The Sarbanes-Oxley Act: main provisions and implications
BRANISLAV BERNADIČ
Vysoká škola manažmentu, Panónska 17, Bratislava
Abstract:
Adoption of the Sarbanes-Oxley Act in 2002 has been the most important and the most complex reform of the
corporate sector since the 1930s. The massive corporate frauds at the beginning of 2000s not only significantly
harmed the American and global stock markets, and destroyed the investments and pension savings of thousands
of employees and investors, but essentially attacked the fundamentals of corporate capitalism.
In the majority of the cases, the executives of the mentioned companies heavily engaged in restatement of
financial records, covering up losses and expenses, insider trading and destruction of evidence.
Adoption of the new regulatory legislation, particularly the Sarbanes-Oxley Act and Credit Rating Agency
Reform Act has certainly improved and updated control mechanisms in public capital markets. However, its
implementation and ability of the new system to adjust to a rapidly changing business environment seems to be
equally important.
Experience proves that weak implementation and inconsistency were the main drawbacks of the financial
regulation in the pre-Enron era.
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Key words: Sarbanes-Oxley Act, financial regulation, capital markets, financial reporting
1 Introduction
The purpose of this paper is to briefly introduce fundamental provisions of the Public Company Accounting
Reform and Investor Protection Act of 2002 (also known as Sarbanes-Oxley Act – abbreviated SOX).
Adoption of the Sarbanes-Oxley Act in 2002 has been the most important and the most complex reform of
the corporate sector since the 1930s. Similarly as nowadays, a crucial problem then (after the Wall Street crash in
1929) had been accuracy of information offered to investors and the weakened integrity of financial markets.
The response consisted of two acts, the 1933 Securities Act and the 1934 Securities Exchange Act, which set up
the Securities and Exchange Commission and obliged public corporations to disclose financial information
verified by independent auditors. The Glass-Steagall Act, adopted in 1933, formally separated investment and
commercial banking activities of American banks.
However, some other decades (mainly the 1980s and 1990s) had witnessed strong deregulation, which had
been believed as a necessary step toward greater economic growth, which in the end was the case. These
deregulation tendencies culminated in the revocation of the Glass-Steagall Act in 1999.
The Sarbanes-Oxley Act came into existence in difficult times, in which the American economy as well as
the whole society had to face several extraordinary challenges, which in the end substantially influenced the
strength and width of the new legislation.
The massive economic growth of the 1990s ended with a rapid decline in stock markets, mainly influenced
by the burst of the dot-com bubble, and the transition into an economic slowdown.
The September 11, 2001 terrorist attacks in New York City and Washington D.C., as well as the subsequent
security uncertainty and the prospects of war in the Middle East region contributed to the slowdown. However,
the series of corporate scandals had the most devastating impact on the American and global economy, and soon
after the first affairs erupted, it became clear that the recovery would be difficult.
These tremendous corporate frauds not only significantly harmed the American and global stock markets,
and destroyed the investments and pension savings of thousands of employees and investors, but essentially
attacked the fundamentals of corporate capitalism.
Everything had begun with the fall of energy giant Enron in December 2001, followed by
telecommunications leader WorldCom in 2002 and other corporations - one of the „Big Five“ global accounting
firms Arthur Andersen, Adelphia Communications, ImClone Systems and some others.
In the majority of the cases, the executives of the mentioned companies heavily engaged in restatement of
financial records, covering up losses and expenses, insider trading and destruction of evidence.
These corporate scandals, particularly the Enron collapse, were the immediate impulse for the legislative
response.
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2 Public Company Accounting Reform and Investor Protection Act
Public Company Accounting Reform and Investor Protection Act was sponsored by Senator Paul Sarbanes
and Congressman Mike Oxley and signed into law by President George W. Bush on July 30, 2002.
