The Sarbanes Oxley Act is also sometimes known as the Public Company Accounting Reform. It is also called the Investor Protection Act, or The Corporate and Auditing Accounting and Responsibility Act. This law is a U.S. based law that was passed by the Federal Government. Its domain encompasses public limited companies, managements, and other public limited accounting firms. According to the U.S. Government Printing Office (2002), the Sarbanes Oxley Act was basically created to protect the people who invest in a firm. The protection would be against false disclosure by the board of directors or the managers which can mislead the investors and other people in the market. Therefore, it can be said that the Sarbanes Oxley Act is an act related to ethical concerns and therefore it focuses on corporate social responsibility.
Reasons behind enactment of the Sarbanes Oxley Act
Everything happens for a reason. So was the case with the enactment of the Sarbanes Oxley Act in 2002. A set of incidents led to the enactment of this act. Bankruptcy and accountancy scandals had become common. Due to this companies had to be shut down. Investors lost their money and a great amount of people suffered heavy losses along with the economy as a whole. WorldCom, Adelphia Communications, Tyco, Sunbeam, Waste Management, Xerox, and Global Crossing are some of the few that have committed such scandals.
According to Kuschnik (2008), all these incidents greatly affected the stock value of companies. Bullish markets were present in the 1990s. This implied that there was great potential in the stock market and that investments in stocks would be highly profitable. Therefore, the potential for growth was more important for the investors rather than the current profits that the companies were making.
Moreover, the people who lead giants like Enron at that time were highly ambitious and willing to beat the expectation of the analysts. This meant that they were willing to take great risks in order to secure maximum profits for their firms. To secure profits they resorted to amalgamations or takeovers of other firms. This was risky as well as costly. Tampering with the financial statements was also common so that the benefit would go to the firms as managers. Most of the time, stocks were overvalued by manipulating the financials of a firm. Now stock buyers would need to pay more for stocks rather than they would have to pay earlier. This was because the financial were deliberately overstated.
On the other hand, banks and loan providing organization were also ready to lend massive amounts to these corporations due to their strong financial positions. According to Kuschnik (2008) the banks were willing to lend great amounts because they wanted to be part of the big profitable game that was about to take place. Secondly, if the companies that they lent their money to would succeed, this would result in better opportunities for the banks. Other such companies would take notice of high credit rankings of the banks and try to get loans from them. This was another reason why the stock values of companies shot up dramatically. With the shooting of the stock prices, chief executive officers became like Gods to the general public of the U.S. They were seen as trustworthy and intelligent people who brought business to the firms and increased the returns on investments of the people who had invested in their firms.
The popularity of the C.E.O.s had grown drastically. Thus, the managers were able to claim huge salaries and remuneration packages as they were bringing extensive business for the firms. Therefore, C.E.O.s also started making money more than the acceptable limit. The Securities and Exchange Commission (SEC) has to be blamed as well. This is because the SEC was responsible for auditing the financials of the firms. It was their mistake that frauds were not caught and reported to the legislative authorities. Fraud might also be prevalent within the SEC which resulted in more problems as fraudulent material was hidden by the SEC. Fortunately, with the burst of the hype regarding stock prices and with the elections near at hand, the U.S. government decided to take strict measures to stop this nuisance and to take measure to prevent such incidents from occurring again. To understand the necessity of laws that can control scandal and frauds, Tyco International’s case is explained below.
Tyco International is a diverse manufacturing company that operates globally. It is incorporated in Switzerland but has operational headquarters in New Jersey, U.S.A. Tyco offers its customers with fire protection, security solutions and flow control.
Tyco was a very profitable company under the leadership of L. Dennis Kozlowski, the chairman and Chief Executive Officer of Tyco International. Kozlowski served Tyco from July 1992 till June 2002 when the directors asked for his resignation. Kozlowski was charged with massive scandals and corruption on a large scale. Galvani et al. (2002) charged Kozlowski with extreme levels of corruption that included, awarding unauthorized special bonuses to him as well as 40 other employees, misappropriating 100 million dollars to him and millions of dollars to others as well. The list of the charges made by Boies, Schiller & Flexner LLP was endless. These accusations were clear as the company had begun to face decline. However, Kozlowski was to be taken to court and given a trial.
According to Boostrom (2011), in the September of 2002, the U.S. televisions broadcasted the news that L. Dennis Kozlowski (CEO) and Mark H. Swartz (CFO) of Tyco International were being arrested. They were charged with involvement in corruption of more than 170 million dollars from Tyco International. Moreover, another charge was pressed against them that they had personally gained 430 million dollars just by illegally selling company stock and by hiding vital data from the investors in the company. All in all, the two top executives were accused of more than 30 crimes. These included grand larceny on a massive scale, enterprise corruption, and tampering with the financial records of Tyco International’s records. Mark A. Belnick was another individual of the firm who was charged with the stealing 14 million dollars in the form of personal loans. Long time had passed since the early arrests of the executive of Tyco International. However, the accusations and lawsuits were still filed against Tyco International. This was a display of poor corporate responsibility and it was one of the reasons why the Tyco case became one of the most popular scandals of the business world in the early 2000s.
The failure of Tyco international was due to fraud on a mega scale and corruption. The corruption started after Dennis Kozlowski joined Tyco in 1992. Although Kozlowski was the CEO when the fraud occurred, by using the theories mentioned above, we can state that Kozlowski was not the only one responsible for what happened to Tyco International.
