audit committees, consultants , the purchaseq of software requirements, and the implementation of the new legislation. In response to section IV of the SOX requirements, companies did probably hire expert or additional personnel, or consultants and new board of directors to comply with the disclosure requirements. The costs of these new personnel were probably very high as the need to hire experts in any new legislation is lways costly.
Another type of direct cost increase was the extra litigation costs and an increase in directors and officers insurance premiums for the firms (Carney, 2006). However these costs differ per each type of organization. In a study that looked at an increase in direct costs associated with audit fees for the period directly following the enactment of SOX, Millar and Bowen (2011) concluded that both small and large firms experienced a significant increase in the cost of their audit fees. But the increase was significantly larger for smaller companies as compared to larger ones.
It is possible to argue that this difference could have affected the ability of these companies to compete in the market. Indirect costs associated with the legislation were the extra time spent by executives in sorting out the new legislation, instead of focusing on the profitable operations of the business (Volcker, & Levitt, 2004). These costs were also incurred with extra man hours employed in complying with the new Act. Other type of indirect costs were incurred by smaller firms as they looked for different ways to raise capital instead of offering IPO because of additional cost of compliance (D’Aquila, 2004).
Basu and Dimetrov, (2010), in their study of governance, performance and valuation, concluded that “all the previous studies showed a negative stock price reaction to SOX-related announcements, increased auditing expenses, higher propensity of firms to go private and lower propensity of foreign firms to cross-list in the USA” (p. 32). Additional indirect costs could have been incurred with the requirement on independent audit committee members. This requirement meant that the members were outsiders who did not have knowledge of the financial statements they were judging and needed training by inside managers.
In addition to direct and indirect costs incurred by companies for compliance, there were costs on some stakeholders in the form of charges passed on to them as the users of products and services offered by these companies. We all know that when most companies incur additional fees, they usually passed them on to buyers in form of higher prices. Although, the implied objective behind the regulation brought in by SOX and the SEC was to improve the functioning of public corporations, many in the industry noted that the associated costs outweigh the benefits intended (Zhang, 2007).