Accounting Theory and Contemporary Issues
THE SARBANES-OXLEY ACT
Public Company Accounting Reform and Investor Protection Act of 2002 commonly known as Sarbanes-Oxley or SOX Act was enacted by US Congress to handle concerned issues surrounding business management and financial reporting as a way to restore and maintain investor confidence in the US capital market grappling with corporate scandals and accounting irregularities. With the integrity of the market further compromised by the failures of Enron's bankruptcy and WorldCom, the act considered as the most significant corporate regulatory reform since the Securities and Exchange Act of 1934, sought to curb the ongoing-spectacular corporate failures and scandals occurring in North America. The WorldCom's failure was the last straw, prompting the speed passage of most drastic legislation to affect the accounting profession since1933.
The major purpose of this act is to provide reliable and accurate information to the investors. The formation of this act had to undergo a detailed process of iteration and redaction to ensure its comprehensiveness. This act deters reporting misleading and fraudulent financial information of corporations, by establishing increased sense of responsibility on the administrative bodies and directly to the management. Although prior to the act, the financial statements of some companies were perceived to be sceptic by a few, but the significance of the inception of an act was prompted by the implausible failure of Enron and WorldCom. They were the leading companies in their respective industry and in early 2000s; they filed bankruptcy on divulgence of their accounting fraud. The divulgence of their accounting fraud raised questions over the credibility and reliability of the financial statements of the companies that existed in the market. The distrustfulness in financial reporting caused reluctance in investors to invest and subsequently led to contraction of capital market.
One of the major elements composed in the act is the responsibility of the executives, the act holds the executives liable for any fraudulent activity, thus encouraging them to implement effective internal control and precisely amenable to the act and policies. The past judgements elucidated that the executives were directly involved in the violations, therefore in order to counter that, the act requires the executives to submit forms in which the executives hold themselves responsible for completeness and reliability of the financial statements. In case of any infringement, the executives will be liable even if the employees were the perpetrators, because the executives are supposed to implement internal control and supervise adherence to the policies. The addition of executives' responsibility is considered highly imperative as the executives tend to incriminate the employees for the wrong doings in the past. The act not only emphasises the accountability of the executives but also others through which the information is processed, formatted and verified, such as auditors and accountants. The formation of Public Company Accounting Oversight Board (PCAOB) was imperative to increase control and independence of auditors so that unbiased and reliable information can be delivered without being influenced by the management. The example of Arthur Anderson can corroborate the necessity to incept an institution like PCAOB, who can monitor the auditors.
The accounting profession was largely self-regulating around the world. Now it has changed (though in Canada it hasn't changed), it is no longer considered acceptable to limit monitoring of the profession to the professionals themselves because it had become painfully obvious how the profession's perceived failures impacted extensively on the market. The market hit multi-year lows at the height of the corporate scandals on 2002 and SOX was seen as solution to regularize the situation. Since then the influence of SOX has spread throughout the world and in much broader areas of corporate activities.
The provisions of the act are implementable and they can be effective, however it is subjective to the performance of the institutions and credibility of the personnel. The apprehensiveness of being prosecuted for not adhering to the policies contributes to the effectiveness of the act, for vocations like auditors and accountants. The act demands scrupulous process of auditing and preparation of financial statements. A stringent series of verification process should be formulated to ensure high assurance of minimal misstatement.
Although performances of auditors can be monitored by an institution, there is always tendency that auditors present bias information if they are influenced by the executives. In response to this relationship between auditor and client, Sarbanes Oxley further defines auditor independence and created mechanisms (Public Company Accounting Oversight Board) to enforce and maintain auditor independence. In light of this, auditors should be rotated every few years which will not only allow auditors to provide bias free information but it also is an effective method of verification. It is plausible that auditors who work for a client for several years create the tendency to be influenced by the executives to present financial statement in accordance with the corporate goals and objectives rather than real economic situation, thus becoming part of the corporation and compromising their independence. It is highly imperative to establish independence of auditors that can be achieved by rotating auditors every few years. By doing so, not only it will assist to examine the performance of predecessor but also restore confidence in investors for auditors and financial statements.
The growth of the American economy has been fuelled by successful American corporations, propelled by the capital of investors and based purely on capitalism. Capitalism gave rise to a free enterprise system and the economy nurtured with it. Investors throughout the years cashed in and with it, their faith matured in the American capitalist system whose sole aim was to maximise investor profit. The increase in corporation and their assiduous augmentation surged capital of the world economy. During those fruitful years, the stakeholder's never reasonably observed the financial statements and the accounting practices associated with it. In the process, the cupidity of corporations to depict consistent growth prompted them to take the route, aberrant from the ethical standards. Maximised earnings blurred accounting's main purpose that was to protect financial statements from uncertainty and fraud.
