No course in contemporary Accounting is complete without a mention of the various accounting related scandals that have plagued and besmirched the name of the profession. There have been quite a few such cases in recent years that have caused panic and embarrassment to accountants and piqued the interest of neutral parties.
The Enron case is discussed briefly as an example of such accounting frauds. It is a basic introduction to this report. Enron is provided as one of the main reasons for the Sarbanes Oxley Act. The Sarbanes Oxley Act is then discussed in detail and an analysis is provided whether it is a useful detector of accounting fraud.
It will not be an easy task to locate a book or article that relates to recent accounting scandals and corporate fraud and does not provide a detailed analysis of the Enron debacle. Enron commenced operations in 1985 with the merger of Inter North and Houston Gas. Enron was initially an energy producer then became an energy trader (BBC News, 2006).
Enron got the idea items like energy and water could be traded on the market and also traded in futures. This was one of the main reasons of their exponential growth and multiple corporate awards such as the coveted “America’s Most Innovative Company” by Fortune magazine (BBC News, 2006).
Someone reading the Enron case will definitely be flummoxed about how such a successful company a few years ago had to file one of the largest bankruptcies in corporate history. The reason was that Enron was dealing in futures and began to lose tons of money in this market. To prevent a free fall in share price, Enron created various companies to buy failing Enron ventures to keep the losses off its balance sheets and keep investors satisfied (BBC News, 2006).
Moreover, many top level managers at the firm were involved in the fraud and made millions by offloading their stock before the problems became household knowledge in 2001. In the end, Enron had more than 31 billion dollars of liabilities and more than twenty thousand people lost their jobs (BBC News, 2006).
The Sarbanes Oxley Act as a Response
After the Enron saga and a number of other such cases, including WorldCom and Adelphia Communications, there was a great deal of panic and anxiety in the minds of the investors. There was a general level of distrust regarding the US economy and this was emphasized by Senator Sarbanes as he commented that ‘the Senate Banking Committee undertook a series of hearings on the problems in the markets that has led to a loss of hundreds and hundreds of billions, indeed trillions of dollars in market value’ (Lucas, 2004).
For the purpose of applying stringent regulations to financial reporting, Senator Paul Sarbanes and Representative Michael G. Oxley presented guidelines for financial reporting which were approved by Congress and signed by then President George W. Bush to bring into existence the Sarbanes Oxley Act 2002 (referred herein as ‘SOX’).
Description of the SOX
The SOX checks and upgrades the accuracy of final statements. It emphasizes the basic accounting concepts and what should be included and what should be left out of the reports and in which time frame. There are 11 major sections in the SOX which include corporate responsibility for financial reports (Section 302), disclosure of financial reports (Section 401), management assessment of internal controls (Section 404), and also a basic structure of penalties for perpetrators of the SOX. Also, it establishes criteria for reporting relating to financial transactions, signatures and approval of the Chief Executive Officer or the Chief Financial Officer, and fiduciary duties of company heads and forbids loans to the directors.
The auditors are investigated by the Public Company Accounting Oversight Board (PCAOB) a body set up through the SOX. PCAOB looks out for breaches and has the authority to cancel or suspend a firm’s license and can also punish the accounting firm for any unlawful or unethical conduct (SOX, 2006).
Objectives of the Research
The main objective of this research is to analyze the effectiveness of the SOX as a response to Enron scandal and other scandals and whether the SOX will serve as a detractor from potential cases of accounting and corporate frauds in the future.
Shister (2005) states that there are three basic aims of SOX. These are the accountability of senior executives, stricter punishment for perpetrators and to relieve the anxiety and gain the trust of the investors (Nadler ; Kros, 2008). There has been dissent and criticism due to the penalties as this has negatively affected the competitiveness of the American corporations (Freeman, 2002). SOX was established for the protection of the investor, but it puts a strain on auditors (Rezzy, 2007).
Findings and Analysis
Despite the hype created by the government regarding the SOX act, there has been a great debate regarding the fact that the additional restrictions nullify the benefits (Freeman, 2002). The equilibrium of the stock market will be disrupted and corporations will attempt to privatize to avoid the stringent regulations. Investors wanting to reduce their risk by investing in diversified portfolios will be unable to do so (Butler ; Ribstein, 2006).
There have been critics who believe that the cost to small firms will be greater and the returns and the stock price will suffer a great extent of damage. The advocates of the SOX refute this claim, saying that those firms who have in place excellent systems in their internal operations will benefit and the costs of following and complying with the PCAOB will be low for these firms and the SOX will provide greater safety to their investors (Butler ; Ribstein, 2006).
The act places huge obstacles and sufferings on the accounting firms for the purpose that these firms make conscious efforts to upgrade their internal control mechanisms and standards for presenting information to investors. The act aims to develop the procedures of corporations and tries to remove all agency conflicts, for example it has made it compulsory that the directors of the business and the auditing company are mutually exclusive. The practices and procedures of all these accounting companies have been questioned, those practices especially that have been age old traditions for these accounting bodies.
