I started this current series to discuss what is wrong with our country and what we need to do to fix it. While I have discussed some of the topics that I will be including in this series, they have been included in other articles. In this series I will concentrate on a single topic. This will also mean that some of the articles may be slightly shorter than my readers have grown accustomed to, however they will still be written with the same attention to detail. This series will have no set number of articles and will continue to grow as I come across additional subjects.
Why Was the Sarbanes-Oxley Act Created?
There is always a story behind a law. There is always a reason it was passed and a purpose for it. If you have heard of the Sarbanes-Oxley Act, then you know that this piece of legislation overhauled corporate regulations back in the early 2000s. A comprehensive reform of the financial practices of businesses, the Sarbanes-Oxley Act put a number of important regulations in place with which businesses must remain in compliance to this day. Let’s take a look into the background of the Sarbanes-Oxley Act.
In 2002, the Sarbanes-Oxley Act, a piece of federal legislation aimed at the internal financial regulations and external auditing of financial reports of publicly held corporations was passed. After a series of serious cases involving corporate corruption between 2000 and 2002, the federal government needed to respond and form a plan of how to address the widespread corruption that apparently had become so prevalent at major corporations in the U.S.
The large-scale scandal at publicly traded Enron was eye-opening for many Americans as well as their congressional representatives. When Enron, a company that was, at the time, viewed as one of the financially sound stalwarts among major U.S. corporations, ended up filing for bankruptcy, the world was shocked at what was revealed. Enron was an oil and gas giant that had diversified dealings with both oil refineries and power plants, among other endeavors. As it turned out, Enron was taking advantage of government deregulation of the oil and gas industry.
It was revealed that Enron officers and employees misrepresented earnings reports to shareholders and other acts of fraud that led to shareholders ultimately suffering devastating financial losses when the truth of Enron’s failure surfaced. It was also revealed that Enron executives were actively embezzling corporate funds. On top of all of this, the company was illegally manipulating the energy market. Unfortunately, the crimes of Enron were occurring in other major U.S. corporations, such as Worldcom at this time.
The Sarbanes-Oxley Act followed in the wake of these corporate scandals. The confidence of investors in the financial markets had taken a serious hit and the government felt compelled to act. The Act itself had a serious impact on the way that corporations are governed and regulated in the U.S. Among other reporting and regulation requirements, the Sarbanes-Oxley Act required corporations to:
- Strengthen audit committees
- Perform internal control tests
- Strengthen disclosure requirements
Under the Act, corporate directors and officers can be held personally liable for the accuracy of company financial statements. Top-level managers must actually personally certify the accuracy of financial reports. A top-tier manager who is found to have knowingly or willfully made false certifications of financial reports can face anywhere between 10 to 20 years in prison. The Act also established harsher criminal penalties for those engaging in securities fraud.
4 Serious Pros and Cons of the Sarbanes-Oxley Act
The Sarbanes-Oxley Act was passed by US Congress in 2002 as a legislative response to several corporate scandals that shocked the world financial markets. Some of the biggest names involved were Enron, Tyco and Worldcom. The act serves to protect investors from fraudulent activities performed by corporations.
Commonly referred to as SOX, the act attempts to strengthen corporate oversight and improve internal corporate control. Then main purpose of the act is to protect shareholders from fraudulent representations in financial statements. Through the act, investors are assured the financial information they rely on is truthful, and that it was verified for accuracy by an independent third party.
The act is named after its sponsors, US Senator Paul Sarbanes and US Representative Michael G. Oxley. It’s known as the Public Company Accounting Reform and Investor Protection Act in the Senate and the Corporate and Auditing Accountability and Responsiblity Act in the House. It’s also known as just Sarbanes-Oxley or Sarbox.
Sarbox contains eleven sections. In other words, it’s a long and complicated law, but it does outline a few key provisions, and these include:
Section 302 – requires corporate management to certify that financial statements have been reviewed by them, and that those statements are accurate and truthful
Section 401 – requires financial information to include disclosures on any relevant off-balance sheet obligations that may exist
Section 404 – requires management to indicate whether or not the internal control procedures of the company are sufficient and effective. That said, this has costly implications for companies that are publicly traded as it requires lots of resources to establish and maintain the internal controls required by the law.
Section 409 – requires management to update the public when significant financial matters when they happen rather than wait for the quarterly or annual report to do so
Section 802 – imposes penalties for violations of SOX rules, which include fines or time spent in jail
Sarbanes-Oxley has been hailed as one of the most important pieces of security legislation since the foundation of the Securities and Exchange Commission in 1934. The act was unleashed into a world that was still reeling from the burst of the high-tech bubble and scandals involving major corporations. The SOX act was meant to enhance corporate governance, as well as restore the faith of investors.
