The Sarbanes-Oxley Act to Handle Corporate Fraud

Introduction

In 2002, the legislature passed the Sarbanes-Oxley (SOX) Act to handle corporate fraud and governance issues related to the rising violations of investor trust (Fletcher & Plette, 2008). The Act was also a response to the perceived imbalance between public and privately listed companies. To understand the impact of the SOX Act on public and private companies, this paper analyzes its role in the governance and operations of firms. While the regulations do not require private companies to follow the provisions of the Act, instances such as going public with an IPO’s requires compliance. This act followed the massive mismanagement of large organizations like the Enron Company.

Benefits of going public for medium-sized private firms

A medium sized private company can benefit from going public in three major dimensions. First, going public will enable the medium sized company to raise capital in public markets (Fletcher & Plette, 2008). Accessing public markets will allow the private firm to fund its daily operations and to grow the business. In addition, selling a portion of the company through a public offering will flood the company with the required capital. In turn, this capital can be used for purchasing other companies or compensating its workers.

Second, going public allows a company to offer its stock to outside investors who are mostly venture capitalists (Fletcher & Plette, 2008). Going public subjects, the company to the rules of the Securities Exchange Commission that necessitates yearly reports and audits by third parties. This move exposes the company’s finances to the public, thereby allowing investors to make valuations that may encourage significant investments in the company. These standards ensure that investors receive accurate reporting through their stringent rules and standards.

A company, which anticipates an acquisition by a public company, should comply with the SOX Act, if its operations will materially affect the operations of the public company (Jackson, 2006). Public companies who view SOX compliance as the best practice, will consider acquiring this company over non-compliant companies.

How a company can achieve similar benefits by remaining private

While going public has the allure of pooling more capital from the public markets, private firms are capable of raising capital through other means (Jackson, 2006). Markedly, non-public entities can generate the start-up funds from profits obtained from both internal and external investors. Even though these institutions cannot obtain start-up funds from the public markets, other avenues such as bank financing remain the core financing points.

Next, investors who desire to access the financial reports of a company, can access them for private evaluation of the stock (Jackson, 2006). According to Jackson (2006), investors who have stocks in privately held companies only accept valuations dictated by the terms of the company. This gives privately held companies authority over operational decisions because the expectations and interference of shareholders are kept at bay.

Last, a company that does not comply with the SOX Act may increase its value to SOX compliant public companies through other means to encourage its acquisition (Strayer University, 2013). Engaging independent reviewers and instituting strong internal controls will ensure that the company is valued internally and that its value increases.

Financial ratios used to evaluate expansion funds

The four financial ratios used in assessing the financial capability of a private company’s capital structure are debt, debt to equity, capitalization, and cash flow ratio (Leonard, 2011). By leveraging debt, a company can increase the size of the resources it requires to grow and expand. In addition, the company’s management can earn more on borrowed money as compared to interest expenses. Next, debt to equity ratio compares the total liabilities to shareholder equity (Leonard, 2011). Debt to total assets ratio may restrict the freedom of the company if the debt to equity ratio is exceedingly high. It may also hurt the company’s profitability given the high-interest costs associated with the move. This suggests that a company should have a lower debt to the higher equity level. On the other hand, capitalization ratio offers the best insights applied in evaluating the capital position of a firm (Leonard, 2011). Capitalization ratio compares total debt to total capitalization and is often expressed as a percentage. Last, cash flow ratios are used to tell whether businesses generate sufficient cash for sustenance, growth, and repayment of borrowed capital (Leonard, 2011). Overall cash flow ratios that are greater than one indicate that a company is making enough cash to operate efficiently. Together, the results of these ratios definitely affect the company’s decision to go public.

The impact of SOX for a company that goes private

There are both negative and positive financial impacts of the SOX on businesses that go public. The provisions of the SOX protect whistle-blowers and institute stricter punishments for officers and board members who destroy company documents (Strayer University, 2013). This increases financial integrity as well as investor confidence significantly. Despite its positive impact, the financial costs of SOX for public companies are more burdensome. The upfront costs of complying with the Act and the costs of continued compliance are costly. For instance, section 404 of the Act mandates strict oversight of internal controls by either the CEO or the corporate board of the company (Prakash, 2008). This requires corporate boards to spend additional time and resources reviewing internal controls of the company. Additional costs that the company incurs include the fees paid to auditors, the newly hired personnel, and documentation. Thus, the private company cannot overcome the challenges posed by SOX compliance because it lacks the economies of scale to pay the extra hours and new contracts associated with external auditors. Since the costs are even greater for publicly traded companies, the company may opt to leave the public realm to save on costs or seek a merger with larger companies.

Recommendation to the CEO on whether to go public or stay private

I recommend that the CEO keeps the company private, if it is to expand successfully. While remaining private, the company has access to other financing options, which will make sure that it meets its financial obligations. Majorly, the company should focus on establishing relationships with banks to enable it access commercial credit lines when the need arises. In addition, the private organizations can obtain loans using their inventories as security. Only when the company requires more capital for growth past its current position, can it offer its stock to the public. Although the most common reason, that may push a company towards going public, is raising large capital, this access attracts scrutiny from the SEC and shareholders. This will definitely push the company towards staying private and looking for alternative capital sources.

References

Fletcher, W. & PLette, T. (2008). The Sarbanes-Oxley Act: Implementation, Significance, and Impact. New York: Nova Publishers.

Jackson, P. (2006). Sarbanes-Oxley for Small Businesses: Leveraging Compliance for Maximum Advantage. New York: John Wiley & Sons.

Leonard, B. (2011). Study of the Sarbanes-Oxley Act of 2002 Section 404: Internal Control over Financial Reporting Requirements. US: DIANE Publishing.

Prakash, S. (2008). The Sarbanes-Oxley Act and Small Public Companies. US: ProQuest.

Strayer University. (2013). Graduate accounting capstone. Mason, OH: Cengage Learning.