There are many obstacles that the accounting companies have to overcome. These include various rules and regulations to be followed related to the actual services that these companies provide. A great deal of importance is placed on correctness and clarity and of the audits that these companies do for a company’s final statements. Moreover, the auditors have to be completely free and oblivious to any influence that might be exerted upon them. This is somewhat similar to a confirmation bias in the minds of auditors. What this means is that the auditor’s profession, which is by nature inferential and requires deductive reasoning, now requires due to the SOX that the auditors try their utmost to find any cases of misrepresentation or malpractice as soon as possible and inclines the auditors to find faults in completely innocent situations.
Besides the accounting bodies, the act has influenced the practices of various other parties which consist of management, analysts, government officials and regulatory bodies. The management has to ensure and uphold the law incorporated in the act continuously and slavishly. The management people responsible are continuously under pressure to upgrade and perk the control mechanisms within their company and provide statements clearly mentioning the validity and authenticity and honesty of the figures and claims made in the final statements of that company. Then the law also postulates that there should be no influence exerted by management on the auditors while they are assessing the internal mechanisms of the company in question.
The auditors for the company are, according to the Act, outside consultants and a separate legal entity; completely unaffiliated and uninfluenced by any of the activities of the company for whom they are providing auditory services. The act has clarified that separate audit committees shall be set up and these committees will be held accountable for the entire auditing process which includes any appointments made, remuneration and overlooking of any relevant information by the public accounting firm (SOX , 2006). Another task of the audit committee is to act as an arbitrator to settle any disputes or conflicts that might arise between management and the firm conducting the audit. A huge deal of emphasis is placed on the audit committee to develop solid communication bases with the auditor firm. This requires a large amount of time for the auditing firm, but eventually, if the relationship is cordial and of a healthy nature, auditors who previously may have chosen to overlook certain facts and figures regarding the company may now be more willing to cooperate with the audit committee and reveal any discrepancies that may have surfaced during their analysis of the company’s financial statements.
Any public accounting firm has to meet the approval of the audit committee. Also, it is not permitted to hire outside auditors for internal audit, managing information systems or other services of consultants that are unrelated to the audit. Auditor has to make an analysis of the internal control structure and provide a detailed conclusion to the audit committee. Moreover, foreign firms are also required to follow similar regulations if those firms are supplying any consultancy or advisory services in tandem with audits. This is not easy as these firms have been supplying services for many years with differing methodologies and mindsets. With the implementation of SOX, a great deal of time and money will be used and a lot of change in both work methods and ideals will be needed. SOX explicitly states that the main purpose of the act is to revive the enthusiasm and confidence of the investors relating to the stock market and implement and enhance corporate government procedures and encourage ethics and impose transparency and comprehensiveness of the financial reporting procedure (Donaldson, 2003).
After all these rules and regulations regarding the Sarbanes Oxley Act, the investor or any neutral party would expect that the degree of fraudulent behavior among companies would register a drastic decrease. However, this has not been the case. A recent report discovered that in companies where SOX was implemented incurred larger losses that were a result of accounting fraud as compared to those companies which had not implemented these controls. Furthermore, the companies that applied SOX also had to incur time costs as the duration of fraud detection is larger in these companies as compared to those who do not have the controls in place (Rappeport, 2008). These points raise a huge concern for the corporations regarding the usefulness of the SOX and the severe burdens it places on the companies. The time to detect fraud is larger which means that the guilty parties have a greater chance to escape. And the magnitude of the theft is also larger.
Also important is that while the SOX had been successful in curbing fraud at the lower levels of the hierarchy, it failed to do so at the senior management level because the internal auditors of the company in question report to the higher ups directly and were influenced by them (Rappeport, 2008). This is a major problem as many of the scandals and frauds such as Enron have been committed by senior level executives.
There is no denying the fact that the SOX has been a decent attempt by a much aligned government to bring discipline and stricter regulations for the companies to adhere to. This means that criminals and embezzlers will have to think twice about their actions. However, the SOX needs to be amended in many areas and its performance measured continuously to find areas for improvement. As the act currently stands, it will not be able to curtail perpetrators from their misdeeds. It needs to change and adopt a dynamic nature similar to the environment.
Also, there needs to be a degree of uniformity in accounting processes for all major corporations so that any irregularity is detected. This should be the case for all corporations, not merely US corporations. For this purpose, the International Accounting Standards Committee (IASC) is working with FASB to implement these measures both in the US and abroad (McCarthy, 2003). If uniformity is achieved in accounting standards, it will be easier to detect fraud and the SOX will succeed in the case.
BBC News. (2006, July 5 ). Q;A: The Enron case . Retrieved February 18, 2009, from http://news.bbc.co.uk/2/hi/business/3398913.stm
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Donaldson, W. (2003). Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002. Retrieved February 19, 2009, from http://www.sec.gov/news/speech/spch073003whd.htm
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