The global business community is not unaccustomed to financial scandals. The competitive nature of business often leads to some unscrupulous business practices sometimes with catastrophic results. Owing to such risk it is also expected that government provide legislation that can help control or limit the occurrence such practices. The Sarbanes-Oxley Act is an example of such legislation and its birth was the result of the unfair business practices of the multinational corporation Enron, and the financial scandal that led to the collapse of this once huge company (Bainbridge, 2007).
Enron Corporation was formed in 1985 following a merger between Houston Natural gas and Internorth. This corporation represented the first natural gas pipeline network to run across America. As the organization grew the business focus shifted from transportation of natural gas to unregulated energy trading markets. This was probably guided by the principle that the organization could earn more through trade in the financial contracts linked to the value of energy assets than in actual ownership of the physical assets. This concept was considered a success by Wall Street observers till late 2001. It has been reported that the organization’s annual revenue grew from under $10 billion in the early 90’s to $101 billion in 2001 (Sterling, 2002).
The organizations problems did not arise in its core energy related operations but in other ventures. More specifically its downfall can be attributed to internet and communications investments as well as in other foreign based subsidiaries. Instead of recognizing the losses the company conspired to assign business losses and near worthless assets to unconsolidated partnerships. The purpose of this being inflation of its reported bottom line through disguise of its debt as energy derivative trades to conceal the extent of its financial troubles (Sterling, 2002). To achieve this, the company used the services of its auditing firm. On further investigation the company was taken to court and forced to shutdown its operations resulting in heavy losses for its shareholders.
The Formation of the Act
As expected the collapse of this huge corporation and the resulting losses incurred by shareholders sparked controversy throughout the world forcing the US Government to take some remedial action. The Government was in desperate need of a response that would restore the faith of its citizens and the world and resorted to lead by example. Prior to this the Government the regulation of Capital Markets was an affair entirely in the hands of the Securities and Exchange Commission (SEC).
In May of 2002 following the hearing and collapse of both Enron and the Anderson accounting firms the Senate Judiciary Committee unanimously reported its findings and presented proposed legislative reform with regards to the scandal (Kohn, Kohn & Colapinto, 2004). In less than three months following this action the Judiciary Committee including a provision for protection for corporate whistleblowers was incorporated in the final version of the Sarbanes-Oxley Act following a 97-0 vote in the US Senate. The approved provision was enacted into law in July 2002, by the then Us President George W. Bush (Kohn et al. 2004).
The contents of the Judiciary Committee had indicated that investors who included pensioners were being robbed by highly educated professionals using an intricate web of deceit. It further roved that corporations placed higher value on profit than on honesty and were prepared to hatch schemes to circumvent even the federal regulatory bodies. It also established that auditors who were meant to assist investors had also been drawn into the scheme and had taken advantage of the system to behave in a fraudulent manner. The Judiciary Committee realized that there was a need for the entire system to be redesigned for the restoration of trust and honesty within the corporate business community (Kohn et al. 2004).
Cost and Benefit Analysis of the Act
|Component||Sarbanes –Oxley Act Costs|
|Short Term||Long Term||Total|
|Direct Cost (Firms with Market capitalization >$700 million)||$2 Million||$2 Million|
|Cost of publicly Disclosed Weakness Material (@2% x 700 million)||$14 Million||$14 Million|
|Reduction in Cash Flows (@1.3% of Total Assets or 700 Million)||$ 9.1 Million||$ 9.1 Million|
|Non Audit Costs (Legal, Insurance, Compensation, etc.)||$39 Million||$39 Million|
|Audit Costs(Capitalization > 700 Million)||$ 1.5 Million||$ 1.5 Million|
|Total costs||$ 65.6 Million|
|Sarbanes –Oxley Act Benefits|
|Short Term||Long Term||Total|
|Growth Opportunities (6.1%)||$ 42. 7 Million||$ 42.7 Million|
|Total Benefits||$ 42.7 Million|
As mentioned in the previous sections of this paper the act was introduced with a view to protect investors through improvement of accuracy and disclosures of corporate information (Ahmed et al., 2010). Proponents of the act have been reported to argue that though it has become apparent that the costs outweigh the benefits the main benefit lies in restoration of trust in the capital markets. There have been several debates on the subject of profitability of the Act but most findings appear to agree on the ruling that the costs outweigh the benefits. Even the concept of fraud reduction appears inadequate in its defense given that in the period1980-2001 the frequency of fraud occurred at a rate of less than 1.2% annually.
In addition to this fact these incidences only occurred in 2% of organizations that had a market capitalization of more than $ 1 Billion (Ahmed et al., 2010). This suggests that such a high cost has been imposed upon the business community to reduce criminal incidence with extremely low occurrence rates. In addition to that it also suggests that organizations with high value of market capitalization already had independent controls that were adequate to prevent occurrence of fraud.
It has also been reported that the Act that was meant to increase trust in the capital markets is also considered as inappropriate owing to its potential to cause decline in stock prices post implementation. This is because even firms with internal controls are forced to incur additional compliance costs. These resources being diverted to other activities are unlikely to be offset simply through restored trust in the market. It has been reported that these declines are likely to continue even after implementation of the Act (Ahmed et al., 2010).
According to Bainbridge, the constituents of the act appear that they will be in place for a while yet especially since the US Congress does not indicate any signs of budging to the pressure of the business community (2007). The only sign of change were made in a speech delivered in 2006, which mentioned the possibility of making adjustments that would suit smaller corporations. This being the case it would appear that organizations should get accustomed to the requirements of the act and stay up to date with the required schedule. It has been recommended that on going employee training may be useful in ensuring employees clearly understand their roles (Bainbridge, 2007).
It would appear that in a bid to pass the blame on the Government made a serious mistake in preparing a piece of legislation without giving it the due consideration required. Though the Government has to some extent admitted short comings in the law changes are yet to be made to prevent the damage it causes. It is hoped that this event could be used as a point of reference in future when Government urgently needs an escape route. It is sad to note that the high compliance costs associated are most burdensome for growing organizations as they represent as significant proportion of their revenue. That being said, the increased internal controls must also be praised for increasing the degree to which investors assets are safeguarded within the capital markets (Bainbridge, 2007).
Ahmed, A. S., McAnally, M. L., Rasmussen, S., & Weaver, C. D. (2010). How Costly is the Sarbanes Oxley Act? Evidence of the Effects of the Act on Profitability. Journal of Corporate Finance, 16, 352-369.
Bainbridge, S. M. (2007). The Complete Guide to Sarbanes-Oxley: Understanding how Sarbanes-Oxley Affects your Business. Avon, MA: Adams Media.
Kohn, S. M., Kohn, M. D., & Colapinto, D. K. (2004). Whistleblower Law: A Guide to legal Protections for Corporate Employees. Westport, CT: Praeger Publishers.
Sterling, T. F. (2002). The Enron Scandal. Hauppauge, NY: Nova Science Publishers Inc.