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Agency theory was developed by Jensen and Meckling in 1976. Solomon (2004) explains agency theory in light of managers and board of directors as the agents and the investors and shareholders as the principles. The principles invest in the company and base their faith and trust on the agents to conduct business operations ethically and maximize shareholder value. Any decision made by the agents should be in the best interest of the organization. On the contrary, corporate collapses portray a different picture of the motives and interests of the corporate leaders.
There exists a central problem in the with regards to shareholders' interests in a public corporation, that is, top management do not always act towards maximizing shareholders' return on investment (Kulik, 2005). This divergence of interest poses risk to the corporation as well as its investors.
Sherman and Chambers (2009) cite Waddock's (2005) work in noting that the corporate leaders and financial advisor in the contemporary days lack "fundamental integrity." These shortcomings of the managers were evident in the much published corporate scandals at WorldCom and Enron. Canary and Jennings (2007) posit that collapse of Enron and WorldCom was a result of unethical conduct. Such scandals result in huge losses which range from financial loss to loss of investor confidence.
This paper is divided into four sections. The first section takes a brief look at the history of Enron Corp. and the financial issues which led to its dramatic collapse. The second section highlighst the reasons behind the enactment of the Sarbanes-Oxley Act (SOX) and outlines its contents and mandates. This follows a brief look at the pros and cons of Act. The third section discusses the ability of SOX to prevent future corporate collapses such as Enron. The last section concludes the paper.
Impact of Corporate Collapses
Mckay (2007) dubbed year 2002 which saw the business world taking a radical change. Corporate scandals not only result in loss of billions of dollars but also cause job losses and loss of valuable credibility. The Enron and Worldcom saga brought great disrepute to the accounting profession. Investors lost confidence in the market as they suffered drastic losses to their investments.
Background of Enron Corp
Enron Corp. (referred to as Enron hereafter) was formed in 1985 from a merger of the Houstan Natural Gas and Internorth. Enron was the first nationwide natural gas pipeline network (Jickling, 2002). It then diversifies to providing products and services related to natural gas, electricity and communications (Tonge et al, 2003).
Enron became the seventh largest listed company in the United States by employing questionable accounting methods and techniques (Bryce, 2002). Observers and analysts from the Wall Street dubbed Enron's transformation as an outstanding success (Jickling, 2002).
On 16th October, 2001 Enron reduced its after tax net income by $544 million and its shareholders' equity by $1.2 billion. It then restated its net income for the years 1997 - 2000 following accounting errors (Benston and Hartgraves, 2002). Enron eventually filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code (Tonge et al, 2003).
This was the largest corporate bankruptcy in the history of United States. Enron's stock price which had increased tremendously from the 1990s to early 2000 (from $7 to $90) fell to under $1 towards the end of 2001. Following Enron's bankruptcy, their auditors, Arthur Andersen which was one of the Big 5 CPA firms back then, was charged with failing to do their job right. Arthur Anderson was fined and it eventually went out of business (Benston and Hartgraves, 2002).
Financial Practices at Enron Corp
Enron used complex finance structures and accounting practices to attain various advantages including financing, taxation and accounting advantages (Benston and Hartgraves, 2002).
Enron used various accounting techniques and auditing issues to manipulate the figure it reported. The six extensively practice is of primary importance. These are discussed at length below (Benston and Hartgraves (2002).
Enron's accounting policy was not to consolidate its special-purpose entities (SPEs).
Enron funded numerous SPEs and did business with it. It used some of these to evade US taxes for its foreign income. Other major SPEs were used to do business with Enron domestically. GAAP rules prevalent in those days did not require Enron to consolidate its SPEs with its financial statements if independent third parties had a controlling and substantial (3% of the SPEs assets) equity interest in the SPE. Enron guaranteed most of these SPEs bank debts and had to assume these debts when the SPEs assets were insufficient to cover its debts. Enron however, did not consolidate these SPEs into its financials hence was understating its real debts from its investors.
Enron's treating sale of merchant investments to unconsolidated SPEs and recording it in its accounting books as they were arm's length transaction.
If there is a forward contract with fixed price, GAAP does not allow increases in the value of the stock as income because the gain was merely a result of increase in the companies own stick. Enron however, used gains from such forward contracts to sponsor numerous SPEs it funded.
