Sarbanes-Oxley Act Research Paper

Abstract

In this research paper I will investigate in the issues related to the Sarbanes-Oxley Act, its overview, contents, historical prerequisites, as well as present research materials regarding the factual benefits of its implementation on practice. I will also attempt critically evaluate Sarbanes-Oxley Act and present its advantages and disadvantages from the standpoint of current economic situation.

1. Introduction

Sarbanes-Oxley Act, which is frequently referred to as SOX or Sarbox, was introduced 6 years ago in 2002, or to be more specific, was enacted on July, 30 2002. This act is also known as the Public Company Accounting Reform and Investor Protection Act of 2002. This act appeared not at once without any reasons, there were serious prerequisites for its development and enactment. There was a series of accounting and corporate scandals that influenced such companies as Tyco International, Enron, ImClone, WorldCom, Global Crossing, Adelphia and Peregrine Systems. During scandals with mentioned companied involved, investors lost billions of dollars and there was no legal act to protect their investments in any way. These scandals not just caused enormous money loss, but also severely decreased public confidence in the securities market of the USA.

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The Act was named after its sponsors- Senator Paul Sarbanes and Representative Michael G. Oxley, approved by the House of Representatives and signed into law by the President George W. Bush. This act is often considered one of the most outstanding proactive reforms during last several decades. Sarbanes-Oxley Act contains 11 titles, which provide the description of specific requirements and mandates for financial reporting. There are several sections in each title. Major titles are: Public Company Accounting Oversight Board (PCAOB)(9 sections), Auditor Independence (9 sections), Corporate Responsibility (8 sections), Enhanced Financial Disclosures (9 sections), Analyst Conflict of Interest (1 section), Commission Resources and Authority (4 sections), Studies and Reports (5 sections), Corporate and Criminal Fraud Accountability (7 sections), White Collar Crime Penalty Enhancement (2 sections), Corporate Tax Returns (1 section) and Corporate Fraud Accountability (7 sections).

2. Circumstances that Led to the Sarbanes-Oxley Act

A series of complicated factors formed the conditions and culture in which many significant corporate frauds took place between years 2000 and 2002. The dramatic frauds at Enron, WorldCom, and Tyco, which received wide publicity, exposed important problems with conflicts of interest and practices of incentive compensation. The analysis of their complicated and controversial roots causes made contribution to the passage of Sarbox in 2002.

Before the adoption of this act, there were numerous cases of auditor conflicts of interest. Before Sarbox, auditing companies, chief financial supervisors from investors’ side, were self-regulated. They also performed essential consultancy or not related to audit work for the companies they performed audit for. All consulting services were based on agreements many of which were far more profitable for auditors than that of the auditing services provided. This is factual representation of the conflict of interest. For instance, indicating that there are particular problems the company's accounting approach might aggravate relationship with client with correspondent risk on essential consultancy and other arrangements, which can do harm to the bottom line of the audit firm.

Boardroom failures were also a real problem. Boards of Directors, especially Audit Committees, are burdened with the establishment of oversight mechanisms for financial reporting in corporations of the USA on the investors’ part. Scandals that took place revealed that Board members either did not perform their direct duties and exercise their responsibilities or did not possess enough expertise to understand the businesses complexities. In many cases, Audit Committee members were very much dependant on management and were not able to make independent decisions. Conflicts of interest of stock market analysts also took place. Roles of stock market analysts, who make recommendations regarding buying and selling on company bonds and stock, and of investment bankers, that assist companies in provision of loans or handle mergers and acquisitions, are said to be another source for conflicts. This type of conflict is somehow similar to the auditor conflict, as when analysts make buy or sell recommendations regarding stock when they additionally provide profitable investment banking services, there is the presence of conflict of interest.

There are some cases when excessive funding is not better then insufficient funding. The Securities and Exchange Commission (SEC) budget has dramatically increased and almost doubled the pre-Sarbox level. Sarbanes in the interview to the Journal of Leadership and Organizational Studies in summer, 2004 indicated that rule-making and enforcement are more effective post-Sarbox. Banking practices were also experiencing conflict during the period from 2000 to 2002.When the bank lends money to the company it is the particular signal to investor about the possible risk the company might have. Referring to the Enron case, several main banks accommodated with the large loans this company without any understanding, or probably ignoring, company possible risks. Investors of these banks, as well as their clients were damaged by such loans, and in the long run this resulted in large banks’ settlement payments. Some people, on the other hand, read readiness for loans provision as the sign of Enron’s integrity, health and prosperity, and as a result they were confidently investing their money into Enron’s securities. Such people experienced significant losses as well, of course depending on how much had they invested.