A series of fraudulent practice of different corporate vocations became evident, accounting and auditing in particular in the 1990s and 2000s. The corporations overstated their income and asset to maximise profits to sell their stocks. The idea to deter such practices was considered frivolous, based on the assumption that they were non-recurring and inadvertent mistakes. It was later ignored with the emergence of frequent fraudulent cases of Enron and WorldCom. It can be argued that they were being consistent with the doctrine of capitalism on which the economy was based on, since there were no law concering such issues. When these fraudulent activities came to light the American government felt the pressure to take action, which led to the enactment of Sarbanes-Oxley Act 2002- a direct product of consistent financial delinquencies that emerged in the early 1990s and 2000s.The government intervention was implausible for the corporations as it is repugnant to the notion of capitalism.
The constant growth of corporations in the late 1900s surged capital from investors which propelled the engine of the economy. Most executives indulged in unfair practices when face critical impediments in the growth of their companies which caused extraction of investment pushing the corporations on the precipice of bankruptcy. In order to retain the investment and maintain mercurial inflow of capital, executives were prompted to exaggerate the financial statements. It was inevitable or perhaps the only route to survive the competition as they perceived. The executives abused the leniency of the administrative bodies motivated by their own compensation which also helped the management to enshroud their incompetency and yet maintaining the cash inflow through capital investment, creating information asymmetry in the market.
The information asymmetry jeopardized the investor's capital and the divulgence of the financial delinquencies, causing investor's confidence to distort. The intervention of the US government became imperative to halt such delinquencies because, had it continued for longer period of time, more investors had suffered losses. The purpose of financial statement is to depict the economic condition of a corporation and ability of to operate efficiently by generating profits, which help the investors to make their decisions based on it; rather it was used to curtain inefficiency of the company and incompetency of the executives, hence distorting the confidence of the investors, the decision usefulness.
There have been several criminal investigations regarding financial frauds for decades but the enactment of Sarbanes Oxley stimulated the federal investigation and prosecution of corporate and securities fraud that sent a powerful signal of the seriousness with which the federal government approached corporate governance. It has only been 7 years since Sarbanes Oxley was implemented and there have been positive and negative implications of the act. The enactment of the act has not brought any major frauds or accounting misrepresentations by corporations though in recent times the capital market have gone through financial meltdown for reasons other than accounting misstatement. On the other hand, it has brought a lot of changes in financial presentation and reporting disclosures. It is implausible to comply with the SOX policies for corporations as the cost of adherence exceed the benefits, which galvanized them to shift toward privatization. It has cost corporations excessive amount of money to comply with the act which is why many small public corporations are tending to become private companies.
It can be argued that with firms spending excessive amount of financial resources to comply with the act, rather they can be spending that shareholder's money on research and development or to introduce new products. The law is composed of regulatory mandates that will absorb large amounts of director's time and energy regardless of whether they improve the accuracy of financial reporting or investor's protection. That time could rather be spent on proliferation of other economic resources to become more productive. This can lead to failure of the business and even further contraction of capital economy. Also, the capital of investors can stream to other financial markets as they consider the financial burden in meeting the requirement of the act.
Furthermore, it offers the undue opportunity to the government to interfere with the supposedly free market system. How can the government hold a businessman criminally responsible for any mistake in a financial report, which is the product of people making thousands of individual judgments and estimates? The SOX says the mistake is intentional if the internal control system which management established to prevent error and fraud was not adequate. But since the government does not define adequate, anytime a regulator decides there should have been still one more control to prevent even the most inconsequential of errors, the management is guilty of fraud. Section 404 of the act requires extensive testing and documenting of internal controls and because of that companies avoid any potential action the government might frown upon, and avoid pouring endless time and energy into monitoring and cataloguing anything that a government inspector might conceivably believe is relevant to financial reporting.
It has also deterred foreign firms to list their shares in the US stock exchange due to complexities and cost of compliance to the act. Moreover, Sarbanes Oxley re-enacted or rehashed some of the provisions that already existed, such as criminal liability for fraudulent financial disclosures, which did not make a difference as the law before Sarbanes Oxley did the same. Also, a major motivation for fraud in accounting was executive compensation and Sarbanes Oxley does not highlight this fact in its provisions. The act failed to touch on the issue of the ethical implications on the society as a whole, as we witnessed in recent past the unethical behaviour of executives and their compensation issues that almost led to the meltdown of the financial market.
The Sarbanes-Oxley act has helped to restore the lost investor confidence in the accounting system of the corporations but laws has constraints and limitations. The act was formed based on the assumption that the investors would be prudent and knowledgeable to understand the financial statements. If however the investors are imprudent, no law can guarantee the protection of their investment. In recent times, the Sarbanes-Oxley act has not been able to avert the financial meltdown, due to its incomprehensiveness. The various elements of financial markets are not composed in the act, and it gives leverage to further delinquencies. It should be expanded to cover all the aspects of the capital market. Consequently, the meltdown indicates the inadequacy of the law to prevent further violation. The implementation of the act and subsequent meltdown further distorted the credibility of the market which was the government's action to prevent financial irregularities.