The Sarbanes-Oxley Act of 2002 was a response to corporate fraud and failures. It implemented new rules for corporations, such as setting new auditor standards to reduce conflicts of interest and transferring responsibility for the complete and accurate handling of financial reports. The act imposes harsher penalties for violators to deter fraud and misappropriation of corporate assets. Additionally, the act enhanced disclosure requirements, such as disclosing material off-balance sheet arrangements to increase transparency.
Corporate scandals such as Enron and Worldcom in the US between 2000 and 2002 prompted the passing of the Sarbanes-Oxley Act (SOX) in July 2002. Its goal was to restore investors' confidence in financial markets, close loopholes that allowed public companies to defraud investors, and have a significant impact on corporate governance.
As part of the act, public companies were required to strengthen audit committees, perform internal control tests, and make directors/officers personally liable for financial statements. The disclosure requirements were also strengthened, and stricter penalties for securities fraud were established. Additionally, the act changed how public accounting firms operate.
The Sarbanes-Oxley Act Effects
Improving Audit Committees in Public Companies
The Sarbanes-Oxley Act had a direct impact on corporate governance by reinforcing the audit committees of public companies. The audit committee, which is composed of non-management members and is a subset of the board of directors, now has more power to oversee the top management's accounting decisions. The audit committee has taken on additional responsibilities, including approving various audit and non-audit services, choosing and supervising external auditors, and managing complaints regarding the management's accounting practices.
Management's Financial Reporting Responsibility
The Sarbanes-Oxley Act made a significant change in management's responsibility for financial reporting. As per the act, top managers are required to certify the accuracy of financial reports personally. If a top manager knowingly or willfully provides false certification, it can lead to a prison sentence of 10 to 20 years. In case of any misconduct from management leading to a required accounting restatement, top managers may have to give up their bonuses or profits from selling the company's stock. If a director or officer is found guilty of a securities law breach, they may be prohibited from serving in the same role at the public company.
Stronger Disclosure Requirements
The Sarbanes-Oxley Act made significant changes to the disclosure requirements. It's now mandatory for public companies to disclose any material off-balance sheet arrangements, including special purposes entities and operating leases. Companies must also disclose any pro forma statements and how they comply with the generally accepted accounting principles (GAAP). Insiders need to report their stock transactions to the Securities and Exchange Commission (SEC) within two business days.
Stricter Punishments for Corporate Fraud and Misuse of Assets
The penalties for obstructing justice, securities fraud, mail fraud, and wire fraud are made stricter by the Sarbanes-Oxley Act. The maximum sentence for securities fraud has been extended to 25 years, while the maximum prison time for obstructing justice has been extended to 20 years. The act also increased the maximum penalties for mail and wire fraud from five years to 20. Furthermore, the fines for public companies committing the same offense were significantly increased by the Sarbanes-Oxley Act.
Internal Control Tests
The most expensive part of the Sarbanes-Oxley Act is Section 404. This section requires public companies to conduct extensive internal control tests and provide an internal control report along with their annual audits. The process of testing and documenting manual and automated controls in financial reporting is a huge task that requires significant effort and the involvement of external accountants and experienced IT personnel. The cost of compliance is particularly high for companies that rely heavily on manual controls. While the Sarbanes-Oxley Act has prompted companies to make their financial reporting more efficient, centralized, and automated, some critics argue that the associated controls make compliance expensive. They also argue that the controls distract personnel from their core business and discourage growth.
Public Company Accounting Oversight Board
The Sarbanes-Oxley Act created the Public Company Accounting Oversight Board. This board makes rules for public accountants, reduces their conflicts of interest, and mandates lead audit partner rotation every five years for the same public company.
New regulations were introduced to improve corporate governance in response to corporate fraud and failures with the passing of the Sarbanes-Oxley Act of 2002. The act reinforced the audit committees of public companies, made top management personally liable for financial statements, strengthened disclosure requirements, and established harsher penalties for violators. While the Sarbanes-Oxley Act has prompted companies to make their financial reporting more efficient, some critics argue that the associated controls make compliance expensive and discourage growth.