The Sarbanes-Oxley Act of 2002 was passed on July 30th, 2002 as a result of several major corporate and accounting scandals. This act is also known as SOX or Sarbox; another name for it is Public Company Accounting Reform and Investor Protection Act of 2002. Corporations such as Enron, Adelphia, WorldCom, Peregrine Systems and Tyco International were greatly affected by these scandals and rumors as their share prices in the market collapsed and proved to be a major loss of billions of dollars for the investors. This also broke customer confidence in the national securities markets (Bumiller, 2002).
The names of the sponsors of this act, Senator Paul Sarbanes and Representative Michael G. Oxley, became the source of derivation of the name of the act. This act was claimed to be “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.” by George W. Bush, who signed this reform into law after it won majority votes at the House and by the Senate.
Factors Leading to the Formulation of the Act:
Between 2000-2002, there was a consecutive chain of corporate scams lead to by various complex contributors. As mentioned, these frauds that were deeply publicized took place in big companies – the reasons behind this deception were clash of interests and incentive compensation policies. The thirst for the investigation of these deceptions led to the birth of the Sarbanes-Oxley Act of 2002. The first reason was auditor’s conflict of interest, which means that the auditors, before SOX was introduced, provided non-audit or say consulting services to firms they went to audit. This was basically done for the financial interests of the auditor since the auditing activities were not enough as a source of income. They got away with it earlier because these “Watchdog” bodies were self-regulated. Additionally, the Board of Directors of Audit Committees responsible for forming supervision mechanisms for financial reporting on behalf of all the investors of US corporations were not able to fulfill their job either because they did not have the expertise or they did not bother performing the tasks assigned to them. Just as the auditors, even the securities analysts have a clash of interests; apart from the usual buy or sell recommendations, they provide other investing consultation which proves to be more lucrative than the usual activities including assisting companies in mergers and acquisitions, and stock and bonds dealings (Shakespeare, 2008).
There were some significant mistakes made by the bank which led to many investors losing their money. When usually a bank lends to the firm, the investors are informed so that they have a clear picture of the risks of their investment in that firm. A number of banks lent money to Enron without informing the investors who made huge losses. Normally, when a bank agrees to lend money to firms, it shows that the firm is capable of paying it back; thus, showing that the firm is healthy and profitable. This irrational lending by the banks portrayed a wrong image of Enron, causing many people to invest in Enron and losing money as a return. Moreover, in 2000, there was a sharp downfall in the technology stocks which caused a decline in the overall market and thus, leading to losses. The last factor that led to formulation of the Sarbanes-Oxley Act of 2002 was the stock compensation practice; there was a huge risk attached to all the bonus and compensation stocks issued, thus the managers had to work extraordinarily hard to meet their targets so that they could reap the benefits of the bonus stocks rewarded to them.
The frauds taking place in such big companies was not a good sign for the development and progress of not only the auditing industry and the concerning sector, but also hazardous to the growth of the United States as a whole. There was a dire need to eradicate all these practices and bring about a uniform and rational Act that would cater to all these problems. This is exactly when the Sarbanes-Oxley Act of 2002 was formulated as a means to deal with these problems and to bring about a positive change.
Purpose of this Act:
The purpose of this act is to establish improved benchmarks for all the public; and not private; company boards, accounting firms and even their management operating in the United States. In the total of the eleven sections that this Act comprises of, there are various topics addressed – criminal penalties, Corporate Board task accountability, auditor independence, corporate governance, internal control assessment, and improved financial state.
In order to make sure that this Act was a success, there was a need of collaboration with the Securities and Exchange Commission (SEC), so that they formulate rules for complying with the Sarbanes-Oxley Act of 2002. A new agency called the Public Company Accounting Oversight Board (PCAOB) was introduced under this Act – this was a quasi-public agency. This company plays the role of auditors for all these accounting firms and is responsible for supervising, regulating, scrutinizing and disciplining them.
There were eleven basic titles, with several further sections, under this Act; these were the rules for financial reporting in the US. Title one is regarding the Public Company Accounting Oversight Board (PCAOB), which was introduced to be the auditor of all financial companies and had the responsibility of supervising all activities taking place. It also defined the correct procedure of performing all finance actions along with keeping a check for any frauds. Quality control was also enforced along with rules which advocated the compliance of all policies implemented by PCAOB. In short, this title which had nine sections within is launches PCAOB – a regulatory body that defined the standards of financial reporting in the US (Butler, Ribstein; 2006).
Title two again constitutes of nine different sections but mainly covers the aspect of conflicting auditor interests. It prohibits auditors to provide non-auditing services such as consulting to those clients that the auditors audit for. Additionally, it deals with new auditor approval requirements, partner rotation and reporting standards and requirements.
