The issue of accounting scandals has existed for many years, experienced because most companies suffer from the pressure of meeting short-term markets expectations. One of the companies involved in the scandal in the recent past is Toshiba Inc. In 2015, the Japanese electronics firm, Toshiba, faced the accounting scandal with Chief Executive Officer Hisao Tanaka, who had to resign from the office. As an esteemed researcher in the field of financial analysis at Harvard Business School, I have been instituted by the Japanese electronics firm, Toshiba, to conduct research on the benefits of the stipulated acts of the Sarbanes-Oxley Act, deemed useful in countering accounting scandals experienced on the firm. Furthermore, I have to make recommendation that is likely to help the company prevent such issues from happening again in the future. The conducted research report entails studying Sarbanes-Oxley Act of 2000 passed by the Congress to tackle the accounting frauds within the corporates, reasons for the adoption of the Act, and examination of its effects. Also, the report presents information on how accounting as a profession has been transformed as a result of the stipulated Act, in what ways the educators train the accountants to deal with accounting frauds, recommendations, implementation plan, and lastly, instructions on how to implement the stipulated recommendations in the company.
As such, the research study will be helpful in transforming Toshiba Inc. on the matters related to the accounting scandals. Transformation, in this case, means that the accounting scandals are bound not to happen in the future. Moreover, it will bring back the confidence of the stakeholders to continue with their dealings with the company.
Accounting scandals are experienced because most companies face pressure to meet short-term market expectations. These expectations are represented by share and financial prices (Farrell, 2015). Stiff competition has caused most executives working for top companies to engage in creative accounting, enticed by share options and bonuses hitting specific targets. Some firms have also been recorded to manipulate their operations by disposing off their assets by selling them or delaying investments in order to hit certain targets or goals. This manipulation is mainly done to shore up the performance of these companies in the eyes of the general public (Farrell, 2015). This activity is bound to continue existing as long as there are market pressures.
In 2015, Japanese electronics firm, Toshiba, faced the accounting scandal after which the Chief Executive Officer Hisao Tanaka resigned from office. Tanaka was charged with overstating the operating profits to about $1.2 billion (Carpenter, 2015). It happened after the release of the reports by an investigative panel giving evidence of the improprieties in the company. Details about accounting mischief dated back to 2008, amounting to seven years of ghost operation, embroiling Tanaka alongside two other CEOs. Though the incriminated CEOs were reported not to directly instruct any accountants to cook the books, they resorted to pilling immense pressures on their subordinates (Carpenter, 2015). They then waited for the corporates culture to come into play and give them the results they wanted.
As a researcher in the field of financial analysis at Harvard Business School, I have been engaged by Toshiba and asked to conduct research on the benefits of the stipulated acts of the Sarbanes-Oxley Act, which could prove to be useful when countering accounting scandals experienced by the firms. In order to provide solutions to the firm, I conducted research and made a report that studies Sarbanes-Oxley Act of 2000 passed by the Congress with the aim to deal with accounting fraud by corporates. Furthermore, reasons for the adoption of those laws were regarded, and the examination of their effects, the ways accounting as a profession has been transformed due to the stipulated laws, and how educators are training accountants on dealing with accounting frauds were explored, with recommendations, implementation plan, and instructions on how to implement the stipulated recommendations in the company given. All these aspects are bound to benefit Toshiba as corporate firm and more so, to bring back the confidence of the stakeholders who are already involved with the firm or intend to be so.
2. Sarbanes-Oxley Act of 2002
Between the years 2000 and 2005 (Appendix A), there were massive waves associated with corporate accounting scandals, with 2002 having the most significant share. Enron and WorldCom are, arguably, the most well known scandals that the public knows of, but at the same time, there are other less publicized scandals covered by the media (William & Reiter, 2012). Some of the less publicized scandals included Peregrine systems, Duke Energy, and Homestore.com. These were major scandals, but less publicized, linked with accusations of illegal activities. These activities were characterized by the so-called creative accounting where accountants resorted to overstating expenses, complex methods of misdirecting or misusing funds, underreporting liabilities, understating expenses, and also overstating the value of the corporate assets. Some of the companies have gone ahead to engage in securities fraud, which was also highlighted in the accusations against Toshiba (Sullivan, 2006). Investigations were launched in 2000 by various departments, including Department of Justice, DOJ, and Securities and Exchange Commission (SEC), which are the Federal government oversight agencies to scrutinize the accounting practices of twenty major firms. To their unprecedented realization, they ended up with an indictment of top executives. Moreover, illegal activities forced the government to impose huge fines and settlements that amount to millions and billions.