Enron recorded fees for services rendered in future periods as current income as part of its income recognition practice.
The matching concept of GAAP requires that the revenue be recognized and match with the expenses in the period in which it is earned. Enron however recorded upfront income for fees received from SPEs as loan guarantees. Although Enron's income recognition criteria violated GAAP, it is questionable why their auditors accepted these accounting policies.
Enron restated its merchant investments at its fair value but the restatements were not grounded with reliable and trustworthy figures.
Fair value requires that transactions be recorded at market prices derived from arm's length transaction. GAAP requires investment funds to be revalued to their fair values. Enron had many financial assets (merchant investments) which did not have reliable market prices. This gave them an opportunity to assign values to these financial assets and record earned revenue.
Enron issued stock to its SPEs which were held by them. The accounting of this stock moving transaction was questionable.
GAAP does not allow companies to record increased in the value of its own stock as income. None the less, Enron employed this technique. It recorded investment in one of its SPE (JEDI) using the equity based method and when the accounting for the increases in the market value of its own stock, Enron recorded this appreciation as income. When the Enron's stock held by JEDI declined, it did not record loss in its books. Both these events were identified by Enron's auditors (Arthur Andersen) but not correction was made to Enron's accounts.
GAAP also disallows recording companies from recording exchanges of their stock for notes receivable as increase in equity. The amount receivable should be deducted from equity. Enron, however, recorded such transaction as assets which increased its stockholders equity.
Enron inadequately disclosed related party transactions and conflicts of interest and their cost to stockholders.
Enron failed to adequately disclose transactions relating to its executive officer in which he had material interest. Enron's Executive Vice-President and Chief financial Officer, Andrew Fastow, had several linkages with its SPEs and had his compensation package with the profitability of the SPE. These however, were not disclosed completely and clearly by Enron. It is clear that Fastow had a conflict of interest and it is seems that the transactions between Enron and its SPEs were not made at arms length.
Enron revealed accounting irregularities in the third quarter of 2001 and this brought their external auditors into the lime light (Nelson et al, 2008). Arthur Andersen were aware of the accounting errors, misstatements, and the consolidation issues of the SPEs. However, they turned a blind eye of these severe deviations from the GAAP. They not only compromised their professional duty but jeopotised the entire auditing profession and led the investors of Enron into financial turmoil.
Arthur Andersen was fined $500,000 and given five years probation after the Enron saga. The once ranked top five accounting firm then lost thousands of employees and later ran out of business as they no longer audited corporations (McKay, 2007).
In addition, the larger corporate scam revealed in 2002, that of Worldcom infuriated the investors more as it was revealed that Arthur Andersen was their auditors as well. This goes on to show that collusion between the auditors, who are supposed to be the watch dogs for corporation, and the corporation results in violation of accounting principles, unethical behaviour, misleading and misinforming investors and at the end of the day, leading to corporate collapses and billions of dollars of losses.
Background of WorldCom
Worldcom was founded in 1983 as LDDS Communnications, was the second largest long distance telecom company in the United States. It was announced on the 25th of June, 2002 that Worldcom was part of the largest corporate fraud in the history of the United Stated. The stakes reached up to $3.8 billion (Snee, 2007)
Financial Practices at WorldCom
Worldcom had overstated its revenues and profits. This it did by playing with its balance sheet to inflate revenues and profits while obscuring expenses. Worldcom classified its daily expenditure as investments and long-term expenditures associated with capital assets. It was able to hide expenses escalating to $3.8 billion and portrayed this as profit (Shridhar, 2002)
Background of Sarbanes-Oxley Act (SOX)
Dey (2010) dubs the Sarbanes-Oxley Act (SOX) as a "highly controversial regulation."
Cullinan et al. (2006) notes the objective of the Sarbanes-Oxley Act (SOX) as to "â€¦improve the accuracy and reliability of corporate disclosures."
Content of Sarbanes-Oxley Act (SOX)
The Sarbanes-Oxley Act (SOX) comprises eleven (11) titles. Each of these titles contains several sections which encompasses specific mandates and requirements for financial reporting. The content of SOX is briefly discussed below.
