Introduction: Need for regulatory environment
It was the time of early 2000’s when the headlines of major newspaper were full of corporate fraud and the companies filing for the bankruptcies. Most of the companies were involved in the accounting restatements, i.e. major corrections of their financial statements and the count of such companies were growing everyday and were also posing a major impact over the stock market performance. Although the list was exhaustive, but the major corporations, that were found to be involved in the financial scandals were:
- Enron
- Worldcom
- Xerox
- Sunbeam
- Adelphia
- Tyco
- Global Crossing
For a country like USA that trades stocks more than any country in the world do and where the investors owns stock either directly or through pension funds, losing 40% stock value of large capitalization stocks in just over 30 months was no less than a nightmare. Hence, the Federal Government could not just sit back as the nation was demanding a stringent regulatory environment to ensure a fair corporate governance and high quality financial statements in the interest of the investors.
It was on July 25th, 2002, the US Congress, passed the Sarbanes-Oxley Act to protect the investors from the any sort of fraudulent accounting activities by the corporations. The act mandated strict legal reforms over the corporate to improve financial disclosures from corporations and prevent accounting fraud. The act was highly appraised by the financial pundits as it was considered to be a far reaching act directly affecting the corporate governance and their independent auditors since 1930’s. Important to note, the rules and legislative policies outlined by Sarbanes-Oxley Act were only the amendment or supplementary to the existing legislations.
Requirements of the Act
Two of the key provisions of the act were:
- Section 303: Introduction of this section in the act, made it a very first legislature that accounted CEO and CFO’s responsible and accountable for the financial disclosures and the related controls. Hence, as per this mandate, the senior management of the companies were also required to certify the accuracy of the financial statements.
- Section 404: This section was one of the most controversial aspects of the Sarbanes-Oxley act, primarily in relation to the costly affair for the public trading companies to establish and maintain the required internal controls. Important to note, Section 404 of the act requires the management of the company to provide assertions of effective internal control over financial reporting, while the independent auditors are required to attest those assertions, which overall will involve significant cost to the company. In addition, apart from the requirement of management’s assertion and the attestation of the auditors, the section 440 also requires the public trading companies to disclose as how the senior financial officers of the companies are dealt and what code of ethics is applicable to them. Two of the primary stock exchanges of USA, NASDAQ & NYSE, has adopted laid down similar requirements for the listed companies where they are required to adopt or disclose on their official websites the code of ethic and business conduct for the directors, officers and the employees of the company. In addition, the listed companies will promptly report any waiver of code granted to any director or executive officer followed by its reason. The NYSE has also provide list of topics that the companies are required to cover while disclosing their ethics code of conduct. Such recommended code of conducts has increased the relevance of ethics in the corporate culture and many of them also consider ethical culture a best practice for organizations of all sizes and types.
Penalties
The act applies to all of the public companies in the United States, irrespective of their size or capitalization. In addition, if any company is found to be non-compliant with the act requirements, the penalties can range from de-listing from the stock exchange to huge fines and possible imprisonment. However, the penalties will vary on which part of the law is violated by the company. For instance, if a CEO or CFO of the company is found guilty of deliberately hiding the information and submits an incorrect audit report as per Section 404, he is likely to charge with a fine of $1 Million and up to 10 years in imprisonment.
What turned Sarbanes-Oxley Act a success
The act, undoubtedly has improved the ethical culture in the US corporate environment and it has been proved many a times that an organization following ethical environment is able to attract the qualified employees and is able to minimize the cost of employee turnover and retraining, resulting in optimal productivity and higher profitability. When evaluating the overall effectiveness of performance of the SOX, the vital consideration is to check as how the act has changed the auditing standards and their regulations.. Important to note that prior the act was passed, auditors were governed by a system of self-regulation which had apparently not preserved their ability to act as gatekeepers. In addition, the increasing incidence of accounting restatements and earnings manipulations were also an indication that the deeper issue was not with the accounting standards themselves but rather the enforcement of those accounting standards through the auditing process.
Hence, in response to these accounting shenanigans, Sarbanes-Oxley act included the set of the unique and significant institution known as Public Company Accounting Oversight Board (PCAOB). At the core, the act was designed to enhance the role of auditors in enforcing the laws against frauds and theft at the public companies by imposing the complex set of nine mandates shown below:
Another reason behind the success of Sarbanes-Oxley Act was its early recognition for problems in the accounting standards itself. Hence, immediate instructions were provided to FASB and SEC to tighten the accounting standards. Two of the prominent changes were involved in the accounting procedures of ‘’Special Purpose Entities’’ and the ‘’Pro-Forma Accounting’’. In addition, rather than being funded by the accountants and the auditors, the companies were now required to fund the FASB so as to ensure that its membership is independent of the accounting profession. Hence, all such mandates relating to the accounting and the auditing procedure lead to the increased confidence of the investors in the stock market performance and provided a success to the act.
Will the act continue to help to avoid the frauds in the near future?
Although the decade of Sarbanes-Oxley Act could be said to be a successful one but at the same time, the financial crisis of 2008 has yet again raised a doubt, if the Sarbanes-Oxley Act is a failure and if it will be able to continue to prevent the frauds in the future. When looking back upon the first ten years of act, we can also conclude that despite of the various changes it proposed in the accounting standards and auditing procedures, the companies were still able to use the new financial instruments such as derivatives to provide an overview of their financial statements that again lead to loss of trillions of dollars to the US economy.
Hence, while the original Sarbanes-Oxley act was written and passed within 30 days, considering the failure of the act to recognize the financial threat of 2008 through its auditing procedures, we highly recommend that it is now the time to go back and reform the act that overlooks its deficiencies that came to view during the financial crisis. Hence, with the existing reforms relating to auditing procedures in the act and with the empirical evidence sourced from the financial crisis, we highly doubt that the act will continue to help in avoiding the accounting frauds in the near future.
Works Cited
Coates, J. (2007). The Goals and Promise of the Sarbanes-Oxley Act. Journal of Economic Perspectives , 91-116.
Magloff, L. (n.d.). How does the Sarbanes-Oxley Act of 2002 affect Small Business Owners. Retrieved September 30, 2014, from http://smallbusiness.chron.com/sarbanes-oxley-act-2002-affect-small-business-owners-877.html