It’s been more than a decade since the inception of the act, but while some argue that it has provided benefits, others are still critical of it. In a Forbes article called The Costs and Benefits of Sarbanes-Oxley, it is stated that “…many in the business world spoke out against SOX, viewing it as a politically motivated over-correction that would lead to a loss of risk-taking and competitiveness.”
If it was enacted to do some good, why are the parties still divided on the effectiveness of the act even after more than a decade of being in place? To understand where each party is coming from, it’s best to look at the pros and cons of SOX:
List of Pros of the Sarbanes-Oxley Act
1. It discloses crucial information to shareholders
In essence, the act was created in order to protect shareholders. Take Enron, for example. It was one of the biggest companies in the world, and due to its shady accounting practices, its collapse affected the lives of many of its employees and caused a major stir on Wall Street when they were found out.
Every company suffers financial losses, but Enron’s CEO Jeffrey Skilling hid these losses and other operations. The method enacted was called mark-to-market accounting which is used in securities trading where the actual value of the security at the moment is determined. This can work in securities, but fall apart for other kinds of businesses.
What Enron did was that they would build an asset like a power plant, for example, and claim the projected profit on its books even if they haven’t made a single penny of off it. When revenue from the plant did arrive and it was less than the predicted amount, rather than take the loss, Enron would transfer the assets to an off-the-books corporation resulting in the loss being unreported. In other words, the loss wouldn’t hurt the bottom line of the company.
This method was able to trick shareholders, but given that the company is now defunct, they were found out and punishments were given. To avoid this from happening again, companies are now required to disclose information about their risk profiles, assets, debts and their commitments. This way, shareholders have information vital to make a sound decision or compare between public companies to make sure they decide on investing.
By doing this, shareholder confidence is increased which then results in capital flowing into the markets.
2. It emphasizes the need for internal controls
In Section 404 of the act, management is required to test internal controls on a quarterly basis and then file a report on whether those controls are sufficient and effective. While it’s considered a benefit, this is definitely the most expensive to comply with. The section was put in place to eliminate management overrides that occurred in cases like that of Enron.
With internal control testing, it is ensured that transactions were executed the way they were supposed to. Internal controls also make sure that checks and balances are in place to catch any abnormalities.
The Goals and Promise of the Sarbanes-Oxley Act
he primary goal of the Sarbanes-Oxley Act was to fix auditing of U.S. public companies, consistent with its full, official name: the Public Company Accounting Reform and Investor Protection Act of 2002. By consensus, auditing had been working poorly, and increasingly so. The most important, and most promising, part of Sarbanes-Oxley was the creation of a unique, quasi-public institution to oversee and regulate auditing, the Public Company Accounting Oversight Board (PCAOB). In controversial section 404, the law also created new disclosure-based incentives for firms to spend money on internal controls, above increases that would have occurred after the corporate scandals of the early 2000s.
In exchange for these higher costs, which have already fallen substantially, Sarbanes-Oxley promises a variety of long-term benefits. Investors will face a lower risk of losses from fraud and theft, and benefit from more reliable financial reporting, greater transparency, and accountability. Public companies will pay a lower cost of capital, and the economy will benefit because of a better allocation of resources and faster growth. Sarbanes-Oxley remains a work in progress–section 404 in particular was implemented too aggressively–but reformers should push for continued improvements in its implementation, by PCAOB, rather than for repeal of the legislation itself.
List of Cons of the Sarbanes-Oxley Act
1. It is costly
One of the biggest criticisms of Sarbox is that the rules are the same for both large multi-national companies and small public companies. In particular, Section 404 hits publicly funded corporations harder as they need to have the resources in place to execute what the section demands.
Bigger corporations have all the resources they need, but smaller companies just don’t have that much. This has been remedied somewhat though since the law was passed where burden has been lifted ever so slightly from small corporations. But despite that, there is still the issue of cost just to remain compliant to what the act states.
2. It results in increased audit fees
Since 2002, audit fees have increases substantially as a result of auditors being forced to be more accountable for the audit reports on their clients. As the liability of auditors increase, so does the audit fee. These added expenses can take a toll on the profit of a company.
What Are the Disadvantages of Sarbanes Oxley?
