The Sarbanes–Oxley Act is a United States federal law that was enacted on July 29, 2002. The Act set up advanced standards for all US publicly traded companies. This Act was named after its two sponsors, Senator Paul Sarbanes and Representative Michael G. Oxley. The act was enacted after a series of major corporate and accounting scandals involving firms such as WorldCom and Enron which resulted in their failures.
These scandals cost investors billions of shillings and they affected public trust in the U.S Securities’ market. Therefore, this Act was enacted to protect investors from such losses by ensuring the accuracy and reliability of financial information disclosures made pursuant to the Securities Exchange Commission (SEC) laws (Presidential statements and documents, 2002).
The Sarbanes–Oxley Act 2002
The Sarbanes–Oxley Act 2002 act demands that financial statements include an internal control report. This implies that the senior management must certify the accuracy and reliability of the reported financial statements. This is meant to show that the company has confidence in its financial statements because it has set up sufficient measures to safeguard the data. The financial reports must contain an examination of the appropriateness of the internal controls to which the auditors must attest to through reviewing the controls, policies and procedures that the firm has set up.
The Act is divided into 11 sections and also requires the Securities Exchange Commission SEC to set up regulations on the requirements of adoption of the bill. These sections are the establishment of the Public Company Accounting Oversight Board, the establishment of the rules to ensure auditor independence, corporate responsibility by senior officers, enhanced financial disclosures by firms, the establishment of rules to govern financial analysts’ conflict of interests, commission resources and authority, studies and reports by SEC, corporate and criminal fraud accountability, white-collar crime penalty enhancement, corporate tax returns and corporate fraud accountability (Jain and Rezaee, 2004).
Limitations of Financial Statements
It is important to note that as important as financial statements are, they are based on historical costs and therefore the impact of price level changes is ignored. The historical accounting assumption is that the value of the dollar remains constant. This means that assets are recorded in the financial statements at their original costs i.e. the price they were acquired for. Under this assumption, liabilities are recorded at the price they were contracted for.
This assumption is not accurate because due to the inflationary pressure, the value of the dollar keeps fluctuating. This assumption, therefore, causes a lot of distortions and changes in the financial statements which are never explained clearly. This is considered the most serious limitation of historical accounting (Porter et al, 2011)
Financial statements have several other limitations. These are: Financial statements represent the past performance of a company that does not necessarily project future results. Investors and other stakeholders use financial information to make investment decisions of the future. This information, therefore, becomes useless for investors in helping them choose which firms to invest in based on future projections.
Financial statements do not capture the qualitative aspects of running a firm. Details and facts that are not recorded in financial books are never represented in the financial statements. Only quantitative aspects like monetary transactions are disclosed. Financial statements should also disclose qualitative aspects such as the integrity of the management, loyalty and efficiency of employees, and also the prestige of the business. Also, they should disclose information about any loss of major customers.
Financial statements do not show the changes in the structure of the company particularly the senior management. Information about change in senior management is crucial to investors since it always has an effect on the share prices of that firm. Also the financial statements should disclose changes such as plans to launch new products or services, plans for mergers or acquisitions, new marketing campaigns, pricing strategies, results of expenditures in research and development, and also plans to enter or exit a new market segment (Porter et al, 2011).
Liquidity ratios are ratios that attempt to “measure the ability of a firm to meet its short term financial obligations”. This is done by matching a firm’s short-term assets against its short liabilities. Common liquidity ratios that a financial analyst may be interested in while analyzing the financial statements of any firm are, the current ratio which expresses the working capital relationship of the current assets available to cover the current obligations.
The second one is the quick ratio which is the current ratio without the inventory. The quick ratio is normally referred to as the acid test of the liquidity of a firm. This is necessary for firms whose inventory is heavy and maybe slow-moving therefore hard to convert into cash (Robinson et al, 2008).
Another liquidity ratio is the debt to equity ratio which “measures how a firm leverages its debt against the capital employed by its owners. In the case where the debt exceeds the net worth then the creditors hold higher stakes in the firm than its owners”. This ratio is obtained by dividing the total debt of a company by the owners’ equity. The other ratio is the cash ratio which is considered the most conservative liquidity ratio as it only considers cash and cash equivalents as the only current assets. It is obtained by dividing cash and marketable securities against the current liabilities (Robinson et al, 2008).
Increasing the EPS
One way a new executive can increase the earnings per share EPS of a firm is to increase its earnings. This can be done through the revenue or reducing its costs and expenses. Reduction of costs can be done through sourcing of cheaper raw materials, reducing the salaries of senior managers, increasing the general level of efficiency.
Revenues can be increased through developing differentiated products and services designed for the high-end market and charging premium prices for these products. Another way of increasing the EPS can be through the buying back of its ordinary stock from the shareholders. This can only be done if the board members feel that the current market value of the firms’ shares is too low. This reduces the number of outstanding shares, therefore, reducing the denominator.
The statement of cash flows is divided into 3 sections; operating activities, investing activities, and financing activities. Operating activities are those activities that relate directly to the “production, sales and delivery of a firm’s products to its customers and also collecting payments sales mad”. These are the activities that relate directly to the core business of a firm. They include receipts from the sale of goods and services, sale of loans, debt or equity instruments in a trading portfolio, interest received on loans, payments to suppliers for raw materials, payments to or on behalf of employees, interest payments and buying of merchandise (Robinson et al, 2008).
Investment activities are activities that affect a firms’ cash position as a result of the gains or losses from investments in the financial markets and changes from cash used on capital investments e.g. money spent on acquiring plants and equipment. Examples are purchase or sale of assets, payments and receipts related to mergers and acquisitions, and loans made to creditors or received from customers.
Financing activities on the other hand are the activities that impact on the long term liabilities and the equity of a firm. These include cash inflows from investors such as shareholders, financial institutions and creditors as well as cash outflows for example dividend payments and repurchase of ordinary stock from shareholders. It also includes repayments of debt principals including repayment of capital leases and cash inflows from issuing short term and long term debt.
A cost benefit analysis of the act indicates on one hand that the compliance costs are very high with a section of market players suggesting that small companies should be exempted from the act due to their low revenues. On the hand however, firms that have complied with the Act are significantly more transparent. Following compliance, corporations are seen “to improve their internal controls and that their financial statements are perceived to be more reliable” (Institute of internal auditors, 2005).
Jain , P., & Rezaee, z. (2004). The Sarbanes-Oxley Act of 2002 and Accounting Conservatism Working paper. Memphis: University of Memphis.
Porter , G. A., & Horton, C. L. (2011). Using Financial Information: The alternative to Debits and Credits (7th ed ed.). Mason, OH: South-Western Cengage Learning.
Robinson et al , R. T. (2008). International Financial statement analysis. New Jersey: John Wiley & Sons, Inc.