The Impact Of Sarbanes Oxley On Businesses Accounting Essay

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The Sarbanes-Oxley Act of 2002 (SOX) is an important piece of legislation passed in response to the accounting scandals that occurred at the turn of the century. This paper will describe the impact that the law has had on American businesses. One of the primary purposes of the act was to restore investor confidence. A key concern is whether the benefits of the act outweigh the cost to the corporations. The costs associated with the Sarbanes-Oxley act can be tied to two parts of the act- Section 302 related to corporate responsibility for financial reporting and Section 404 which covers management assessment of internal controls. These sections will be described in great detail since these are the parts of the law with which companies have the most difficult time complying. Another consequence that will be discussed is the delisting of public companies. Many small and mid-sized companies have considered going private because of costs associated with this act. Lastly, the prevention and detection of financial fraud that this act is supposed to provide will be discussed to measure the effectiveness of the act. Although this act is fairly new it has had a significant impact on the way businesses now operate.

Introduction

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The Sarbanes-Oxley Act of 2002, also known as SOX, is named after Senator Paul Sarbanes of Maryland and Representative Michael Oxley of Ohio. They are the main sponsors of the act. This act was passed because of financial frauds such as WorldCom and Enron. After these major financial implosions it was evident that investors had lost confidence in the U.S. Stock Exchange. SOX was passed to enhance corporate responsibility, change ways in which companies interact with auditors, and protect investors from accounting frauds. SOX only applies to publicly traded U.S. companies and is comprised of eleven titles. Within these eleven titles Sections 302, 404, and 906 are viewed as the hardest to comply with (Klutz, 2006). Section 404 in particular has been a concern for U.S. companies.

The Public Company Accounting Oversight Board (PCAOB) was established by Congress because of SOX. PCAOB is a non profit organization and its mission statement is to "oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports" (PCAOB, 2003-2011, p. 1). PCAOB is overseen by the Securities and Exchange Commission (SEC) and is funded mainly by annual fees based on the company's market capitalization. For brokers and dealers these fees are based on their net capital.

Financial Scandals

SOX was implemented shortly after two of the largest accounting/financial scandals of the 21st century. The companies that committed these crimes were Enron and WorldCom. As a result in the lack of trust in American Corporations, stocks began to drop to very low levels (Thomas, 2002).

There was a time before the Enron collapse that shareholders were receiving an 89% increase on stock. This was great until Enron's scandals started to come to light and in 2001 their stock prices fell from about $90 a share to a $0.26 a share by the end of the year (Time, 2002). In 1990 Enron made 80% of their revenues from their regulated gas-pipeline industry but in 2000 95% of their revenues were from their wholesale energy's operations and services (Mclean, 2001). Eventually the basic question was asked, "How does Enron make its money?" This question could not be answered directly and in November of 2001 Enron admitted to accounting errors and that they inflated income by $586 million since 1997. Shortly after this confession Enron filed for bankruptcy. With Enron's collapse over 20,000 people lost their jobs many of which had their life savings invested in the company (Pasha, 2006).

The WorldCom scandal was unveiled almost immediately after the collapse of Enron. WorldCom was one of the largest telecommunications providers in the world and it was once valued at $160 billion (Belson, 2005). In 2001, WorldCom transferred line-cost expenses to capital accounts that conflicted with the generally accepted accounting principles (GAAP). For the year of 2001 and the first quarter of 2002, WorldCom had to reduce its reported cash flow by $3.8 billion. The result for these time periods was actually a net loss (Ackman, 2002). They eventually filed for bankruptcy and it was the largest ever filed. Over 17,000 employees lost jobs, pension funds, and savings (Hancock, 2002). The company did continue to operate but under a different name, MCI. They have recently merged with Verizon to "deliver innovative local to global communication solutions." (MCI/Verizon, 2010, p. 1)

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Both Enron and WorldCom were once very successful companies and both have similar collapses. Top executives in both cases received jail time as well. Scott C. Cleland, a telecommunications analyst at the Precursor Group, says this about the former CEO of WorldCom, "Every publicly traded company can thank Bernie Ebbers for Sarbanes-Oxley and the handcuffs they operate under today. It's everyone else's punishment for his misdeeds." (Belson, 2005, p. 1)