The Sarbanes-Oxley Act of 2002 (SOX) was passed to prevent companies from engaging in accounting fraud similar to that perpetrated by Enron and Worldcom. While SOX increased the accuracy and validity of financial information for outside stakeholders, it created some challenges for businesses attempting to comply with SOX guidelines.
SOX compliance requires companies to implement several internal controls to safeguard the financial information of a company. Internal controls are specific to each accounting operation, such as accounts payable, cash reconciliations and fixed assets.
Expanded internal controls add processing time to accounting functions, delaying the timeliness of financial information. Additionally, employees must ensure that all paperwork is accurate and approved by supervisors. Increasing the number and functions of internal controls slows the closing time for each accounting period and delays financial statement preparation.
An important function of SOX guidelines is the segregation of accounting duties. This ensures that one individual does not handle certain accounting processes from start to finish, which may increase the chances of fraud or embezzlement. In order to meet the segregation of duties requirement, companies must add additional accounting personnel. Using current employees outside the accounting office is not acceptable because it breaks down the internal controls function.
SOX guidelines require publicly held companies to have an annual audit conducted by a third-party accounting firm. The public accounting firm is limited in the total accounting services that it can perform. The separating of audit functions from consulting functions under SOX helps public auditors maintain an objective opinion about a company, but may require that more than one accounting firm be hired.
Increasing the number of audits and accounting firms that must be used by a publicly held company increases business costs. Higher audit and accounting fees require companies to adjust their budgets to pay for these accounting services.
The SOX legislation was enacted in 2002, less than a year after the major accounting scandals of Enron and Worldcom. While the legislation provides some needed oversight in the accounting industry, it was not determined to be a final solution for the accounting industry. Future government regulations pose increased financial burdens on companies, increasing the costs of conducting businesses. Some regulations may also limit certain business operations.
Penalties for accounting fraud and embezzlement were increased under the new SOX guidelines. Unfortunately, some penalties enacted focused on minimal violations, such as not signing financial statements or issuing statements to the public stating that executive management has approved of any financial information released by the company. Strict penalties on such minor infractions may limit the executive talent pool if future management employees do not wish to be liable for such actions and penalties.
The dumbest government policies are almost always the fruit of the bipartisanship that sets Beltway hearts beating with patriotic arrhythmia. Think the Patriot Act, No Child Left Behind, the authorization of force in Iraq and the TARP.
A particular offender is the Sarbanes-Oxley Act of 2002, which rewrote accounting and disclosure rules for publicly traded companies in the United States. Garnering just three nay votes in the House and Senate and signed by George W. Bush (the nation’s first MBA president), the act was supposed to prevent scandals like those that brought down Tyco, Enron and WorldCom. It created the Public Company Accounting Oversight Board and mandated “internal control reports” – expensive assessments of how well companies are following the dictates of the board. Executives who approve shoddy paperwork face fines of up to $5 million and jail time of up to 20 years.
It was never clear how more accounting and reporting regulations were supposed to squelch fraud. But government bean-counters, even more than generals, always fight the last war.
Larger firms lobbied for passage of the act, figuring they could absorb the costs that would hobble smaller competitors – which is just what happened. According to a 2008 Securities and Exchange Commission survey of officers at publicly traded firms, Sarbanes-Oxley cost the average company $2.3 million a year in direct compliance costs (staff time, documentation and external audits), compared with supporters’ estimates of $91,000 in annual costs.
The same survey found that only 20 percent of respondents believed the benefits outweigh the costs. That result echoes a 2008 report from the Association of Certified Fraud Examiners that found firms with the new controls “experienced greater fraudulent financial statement manipulations than organizations lacking these controls.”
Markets don’t like the law, either: Foreign companies listed on U.S. exchanges show falling stock prices compared with competitors who don’t need to comply.
Even as Washington takes tighter control over U.S. business, Sarbanes-Oxley is the subject of a Supreme Court case (Free Enterprise Fund v. Public Company Accounting Oversight Board) that could undo the whole megillah. Even so, the act should be remembered as a case study in hysterical legislating, which always produces more harm than good.
MIT Sloan study shows negative effects of Sarbanes Oxley on nonpublic entities
CAMBRIDGE, Mass., Nov. 16, 2017––While it’s common knowledge that the passage of Sarbanes-Oxley (SOX) in 2002 impacted public companies, a recent study by MIT Sloan School of Management Prof. Andrew Sutherland found it also had significant effects on private companies and nonprofits. After SOX, the demand for auditors by public companies increased, leaving fewer auditors available for private companies and nonprofits. As a result, audit fees for nonpublic entities increased significantly and private companies applying for bank financing decreased their use of independent auditors.
