Compliance of the Sarbanes-Oxley Act essay

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Pattern of inductive reasoning is as follows: Theory ?Tentative Hypothesis ?Pattern ?Observation. While inductive approach is concerned with the open-ended explanatory, deductive reasoning chooses a narrow perspective by testing or confirming the hypothesis. (Trochim, & Donnelly 2007). Typically, inductive reasoning chooses qualitative approach to test the hypothesis. However, the deductive approach employs quantitative method to test hypothesis before arriving at confirmation. In qualitative research, it is not necessary to generate hypothesis to begin research, however quantitative studies make use of hypothesis to begin research. One of the advantages of deductive approach is that the researcher is able to test the hypothesis by using data. The limitation of quantitative approach is that the hypothesis could only be tested when there is enough data. (Ali, & Birley, 1998).

In accounting research, testing the hypothesis with the use of the statistical analysis is the common method to arrive at confirmation. The validity of the accounting research is to relate various components in a logical manner. The deductive approach is able to test the hypothesis using the data collected to arrive at the confirmation. (Schroeder, Clark, & Cathey, J.M. 2010).With the benefits of deductive approach for the confirmation of the hypothesis, the study employs deductive reasoning to test the hypothesis.

Reviewing of the related literatures is essential to explore the impacts of SOX on the smaller and large companies.

CHAPTER 2: LITERATURES REVIEW

This chapter reviews the previous studies on the theoretical frameworks that lead firms to go private. The literatures are also reviewed to reveal the SOX acts and its impacts on smaller and larger corporations. Review of the literatures elaborates some concepts such as publicly traded companies, privately owned companies, smaller companies and large companies. In the literatures review, the hypotheses are developed and the costs of SOX compliances and its burdens on smaller and larger firms are examined. The literatures are also reviewed to provide greater understanding on the reasons firms migrate from publicly traded companies to privates owned companies.

2.1: Theoretical Framework

There are many theories surrounding the reasons firm go private or stay public. Chemmanur, and Fulghieri, (1999) formulate the theory of the going-public decision. The authors argue that the decision of firms to stay in public is to raise capital rather than using its private equity to finance a project. Decision to go public allows firms' shares to become more liquid. However, Boot, Gopalan, and Thakor, (2004) argue that going private or staying public is explained by the theory of entrepreneurial choice. In the capital market, corporate governance plays a major role in the firm's decision to stay public or remain private. Although, firm may face disadvantages of illiquidity by staying private, however, the ownership structure plays a major role in the firm's decision to stay public or go private. Firm with the public ownership is characterized with control from multiple shareholders, however, in private contracting, ownership is concentrated among the fewer large investors. Market-imposed discipline is the feature of public ownership, while in the private contracting; few powerful investors are monitoring firms. In the public ownership "much of the governance structure and disciplining mechanisms are externally imposed by the financial market regulators and investors" (Boot, Gopalan, and Thakor, 2004 P4).

However, theory of firm does not agree that firm's decision to stay in public or private is from the firm's ownership. Theory of firms argues that profit maximization plays a major role in a corporate decision. In a contemporary business environment, firms interact with the markets to maximize profits. Firm's decision to stay in public or private depends on firm's capacity to maximize profits. In 1990s, many companies went public because firms made superprofits by staying in public. However, in the late 1990s, many publicly traded firms decided to delist and went private because there were decline in the stock markets. In 1999, scores of U.S. companies delisted, 83 U.S. companies delisted. In 2002, 86 companies delisted. 262 in 2003 and 188 in 2004.

"Many have conjectured that the decline in stock prices after 2000 has induced firms to go private, a sort of flip side of the observation that initial public offerings (IPOs) are largely a bull market phenomenon." (Boot, Gopalan, & Thakor 2008 pp 2013-2014).

Although, there are increase in the number of firms that go private after SOX, modern theory of firm argues that the behavior of firms is natural since many firms believe that going private will make them reducing direct and indirect costs and maximize the profits.