Reason SOX was implemented

Two sections of SOX, Sections 302 and 906 are devoted to 'corporate responsibility for financial reports', which state that the signing officer must review the report. This signing officer is usually the CFO or CEO. 302 also states that based on the officers knowledge no untrue or misleading statements are presented in the report. Some other responsibilities of the signing officer are:

Establish and maintain internal controls

Design such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared

Evaluate the issuers controls within 90 days prior to the given report

These rules let stakeholders know that they are getting accurate and reliable financial reports, notes and supplemental disclosures. While this might be a burden to some companies, compliance is mandatory. Non-compliance could result in officers and directors facing jail time and fines. This is where Section 906 adds an amendment for criminal penalties. It states that if the signing official knowingly signs a false report that a fine of no more than $1 million or a prison sentence of no more than 10 years will be given. It also states that if the signing official willingly signs a false report that a fine of no more than $5 million or a prison sentence of no more than 20 years will be given. The difference of a "knowing "and "willful" violation is still unclear (Peng, Dukes, & Bremer, 2007). It is hard to imagine that a corporation would overlook such important issues such as financial reports, but examples like Enron make this issue seem that much more meaningful.

Section 404 covers 'management assessment of internal controls'. Section 404(a) states that each annual report required by Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 shall contain an internal control report that assesses the effectiveness of internal control structure and that management responsibility for these controls is adequate. Section 404(b) states that each public accounting firm that prepares or issues the audit reports will report on the management's assessment of the internal controls. Auditors previously focused on business transactions associated with GAAP and the risk in the information process. These risks would then be evaluated based on the strengths and weaknesses of internal control (Lin & Wu, 2006). Non-accelerated filers, which are companies whose market capitalization is less than $75 million, had been exempt from section 404(b). This exemption recently ended on June 15, 2010 and all companies, regardless of market capitalization, will have to comply with Section 404 (Nolte, 2009). The American Institute of CPA's (AICPA) states that this section has helped to improve financial reporting and has provided greater transparency (AICPA, 2010). While many companies agree that Section 404 gives investors' confidence in financial reporting many of the companies believe the costs outweigh the benefits (NYSSCPA, 2005).

Cost associated with SOX

SOX is supposed to maintain investor confidence but it does come at a cost for public companies. Sections 302, 404, and 906 are generally the areas of focus pertaining to cost. Section 404 appears to be the most costly, but is viewed by most CFO's to provide very little benefit. According to Peng, Duke, and Bremmer (2007), who conducted a survey of 83 CFO's, the average total annual cost estimate of compliance for their companies are $1.77 million with a $2.05 million standard deviation. Based on the research 12 of these companies market capitalization is under $75 million, 43 between $75 million and $1 billion, 27 between $1 billion and $20 billion, and only 1 company over $20 billion (2007). This cost can be a significant expense for most companies, especially the smaller ones.

The SEC concludes that costs regarding Section 404(a) are incurred through increased internal labor and outside vendor expenses, while the costs incurred from Section 404(b) are from increased independent-auditor fees (SEC, 2009). Based on the SEC's survey, companies that complied with Section 404(b) say that the mostly costly component is internal labor which companies spent an average of $1,346,855 in 2008. The companies next highest cost are the fees paid for the independent audit of the internal controls over financial reporting which had an average cost of $2,328,062 in 2008 (SEC, 2009). The third highest cost associated with Section 404 is the outside vendor cost which averaged $311,323 in 2008. Non-labor represents the smallest cost which had an average of $137,702 in 2008 (SEC, 2009).

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It is believed that smaller companies have a higher cost burden when complying with Section 404 than larger companies. The SEC compared the cost of compliance vs. the company's assets as a fraction and on average small companies spent 0.79% of their total assets to comply with Section 404 for their first year of compliance. Larger companies had an average of 0.14% for their first year of compliance (SEC, 2009). One suggestion for this problem is that there should be different standards for companies of various sizes, and as obvious as it sounds a smaller company simply is not staffed to comply at the same level as a larger market capitalization company (Hartman, 2006). According to Hartman, an associate of Foley Research, the impact of corporate governance on public companies 82% of their respondents feel that the governance and public disclosure are too strict. 34% also stated that SOX compliance has influence budgeting and staffing cuts within areas of the company. One other effect that will be discussed more thoroughly is that 21% of Hartman's respondents are considering delisting their companies as a result of corporate governance (2006).