The law consists of 11 titles:
I - PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
II – AUDITOR INDEPENDENCE
III – CORPORATE RESPONSIBILITY
IV- ENHANCED FINANCIAL DISCLOSURES
V – ANALYST CONFLICTS OF INTEREST
VI – COMMISSION RESOURCES AND AUTHORITY
VII – STUDIES AND REPORTS
VIII – CORPORATE AND CRIMINAL FRAUD ACCOUNTABILITY
IX – WHITE-COLLAR CRIME PENALTY ENHANCEMENTS
X – CORPORATE TAX RETURNS
XI – CORPORATE FRAUD ACCOUNTABILITY
2.1
Public company accounting oversight board
Sections under this title establish the Public Company Accounting Oversight Board (PCAOB) as an
independent non-profit corporation in order to oversee the audit of public companies that are subject to the
securities laws.
The main duties of the board are to register public accounting firms preparing audit reports for public
corporations, establish auditing, quality control and other standards related to the preparation of audit reports,
conduct inspections of registered accounting firms, enforce compliance with the Sarbanes-Oxley Act, rules of
the PCAOB and the securities laws governing preparation and issuance of audit reports.
2.2
Auditor independence
Section 201 amends the Securities Act of 1934 and lists non-audit services that are considered unlawful for
registered public accounting firms and any associated person of that firm to perform for the same company for
which they prepare an audit report. These activities include bookkeeping or other performance related to the
accounting records or financial statements, designing and implementation of financial information systems,
internal audit outsourcing services, management or human resources functions, investment advising or
investment banking services as well as all legal and expert services unrelated to the audit.
Section 203 amends the Securities Act of 1934 and makes it unlawful for public accounting firms to provide
audit services for any subject for more then 5 consecutive fiscal years.
Section 204 amends the Securities Act of 1934 and requires all registered public accounting firms to report
all critical accounting practices and policies used as well as all alternative treatments of financial information
within GAAP that have been discussed with officials of audited company and other documents regarding written
communication between the auditor and management of the audited company.
Section 206 amends the Securities Act of 1934 and covers conflicts of interest.
2.3
Corporate responsibility
Section 301 amends the Securities Act of 1934. According to this section, the Securities and Exchange
Commission must direct the national securities exchanges and national securities associations to stop the listing
of any security of a corporation that is not in compliance with the provisions of this title.
Other sections of this title prohibit insider trades during pension fund blackout periods and provide rules of
professional responsibility for attorneys.
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2.4
Enhanced financial disclosures
Section 402 enhances conflict of interest provisions and, in general, makes it unlawful for any public
corporation directly or indirectly to extend or maintain credit to any director or executive officer of the particular
corporation.
Section 404 addressing management assessment of internal controls is expressly the most discussed and
criticized part of the bill. The section requires every public corporation to add an internal control report to its
annual report, which should state the responsibility of management for establishing and maintaining an adequate
internal control structure and procedures for financial reporting as well as effectiveness of the internal control
and reporting procedures. Additionally, the assessment made by the management of a company should be
attested by the company’s auditors.
2.5
Analyst conflicts of interest and corporate and criminal fraud accountability
Section 501 addresses the treatment of securities analysts by securities exchanges and registered securities
associations.
Title VIII - Corporate and Criminal Fraud Accountability Act amends the United States Code. The main
provision addresses destruction, alteration or falsification of records in a bankruptcy or Federal investigation.
Auditors of public corporations are required to maintain all audit or review work papers for a period of five
years.
Section 806 enhances whistleblower protection for employees of public corporations who provide evidence
of fraud.
2.6
White-collar crime penalty enhancements and corporate fraud accountability
This part of the law amends the United States Code and significantly increases the white-collar crime
penalties. For example, maximal penalties for mail and wire frauds have been increased from 5 to 20 years.
Title XI - Corporate Fraud Accountability Act of 2002 establishes a sentence in prison up to 20 years for
whoever corruptly alters, destroys or conceals a record, document or other object or attempts to do so with
intention to impair an official proceeding; or otherwise obstructs, influences or impedes any official proceeding
or attempts to do so.
3 The SOX associated costs
The costs of compliance with the SOX provisions have been the main source of its criticism – especially in
the first years of the legislation.