After the case of Tyco, it became crucial that laws were needed that could control this situation. Thus, the Sarbanes Oxley Act was passed. As discussed earlier, it would be dealing with the management of public companies and the management of the auditing firms so that such scandals do not occur in the future. Some salient features of the Sarbanes Oxley Act are mentioned in detail below.
Sarbanes Oxley Act (Salient Features)
According to Litvak (2007), Sarbanes Oxley Act contains many sections and these sections are there to have a direct impact on the listed companies of U.S. and also the Non-U.S. companies present in the United States. . The sections specifically deal with different areas. 5 sections are the most crucial sections of the Sarbanes Oxley Act. According to Soxlaw.com (2003), these sections are Section 302, Section 401, Section 404, Section 409, and Section 802.
Section 302 comes under the heading of title III of the act. This title discusses corporate responsibility for financial reports. It states that the signing officers of the financial reports must have reviewed the reports. This means that they would not act carelessly or just sign the report without even looking at them. The reports must be reviewed before signing.
Secondly, all material must be included in the financial report regarding the financial performance of any business. No false claims are allowed. Moreover, misleading statements that are ambiguous and can mislead the investors of the firm are also strictly prohibited from including into the financial reports.
Thirdly, the financial statements must be a true representative of the financial position of the business and that the material standings of the business are clearly reflected in the financial statements of any firm.
The officers who sign the reports have to take care of internal controls. These controls are related to the gathering of the financial data. The revision of the internal control measures must be conducted within ninety days of the commencement of the formation of the report.
Furthermore, evaluation reports have to be created for the internal control measure. If deficiencies are found by the controlling officers in the internal control measure then those deficiencies must be reported immediately. Any fraudulent activities related to the internal control measure must also be noted.
Any changes that might negatively affect the controlling and monitoring the process of creation of the financial statements must also be informed to the authorities and mentioned in the reports.
Then there is Section 401. This comes under the heading of Title IV of the Sarbanes Oxley Act named Enhanced Financial Disclosure. The primary requirement according to this section is that the financial statements need to be accurate. The presentation of the data must also be clear and unambiguous as that might cause problems for people who view the financial records.
Another requirement is that the financial statements must also contain off-balance sheet liabilities, obligations or transactions. The commission had to study the off-balance transactions and then decide on the laws for transparent reporting standards. The Commission also has to decide and evaluate whether the general accounting principles and other related accounting standards result in clear and accurate financial information.
Section 404 is also crucial. Again this section is mentioned under the Title Enhanced Financial Disclosure. This section is related to the management and assessment of internal records.
According to Section 404, the issuers of the financial records are required to provide data pertaining to their internal records. These internal records include the internal control structure for financial reporting and also the accounting standards that are used for the reporting of financial data. The report that is issued would also include an unbiased report on the effectiveness of the internal control standards that are implemented. This does not end here. The firm that is issuing the financial reports must attest the internal records report as well and if later in time it is found that the reports were corrupt then the firm would suffer heavy damages.
Section 409 also comes under the Title IV which is named Enhance Financial Disclosure. This section is related to real time issuer disclosures. According to this section, issuers need to submit their material changes in financial position or in their operations of business. This is again to maintain transparency. Furthermore, this information has to be presented in a way which is understandable by the general public. Graphs and trend lines have to be used so that data can be easily made use of.
Finally, Sarbanes Oxley Act has Section 802. This section comes under the Title VIII named Corporate and Criminal Fraud Accountability. It is under the heading Criminal Penalties for Altering Documents. According to the section there are penalties of imprisonment for up to 20 years if a person is found responsible for eliminating, mutilating, hiding, falsifying, and duplicating financial or legal documents. Auditors and accountants are also under this penalty as they can have imprisonment or fines of up to 10 years if they were found hiding or incorrectly auditing the financial records of any business.
Therefore it can be concluded that the Sarbanes Oxley Act is a strong measure against frauds that might occur in the business world. By setting strict parameters for auditing, clear presentation of financial records and punishing those who go against the law, SOX can prove to be extremely beneficial in the fight against frauds like those that occurred in Tyco International.
Impact of SOX on the Business World
Wagner and Dittmar (2006) find that by 2006 the Sarbanes Oxley Act had brought about drastic changes in the business world. Basically the measure to control were strengthened which resulted in lessened corruption levels according to some corporate executives. These top level managers also believed that SOX forced them to take decision after proper analysis and thought. Rash decision making was stopped by the implementation of SOX as now the people would be held accountable for their deeds.
Some people also say that what SOX made legal requirement, they had already decided to do it in their firms. However, due to legal restrictions, they were now facing difficulties in carrying out the necessary requirements according to SOX because of the costs and legal issues involved in following SOX.
Furthermore, another dimension was brought into the limelight by Qian, Strahan, and Zhu (2009). They state that although corporate governance enhanced, the investments and growth of the companies occurred at a slow speed. This leads us to the conclusion that risky investments were stopped and the businessmen were thinking twice before making risky investments or entering into risky businesses.
It can thus be argued that corporate governance improved but it came at the costs of decreased growth and profits for the firms. The small firms had to face more difficulty as they could not bear the changes with as much ease as did the larger companies.
Boostrom, R. 2011. Tyco International: Leadership Crisis. Daniels Fund Ethics Initiative. [pdf]. Accessed 6th April 2013. Retrieved from http://danielsethics.mgt.unm.edu/pdf/Tyco%20Case.pdf