Question

Review the provisions of the Sarbanes-Oxley Act of 2002 to address the accounting scandals in the late 1990s and early 2000s (Enron, WorldCom, etc.)BELOW:

List the existing provisions in the Act do you believe (if any) are unnecessary or over-regulate the profession?

As a result of corporate accounting scandals, such as those at Enron and WorldCom, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX). The purpose of SOX is to restore trust in publicly traded corporations, their management, their financial statements, and their auditors. SOX enhances internal control and financial reporting requirements and establishes new regulatory requirements for publicly traded companies and their independent auditors. Publicly traded companies have spent millions of dollars upgrading their internal controls and accounting systems to comply with SOX regulations. As shown in Exhibit 1-10, SOX requires the company’s CEO and CFO to assume responsibility for their company’s financial statements and disclosures. The CEO and CFO must certify that the financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the company. Additionally, they must accept responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. The company must have its internal controls and financial reporting procedures assessed annually. Some Important Features of SOX SOX also requires audit committee members to be independent; that is, they may not receive any consulting or advisory fees from the company other than for their service on the board of directors. In addition, at least one of the members should be a financial expert. The audit committee oversees not only the internal audit function but also the company’s audit by independent CPAs. To ensure that CPA firms maintain independence from their client company, SOX does not allow CPA firms to provide certain nonaudit services (such as bookkeeping and financial information systems design) to companies during the same period of time in which they are providing audit services. If a company wants to obtain such services from a CPA firm, it must hire a different firm to do the nonaudit work. Tax services may be provided by the same CPA firm if pre-approved by the audit committee. The audit partner must rotate off the audit engagement every five years, and the audit firm must undergo quality reviews every one to three years. SOX also increases the penalties for white-collar crimes such as corporate fraud. These penalties include both monetary fines and substantial imprisonment. For example, knowingly destroying or creating documents to “impede, obstruct, or influence” any federal investigation can result in up to 20 years of imprisonment. SOX also contains a “clawback” provision in which previously paid CEO’s and CFO’s incentive-based compensation can be recovered if the financial statements were misstated due to misconduct. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further strengthens the clawback rules, such that firms must recover all incentive compensation paid to any current or former executive, in the three years preceding the restatement, if that compensation would not have been paid under the restated financial statements. In other words, executives will not be allowed to profit from misstated financial statements, even if the misstatement was not due to misconduct.

Answer 1

The Sarbanes-Oxley Act of 2002 (SOX) is an act passed by U.S. Congress in 2002 to protect investors from the possibility of fraudulent accounting activities by corporations. The SOX Act mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud. The SOX Act was created in response to accounting malpractice in the early 2000s, when public scandals such as Enron Corporation, Tyco International plc, and WorldCom shook investor confidence in financial statements and demanded an overhaul of regulatory standards.

The rules and enforcement policies outlined by the SOX Act amend or supplement existing legislation dealing with security regulations. The two key provisions of the Sarbanes-Oxley Act are Section 302 and Section 404.

Section 302 is a mandate that requires senior management to certify the accuracy of the reported financial statement. Section 404 is a requirement that management and auditors establish internal controls and reporting methods on the adequacy of those controls. Section 404 has very costly implications for publicly traded companies as it is expensive to establish and maintain the required internal controls.

In addition to the financial side of a business, such as the audits, accuracy and controls, the SOX Act also outlines requirements for information technology (IT) departments regarding electronic records. The SOX Act does not set forth a set of business practices in this regard but instead defines which company records need to be stored on file and for how long. It does not specify how a business should store its records, only that the IT department is responsible for storing them, according to standards outlined in the SOX Act.

SOX exists and is appropriate for this situation

precisely because it imposes baseline obligations with which

corporations are required to comply. Moreover, other regulations

regarding independent directors, expensing of stock options, etc. are

needed and are vital to keeping business interests in line with society’s.

However, business leaders and regulators will have an easier time

promoting a healthy marketplace if industry gets “ahead of the curve.” In

the end, business leaders must do just that by leading and implementing

broad mechanisms of self-regulation and monitoring. Most important,

the changes that need to be made are neither radical nor difficult.

Executives and regulators must adopt common-sense reforms. Through

proactive regulation, public officials should create and align

corporations’ incentives so that they can then find market solutions to

governance issues. Business leaders, regulators and citizens can work

together to create a climate of corporate integrity.

Business leaders should:

• Conduct independent audits of governance structures,

focusing on ethical conduct,

• Enact aggressive “clawback” provisions to keep CEOs

accountable,

• Empower boards of directors to properly serve shareholders’

interests,

• Recognize that “doing well” involves “doing good,” and

• Use independent professionals as ballast to corporate leaders.

Regulators should:

• Recognize and reduce the high compliance costs on small-

and mid-sized firms,

• Allow differently-situated firms to adopt different

compliance procedures,

• Provide amnesty to companies that disclose wrongdoing up

front, and

• Prosecute as a means toward an end, not as an end in itself.

Citizens and investors should:

• Demand good governance from the companies they invest in,

even when markets are doing well.

The most important thing to note about recent corporate scandals is

that they have continued unabated since the crisis in the early 2000s.

Enron was just the tip of the iceberg: there was much more fraud, and it

infected companies of all sizes in all industries. A sample of corporate

scandals for everything from insider trading to outright theft includes

ImClone (2001), Tyco (2002), WorldCom (2002), Adelphia (2002),

HealthSouth (2002), Qwest (2002), NYSE (2003), Parmalat (2003),

Marsh and McLennan (2004), AIG (2005), Krispy Kreme (2005), and

Fannie Mae (2006), to name a few.25 Wall Street did not escape

unscathed, with Merrill Lynch, J.P. Morgan, Citigroup, and many other

Wall Street brokerages all under investigation at some point for

everything from illegal trading to conflicts of interest.26 The mutual fund

scandals particularly brought small investor and middle class attention to

the dangers and costs of poor governance.27 Politicians and

governmental entities can no longer afford the appearance of being soft

on corporate excess, and corporations are likely to feel the sting of an

angry public as well.

Shareholder activism has even pressured those indirectly involved

in malfeasance. For example, J.P. Morgan reached a $1 billion

settlement with Enron after the energy giant sued the bank, saying that

J.P. Morgan contributed to the company’s spectacular bankruptcy.28 The

SEC separately charged the banks with being complicit in the fraud,

adding hundreds of millions more dollars to the disgorgements, fines.