Some companies, such as PricewaterhouseCoopers, Deloitte & Touche, KPMG, and Arthur Anderson, which are the public accounting mega-firms, confessed to taking part in the illegal accounting fraud. They faced huge charges amounting to billions for neglecting to discharge their duty effectively as auditors, and for failing to identify and prevent their corporate clients from publishing false financial reports to the public. It is with this fact and reaction to these malicious accounting scandals that the Congress decided to pass Sarbanes-Oxley Act of 2002, P.L. 107-204. Sarbanes-Oxley Act was formulated together with other Acts devised by Connecticut General Assembly (Williams & Reiter, 2012). These Acts were characterized by the various provisions that expanded the oversight of the public accounting firms. Provisional Acts were also crafted to protect employees, deemed paramount in the provision of information or assisting agencies in their investigations involving the violation of accounting protocols as required by the State or Federal law. Moreover, the Acts composed both the criminal and civil penalties, imposed when the companies falsify financial statements.
The corporate scandal that manifested between 2000 and 2005 compelled the Congress to pass legislation that would renew the faith of the general public and the stakeholders in the accounting profession. The associated acts place strict prohibitions and requirements guiding the accounting firms. First, they outlaw the companies that are not registered lawfully by the board, preventing them from undertaking the auditing activities of public companies across the nation. The Sarbanes-Oxley Act of 2002, P.L. 107-204, recommended the creation of Public Company Accounting Oversight Board, PCAO. This is a private-sector, non-profit corporation mandated to oversee the auditors of publicly trading firms (Williams &Reiter, 2013). The primary concern of the corporation was to protect the interests of the investors and promote the independence, accuracy, and information-based audit reports. The board was mandated with four major responsibilities that included the following.
- Disciplining and investigating the accounting companies that were registered for violating the law or professional standards.
- Disciplining and investigating the employees working in the companies involved in accounting fraud.
- Registering accounting companies involved in auditing public companies trading in securities markets in the United States.
- Establishing standards for auditing, independence, ethics, and quality control over the accounting registered firms. Moreover, they inspect the registered accounting firms.
Apart from placing requirements and prohibition on the accounting companies, Sarbanes-Oxley Act of 2002 (Public Law 107-204, 2002) has other key stipulations that include the following.
- Provision of comprehensive whistleblower protections.
- Determining if there is a crime any individual hides and watching so they would not alter or destroy any paramount documents in the course of an investigation in order to prevent the authorities from using them in the official legal proceedings.
- Prohibition of the accountancy firms from processing loans to any of their executives and directors.
- It makes it clear that the auditors in the accounting firms should report all critical accounting policies, including practices of the firm’s audit committee.
- It requires that public firms to have rapid disclosure of material changes of their financial conditions.
- The Act prohibits the provision of non-audit services by public accounting firms. These non-audit services include appraisal without pre-approval from the board and bookkeeping.
- The Act requires the establishment of an audit committee by public accounting firms.
- It requires all critical accounting policies and practices to be reported by auditors to the firms audit committee.
- It requires the establishment of an internal control system by the public firms, put in place in order to allow tracking and auditing financial processes. Moreover, it requires an external auditor’s report about the system on management assertions (Public law 107-204, 2002).
- The Act requires the lead audit to include their reviewing partners, rotating off an audit every 5 years. They are also required to be subjected to a 5-year time-out period after rotation has been done.
