Sarbanes-Oxley Act of 2002

Introduction

Project’s Main Objective

The objective of this project is to shed light on the 2002 Sarbanes-Oxley Act. The aim is to reveal the Act’s role enhancing protection of investors from corporate crimes. The Act pays emphasis on disclosure of accounting information through legal frameworks in a bid to minimize fraudulent activities within corporations. Organizational management has a mandate of ensuring that inventors’ funds are not exposed to any risk as part of social corporate responsibility. However, in 2001 and 2002, the US experienced three of the largest cases of fraudulent activities, which were acerbated by corporate managers.

General Plan of the Project

With this objective in mind, the project starts by offering a historical overview of the Act. Secondly, it highlights the Act’s implementation process. Thirdly, the project presents the effects of the Act on corporations and other business establishments and society. Lastly, it will offer a detailed analysis of the policy in an effort to discuss its success, strengths and weaknesses before offering recommendations of similar policies in the future.

History of the Act

Why the Law was Necessary

Before the enactment of the Sarbanes-Oxley Act, the US suffered from various corporate fraudulent crimes, which led to embezzlement of billions of investors’ money. Bodies that are mandated to conduct oversight roles on behalf of investors also experienced challenges due to lack of policy frameworks to foster their independence while scrutinizing corporate financial accounts. In some instances, auditing organizations also engaged in other businesses such as consulting arrangements with organizations that they were required to audit. These concerns led to a reduction of investor confidence.

When Enron, Tyco, and WorldCom fraud took place, the US legislators sought to develop a policy that would not only rekindle corporate investor confidence, but also ensure that such frauds would not occur in the future. Consequently, the Sarbanes-Oxley Act was enacted.

With the onset of WorldCom, Enron, and Tyco frauds, the Senate Banking Committee held various hearings on a range of challenges that were encountered in the US financial markets, which had culminated into the disappearance of huge sums of money. During the hearings, the committee heard several complains, which led to the establishment of several causes of fraud in the corporate sector.

These causes included “inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analyst conflicts of interests, inadequate disclosure provisions, and gross inadequate funding of the Securities and Exchange Commission” (Lucas, 2004, p.17). The committee was convinced that any policy framework for curbing corporate frauds had to reflect these concerns in its formulations.

Auditing firms comprised the only watchdog for corporate investors before enactment of the policy in 2002. However, their reliability and dependability was compromised by the fact that they self-regulated themselves whilst engaging in other activities such as offering consultancy services with the organizations they audited (Geiger, Raghunandan, & Rama, 2005, p. 24).

Some of consulting contracts outdid auditing work in terms of net returns. This observation implied that any attempt to pose interrogatives on accounting approaches in the corporations to be audited would negatively impair any forthcoming consulting arrangement. Such conflicts of interest exposed investors at higher risks of losing their investments through fraud.

Regulations on acquiring loans were also important to help curb fraud. Prior to the enactment of the Sarbanes-Oxley Act, various financial institutions authorized credit to corporations without a clear consideration of any involved jeopardy. This assertion is well evidenced by Enron’s situation. This blindness made them incur large losses. These experiences in the pre-Sarbanes-Oxley Act period prompted its enactment to ensure that investors made investment decisions, which were backed by properly represented accounting information for any corporation.

The name Sarbanes-Oxley Act emanated from its sponsors: Michael Oxley (US representative) and Paul Sarbanes (a U S senator). First, the house passed bill number H.R.3763, which was prepared by Oxley on 21thApril, 2002. It also received support from President Bush and Securities Exchange Commission (SEC). In the mean time, Paul Sarbanes was busy preparing his proposal bill number 2673 for submission to the senate (Jain & Rezaee, 2006, p. 629).

On 18 June, the proposal received a popular vote before Senate Banking Committee. A week later, WorldCom revealed its overstatement of earning by $3.8 billion and above, thus suggesting that the two bills came just at the right time. When the senate and the house held a conference committee with the objective of reconciliation of differences between the two bills, the outcome was the Sarbanes-Oxley Act.

Public Policy Description

The Sarbanes-Oxley Act’s requires top management within an organization to provide certification of accuracy of all provided financial information. It imposes heavy penalties in case of identification of financial fraud. The Act has 11 titles that are divided into various subtitles. In the nine subtitles, Title 1 provides addresses the roles of the board in charge of public company accounting oversight (Public Law, 2002, p. 752).

Title 2 offers guidelines for fostering auditors’ independence while Title 3 lays the foundations for corporate responsibility in organizations. In titles 4, 5, and 6, the Act makes provisions aimed at enhancing financial disclosure and resolving analysts’ conflicts of interest. It also discusses authority of the commission (Public Law, 2002, p. 748).