Title three, consisting of eight section, deals with corporate responsibility. It is mandatory for each corporation to release their financial reports; it is the job of the senior executives to make sure that the report is completed on time and it not forged – precision is the key value. It also defines the etiquettes and professionalism that should exude when the external auditors meet the corporate audit committees. It describes certain disciplinary rules that should be abided by regarding behaviour and compliance of rules; civil penalties of non-compliance are also clearly stated in this title.
Title four is divided into nine sections that deal with the financial report accuracy and the revelation of the internal controls. It is based on these internal quality and accuracy controls that the reports are then judged. It not only needs to publish its balance sheet, but also the items that are not visible on the balance sheet; that is, the pro-forma documented figures and the stock transactions done by the corporate personnel. It is required of the company to keep updating and reporting if there are any changes in the financial statements so that the most recent records are available.
Title five is based on just one section; it deals with the analysts and their clash in interests. It has been difficult for investors to rely on and trust the security analysis due to the analyst’s conflict of interest. Specified, uniform and just code of conduct was released for these securities analysts to abide by (Rezzy, 2007).
Title six defines the bar or standard of firing securities analysts. With four sections, it states the conditions under which a broker, advisor or dealer can be disallowed to practice. This is also a step towards increasing securities analyst’s reliability; if those who are not working sincerely are not allowed to practice, the investors will start believing that only quality analysts are working; thus, their confidence is gained back.
The seventh title, with five sections, emphasizes on the research that needs to be done in order to formulate actions taken against violators such as the companies and auditors. Proper in depth studies needs to be performed in order to find out the effects of two accounting firms being consolidated, the operations of securities markets and the involvement of credit rating agencies in that, actions to be taken against violators and lastly but very importantly, to investigate whether the banks were involved in helping Enron maneuver their financial earnings and portray a wrong picture.
Title eight is extremely important because it is based on one of the core reasons for the formulation of the entire Sarbanes-Oxley Act of 2002. With seven in depth sections, this title, due to its nature, can be easily referred to as ‘Corporate and Criminal Fraud Act of 2002’. Be it exploitation; influence; deception; hypocrisy; annihilation or shift of financial records; any undue changes in the records; or any other hindrance in the investigation, there is a criminal penalty specified for each action. Therefore, it is required to refer to this part of the Act when punishing somebody for their wrong action in the corporation that disturbs its normal financial reporting process.
The next title (nine) is a kind of continuation of title eight as it deals with punishments and penalties as well; only more severe. This title, which is also known as the “White Collar Penalty Enhancement Act of 2002”, contains two sections. This title mentions the punishments for frauds or conspiracy at a white collar level. It not only suggests a severe punishment guideline; but it clearly states that if there is a failure to authenticate the financial statements and the overall report, it will be straight forward considered to be a criminal offence and will be penalized accordingly (Iliev, 2005).
The tenth title is very simple and has just one section – it just required the company’s Chief Executive Officer (CEO) to sign the company tax return. Since the CEO has the highest post, it is his responsibility to sign on important documents; plus the signature of the CEO increases reliability of the documents.
Lastly, but most importantly, title eleven, with seven sections, deals with the accountability of any fraud involved within the corporation. This title is also named as ‘Corporate Fraud Accountability Act of 2002’. As this entire Act recognizes the alteration of the financial reports and record as a corporate fraud and offence, a certain penalty for this deception is assigned. An even rigorous punishment is that the SEC has been given the right to seize large amounts of curious and anomalous payments temporarily.
Some major provisions of this Act are: SOX Section 302 – this is regarding the internal control of a company and its certifications. It is said that the company with a well organized internal control system have a lower borrowing cost. Thus, it is extremely advantageous for companies to have a healthy internal control system. There were two certifications of internal control; one civil and the other criminal. This includes a fixed pattern of procedures that guarantee accurate financial statements. These systems are then to be evaluated and maintained by officers who take care of the entire system. The effectiveness of the internal procedures is then to be disclosed through a report.
Secondly, SOX Section 404 talks about the assessment of these internal controls. This is where the management and the external auditors come in – they examine the company’s internal control over financial reporting (ICFR) and state its satisfactoriness. Doing this requires a great amount of effort; thus, this activity is claimed to be one of the toughest and the most costly of all. Again, the results of these observations are to be shown as part of the financial reports. To reduce the high expense of violation, companies have starting abiding by the laws and compliance is a norm.
Furthermore, SOX 404 talks about smaller public companies and the rules and regulations designed for them under the Sarbanes-Oxley Act of 2002. Since, there is a great cost involved in this assessment; this impacts the small public companies the most. This impact is disproportionate as the larger the revenue of the company; because keeping in mind some examples, companies with higher revenue paid lower compliance charges compared to smaller companies with lesser revenues. Due to this very reason, PCAOB intends to issue a guideline which will help people to assess their companies based on their sizes, causing the cost to be proportionate.
