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.
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.