Title I - Public Company Accounting Oversight Board (PCAOB)
The first title of the Act comprises of nine sections. Through this title, the Act establishes an oversight board responsible for providing independent supervision of auditors (public accounting firms providing audit services). This Board called the Public Company Accounting Oversight Board or PCAOB in short, has the task of registering auditors and outlining certain processes and procedures for compliance audits along with inspecting and policing conduct and quality control and imposing compliance with SOX.
Title II - Auditor Independence
The second title of the Act also contains nine sections which set out to limit conflict of interest between auditors and firms which the audit by establishing standards for external auditor independence. This title also encompasses issues of new auditor approval requirements, rotation of audit partner, and reporting requirements of auditors. Via this title, the SOX provide restrictions on the extent of non-audit services provided by auditing companies to the clients which it audits.
Title III - Corporate Responsibility
The third title mandates the senior executives are required to take independent responsibility to ensure that the corporate financial statements are valid, complete and accurate. It also highlights the interaction requirements between audit committees and external auditors.
Title IV - Enhanced Financial Disclosures
The fourth title requires enhanced reporting requirements for financial transactions including off-balance sheet items such as corporate officers' transactions with the company. The nine sections under this title require internal control to ensure accuracy of financial reports and disclosures. It mandates that these controls be audited by external auditors and be reported upon.
Title V - Analyst Conflict of Interest
The fifth title contains only one section aimed at the securities analysts. This is designed to restore investor confidence in these analysts reporting. Under this title there is a code of conduct for the analysts which require them to disclose any conflict of interest.
Title VI - Commission Resources and Authority
The sixth title also aims to restore investor confidence in securities analysts. The four sections under this title outline SEC's authority to censor or bar securities professionals from practice and the conditions in which this can be done.
Title VII - Studies and Reports
The seventh title is aimed at the Comptroller General and the SEC. Through this title, the Act requires them to perform a range of studies and report their findings. These include and are not limited to the impact of consolidating public accounting firms, securities violation and enforcement actions and Global Crossing.
Title VII - Corporate and Criminal Fraud Accountability
The eight title introduces criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations. It also provides protection to whistle blowers. The seven sections collectively are also referred to as "Corporate and Criminal Fraud Act of 2002".
Title IX - White Collar Crime Penalty Enhancement
The ninth title, also known as the "Whit Collar Crime Accountability Act of 2002" has six sections. The objective of this title is to address criminal penalties associated with white collar crimes and conspiracies. It has stringent sentencing guidelines and highlights that failure to sign corporate financial report is a criminal offense.
Title X - Corporate Tax Returns
The single section of the tenth title requires the Chief Executive Officer to sign the company tax return.
Title XI - Corporate Fraud Accountability
The eleventh title consists on seven sections and is also called the "Corporate Fraud Accountability Act of 2002". This section links offenses to specific penalties and makes corporate fraud and record manipulation a criminal offense.
Advantages of Sarbanes-Oxley Act (SOX)
Disadvantages of Sarbanes-Oxley Act (SOX)
Sarbanes-Oxley Act (SOX) in the South Pacific
Can Sarbanes-Oxley Act (SOX) avoid future corporate collapses and frauds?
The issue with corporate failure is more an ethical failure rather than a system failure. The Sarbanes-Oxley Act (SOX) addresses both the ethical and the system failure. A system can be corrected through enforcing regulations and stipulating rules. However, ethical failure is one which is borne with individuals. The level of morality and ethics that a person has will impact on his role in the organization. Regulation can prohibit people from undertaking certain courses of action but this does not stop them from circumventing or bending the rules.
Sarbanes-Oxley Act (SOX) is like a well and the managers are like a horse. And as the famous saying goes - you can take the horse to the well but you can not make him drink. If the managers are unethical and want to work in their self interest, they will by all means attempt to do so. Laws act as a deterrent but managers who are willing to take the risk will foster to find possible loopholes to profit from the organization at the cost of the investors.
SOX has closed many doors for managers to indulge in fraudulent activities but research has shown that despite the introduction of SOX, corporate fraud is on the rise.
The issue of agency problem discussed earlier could be seen as the basis for these potential corporate failures. The investors put their money into organizations hoping to get returns and they base their faith in the management that runs the companies. The board and management however, do not have the same motives and goals as the investors. They tend to work in self interest and as long as this occurs, no regulation would be able to completely combat corporate frauds.