One of the most important provisions which led to the compliance of the Act was the SOX Section 802 that emphasized on criminal penalties if the SOX were violated. This part simply means that if somebody changes, damages, annihilates, fakes, hides, misguides, falsifies, or wrongly presents any financial record, he will be severely penalized for that. Punishments can be to extent of being heavily fined, or even being imprisoned for 20 years.
Lastly, SOX Section 1107 mainly talks about crime penalties that are implemented if there is retaliation shown against the whistleblowers. This clearly states that if any action is taken against or if any harm is done to anyone who is trying to do his job will be charged. Example, if a personnel of PCAOB is interfering as a form of inspection and if there is any retaliation shown, a penalty shall be made.
Benefits of the Sarbanes-Oxley Act of 2002:
With increasing number of frauds in big companies, it was difficult to keep track of genuinely successful companies or forged companies. The standard of financial reporting in the US was declining sharply; it was a recession for the overall investing industry. This is because the investors were losing confidence in the corporations and did not wish to invest due to a lack of accuracy of the profitability margins. With The Sarbanes-Oxley Act, it can be made sure that the investors have the proper status of the company in front of them, thus, the decision made by them will be precise (Rittenberg, Miller, N.D). This Act is advantageous for employees as they get special benefits under certain policies. Additionally, there are certain alterations made to the equity compensation and contribution plans that were earlier stated in the Act – these changes are expected to bring about a positive impact. This Act is a benchmark of how a company should perform. Although, this act is only for public companies, the benchmarking also sets a standard for private companies. This happens because when public companies become well organized, investors become more involved in public companies. However, private companies also want to attract investors, for which they try to raise their standards too to meet the public companies’ standards. Lastly, a certain part of the Act also helps the companies to pre plan their crisis situation by preparations of sponsorships and services provided to them by various companies. In short, it not only regained investor confidence in the US capital and money markets, but also fortified the country’s accounting controls.
Everything has a flip side to itself – opponents of this Act claim that it is an extraordinarily complex Act. They claim that with such a high regulatory environment, the US financial market is losing its competitive advantage over other foreign markets. Critics say that this new Act caused business downfall in United States and that potential market of investors moved elsewhere. Opponents claim that it was a totally unnecessary and yet extremely costly intervention of the government into the corporate world. This Act caused many small firms to leave the US stock exchange and not remain a part of it, as following the rules and policies of this Act is difficult for a smooth business. According to a research in the Wharton Business School, ever since the Sarbanes-Oxley Act was implemented, the number of public companies who refused to stay a part of the US stock exchange, increased by three times its original amount. Also new foreign firms had also stopped enrolling themselves into the US stock exchange (S. Kohn, M. Kohn, Colapinto, 2004). All this was a result of extremely high costs that are imposed due to the Sarbanes-Oxley Act. Korn/Ferry International conducted a survey in which they discovered that it cost Fortune 500 companies who on average had to pay $5.1 million as a result of violation of the Act in 2004.
It was an Act that was formulated for a good cause of eradicating fraud and making sure companies have accurate accounting and internal control systems and processes. It was successful to a great extent where companies became better organized and their standards rose, but at the same time a high cost was borne for violators of the Act. Those who indulged in any kind of unfair means to promote their company or to fool the investors into investing into your corporation, or even misleading banks into lending them large sums of money, will be charged and punished for their wrong act. Such Acts are very necessary to eliminate treachery from the corporate world and make it full of clean and healthy competition with a fair playing field.
Elisabeth Bumiller, “Bush Signs Bill Aimed at Fraud in Corporations”, The New York Times, 2002
Catharine Shakespeare,. “Sarbanes-Oxley Act of 2002 Five Years On: What Have We Learned?”, Journal of Business & Technology Law, 2008
Five Years of Sarbanes-Oxley, The Economist, 2007
Henry N. Butler, Larry E. Ribstein, The Sarbanes-Oxley Debacle, What We’ve Learned; How to Fix It, 2006
Peter Iliev, The Effect of the Sarbanes-Oxley Act (Section 404), 2005
Oleg Rezzy, Sarbanes-Oxley: Progressive Punishment for Regressive Victimization, 2007
PCAOB Statement on Favorable Decision, In Free Enterprise Fund v. PCAOB, 2008
Ron Paul, Repeal Sarbanes-Oxley!, 2005
Stephen M. Kohn, Michael D. Kohn, and David K. Colapinto, Whistleblower Law: A Guide to Legal Protections for Corporate Employees, 2004
Larry E. Rittenberg, Patricia K. Miller, Sarbanes-Oxley Section 404 Work: Looking at the Benefits, The IIA Research Foundation, (N.D)