Title 7 on the policy is dedicated to studies and reports. Titles 8 through 11 deal with “corporate and criminal fraud accountability, white-collar crime penalty enhancement, corporate tax returns, and corporate fraud and accountability” (Public Law, 2002, p.746). These objectives of the policy imply that it currently emphasizes curbing fraud in publicly traded companies.

Corporate management scholars contend that the law is incredibly important in helping corporate governance in terms of increasing control and monitoring of financial accounting patterns whilst ensuring financial disclosures within organizations (Gaynor, McDaniel & Neal, 2006, p. 892). Currently, the policy also highlights the significance of corporate social responsibility. It also sets rules on compliance with specific reporting deadlines.

For instance, all companies must meet certification on all financial reporting for statements filed after 15 November of any financial year (Public Law, 2002, p. 767). Small organizations and foreign business firms have to fulfill these requirements after July 15 of every fiscal year, which was set in the original Act as April 15 in every accounting year (Gaynor, McDaniel & Neal, 2006, p. 893).

Market Failure or Government Failure

There has been raging debates on whether the Act was implemented following government or market failure. However, this section clarifies that the Act was enacted in the wake of increasing corporate scandals that were aimed as embezzling funds. Such crimes include Tyco and Enron scandals (Abbott, Parker, Peters, & Raghunandan, 2003, p. 18). Enron, an American energy organization, was declared bankrupt on October 2001. The company had misrepresented its financial accounts to woo investors without their knowledge that it was already sinking into financial troubles.

In 2002, yet another giant American conglomerates, Tyco, experienced another setback. Its CEO and CFO had stolen over $150 million from the organization, thus making it top in the list of some of the biggest financial corporate frauds in the US and across the globe. The crime was executed through selling of stocks and receiving various unapproved loans (Carcello, Hermanson, Neal, & Riley, 2002, p. 368). Unaware of the crime, investors continued to pump in their funds into the organizations.

In 2002, financial records of WorldCom, a US telecommunication organization, were misrepresented with the aim of embezzling investors’ funds. Organizational expenses were misrepresented as future investments. The scandal was estimated to cost investors $3.8 billion. Profits were exaggerated by more than $1.3 billion (Abbott et al., 2003, p. 21).

The scandals attracted the attention of lawmakers in the US, as they threatened to erode of investor confidence. Thus, designing of the Sarbanes-Oxley Act was the only way out in an attempt to curb future corporate crimes. The US Congress became aware that principles of corporate social responsibility or corporate citizenship failed to offer adequate protection to investor interests in corporations (Norman & Neron, 2008, p. 24). Dealing with these problems required the establishment of legally enforceable guidelines on how corporations could prevent fraud to foster accountability in a bid to boost investor confidence. Sarbanes-Oxley Act served as the most rational way to accomplish this task.

Boardroom failure also encompasses an important rationale for designing the Sarbanes-Oxley policy. In the US, the board of directors plays the role of offering oversight for the financial reporting systems deployed by different corporations. It executes this work on behalf of the corporations’ investors.

Scandals executed in 2001and 2002 reflected failure of the board of directors to execute this responsibility or people who did not possess requisite expertise to understand complexities that are associated with the corporation to which they provided oversight. Again, committee members did not enjoy sovereignty from the management. In the pre-SOX period, banks’ practices and conflicts of interest between corporations and auditors, as discussed before, also constituted an important rationale for developing the Sarbanes-Oxley Act.

Implementation of the Policy

Policy implementation follows the process of policy formulation. Mazmanian and Sabatier (1983) describe policy implementation as encompassing various particular policy decisions in a manner that is directed by the prescriptions of an administrator, law, and/ or court guidance (p. 38). In the context of Sarbanes-Oxley policy, the legislative arm of the US government with the support of the president Bush set out its implementation. The policy required various parties within corporations to play different roles for its successful implementation as discussed in this section.

Problems that led to the formulation of the Sarbanes-Oxley policy were attributed to the top organizational management. Indeed, this group of people, especially the board of directors and CEOs, has the mandate of ensuring that corporations adopt effective controls (Jahmani & Dowling, 2008, p. 63).

However, Tyco and WorldCom scandals revealed that either these people participated in fraud, or they had inadequate expertise in reading financial information in a bid to establish any misrepresentations. In this extent, they failed in their mandate of setting and implementing various business codes of conduct that provide guidelines to acceptable business practices. While Sarbanes-Oxley Act relieved them of some of these duties, its implementation required their input.

SOX demanded that top organizational management people, particularly the board of directors to conduct assessments and tests whilst carrying out an evaluation of various internal control approaches for financial reporting. They were also required to ensure general compliance with the Sarbanes-Oxley policy by the corporations they oversee. This requirement suggests that the success of the Act was dependent on their commitment to enhancing its implementation.