Most of the discussion and analysis about SOX has focused on publicly-held companies, but private companies and nonprofits also have substantial financial reporting needs, says Sutherland. “For example, many organizations in a banking relationship will need an audit to establish creditworthiness. Financial reporting may also be required to establish payment plans with vendors and suppliers. And charities need to show they are responsibly spending donors’ money.”
In this study, Sutherland and his colleagues examined how shifts in the public company audit market from SOX affected the nonpublic audit market. They examined two U.S. nonpublic settings: private companies and nonprofit organizations, including charities and governmental entities. “We found that SOX decreased the common pool of auditors, causing shocks in the market that affected supply across other types of organizations,” he says.
For nonprofits, they found that annual auditor fee increases more than doubled. The study also revealed that the likelihood of a nonprofit losing its current auditor doubled after the passage of SOX due to fewer available auditors. These switches in the nonprofit market changed the audit supply structure, with the usage of large audit firms – the “Big 4” market – decreasing by half.
Private firms reduced their use of independent financial reports in bank financing by 12%, instead relying on documents such as tax returns or unverified reports, both of which lack the timeliness and neutrality of an independent audit.
Auditors were also impacted by the regulation, as many previously served both the public and private markets. After SOX, the increasing complexity in accounting rules caused many auditors to specialize in just one market, contributing to the labor shortage problem.
“Our study shows that the audit markets were very connected. A development that affected one of the three segments of public, private and nonprofit, had negative spillover effects on the other two,” says Sutherland.
He notes that these effects can be part of the conversation about future regulation, concerning both public equity markets and occupational licensing standards that restrict the entry of new labor into the market. “When the regulators of public firms implement new accounting rules, they don’t tend to consider the effects on unregulated parties, even though those effects can be significant.”
The good news is that the pool of independent auditors is now back to a sufficient level, adds Sutherland. “As is the case with many professions, it takes several years for people to obtain the training and certifications required. The labor shortage is less of an issue today, but this is still a cautionary tale for future regulatory changes.”
Has Sarbanes-Oxley Failed?
Sunday will mark 10 years since the Sarbanes-Oxley accounting law was enacted, after the scandals at Enron, WorldCom and elsewhere. Many in the business world said complying with the law would be expensive and burdensome, and others called it ineffective. Indeed, since those crises other huge corporations have imploded, like Bear Stearns and Lehman Brothers.
Has Sarbanes-Oxley failed? After a decade, are there aspects that seem too onerous or too weak?
Not at all! The law has made an enormous difference, but not in the way you might think.
The impact of Sarbanes-Oxley isn’t necessarily found in the collective impact of its substantive provisions. Rather, it is found in the profound way the law has reshaped attitudes toward corporate governance.
The old ways weren’t working. That idea lit the corporate responsibility movement.
The need for fundamental change in boardroom behavior was a message that transcended the text of the Sarbanes law. The old ways weren’t working. That idea lit the corporate responsibility movement, igniting a more robust respect for corporate compliance, fiduciary duty to shareholders and ethical behavior.
When you zoom out to that level, the law has been spectacularly successful. Sarbanes-Oxley has forever changed the landscape of corporate governance. It has increased the accountability expectations we have of directors and officers, and their legal and accounting advisers as well.
Sarbanes-Oxley seized the center of corporate direction from the corner office and returned it to the boardroom, where it belonged. Moreover, the law encouraged the identification of “best practices” to guide boardroom conduct. It has helped to shape the focus of state courts and regulators on the proper application of other fiduciary duty laws. It has raised the public consciousness of corporate governance.
This much higher sense of fiduciary obligation has proved to be a powerful “check and balance” on corporate misconduct. We see the “Sarbanes DNA” beyond the requirements of the statute. It also appears in more attentive board oversight, decreased tolerance for ethical lapses, greater focus on corporate reputation and more intense awareness of enterprise risk. All of these are hallmarks of a more active, engaged and informed board.
The success of the Sarbanes-Oxley law is best measured by its extraordinary impact on fiduciary behavior. So celebrate its 10th birthday with a little bit of education on where we once were, how far we’ve come and how hard we still need to work. As recent headlines suggest, the job is not complete.