3. In-depth Study of the Laws
3.1 Whistleblower Protection
This Act was implemented to protect the employees from threats by the top executives in the publicly held corporations because of providing information or assisting the investigation team in their quest to bring up accounting issues in an institution. This Act stems from the belief that the committed accounting fraudulence violates either the Federal or States law pertaining to the frauds against the shareholders, Securities and Exchange Commission rules and regulations, and federal bank or securities fraud laws. As such, the whistleblowers are protected from being discharged from the duties, threatened, or even being demoted. Violation of the whistleblower brings an action by the superior court against the violators of the damages caused.
3.2 Concealing, Altering, and Destruction of Documents
Under this act, accountants conducting an audit in a public company are prevented from alteration, hiding, or destruction of prior documents created in association with audits, which contain audit information from the end of the fiscal year that has just been concluded. Storage of these paramount documents should be ensured for a period of seven years after the audit’s conclusion. This same act applies to accounting licensees in the public corporations who prepare work papers during the auditing period. States Board of Accountancy will impose conduct penalties on the public accountants for failing to show their professional fitness as required by the board (Williams & Reiter, 2012). Accountants involved in the violation of the law are bound to the imposition of a civil penalty of about $50,000, suspension, revocation, and refusal to renew their permits, certificates, and licenses.
3.3 Financial Statements Certification
Sarbanes Oxley Act requires the top officials to certify financial statements correctly, in which violation will lead to hefty financial penalties or imprisonment. It is explained by the fact that CEOs and CFOs have been found to willfully give false information about their corporations financial condition while knowing it is not true. In this case, the perpetrators are fined up to five million dollars or twenty years imprisonment. On the other hand, those found to give information that does not fairly reflect the financial condition of the firm are fined up to one million dollars or up to ten years imprisonment.
3.4 Audit Committee
The Act stipulates that the audit committee, which is competent and independent, should be created by the public firm pursuant to section 301. The directors who are not affiliated with the company or its subsidiaries are to be included as the serving members. Furthermore, they are not supposed to take advisory or consulting roles in the firm, including the compensation fees other than the stipulated committee and directory fees. The committee is mandated to oversee and appoint publicly traded auditor to the company. They are to take care of the concerns anonymously submitted by the employees on matters concerning accounting. In addition to that, they receive and address complaints gathered by the company.
3.5 Prohibition on Personal Loan by the Executives
The executives are prohibited either directly or indirectly from taking loans from their accountancy firms. It is unlawful for the public firms to process loans to the executives through subsidiaries, the extension of credit, or personal loans.
3.6 Assessment of Internal Control Systems
According to the act of assessment of internal control systems, management is required to produce an internal control report every year as part of the Annual Exchange Act report. The report must affirm management responsibility by proving that it has effectively established adequate internal control structure in the public firm, as well as the procedures for the accurate financial reporting. The report should include internal financial assessment of the most recent fiscal year report of the company. The internal control systems include assessment performed in order to evaluate, prevent, and detect fraud, scale assessment based on the complexity and size of the company, fraud assessment, management assessment aimed to highlight issues such as objectivity, competency, and risks, evaluation of IT aspects, flow transactions aimed to identify points to which misstatements could arise, and lastly, evaluation of the company-level controls.
3.7 Rotation of an Audit Every 5 years
The act requires the lead auditors to include their reviewing partners, rotating off an audit every five years (William & Reiter, 2012). They are also required to be subjected to a 5-year time-out period after rotation has been done, which establishes the standards for the external auditor independence and in doing so, limits the conflicts of the auditors interests. Furthermore, it addresses the issue of auditor reporting requirements, new auditor approval, and audit partner rotation.
3.8 Rapid discloser of material changes
The act requires the public firms to have rapid disclosure of material changes of their finances. The disclosure by the firms, in this case, involves providing relevant documents to the board for scrutiny and investigation, including transferring materials on the current forms obtained from the periodic reports for easier comprehensibility. Disclosure materials may include periodic reports or expanded disclosure items. In this case, periodic items include unregistered sales of equity securities and modifications amended in the materials on the rights of security holders (The Sarbanes-Oxley Act at 15, 2017). Expanded disclosures include appointments or departure of the principal officers and directors, elections of the directors, and amendments of the Bylaws or accounting changes in the corporation in the fiscal year.
