Introduction
The early 2000s was characterized by an increase in the number of financial scandals in the US. Some of the notable scandals include WorldCom, Tyco International, and the Enron Scandal (Anand, 2013). The financial scandals culminated in massive financial losses. The US government enacted the Sarbanes-Oxley Act in 2002. The objective of the Act is to restore confidence and trust amongst creditors, stockholders, investors and the public regarding businesses’ financial reporting. The main objective of the SOX is to augment the quality and accuracy of financial information that companies provide to different stakeholder groups.
The Sarbanes-Oxley Act targets public companies that are listed on the stock market. Warren, Reeve, and Duchac (2012) categorize the Sarbanes-Oxley Act as one of the most important laws in the business sector. The Act underscores the importance of entrenching optimal internal control mechanisms in organizations’ financial reporting processes. The rationale for integrating internal controls is to minimize the occurrence of unethical accounting practices such as fraud. Therefore, a firm can safeguard its assets coupled with promoting a high level of compliance with laws and regulations. Under the SOX, companies must disclose the internal controls adapted to the different stakeholder categories. The enactment of the SOX has generated extensive debate regarding its appropriateness in the business sector. This paper assesses some of the fundamental issues that have arisen from the SOX.
Key components of the SOX
The SOX is made up of several components as evaluated herein.
Independent oversight
The enactment of the SOX Act “ended over a century of self-regulation within the public companies’ audit profession” (Anand, 2013, p. 83). By promoting the auditors’ independence, the Act eliminates the conflict of interest. Currently, the ethics and auditing standards in the accounting field are regulated under the watch of a central body, viz. the Public Company Accounting Oversight Board [PCAOB]. The PCAOB undertakes the oversight role through three main approaches. First, the PCAOB sets the standards that guide auditors in undertaking audits on public companies. For example, the Act restricts auditors from offering non-audit services unless approved by the PCAOB (Ernst & Young, 2013).
Moreover, the PCAOB reviews and analyzes the information provided by the Standing Advisory Group (SAG), albeit periodically. The SAG is constituted of different parties, viz. a representative of public company board members, investor groups, and the audit profession. The process of setting standards further considers extensive public participation by conducting roundtables and public comment processes. Anand (2013) adds that the “standard setting under the SOX has mainly emphasized several issues, which include the content and nature of the audit report coupled with the auditors’ communication and risk assessment” (p. 86). The consideration of the above issues has played a critical role in improving the quality of the audit report.
The PCAOB has further developed an inspection process that is used in evaluating the effectiveness of all the registered audit firms. Under “Section 404 of the SOX, both the independent auditors and companies’ management teams must present separate assessments on the internal controls implemented in the financial reporting processes” (Sheryl-Ann, 2008, p. 94). The PCAOB further “sanctions the audit firms and auditors for any violations of professional standards and regulations” (Sheryl-Ann, 2008, p. 104). The sanctions may include revoking the auditors license, deregistration from the auditor’s association, or imposition of a fine.
Strengthening corporate governance and the audit committee
The SOX is further concerned with strengthening corporate governance within companies. The Act requires the management committees of publicly traded companies to institute an audit body comprised of board members who are not a part of the management. The independent audit committee is tasked with appointing, compensating, and reviewing the performance of the external auditors. Through this approach, the Act has enhanced the level of independence in preparing financial statements by ensuring compliance with the set financial reporting framework. The SOX Act advocates the audit committees to include at least one financial expert to improve the effectiveness with which the committee handles complex duties (Ernst & Young, 2013).
The SOX has entrenched the position of the audit committee in undertaking corporate governance. Due to the level of independence, the audit committee is in a position to “review and challenge the financial statements, evaluate the efficacy of the internal controls, and take the necessary actions to defend the shareholders’ interests” (Sheryl-Ann, 2008, p. 96). One of the fundamental aspects that the Act has considered in strengthening corporate governance entails the protection of whistleblowers under the provisions of section 806 and 1107.
Enhanced executive accountability, transparency and investor protection
The SOX has clearly instituted measures aimed at promoting a high level of accountability amongst companies’ executives. Some of these measures are focused on deterring the executive officers from engaging in unethical practices. Titles VIII, IX, and XI of the Act have stipulated the penalties that individuals can face due to non-compliance. The Act has broadened the Securities Exchange Commission oversight and enforcement mandate significantly. Due to the Act, the SEC is in s position to institute civil and criminal action against any party that engages in actions that influences the auditor’s independence negatively. The punishment for non-compliance may include a 10 and 20 years imprisonment or a $1 million to $5 million penalty (Sheryl-Ann, 2008). Moreover, the executive may be forced to forfeit any bonuses, profits, and other benefits accrued. The SOX Act focuses on improving explicit disclosure and reporting amongst firms. This aspect plays a fundamental role in enhancing the level of confidence amongst investors (Ernst & Young, 2012).
Criticism of the Sarbanes-Oxley Act
The SOX Act has led to the development of varied perspectives amongst different stakeholder regarding its enactment. Investors have lauded the move and advocated its strict implementation. Investors are of the opinion that the Act will lead to remarkable improvements in the companies’ approach to financial reporting. Conversely, business groups and corporate insiders have criticized the implementation of the Act. In their opinion, the business groups and corporate insiders argue that the implementation of the Act is burdensome. Moreover, the cost of complying with the Act is considerably high. Thus, businesses and especially the small public enterprises may be affected negatively.