According to the fifth annual study conducted by Foley & Lardner, LLP in 2007 the average annual cost for
companies with annual revenues less than $1 billion was $2.8 million, an increase of more than $1.7 million
since 2002, which represents a 171 percent overall increase in compliance costs between fiscal years 2001 and
2006. (Hartman, 2007)
American Electronics Association estimates in 2006 showed that US companies were spending an aggregate of
$35 billion just on compliance with 404 Section of the Act.
Another study published in The Economist, reported the overall cost of the compliance in fiscal year 2004-05 to
be $1.4-trillion, AMR Research reported spending roughly $6 billion a year in 2005 and 2006, another study
showed average costs per company $2.9 million in 2006, $3.8 million in 2005 and $4.5 million in
2004.(Bradford, Brazel, 2007)
Even though the numbers of various reports may vary, thanks mainly to the different methodologies, one thing is
for sure: the costs of compliance with SOX have been much higher than initially predicted by SEC and the
government.
Even though first estimates were that the costs would significantly go down after gaining experience with new
requirements, so for example less audit hours would be needed to get the same work done, statistics have
repeatedly proved that this was not always the case (for example in the case of external audit costs).
Hiring and retaining qualified directors and executives became also more costly after the SOX, as they
became more involved in the financial reporting and control processes so they ask for additional compensation
and moreover many of them demand Directors' and Officers' insurance in order to increase their legal
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protection. This of course have pushed prices of the insurance policies up, which just adds to the higher costs
related to deployment of corporate directors.
4 The SOX: Impact on the U.S. Capital Markets
Another main source of the SOX criticism was its impact on the U.S. capital markets. The main argument
was that there had been less IPOs happening in the U.S. capital markets and there had been the trend with public
companies going private.
In their study, Engel, Hayes and Wang examined a sample of all going private companies from 1998 to 2004
and found that frequency of going private decisions modestly increased after the passage of SOX and they
conclude that empirical evidence supports conclusion that SOX affected going- private decisions. (Engel, Hayes,
Wang, 2004)
Another study found that between 1998 and 2004, 920 firms deregistered securities with the SEC and 450
of the deregistrations occured in 2003 and 2004. ( Bradford, Brazel, 2007)
According to the survey conducted by Foley & Lardner, 25 percent of the responding public companies
reported they were considering going-private transactions and approximately 15 percent considered sale of the
firm or a merger with another firm. (Broude, 2007)
According to Mallory Factor of Free Enterprise Fund, in 2002 nine of the 10 largest IPOs in the world
involved the U.S. capital markets, while in 2005 nine of the 10 largest IPOs avoided the U.S. capital markets. In
2005, 23 of 24 firms that raised over $1 billion did not register with the U.S. securities exchanges, 129
companies listed with the London Stock Exchange, six listed on the NYSE and 14 on Nasdaq.
One of the surveys studing new listings discovered that 90 percent of companies considering listing in the
U.S. said SOX made London more attractive. (Capitol Hill Hearing Testimony, 2006)
However, even though the statistics supported the critical voices, later development proved the explanation of
the reasons to be more complicated that just pointing the finger on SOX (considering factors like globalization
and liberalization, technological innovations and so on).
Closer investigation proved, that some of the trends which the critics tended to attribute to the SOX had
started before its adoption. According to the SEC report presented by its chairman Christopher Cox, the U.S.
market share for worldwide listings has been declining steadily since 1997, at the rate of about 2% a year and the
trend even includes the tech boom of the late 1990's. (Cox, 2007)
5 Challenges of Today’s Financial Reporting and Conclusions
The current economic environment, essentially determined by rapid technological and financial innovation,
creates new challenges for management and accountants.
Constantly growing number of trades in capital markets, wide availability of instant business and economic
information as well as difficult economic times increase sensitivity in capital markets and pressures on economic
performance, particularly short-term performance, which is one of the side effects of the fast nature of current
capital flows.
Thus beside other things, accounting practices and business structure strategies are increasingly employed in
management’s efforts to create value and support their short-term indicators.