Going Private/Delisting in response to SOX

"Going private" and "delisting" are used interchangeable when in fact there are some key differences. "Going private" involves corporate transactions such as leverage buy-outs or management buy-outs. When referencing "delisting", the SEC allows an issuer to "opt-out" of the public company reporting system. Companies are allowed to delist based on their number of "holders of record", which are the owners of the security. When a company considers doing either it affects many individuals including stockholders, employees, lenders and many others (Morgenstern & Nealis, 2004).

Besides avoiding cost of SOX, another benefit of going private is that companies have no obligation to release financial information. Though this may be good for companies, shareholders do not view this as positive. A disadvantage of being private is that transactions trigger litigation and stockholders frequently question the value of the stock price (Morgenstern & Nealis, 2004).

Below are figures from the SEC's survey that asked companies if Section 404 had an impact on their decision to stay public or delist from the U.S. exchange. (SEC, 2009)

26% of foreign companies that were surveyed report that they have seriously considered delisting while 25% reported this option less seriously (SEC, 2009).

Syms, a retail clothing store, delisted its stock as a direct result of corporate governance, including SOX. Despite shareholders fear of harm, Syms decided to de-register its stock from the U.S. Stock Exchange. In response, the stock price dropped more than 40%. Shortly after, Syms re-registered its stock on the NASDAQ and within the same day stock prices rose more than 11% (DealBook, 2008). Though some companies see SOX as overbearing, it does in fact give shareholders confidence in the U.S. Stock Exchange.

Although firms are going private and delisting to avoid SOX, some studies have shown that they are still complying with the law. One reason is that the company will need a private bank debt or cash on hand to finance going private. Most often the firm turns to a high yield debt market to fund the transaction which the SEC requires filing periodic reports which are now subject to SOX compliance (Barlett-III, 2008).

The Effectiveness of SOX

One main purpose of SOX was to restore investor confidence and enhance corporate responsibility. Though it is hard to measure the quantitative benefits of SOX, some firms believe that Section 404 has helped improve confidence in the audit committees and improve the quality of financial reporting (SEC, 2009). Though no law will completely eliminate fraud, it is believed that SOX will have a positive effect on investor confidence (Vay, 2006). A survey conducted by Vay concludes that 58.1% of the respondents state that SOX is not effective in the prevention and detection of fraud within financial statements though only 25% believe that SOX should not be in effect at all (2006). Some complaints of Vay's respondents were that foreign companies have a competitive advantage over U.S. companies because they do not have to invest the same time and effort to comply with SOX (2006). Section 404 costs are believed to not outweigh the cost of compliance based on the SEC's survey (2009). SEC Chairman Donaldson states that "Section 404 has not been easy for public companies and has required significant outlays of time and expense. The Section 404 effort should improve not only the quality of information to shareholders, but also the quality of information management relies on to make decisions" (Donaldson, 2005, p. 1). It is clear that companies clearly want Section 404 revised and that SOX has been most beneficial to investors.

Conclusion

In response to the major financial scandals of Enron and WorldCom, Congress passed the Sarbanes-Oxley Act of 2002. The main focuses of this act was to restore investor confidence and enhance corporate responsibility for financial reports. Though it was already illegal to provide inaccurate financial statements Section 302 provides a more detailed description of what is to be required by CEOs and CFOs. Section 906 adds amendments for criminal penalties.

The main complaint about SOX from public companies is the cost of compliance with SOX, particularly Section 404. Though it is believed that the costs do not outweigh the benefits there is no doubt that companies believe there are a significant amount of benefits and that SOX should simply be revised to achieve full effectiveness. This Act is still very new and with the recent revisions that all publicly traded companies must comply with Section 404(b), many new reports will undoubtedly now come out assessing the effectiveness of the revisions.