It was obviously not an easy and the fruitful period for investors. In 2000 stock market also experienced the drastic decline in technology stocks and also the whole market in the stage of decline. Particular managers of mutual funds were claimed to have advocated the certain technology stocks purchases, when in reality they were trying to sell them. An again this dramatically affected investors’ expectation and they were already raged due to constant losses they had to experience regularly (Shakespeare, 2008).

Executive compensation is the final issue that led to the adoption of Sarbox. Bonus practices and stock options, in combination with instability in stock prices for small earnings “failures”, resulted in pressures that earnings should be managed. Stock options were not referred to as companies’ compensation expenses, which would encourage this compensation form. And consequently with a significant stock-based bonus at risk, managers had to meet their goals.

So, it becomes obvious that something should be done in order to protect investors’ interests and stabilize the overall situation. The act was passed by Congress of the USA for protection of the investors from the occurrences of fabricated financial activities by corporations. When the scandal of Enron and Andersen first broke out in late 2001, ImClone, Global Crossing, and other companies didn’t make to wait for a long time, Congress paid no attention to that. Several committees were trying to do something and even series of bills was introduced to address corporate misbehavior. At the same time, the differences between the Senate under Democratic control, and the House of Representatives and White House under Republican control, regarding on how to resolve such problems was so great that appeared that there is no law or act that could be attributed in those cases. It is also appeared that all corporate reform efforts were not successful.

After the second wave of scandals, which were led by Adelphia and WorldCom in the summer of 2002, the situation began to worsen. As the securities market continued to take the plunge only a few months before the fall elections, the White House and Congress realized the strong necessity in actions. But that time, Congress rushed to pass the complex Sarbanes-Oxley Act before the recess in August of 2002. And if before this proposal was considered very controversial, it had abruptly become very central, and passed with 99-0 in the Senate and with 423-3 in the House of Representatives. President George W. Bush, who was very skeptic about certain act's major provisions, still signed act into law on July 30, 2002.

Nevertheless, act implementation did not go in the smooth manner as it was probably expected. One of the most essential act provisions establishes the Public Company Accounting Oversight Board, which was designed to prevent auditing abuses similar to observed at Enron. SEC was consequently provided with the responsibility to name the five members of the new board. SEC Chairman Harvey Pitt led the research for a chairman and members of the new accounting oversight board. Harvey Pitt previously was the representative of the main accounting companies and many large corporations and had a reputation of as a highly successful and qualified securities lawyer. John Biggs, who was the head of a main pension fund and an advocate for firm accounting oversight, became the initial choice of SEC to become the chairman of the new board. And after significant opposition to Biggs introduced new direction of development, the SEC obviously changed course.

Preferably, on a controversial 3-2 vote of the SEC, Pitt and the two other Republican commissioners selected William Webster, who was the former federal judge and former head of both the CIA and FBI, to take the position of the first chairman. But Pitt's team failed to find out that Webster himself had been on the audit committee of a nearly bankrupt public company, accounting practices of which were explored by the SEC. After such a shame, in several weeks, both Pitt and Webster resigned. This occasion greatly embarrassed the SEC and damaged severely the reputation of the new accounting oversight board even before it was even officially presented to business.

3. Key Provisions

So, the Sarbanes- Oxley Act was enacted July 30, 2002 and established the new standards for all public company boards, management and public accounting companies of the United States. There were many debated regarding the ratio of the true benefits from the act and its costs, though supporters of this act argue that it was completely necessary and played an important role in the restoration of the confidence of public in the U.S. financial and stock markets, as well as in strengthening control of corporate accounting principles. Though opponents claim that after enactment of this legislation, the competitive edge against foreign providers of financial services significantly decreased due to introduction of complex Sarbox regulatory environment (Farrell, 2005).

It is important to understand key provisions of the Sarbox and how can they be put on practice. I would like to start with the Section 302 of SOX, which is called Internal control certifications. Under this act, two separate significant certifications were introduced- civil and criminal. In general this section introduced the set of internal procedures that were created to ensure the correct disclosure of financial information. Signing officers should certify that they are having the responsibility for establishment and maintenance of internal controls, as well as verify that financial and other necessary information is disclosed to such officers during specific time period. Internal controls of the company must be evaluated by the officers within the period of 90 days before the final report is submitted to the commission. They are also responsible for the presentation of their conclusions regarding the effectiveness of internal control on the ground of their evaluation. SEC issued he special Rule (33-8124) as the interpretation of this section and defined the new notion there as “disclosure controls and procedures”, which is separated form the “internal controls of financial reporting”. SEC was also directed by the Congress to develop regulations to enforce provisions from sections 302 and 404. In this scheme, external auditors are responsible for issuing an opinion regarding the efficiency of financial reporting internal control by management. This opinion is said to be an addition to the financial statement and to the opinion about financial statements accuracy. There was also the third opinion required about management assessment, but it was canceled in 2007.