One of the interesting trends generally observed in the last decades was that even though general business
information became more accessible, quality of financial reporting decreased.
Financial globalization and liberalization have also contributed to the problem, as firms operating globally
must often deal with different accounting and auditing standards, which in the end further complicates an already
intricate situation.
Adoption of the new regulatory legislation, particularly the Sarbanes-Oxley Act and Credit Rating Agency
Reform Act have certainly improved and updated control mechanisms in public capital markets. However, its
continuous implementation and ability of the new system to adjust to a rapidly changing business environment
seems to be equally important.
Experience proves that weak implementation and inconsistency were the main drawbacks of the control
system in the pre-Enron era. For example, the requirement that all public companies had to regularly present
their financial statements to the SEC was certainly right, the problem was that in 2001 the SEC reviewed only 17
percent of the received annual reports. As the Senate investigation found out more than half of all public
companies had not their annual reports reviewed by the SEC in the last three years before 2002. Enron’s
financial statements belonged to this group, even though in 1992 the SEC allowed Enron to use mark-to market
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accouting method, which enables companies to inflate their income, and thus there was a substantial reason to
monitor its financial reports more closely.
.
References
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2.
BERNADIC, B. Introduction to the public company accounting reform and investor protection act of
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BRADFORD M., BRAZEL J. 2007. Flirting with SOX 404, Strategic Finance. Montvale: Sep 2007.
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BRONSTAD, A. 2005. Corporate reform. Los Angeles Business Journal, July 4, 2005
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BROUDE P. U.S. FINANCIAL MARKETS STILL ATTRACTIVE DESPITE INCREASING
COMPLIANCE COSTS, New England In-House, 2007
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Employee morale is one factor driving SOX compliance automation. Corporate Board. 2005, vol. 26,
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7.
Engel E., HAYES R. M., WANG X.. 2004. The Sarbanes-Oxley Act and Firms' Going-Private
Decisions, May 6, 2004.
8.
EU finances: Businesses attack US listing requirements. Economist Intelligence Unit: Country
ViewsWire, Sept 16, 2002.
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FRANCIS, R. D. 2005. The corporations strike back. Christian Science Monitor. Boston, Mass.: Jun 6,
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11. HARTMAN E. THOMAS. 2007. How Much for SOX? Legal Times, November 2007, No. 47
12. HUME, L. 2005. SEC Lays Out Possible Regulatory Regime for Rating Agencies. Bond
Buyer. New York, N.Y.: Jun 24, 2005
13. O'CONNOR, M. C. 2005. Sarbanes-Oxley: Frying the Small Fry As third anniversary looms, many
small caps are turning private or going overseas. The Investment Dealers' Digest. New York: Jun 27,
2005
14. SMITH, K. A. 2005. Business gets put on Hold. Kiplinger's Personal Finance Magazine. July 2005.
15. SWARTZ, N. 2005. Executives praise SOX but seek changes; it's not quite a backlash, but after the first
full year of reporting under the Sarbanes-Oxley Act, many business leaders are seeking changes.
Information Management Journal. July-August 2005
16. TAHMINCIOGLU, E. 2005. Profiting From Cures for the Sarbanes-Oxley Blues,
http://www.nytimes.com, December 29, 2005
Other sources:
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COST OF COMPLIANCE WITH SARBANES- OXLEY FINANCIAL REGULATION ACT: Statement of
Mallory Factor Chairman, Free Enterprise Fund. CAPITOL HILL HEARING TESTIMONY. June 19, 2006
REMARKS TO U.S. CHAMBER OF COMMERCE'S FIRST ANNUAL CAPITAL MARKETS SUMMIT:
SECURING AMERICA'S COMPETITIVENESS BY CHAIRMAN CHRISTOPHER COX.
LOCATION: U.S. SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D.C. March 14, 2007
Kontakt:
Branislav Bernadič, M.B.A.
Vysoká škola manažmentu
Panónska 17
Bratislava
bbernadic@vsm.sk
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