Abstract
The paper will explore the business environment and the fraud scandals that prompted the need for more comprehensive and stringent regulations on financial disclosure by all public business entities operating on U.S. soil. The primary financial issues that the Sarbanes-Oxley Act was meant to address will be addressed, with a specific focus on how to restore investor confidence by imposing more strict rules on companies in terms of recording investments, cash flows and periodic profit/loss statements .
Through an analysis of the basic provisions of the Act with regards to assigning personal responsibilities on officers of the company, as well as the auditing firm involved, the paper’s aim is to establish that the passage of the Act has lowered corporate fraud incidents substantially. While it has its share of critics, especially the corporations it regulates, because of the increased expenses of compliance, establishing greater oversight of audit committees and transparency in reporting financing has ensured that investor interests remain paramount and people are able to make informed decisions on the basis of financial statistics that are comprehensive, yet simple and easy to understand .
Pre Sarbanes-Oxley Act Regulatory Environment
The Sarbanes-Oxley Act was passed by Congress on July 30, 2002 in order to provide increased protection to investors as a result of unethical and fraudulent accounting practices of business corporations. The two individuals responsible for drafting the legislation and lobbying for its approval during the Bush administration were Senator Paul Sarbanes and Representative Michael Oxley, who believed that the 1933 Securities Act was insufficient in ensuring that the interests, rights and assets of individual investors were duly protected . This opinion was formed on the basis of the massive financial scandals at Enron, WorldCom, Global Crossing, Tyco and Arthur Andersen, large corporations worth billions of dollars.
In each of these cases, there was embezzlement of funds by the top executives, overstatement of profits and significant misrepresentations in the financial statements that were disclosed to the investors. It was only after whistle blowers and/or independent audits revealed the financial discrepancies that the world came to know about the massive fraud that for some people, meant the loss of their entire life savings. This not only led to a deterioration of investor confidence in consolidated financial statements released by companies, but also in the inadequacy of regulations regarding corporate governance and asset/liability disclosures by all public businesses conducting their operations within the United States.
Provisions of Sarbanes-Oxley Act
The passage of the Act affected all public traded companies, whether of U.S. origin or not, doing business within the country and also included wholly-owned subsidiaries; the Act even went so far as to require those private companies planning to make their first Initial Public Offering (IPO), to ensure that their financial statements were in accordance with the provisions of the Act. The passage of the Act meant that for the first time, the top management was made personally responsible to submit an evaluation of how effective and relevant their accounting systems are to the Securities and Exchange Commission . Furthermore, the Act also made it compulsory for public organisations to have not just their financial statements, but also the company’s accounting systems verified and checked by external, neutral auditors regularly .
The Sarbanes-Oxley Act comprises eleven sections, but with regards to ethical practices and independent auditing practices, the sections that are the most pertinent include 302, 404, 401, 409 and 802.
Section 302 deals with the mandated levels of corporate responsibility assigned to the individuals who have reviewed, verified and signed the company’s financial statements . The article made the signing parties individually accountable for ensuring that only the information presented in the financial statements was accurate, but that the calculations and systems (software) used for reaching those figures had also been reviewed for potential reporting discrepancies. The companies were also required to mention if any of its employees had been found to be involved in fraudulent practices and if any changes in internal accounting rules had been made. The motive here was to provide as complete and updated a picture to investors as possible about the financial health of businesses they had or were looking to invest in .
Section 401 deals with increased disclosure requirements in periodic financial reports prepared by the company and also specifies the role of the Public Company Accounting Oversight Board (PCAOB) that was formed as a result of the Act, and worked under the supervision of the Securities and Exchange Commission. The Board and Commission were required to review not just the financial statements published, but also all those transactions and liabilities that were not reflected on the balance sheet. This added precaution was to ensure that investors are made aware of all the activities that a business is involved in and how it may impact its financial standing in future .
Sections 404 and 409 deal with the effectiveness and comprehensiveness of the accounting principles being used by businesses. As part of their annual reports, the business itself as well as their registered auditing firm are together required to submit a report on how effective the accounting methods for calculations and reporting that are being used are . Article 409 added that if there are any substantial changes either in the accounting systems or the operations of a business that may impact its asset/liability, cash flow or profit/loss figures, then it is their combined duty to immediately make the public aware of this . This information sharing, in addition to being instantaneous, also needs to be done in a way so that common people are able to understand the implications of the changes; using infographics rather than complex accounting jargon is recommended in these cases.
The one provision of the Act, which in my opinion has been a major contributor to its success, is Section 802 that details the criminal penalties that will be imposed on any party that is found to have altered the financial statements and accompanying reports in any way. The lack of such legal recourse in the past is what I attribute to the billions of dollars of investment losses in the fraud scandals at Enron and Arthur Anderson. The penalties that can be implemented under this article include monetary fines as well as imprisonment of up to 20 years for any individual who has acted to change, falsify, omit or misstate information on disclosed financial reports with the purpose of misleading or thwarting an ongoing investigation .
Not just the business’ management, but any auditor or auditing firm that also acts in compliance with the company to mislead the public will also be held accountable and can be imprisoned for up to 5 years . The aim here was to not only discourage the principal business actors from giving inaccurate figures, but also to prevent any collusion between the external auditors and the company management in embezzling funds or misrepresenting financial records.
Impact on the Audit Process
With the implementation of the Sarbanes-Oxley Act, both the financial reporting as well as auditing SOPs within the U.S. changed significantly.
For one, it has made the organisation responsible for not only identifying its internal control systems, but also to evaluate them and report their assessment to the auditing firm. The auditors on the other hand, have to personally assess the submitted report and verify its accuracy; therefore, simply having the knowledge of ‘what’ the accounting principles being used were, was no linger sufficient to cover the exposure of the concerned CPAs .
Secondly, the implementation of article 404 means that public companies are required to bear all the expenditures associated with centralizing and computerizing its accounting practices. Since the article made it mandatory for companies (for the first time) to submit an Internal Control Report (that is later evaluated by the auditing firm) along with its Annual Reports, having an automated system would streamline the process and reduce the cost burden in the long-run .
Conclusion
While the Act has often been criticized over the years for imposing too many controls on businesses and creating a risk-averse investment environment, both the extent and frequency of investor frauds have substantially reduced since its implementation.
Proponents of this piece of landmark legislation, with whom I find myself in complete agreement, state that what the Act has done is increase the responsibility on businesses of ensuring that the financial information they report to the public is both completely accurate and has been verified by internal and external auditors.
References
Banks, G. Y. (2003). How Sarbanes-Oxley Will Change the Audit Process. Journal of Accountancy, 89-120.
Blokhin, A. (2015, May 28). What impact did the Sarbanes-Oxley Act have on corporate governance in the United States? Retrieved from Investopedia: http://www.investopedia.com/ask/answers/052815/what-impact-did-sarbanesoxley-act-have-corporate-governance-united-states.asp
Floyd, B. (2013, May 5). Auditor independence: mandatory auditor rotation and the increased burden for audit committees. Financier, pp. 9-12.
Hanna, J. (2014, March 10). The Costs And Benefits Of Sarbanes-Oxley. Forbes, pp. 4-6.
Simon, D. R. (2009, December 15). Corporate Accountability: A Summary of the Sarbanes-Oxley Act. Retrieved from legalzoom: https://www.legalzoom.com/articles/corporate-accountability-a-summary-of-the-sarbanes-oxley-act