On other hand, the financial theory suggests that efficiency is the root cause of the advantage buoyant (LBO) going private transactions where small group of investors and often management of firms buy shares of firms from the investing public. (Houston, & Howe 1987). Financial theory argues that the LBO or going private transaction is an important method of corporate restructuring. Typically, LBO method of going private will make firm to create more wealth because of the efficient ownership structuring. Although, this hypothesis has been criticized on the ground that LBO only affect the wealth transfer rather than creating wealth transfer.

These above-discussed theories help to explain the decision of firms from delisting from the stock exchanges and go private. Although, there are changes in corporate governance at post -- SOX, where it has been suggested that high costs of being public discourage firms from staying public, and large proportion of firms delisted and go private. "however, no formal theory that provides any link between a firm's decision to go private, investor participation in public capital markets, the level of its stock price, and the stringency of its corporate governance " (Boot et al. 2008 P. 2013). At post-SOX, many smaller firms go private because of the associated costs burden; the case is different with the larger firms. Many sophisticated investors take the advantages of the abnormal profits after the SOX.

2.2: Overview of SOX Act

Several literatures have revealed the motive behind the action of the U.S. regulators to enact the Sarbanes-Oxley Act (SOX) in 2002. The U.S. regulators enacted the Sarbanes-Oxley Act (SOX) in the July 2002 to protect investors from the high profile accounting irregularities that was very common among the bigger organizations in the United States. (Ahmed, McAnally, Rasmusse et al. 2010).

"The auditing profession came under intense scrutiny following the collapse of Enron and several other leading ?rms. To protect investors from the financial scandals, legislators responded swiftly with the Sarbanes-Oxley Act of 2002. A stringent rules-based system is enacted which is widely considered the most comprehensive economic regulation since the New Deal." ( Vakkur, McAfee, & Kipperman, 2010 P. 18).

The main objectives of SOX are to improve the reliability of corporate disclosures where firms are obliged to publicly disclose their financial statements. "Section 404 of Sarbanes-Oxley Act (Sarbanes-Oxley) requires management of public companies to include in their annual reports an assessment of the effectiveness of their financial controls." (FEI, 2004 P. 1). The public disclosures are to enhance the accuracy of the corporate financial accounting and protect the investors from the accounting misappropriation.

Five main provisions of SOX Acts are as follow:

First, SOX demands CEO and CFO to certify the financial report with regard to balance sheet transactions and special-purpose entities.

Second, SOX mandates public company to maintain internal control, management should evaluate the effectiveness of annual report, and the external auditor must attest to the evaluation.

Moreover, SOX mandates that all the audit committees must be independent, and at least one of them must be a financial expert.

In addition, SOX mandates the corporate insiders to benefit from the firm shares.

Finally, the SOX impose fines or jail terms for non-compliance with the SOX Acts. (Spedding, 2009).

Likewise all regulations, the SOX impose costs and benefits on corporate organizations. Major benefits of SOX are to improve transparency of the financial accounting of the publicly traded companies in the United States. Ahmed et al. (2010) argues that SOX imposes new requirements on firm to improve on the deteriorated internal controls, auditing, accountability and governance. However, to accomplish the SOX requirements, firms need to spend significant direct costs to implement or redesign the internal controls. Firms also needs to borne additional audit fees to adhere with the new controls. Although, SEC estimates that the direct costs of complying with SOX would be up to $91,000 on an average firm, however, the Financial Executives International estimates the costs of SOX compliance is closer to $4.4 million per ?rm. (FEI, 2006). On the other hand, Charles River Associates International (CRA, 2005) estimates the direct costs burden to be about $8.50 millions for firms with market capitalization greater than $700 million, while the direct costs burden is about $1.24 millions for firms with market capitalization of between $75 and $700 million. To comply with the SOX requirements, a firm needs to hire the services of management consultants, lawyers, and financial experts. All these are direct burdens on firms. There are other less observable costs, which could be termed indirect…[continue]

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