The act of reporting makes it clear that the auditors in the accounting firms should report about all critical accounting policies, including practices implemented by the firms audit committee. The communication includes complaints, matters, and concerns involving auditing or accounting brought to the attention of the auditor beforehand (Public Company Accounting Oversight Board, 2017). These complaints or matters presented during the audit are tackled by the auditor, and the results presented to the committee regarding the procedures are used to solve the issue.
3.10 Prohibition of Non-Audit Services
The act of prohibition of non-audit services prohibits the provision of non-audit services by public accounting firms. These non-audit services offered to the clients are divided into three categories. They include services undertaken by the auditors as required by the legislation or contract, most efficient services that the auditors can provide in regard to their existing knowledge of the business, and lastly, services that can be provided by a number of firms, for example tax advice or management consultancy (ICAEW, 2017). Other non-audit services include appraisal without pre-approval from the board.
4. Reason for the Passing Sarbanes Oxley Acts Of 2002
Sarbanes Oxley Act was passed as a result of the governmental response to crisis and issues of corporate frauds. These frauds were characterized by the passivity of the boards of directors, incompetence, and conflicts of interests relating to analysis, legality, and auditing. The need for the spontaneous change was supported by long chains of corporate frauds exposed over the years (Garner, McKee & McKee, 2014). These waves range between 2000 and 2005 (Appendix A) concerned multiple companies, including public accounting companies. The government had to come up with the acts to change the situation and address negative accounting activities in the public accounting firms. Moreover, the government implemented policies had to introduce new cultures of transparency and openness, and more so, the willingness by the government to take action against the crimes breaching both ethical and moral boundaries. Its major intent was to restore the faith of the investors and to improve corporate governance.
5. Effects of the Sarbanes Oxley Act Of 2002
One of the noted direct effects of Sarbanes Oxley Act on the governance of the corporates is the strengthening of the committees, especially those of public companies. In this case, the committee gets wide leverage in checking top management of various companies on issues of decision making in accounting. The members of the committee act independently of the top management and are mandated to approve both non-audit and audit services, handling complaints concerning management, and selecting and overseeing external editors. Research by Coates and Srinivasan (2014) assessed various research findings from a hundred and twenty papers including law, accounting, and finance on the impacts of the Sarbanes Oxley Act. The research was aimed at identifying significant developments of the act amidst severe criticism raging since enactment. Coates and Srinivasan gathered their findings from experimentation, which they believed would guide future reforms and laws in the financial arena.
In their findings, Coates and Srinivasan realized that part of the act that mandated that public firms should obtain internal control practices directly affected small companies. It means that smaller companies, despite the difference in the market gaps of less than seventy-five percent with other firms, acutely felt the costs (Srinivasan & Coates, 2014). In 2007, more changes were made regarding the act, aimed to reduce the costs of many companies by twenty-five percent or even more so during the year. Moreover, Sarbanes Oxley Act has encouraged most companies to make efficient, automated, and centralized financial reporting (Hanna, 2014). It is explained by the fact that Sarbanes Oxley Act in section 404 requires public companies to conduct extensive internal control tests, in which their annual reports will be included.
The market has been recorded to benefit the companies, though initial cost of the internal control was regarded as acutely high. Over time, the managers have improved internal processes, making internal control testing more cost-effective with time (Srinivasan & Coates, 2014). A survey by the Financial Executives Research Foundation (FERF) demonstrated that eighty-three percent of large firms, including Chief Financial Officers, agreed that Sarbanes Oxley Act increased the investors’ confidence. Thirty-three of them agreed that it had reduced fraud in the public corporates.
6. Changes in the Accounting Professions as a Result of the Act
6.1 Standard Setting
Sarbanes Oxley Act (SOX) has set standards for the accountants, which it expects to be adopted by public accounting companies. These standards include quality control of the accounting activity, practicing of ethics, auditing and associated attestation, and independence. SOX reinforces its standards through the authorities to ensure that public companies incorporate them.