Section 404 is called the Assessment of internal control, which is the most controversial section of the whole Sarbox. This section demands an external auditor, as well as management, to complete reports on the internal control of the company over the financial reporting (ICFR). This aspect is not only the most complicated, but also the most expensive and costly for implementation, as it requires a lot of documentation, testing of important financial manual, as well as automated controls. In accordance with this section, management is assigned to production of the internal control report, which must be the part of the annual Exchange Act report. This report should confirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting” (15 U.S.C. p. 7262 (a)). This report should also contain information about the internal control structure effectiveness as of the end of the recent fiscal year. Committee of Sponsoring Organizations of the Tradeway Commission (COSO) described the internal control framework that managers of the companies are frequently adopting in this respect.

In order companies be able to cope with high costs, practices an guidance regarding this section were evolving. First of all, the Auditing Standard # 5 was approved by the Public Company Accounting Oversight Board (PCAOB) on July, 25 2007. Then, an interpretive guidance was also issued by SEC; it was specifically designed for management of the company. According to standards management is required to evaluate operating and design effectiveness of the chosen internal controls that relate to important accounts and relevant confirmations within the frame of material misstatement risks. Management must also understand the transactions flow, especially IT issues to be able to define the points of misstatement arousal. Management must also provide the estimation of company-level controls in correspondence with the components of COSO framework. It should also perform the assessment of fraud risk and estimate controls, which are designed for the fraud prevention or detection, as well as controls management override. And finally management is responsible for internal control adequacy over financial reporting.

Another essential part of the Sarbox is related to criminal penalties for Act’s violation. Theoretically, the crime and punishment section is said to be one of the act’s most harsh provisions. It establishes new or broader federal crimes for justice obstruction and stock fraud, and sets maximum prison time of 20 or 25 years, accordingly. Sentences for many federal crimes that existed were made more severe. Wire and mail fraud maximum penalties were quadrupled, from 5 to 20 years. The maximum sentence for particular securities law violations was doubled from 10 to 20 years, and the maximum fine the company should pay for the same crime raised from 2.5 million of USD to 25 million of USD. Practically, the efficacy of the criminal penalties part of Sarbanes-Oxley will solely depend on the government's success in specific individuals prosecuting. It is obvious that the statute's most rough penalties cannot be utilized for any crimes that took place before the new law was passed.

Sections related to this issue are titles 8, 9 and 11. Title 8: Corporate and Criminal Fraud Accountability. Title 9: White-Collar Crime Penalty Enhancements. Title 11: Corporate Fraud and Accountability. For instance, Section 802 of the Title 8 is called: Criminal penalties for violation of SOX and Section 1107: Criminal penalties for retaliation against whistleblowers.

Section 1107 presents the following information: “Whoever knowingly, with the intent to retaliate, takes any action harmful to any person, including interference with the lawful employment or livelihood of any person, for providing to a law enforcement officer any truthful information relating to the commission or possible commission of any federal offence, shall be fined under this title, imprisoned not more than 10 years, or both”.

4. Advantages and Disadvantages of the SOX

As I have already mentioned some congressmen considered this act to be too costly and unnecessary measure. So, the main disadvantage remains its costs, direct and indirect. Then, management needs more time for making decisions, as well as decision-making process became more complicated. The other difficulty is finding the independent management that would be good from all sides. Then, in order to correspond to this act, company had to perform a lot of manual paper work, which in the situation of rapid development of business environment, is rather difficult (Shakespeare, 2008).

But still, there are more advantages for this legislation, as it ensures the better disclosure of all accounting information of the firm, and correspondently investors are able to analyze deeply company’ s performance and make weighted decisions, acknowledging that they are protected by the government. More transparency is also presumes, as auditors are encouraged not to provide any services that are not related to their direct responsibilities. Companies are thinking more about their growth, savings and investments. Managers are responsible for the disclosure of information and due to severe penalties, they are more careful in making statements regarding financial information.

Information technologies are expected to play crucial role in compliance of the SOX. With IT, the SOX requirements are met thoroughly that brings only positives to the company’s performance and corporate image.

5. Conclusion

In the conclusion I would like to summarize that Sarbanes-Oxley Act was passed in order to increase transparency in the accounting reporting of the companies and defend rights of investors to truthful information. Better data disclosure allows investors make better decisions. It was also aimed to decrease occurrences of corporal frauds and increase the responsibilities of the management board on internal controls on the information disclosure. __________________________________________________________

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