A study conducted by Charles River Associates International, which is a renowned global consulting firm, supports the corporate insiders’ opinion regarding the cost of compliance (Sheryl-Ann, 2008). According to projections made by CRA International in 2004, complying with Section 404 of the Act would have required a large firm with a market capitalization of over $ 700 million to incur an average cost of $ 8.5 million. Conversely, companies with a total capitalization ranging between $ 75 million and $700 million would have incurred a cost of $1.2 million (Sheryl-Ann, 2008). The high penalties and litigation risks intended at entrenching compliance amongst firms’ executive officers might affect their inclination towards taking risky investment decisions. Considering the concept of ‘high risk, high return’, the development of risk aversion behavior amongst executives might reduce the degree to which the CEOs value their organizations. Furthermore, the CEOs might consider changing the business strategies to cushion themselves against investments that might lead to the escalation in the degree of risk.
However, some parties are of the opinion that the Act might signal an increase in the level of rigidity regarding federal legislation and regulation within the corporate sector in the US. The Act is regarded as an exaggerated form of control and an over ambitious move (Dewan, 2006). The outcome of such perception is that the attractiveness of the US business environment might be affected negatively. Fifty-nine percent [59%] of CEOs considered in a survey conducted by PricewaterhouseCoopers identify overregulation as one of the greatest challenges that organizations face in their pursuit of growth (Cascarino, 2013). Governments would be required to implement very stringent internal controls to ensure zero fraud amongst businesses. However, this move would stifle flexibility amongst businesses.
Economic consequences for companies due to implementing the Act
The implementation of the Act has benefited the market substantially. One of the notable benefits has arisen from growth in the level of transparency in financial reporting processes. The number of investors relying on financial reports in making decisions related to investment in public companies in the US has increased substantially since the enactment of the SOX Act. Additionally, companies have undertaken considerable adjustments in their internal processes, thus leading to cost-effective operations.
Corporate insiders are of the opinion that the high cost of compliance might affect businesses’ sustainability negatively. The high financial cost might suppress innovation and risk taking amongst business enterprises. Subsequently, businesses might not be in a position to invest in value creation activities such as research and development (Sheryl-Ann, 2008).
The high cost of compliance might affect the strength of the domestic stock market adversely. The public companies might weight the cost of compliance and decide to delist from the stock market voluntarily, thus privatizing their operations. Alternatively, the firms might consider listing their stocks in stock markets located in foreign countries. Conversely, the small firms that might intend to be listed in the stock market might quash such intentions and prefer to continue operating as private entities (Hanna, 2014). The occurrence of such issues might limit the effectiveness of the primary and secondary market segments in promoting individual and institutional investment. The companies might be forced to seek funds from foreign securities markets. Such incidences might affect the country’s capacity to attract local and foreign investments (Fletcher & Plette, 2008). Therefore, the opportunity cost associated with the Act is considerably high. The overall effect is that the businesses’ contribution to economic growth might be reduced.
Appraisal of the SOX
Since the implementation of the SOX, several milestones have been achieved. First, the SOX Act has led to considerable improvement in the level of reliability regarding financial reporting and auditing. The institution of the PCAOB has strengthened the approach towards corporate governance. This goal has been achieved by eliminating the conflict of interest that arises from the involvement of the companies’ management teams in undertaking audits. Subsequently, the SOX has aided in boosting the level of confidence amongst investors. A study conducted by the Financial Executive Research Foundation in 2005 indicates that the Act has led to substantial gains (Hanna, 2014). Eighty-three percent [83%] of the CFOs involved in the study affirmed that investor confidence had increased while 33% argued that the Act has led to a decline in the level of corporate fraud (Hanna, 2014).
Despite the effort made by the US government to eliminate corporate fraud through the enactment of the SOX, some significant gaps need to be addressed. First, the Act has not fully deterred acts of corporate fraud. A study undertaken by PWC in 2011 indicates that corporate crime increased by 13% between 2010 and 2011 in the US (Cascarino, 2013). Furthermore, KPMG emphasizes that board members perpetrated over 18% of all incidences of corporate fraud in 2011 in the US (Cascarino, 2013). This realization indicates a continuance of opportunistic behaviors and conflict of interests amongst corporate executive officers. Therefore, one can argue that the SOX Act has failed in preventing and detecting accounting fraud. Moreover, the penalties contained in the Act have not deterred corporate fraud successfully.
Conclusion
The US government seeks to improve the country’s business environment. One of the issues that the government must consider while pursuing this goal entails promoting the level of confidence amongst domestic and foreign investors. The analysis above indicates that the enactment of the SOX Act has led to considerable improvements in the level of the investors’ confidence. However, the Act has led to the development of mixed perspectives regarding its effectiveness in promoting economic growth. One of the contentious issues relates to compliance with Section 404 of the Act, which makes firms incur high costs. Therefore, it is imperative for the US government to consider undertaking a review of the Act to increase the chances of attaining the intended objectives.
References
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Cascarino, R. (2013). Corporate fraud and internal control: a framework for prevention. Hoboken, NJ: John Wiley & Sons.
Dewan, S. (2006). Corporate governance in public sector enterprises. New Delhi, India: Pearson Longman.
Ernst & Young: The Sarbanes-Oxley Act at 10, enhancing reliability of financial reporting and audit quality. (2013). Web.
Fletcher, W., & Plette, T. (2008). The Sarbanes-Oxley Act: implementation, significance and impact. New York, NY: Nova Science Publishers.
Hanna, J. (2014). The costs and benefits of Sarbanes-Oxley Act. Web.
Sheryl-Ann, S. (2008). The impact of the Sarbanes-Oxley Act of 2002 on the US financial markets. Ann Arbor, MI: ProQuest.
Warren, C., Reeve, J., & Duchac, J. (2012). Financial and managerial accounting. Mason, OH: South-Western Cengage Learning.