Discipline in the public firms has been improved by the adoption of Sarbanes Oxley Act, where committed wrong acts are punished by law. These wrongdoings are characterized as frauds, document destruction, threatening whistleblowers, failure in maintaining work papers, and ban of personal loans by the executives (McDermott, 2015). These penalties regulate accountants, directors, and CEOs in their operations.
6.3 Work Association in the Accountancy Profession
This association has been characterized by the act of audit partner rotation. In turn, it is manifested by the act rotation by the lead audit partner and audit review partner, who must rotate every five years on their engagements in a public company.
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7. Educators Regarding Programs That Train Accountants
There are several trainers associated with training accountants on issues relating to SOX. One of those groups includes BAI, a financial services association that offers varied courses to the accountants. This association is led by Certified Regulatory Compliance Managers (CRCMs) who are the former examination regulators and certified risk management professionals. This group trains accountants in order to help them evolve the best practices rotating around SOX principles (Half, 2015). The other identifiable group is Governance Risk Group (GRG), which provides SOX compliance training to the accountants. They also provide training and certification programs to their clients in order to meet their objective of imparting knowledge on issues relating to SOX compliance.
The research study done on the Sarbanes-Oxley Act clearly shows that the stipulated acts have transformed public companies into their accounting processes, especially large firms that enjoy leverage from the shared costs in the auditing committee. Most large companies, as opposed to small companies, recorded 25% (less or above) costs cut-outs. Secondly, 88% of Chief Financial Officers from public firms agreed that SOX boosted the confidence of the stakeholders, while 33% agreed that it reduced fraud. Furthermore, managers, after a period of time, have improved the internal processes, thus making internal control testing more cost-effective with time.
Toshiba should adopt and strictly adhere to the principles provided by SOX to avoid the repeat of accounting scandals in the future.
Since Toshiba is a large firm, it will experience little costs to setting up an internal audit committee.
The managers, with the adoption of internal processes, will improve over time, making the internal control testing more effective.
There is a likelihood of boosting the confidence of the Toshibas stakeholders about their relationship with the firm.
Adoption of SOX is likely to reduce the levels of fraud in the company.
10. Implementation Plan
In order to actualize the proposed recommendation of SOX compliance program in a company, an effective implementation plan is necessary. It includes the following:
- Early Start
- Plan development
- Framework identification
- Conducting risk assessment
- Entry-level assessments
- Key controls and document-significant processes
- IT general controls assessment
- Identification of the service providers that consist of the third parties
- Effective internal control tests
- Evaluation of the significant deficiencies identified
- Communication of the results
11. Instructions on the Implementation Plan
The implementation is to be started early as per the guideline and objective of Toshiba Inc. After that, the development plan should draw the framework and determine the risks involved. Understanding the environment for the plan is important before entry, and it is essential to depict significant processes and effectively control communication involved (Weaver, 2015). Once the compliance program has been set, internal control tests are made to evaluate the deficiencies in the firm. The committee can revisit the plan to ensure that it corresponds to the outline and will bring further improvements and sustainability.
There is practical evidence in the research study explaining why Toshiba should adopt Sarbanes-Oxley Act of 2002 in its struggle with dealing with accounting scandals. A case study by Srinivasan and Coates on several companies provides the proof of satisfaction from top officials, including CEOs and CFOs, who have implemented Sarbanes-Oxley Act in their firms. Study and the examination of the effects of the Sarbanes-Oxley Act prove to be beneficial to the accounting practices in various firms, enhancing both independence and competence of the accountants. Moreover, professionalism of the employees is transformed through a myriad of positive practices. To implement SOX among their accountants, Toshiba could incorporate firms or organizations, offering training and education. The implementation plan is crucial in the actualization of SOX as it provides the guidelines for the associated processes. Instructions need to be followed in the process of implementation since wrong moves are linked to negative outcomes and waste of time.