However, this obligation needed not to contravene or interfere with the roles of the auditors. External auditors had to play essential functions in the implementation of the policy by ensuring that they inspected management’s evaluation before offering their conclusions that were free from intrusion by any other party. Auditors and managers have responsibilities of ensuring that other employees comply with various codes of ethical corporate conduct as provided for by the Sarbanes-Oxley Act.

The objectives of the Act reflect the role of auditors in the policy implementation process. It objects to restore investor confidence to accounting practices that are adopted by corporations, enforce and strengthen laws on federal securities, and enhance corporate organization ‘top tone’ with reference to executive corporate responsibilities

It also objects to improve the performance of corporate gatekeepers by facilitating disclosures on financial reporting. These objectives imply that a corporate audit process needs to comply with integrity principles in approaches of financial accounting to ensure reliability of financial accounts. To facilitate the realization of these concerns, the implementation of the Act required several measures as discussed below.

PCAOB (Public Company Accounting Oversight Board) is required by the Sarbanes-Oxley Act to work in collaboration with the US Securities and Exchange Commission to ensure acceptance of accounting firms’ registrations, execute independent funding mechanisms, and/or establish disciplinary and inspection programs.

PCAOB has a role in the implementation of the Sarbanes-Oxley policy by setting auditing standards together with attestation by working from the reports handed over by external corporate auditors (Keinath & WaIo, 2004, p. 25). The policy provides that the members of the PCAOB must be appointed by SEC. The commission also engages in the policy implementation process by approval of rules and professional financial reporting standards (Keinath & WaIo, 2004, p. 27).

SOX guides the implementation of documentation and control practices that are aimed at ensuring the achievement of corporate controls targets. Documenting controls aids an organization to comply with section 404 of the Sarbanes-Oxley policy (Anand, 2007, p. 67). The section places a general requirement for all organizations to properly document and report on their control mechanisms.

Indeed, any documentation of control is incomplete without CEO and CFO’s signatures. This requirement implies that these two top corporate managerial personnel carry a strict liability for any control documentation and reporting practices that are adopted by their companies in a bid to avoid a repetition of Tyco-type of fraud.

This stage of implementation of the SOX requires corporations to conduct reviews for their existing control designs to ensure that any risks that are identified in other steps are prevented from occurring (Anand, 2007, p. 71). In the preliminary evaluation steps, inherent problems to the control measures that are adopted by an organization are addressed. In this regard, evaluation encompasses determining a specific type of control that is necessary to safeguard an organization from any potential risk.

In the implementation of the requirement for exposing codes of ethics statements to the public, organizations are required to file their statements in an exhibit in the form 10-K or 10-KSB annually. They may also post their codes of ethics statements on websites. Where this option is preferred, the US Securities and Exchange Commission (2013) notes that the website address must be provided in the form 10-K or 10-KSB.

An organization may also disclose its codes of ethics statement by issuing a free copy of it to any interested person (Para. 4). Perhaps, all these steps constitute the ways of presenting an organization as a good citizen. Such an organization creates confidence that it does not engage in any financial fraud.

Impact on Business and Society

SOX requires businesses to detail disclosures on their stands on codes of ethics of some of its current top managerial office holders. The US Securities and Exchange Commission (2013) identifies these people as “the principal executive officer, the principal financial officer, as well as the principal accounting officer and other persons in the organization who might be performing similar functions” (Para.3). Failure of businesses to establish codes of ethics implies direct legal obligations for them to explain such failures. Firms that fail to achieve the threshold set out by their codes of ethics statements are required to explain their failure to do so.

The Sarbanes-Oxley policy has varying implications. Annual external audits are executed annually with organizations that are required to pay for them. The policy also increases demands for internal audits to foster accountability and/or ensure compliance with the regulations. According to Jain and Rezaee (2006), section 404 increases the scope of audits that prompt organizations to spend more in fulfilling legal obligations (p. 635). Internal control requirements also raise operation costs for organizations.

For instance, Li, Pincus, and Rego (2008) inform that the policy requires organizations to design and implement internal control software (p. 112). The policy also requires companies to develop well elaborate plans for control in a bid to enable managers track internal performance. Failing to comply with these expensive obligations only raises financial challenges to companies, as they are required to pay large penalties.

Amid the increased costs of doing business, SOX increases value and benefits of societies that exercise their corporate responsibility towards investors through the requirements for them to openly express their codes of ethics. As organizations endeavor to put in place elaborate control and audit measures, organizations’ activities become streamlined (Li, Pincus & Rego, 2008, p. 123).

This situation aids in enhancing business performance, which influences organizations’ financial positions in a manner that directly correlates with investors’ stakes. Indeed, many companies have already developed strategies for ensuring improvement of their operations to ensure compliance with SOX processes (US Securities and Exchange Commission, 2013, Para. 5). This claim suggests the willingness by organizations to respect the necessity for control structures in helping streamline their operations.

