Question

, discuss how the Sarbanes-Oxley Act of 2002 resulted in series of regulatory overhauls among publicly traded companies.  Have these changes been effective in improving firms' internal controls?

Answer 1

The Sarbanes-Oxley Act of 2002 cracks down on corporate fraud. It created the Public Company Accounting Oversight Board to oversee the accounting industry. It banned company loans to executives and gave job protection to whistleblowers. The Act strengthens the independence and financial literacy of corporate boards. It holds CEOs personally responsible for errors in accounting audits.

The Act is named after its sponsors, Senator Paul Sarbanes, D-Md., and Congressman Michael Oxley, R-Ohio. It's also called Sarbox or SOX. It became law on July 30, 2002. The Securities and Exchange Commission enforces it.

Many thought that Sarbanes-Oxley was too punitive and costly to put in place. They worried it would make the United States a less attractive place to do business. In retrospect, it's clear that Sarbanes-Oxley was on the right track. Deregulation in the banking industry contributed to the 2008 financial crisis and the Great Recession.

Requirements:SOX created a new auditor watchdog, the Public Company Accounting Oversight Board. It set standards for audit reports. It requires all auditors of public companies to register with them. The PCAOB inspects, investigates, and enforces the compliance of these firms. It prohibits accounting firms from doing business consulting with the companies they are auditing. They can still act as tax consultants. But the lead audit partners must rotate off the account after five years.

But SOX hasn't increased the competition in the oligarchic accounting audit industry. It's still dominated by the so-called Big Four firms. They are Ernst & Young, PricewaterhouseCoopers, KPMG, and Deloitte.

Internal Controls:Public corporations must hire an independent auditor to review their accounting practices. It deferred this rule for small-cap companies, those with a market capitalization of less than $75 million. Most or 83% of large corporations agreed that SOX increased investor confidence. A third said it reduced fraud.

Whistle Blowers:SOX protects employees that report fraud and testify in court against their employers. Companies are not allowed to change the terms and conditions of their employment. They can't reprimand, fire, or blacklist the employee. SOX also protects contractors. Whistleblowers can report any corporate retaliation to the SEC.

Effects on US Economy:

Private companies must also adopt SOX-type governance and internal control structures. Otherwise, they face increased difficulties. They will have trouble raising capital. They will also face higher insurance premiums and greater civil liability. These would create a loss of status among potential customers, investors, and donors.

SOX increased audit costs. This was a greater burden for small companies than for large ones. It may have convinced some businesses to use private equity funding instead of using the stock market.

Why was it passed?

The Securities Act of 1933 regulated securities until 2002. It required companies to publish a prospectus about any publicly-traded stocks it issued. The corporation and its investment bank were legally responsible for telling the truth. That included audited financial statements.

Although the corporations were legally responsible, the CEOs were not. So, it was difficult to prosecute them. The rewards of "cooking the books" far outweighed the risks to any individual.

SOX addressed the corporate scandals at Enron, WorldCom, and Arthur Anderson. It prohibited auditors from doing consulting work for their auditing clients. That prevented the conflict of interest which led to the Enron fraud. Congress responded to the Enron media fallout, a lagging stock market, and looming reelections.

Conclution:

The Sarbanes-Oxley Act was passed by Congress to curb widespread fraudulence in corporate financial reports, scandals that rocked the early 2000s. The Act now holds CEOs responsible for their company’s financial statements. Whistleblowing employees are given protection. More stringent auditing standards are followed. These are just a few of the SOX stipulations.

Some critics though believe SOX is an expensive compliance, particularly for small companies. But its focus on high auditing quality has restored and strengthened investor confidence in U.S. companies.

The impact:

There are good reasons to believe that the accuracy in reporting huge losses for 2007 by Citigroup, Merrill Lynch, Bear Stearns, MBIA, Ambac, and many other well-known financial companies can be found in the rigorous requirements imposed by the Sarbanes-Oxley Act. The act made it mandatory that the CEO and CFO sign the entity's annual financial statements and assume full personal accountability for their figures and contents.

Indeed, no better example of the Sarbanes-Oxley impact can be found than the financial reporting on the aftereffects of the 2007 crisis in the subprime mortgage market, which created a torrent of red ink and brought many of the world's bigger banks against the wall. This was a crisis created single-handedly by the banking industry, rather than being due to an external event like sovereign bankruptcies in emerging markets.

Back in 2002, many persons suggested that compliance with SOX would be a costly enterprise, although few openly expressed the opinion that business pressure would eventually be instrumental in changing some of the Sarbanes-Oxley provisions. Yet this is exactly what happened in mid-2007, under fire from lawmakers and business groups, who blamed the Sarbanes-Oxley Act for driving the costs of compliance higher and pushing firms to relocate to less-regulated markets overseas.

In May 2007, the Securities and Exchange Commission announced new guidelines along with a revised auditing standard from the Public Company Accounting Oversight Board (PCAOB). These guidelines and standards have aimed at ending more than a year of debate over whether the law's costs outweigh its benefits.

The Sarbanes-Oxley Act not only improved the reliability of financial reporting, but also made it much harder for firms to get private securities fraud claims thrown out of the bankruptcy courts, as used to happen routinely. External auditors are now required to provide opinions on the effectiveness of internal control in a company's financial statement, and had better get more efficient in internal control assessment by employing individuals with a wide range of experience, helping the client company to identify key exposures in the armory of internal controls.

To deal with potential management malfeasance, there is no alternative to critically reviewing the control environment, including organizational and governance issues; human resources; monitoring procedures; and more-covering not only financial, but also operational matters such as authorization procedures and segregation of duties, internal auditing information practices, and information technology policies able to assist management in decision making and in internal control.