What is the Sarbanes-Oxley Act?
After an explosion of corporate scandals came to light in early 2000’s, Congress addressed this issue by passing the Sarbanes-Oxley Act of 2002 (SOX). Under SOX, all publicly traded U.S. corporations are required to maintain an adequate system of internal control. Corporate executives and board of directors must ensure that these controls are reliable and effective. In addition, independent outside auditors must attest to the adequacy of the internal control system. Companies that fail to comply are subject to fines, and company officers can be imprisoned.
SOX came into United States federal law enacted on July 30, 2002 as a reaction to a number of major corporate and accounting scandals including Enron, Tyco International, Adelphia, and WorldCom. These and other scandals cost investors many billions of dollars and ultimately shook public confidence in the nation’s securities markets. Named after its sponsors, U.S. Senator Paul Sarbanes and U.S. Representative Michael G. Oxley, SOX was signed it into law by President George W. Bush.
The corporate governance rules in the U.S. are designed to protect the interests of shareholders that may include individual owners of stock, companies owning and/or controlling corporate entities, and institutional investors such as the California Public Retirement System (CaliPERS). The Securities and Exchange Commission (SEC) establishes accounting and financial reporting rules for publicly-owned companies in the U.S. while the Public Company Accounting Oversight Board (PCAOB) that was established by SOX oversees public company audits and reports to the SEC. SOX requires that a majority of the members of the board of directors should be independent of management. Other provisions of SOX include:
- All members of the audit committee should be independent of management.
- One member of the audit committee must possess “financial expertise.”
- The audit committee appoints the external auditors, reviews and resolves differences between the auditors and management, reviews internal controls, and reviews major changes in accounting methods.
- Under Section 302 of the Act, the CEO and CFO must certify in a statement that accompanies the audit report the appropriateness of the financial statements and disclosures and that they fairly present, in all material respects, the operations and financial condition of the company. A violation of this provision must be knowing and intentional to give rise to liability.
- Under Section 404, management should review internal controls and the auditors should independently assess its operation and issue a report that is part of an integrated audit of the financial statements.
Key Ethical & Social Responsibility Components
SOX contains many provisions of ethical guidance that attempt to deter unethical practices. One of the requirements is that corporations develop a Code of Ethics particularly for senior executives that outline enforcement mechanisms. Another primary attribute of SOX to deter poor ethics is the requirement that internal auditors be rotated on a regular basis to ensure accuracy. The Code of Ethics requirement provides a blueprint for internal corporate governance that outlines standards of conducts for all levels of employees. Everyone apprised to the organizations code of ethics are expected to understand and follow the examples laid forth. Organizations expect the principles of the code of ethics to be exemplified and failure to do so will be a cause of disciplinary action.
Advantage of SOX
The biggest advantage of SOX has to be the restoration of investor confidence, which was the primary purpose of the act. Additionally, it emphasizes the impact controls have within each organization, particularly IT-related controls. Prior to compliance with the act, many CFOs and other members of senior management were oblivious to the actual and potential system and financial overrides.
The general perception of SOX is that it has had a strong impact on reducing unethical business practices. Ethics are not typically taught at home or in the educational system. Most people have received little to no formal education in ethics except at the most basic level. SOX attempts to ensure that instilling a code of ethics is more than a façade. It empowers the SEC to enact such rules and enforce them with strict consequences.
Criticisms of SOX
One of the biggest criticisms of SOX is the expenses associated with the enactment that present an unfair burden for businesses. SOX is such a comprehensive, sweeping piece of legislation that it is susceptible to over assessment by companies and practitioners, which costs time and money. Although many businesses have tried to instill a level of practicality in the assessment of internal controls, it took several years for the universal support and legislation to follow suit.
The main policy question is whether SOX had net costs or benefits for the shareholders of publicly traded corporations? Supporters argue that SOX may benefit shareholders by improving the monitoring of management and transforming broader culture. Opponents argue that monitoring is best left to market forces and that SOX needlessly imposes bureaucratic burdens. Since an important benefit of good governance is the improved ability to raise capital, firms with greater need for external financing should benefit from externally imposed improvements in governance more than the rest. This is especially true for high-growth firms that cannot use domestic laws and institutions to commit themselves to higher governance standards.
However, since a large fraction of the SOX compliance costs are fixed and there are economies of scale in implementing SOX requirements, small firms are particularly disadvantaged. Also, if SOX contains a mix of beneficial and harmful provisions, companies from countries with high levels of investor protection might be hurt more than companies from countries with poor levels of investor protection.
Improvements to SOX Legislation
Studies conducted shortly after the SOX took effect in 2002 suggest that the average compliance cost for implanting SOX ranged from $4 to7 million. Large corporations with more than $10 billion in annual revenue spent consistently more than $10 million in compliance costs. These costs have risen since then and will certainly continue to rise with inflation. Evidence indicates that SOX might have improved financial reporting quality, though it may not have deterred actual fraudulent behavior.
The Sarbanes-Oxley Act of 2002 (SOX) was created in response to the accounting scandals of several companies including Enron, WorldCom, Adelphia, and Tyco. SOX ensures that all publicly traded U.S. corporations are required to maintain an adequate system of internal control. Corporate executives and boards of directors must ensure that these controls are reliable and effective. SOX has provided an excellent outline that helps with instilling a more ethical fundamental corporate culture and modulating accounting disasters of the past. Overall, instilling of a code of ethics has made some inroads in creating a stronger organizational culture.
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