This case encompasses a major step towards mitigation of risks of defrauding money by management without suspicion. However, investors may not have certainties on the efficacy of the instituted control measures as provided for by the policy. Nevertheless, holding top management liable if any fraud occurs through ineffective control measures can help create confidence that its investments are not at risk.

Policy Analysis

Did it Work?

It is indeed true that Sarbanes-Oxley policy has been a success since it came into force when investor confidence was at its worst situation. Sentt and Gallegos (2009) confirm that it has enhanced transparency for corporations by ensuring reliability in financial reporting standards. Although this conclusion is an important strength of the policy, it also has its negatives (p. 46). For instance, implementation of the provisions of the Sarbanes-Oxley Act policy has led to escalation of corporations’ cost of operation.

Strengths

Sarbanes-Oxley Act ensures renewal of investor confidence to provide a room for prosperity and higher economic growth (Sentt & Gallegos, 2009, p. 53). Detailed documentation permits workers to acquire knowledge on crucial business processes. Through the Act, it becomes possible for corporations to seal all loopholes that potentially give safer grounds to carry out fraud.

Before enactment of the SOX, organizations developed their own internal controls to ensure that they abided by the principle of corporate citizenship. However, while subscribing to the principle of social corporate responsibilities, Tyco, WorldCom, and Enron corporate crimes gave rise to interrogative of the capacity of corporations to safeguard the interests of stakeholders, especially the investors as prescribed by the principle of social corporate responsibility.

Carroll (1991) asserts, “Social responsibility can only become a reality if more managers become moral instead of amoral or immoral” (p.39). Perhaps, where managers become irresponsible and immoral in the extent that they make decisions to engage in fraud, a plan to design and implement legal frameworks to curtail them from engaging in unethical acts becomes necessary (Jasso, 2008, p. 95). Indeed, Sarbanes-Oxley Act policy is effective in this end.

Through the provisions of social corporate ethics and social corporate responsibility, Sarbanes-Oxley Act forms an important strategy for placing corporations’ role in stakeholders on the right track. Dishonesty undermines the interests of investors in an organization. Through the Sarbanes-Oxley Act, investors rest assured that corporations yield long-term benefits. This outcome creates an opportunity for them to solve social challenges via shared value approaches.

By curbing possibilities of defrauding investors of their funds, corporations acquire “the opportunity to utilize their skills, resources, and management capability to lead social progress in ways that even the best-intentioned governmental and social sector organizations can rarely match” (Porter & Kramer, 2011, p.77). In this extent, Sarbanes-Oxley Act may enable corporations acquire societal respect amid the past dwindled public confidence.

Weaknesses

Although Sarbanes-Oxley Act played important roles in the restoration of investor confidence, it also places organizations at some disadvantages. Auditing procedures are expensive. This observation means that the policy leads to a reduction of organizations’ profit margins. Pathak (2005) notes that corporations were also forced to alter their financial reporting standards in the effort to enhance transparency and accountability (p. 28).

For the implementation of the policy, organizations were required to adopt change by employing additional staff members. However, this move constrains an organization’s financial resources.

While implementing fully the SOX, smaller organizations are generally affected negatively. Jahmani and Dowling (2008) support this assertion by claiming that such organizations have limited capacity for outsourcing services such as implementation of controls and their evaluations (p. 59). This challenge compels them to deploy their existing employees to execute additional functions as prescribed by SOX, which do not add any output value. Indeed, additional tasks to the existing employees limit the ability of people to perform their organizational mandates, which limit them to focus on their performance objectives.

Recommendations for Future Policymakers

Policies are put in place with the objective of offering benefits to the society. This claim suggests that all affected stakeholders must be incorporated in their design and implementation phases. However, in case of Sarbanes-Oxley policy, there exists evidence that the legislators never compiled stakeholders’ views during its formulation. For small enterprises and corporations, they were required to implement various provisions of the policy without considering their human resource capability and capacity.

Therefore, the policy turned out as an expensive legal requirement where the management did not have inputs so that its provisions can apply differently in different organizations depending on their resource capability. In this extent, it is recommended that future policies that are similar to Sarbanes-Oxley policy will have to consider inputs from all stakeholders.

Public policy designers need to consider the magnitude of regulations in a particular policy. Many regulations increase sophistication in policy comprehension and implementation processes. The Sarbanes-Oxley policy sought to protect investors from frauds that were acerbated by managers and other people who were entrusted in the protection of their interests.

The number of provisions that sought to help the policy achieve these objectives may scare potential future investors since their resources might be significantly committed in running organizational functionalities as opposed to activities, which directly increase their gains. Policy developers also need to ensure even distribution of responsibilities in policy implementation processes since Sarbanes-Oxley policy mainly bestows implementation requirements to managers where the CFO and CEO take strict liability of control practices adopted by their organizations.

Reference List

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