The process by which Sarbanes–Oxley was enacted has been criticized for being rushed and for ignoring relevant research. Neither criticism is fair. The core ideas behind Sarbanes–Oxley had developed for years. Federal bills to create an auditing oversight body date to 1978, after hearings and reports prompted by auditing failures in the market downturn of the early 1970s. Similar legislation was debated again in 1995. In the run-up to Sarbanes–Oxley, Congress heard scores of witnesses debate in detail how auditing should be regulated. In a number of other controversial areas—executive compensation and stock options,
audit firm rotation, general design of accounting rules—Congress showed a willingness to choose further study over either regulation or delegation.
Congress acted no differently in passing Sarbanes–Oxley than it does in passing most significant legislation. In fact, perhaps the most important component of Sarbanes–Oxley was precisely to delegate power to PCAOB, so that it could customize rules and respond to feedback much more rapidly than Congress could do on its own. Professional lobbyists, of course, may seek the outright repeal of Sarbanes–Oxley as a bargaining tactic while planning to settle on regulatory reform
as a compromise, but academics, policymakers, and the public would do well to see those tactics for what they are and recognize Sarbanes–Oxley, like many regulatory institutions, as a work in progress. Rather than pushing for repeal of Sarbanes– Oxley, a more cost-effective approach is to push for the SEC and PCAOB to use their authority to exempt or curtail requirements or prohibitions that are unnecessarily costly.
Of all the articles that I have posted in this category, this one is the most grayish. Only time will tell which side of the fence it will fall.
cmlaw.com, “Why Was the Sarbanes-Oxley Act Created?”; connectusfund.org, “4 Serious Pros and Cons of the Sarbanes-Oxley Act.” By Natalie Regoli; theclassroom.com, “What Are the Disadvantages of Sarbanes Oxley?” By Osmond Vitez; washingtonpost.com “The Worst Ideas of the Decade: Sarbanes-Oxley.” by Nick Gillespie; mitsloan.mit.edu, “MIT Sloan study shows negative effects of Sarbanes Oxley on nonpublic entities.” by MIT Sloan Office of Media Relations; nytimes.com, “Has Sarbanes-Oxley Failed?” corpgov.law, “The Goals and Promise of the Sarbanes-Oxley Act.” by John Coates; investopedia.com, “Sarbanes-Oxley vs. Dodd-Frank.” By The Investopedia Team;
Sarbanes-Oxley vs. Dodd-Frank
The Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act have been hailed by some as two of the biggest pieces of corporate reform legislation passed by the U.S. in recent decades. Both followed costly but very different kinds of scandals and corporate collapses that rocked Wall Street.
Sarbanes-Oxley was intended to protect investors from corporate accounting fraud by strengthening the accuracy and reliability of financial disclosures. It was passed by Congress in 2002 after a number of billion-dollar accounting scandals, perhaps most famously at energy-trading company Enron and telecommunications company WorldCom.
The Dodd-Frank Act was passed in 2010 in response to the 2007-08 financial crisis, which brought Wall Street to its knees. Dodd-Frank was meant primarily to reduce risk in the financial system by more closely regulating big banks and financial institutions.
The Sarbanes-Oxley Act
To protect investors from corporate accounting fraud, Sarbanes-Oxley placed responsibility for a company’s financial reports squarely on the shoulders of its top executives. It mandated that chief executive officers (CEOs) and chief financial officers (CFOs) personally certify the accuracy of the information contained in financial reports, and to confirm that controls and procedures were in place to assess and verify that accuracy.
In fact, CEOs and CFOs were required to personally sign financial reports, confirming that they were in compliance with Securities and Exchange Commission regulations. Failure to do so could result in fines of up to $15 million and prison terms of up to 20 years.
The Dodd-Frank Act
The massive Dodd-Frank Act aimed to protect investors and taxpayers by strengthening the regulations of the financial system, with an eye on containing risk and ending bailouts of “too-big-to-fail” banks, such as those that occurred during the financial crisis.
Among Dodd-Frank’s key provisions were the Volcker Rule, the regulation of risky derivatives such as credit default swaps and mortgage-backed securities, and increasing banks’ financial cushions.
The Volcker Rule, named for former Federal Reserve Chair Paul Volcker, prohibited commercial banks from engaging in short-term speculative trading with depositors’ money. These measures were meant to prevent the build-up of excessive risk-taking by big financial institutions, which was a major factor in the financial crisis and Wall Street’s collapse.
Dodd-Frank also created the Financial Stability Oversight Council to monitor risk in the financial system, and the Consumer Financial Protection Bureau to protect consumers from predatory lending practices. Abusive lending practices were blamed for contributing to the sub-prime mortgage collapse at the heart of the financial crisis.
What Is Wrong With Our Country?