Exploring the request for balance in the Sarbanes Oxley rules


The Sarbanes-Oxley Act, which is also known as Sarbox or SOX, was enacted on July 30, 2002 as a United States federal law. It set new standards for all U.S. public companies and public accounting firms. As a reaction to a few major corporate and accounting scandals, the Sarbanes-Oxley Act was carried out. The companies which fell in the accounting scandal included the Enron, Adelphia, Tyco international, Worldcom, peregrine Systems. The scandals of these once big and famous companies cost investors billions of dollars and shook public confidence in the nation's securities markets. Bumiller and Elisabeth(2002) in their news release stated that the act was approved by the House by a vote of 423-3 and by the Senate 99-0 and President George W. Bush signed it into law, stating it included "the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt." However, Is the Sarbanes-Oxley Act a perfect bill or does it also have its flaws?

2. Overview of Sarbanes-Oxley rules

why the Sarbanes-Oxley Act was introduced

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The Enron scandal deeply influenced the development of new regulations to improve the reliability of financial reporting, and increased public awareness about the importance of having accounting standards that show the financial reality of companies and the objectivity and independence of auditing firms (Ayala & Giancarlo, 2006). Farrell (2005) thought that a variety of complex factors created the conditions and culture in which a series of large corporate frauds occurred from 2000 to 2002 and the spectacular, highly-publicized frauds at Enron, WorldCom, and Tyco exposed significant problems with conflicts of interest and incentive compensation practices. So, he concluded that the analysis of their complex and contentious root causes contributed to the passage of SOX in 2002

the Sarbanes-Oxley-Act's contents.

The Sarbanes-Oxley Act contains 11 titles that describe specific mandates and requirements for financial reporting. Each title consists of several sections, summarized below.

Public Company Accounting Oversight Board: Title I consists of nine sections and establishes the Public Company Accounting Oversight Board, to provide independent oversight of public accounting firms providing audit services.

Auditor Independence: Title II consists of nine sections and establishes standards for external auditor independence, to limit conflicts of interest.

Corporate Responsibility: Title III consists of eight sections and mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports.

Enhanced Financial Disclosures: Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, pro-forma figures and stock transactions of corporate officers.

Analyst Conflicts of Interest: Title V consists of only one section, which includes measures designed to help restore investor confidence in the reporting of securities analysts.

Commission Resources and Authority: Title VI consists of four sections and defines practices to restore investor confidence in securities analysts.

Studies and Reports: Title VII consists of five sections and requires the Comptroller General and the SEC to perform various studies and report their findings.

Corporate and Criminal Fraud Accountability: Title VIII consists of seven sections and is also referred to as the "Corporate and Criminal Fraud Act of 2002".

White Collar Crime Penalty Enhancement: Title IX consists of six sections. This section is also called the "White Collar Crime Penalty Enhancement Act of 2002."

Corporate Tax Returns: Title X consists of one section. Section 1001 states that the Chief Executive Officer should sign the company tax return.

Corporate Fraud Accountability: Title XI consists of seven sections. Section 1101 recommends a name for this title as "Corporate Fraud Accountability Act of 2002".

3. Arguments for and against introducing the Sarbanes-Oxley Act

3.1 Identify and discuss the arguments against regulation

The impact on the smaller public companies

For smaller public companies, the cost of compliance has been higher than for large public companies, as a percentage of revenues. This is especially high because of the internal control reporting provisions in section 404 and related audit fees. The costs associated with complying with the act may be encouraging some smaller companies to become private. Though the companies going private were smaller than any estimation and only represented 2 percent of total public companies in 2004. We can see that the full impact of the act on smaller public companies remains unclear because the majority of smaller public companies have not fully implemented the section 404. Wilma(2008) think that through the data from SEC filings provided through a licensing agreement with audit analytics and analyzed data elements including auditing fees and auditor changers to determine costs of compliance, then we can analyze the impact on the smaller public companies. The author concluded in his report that the costs of complying the Sarbanes-Oxley Act play a important role in these companies' profits.

The impact on the smaller privately held companies

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For the smaller privately held companies, it becomes more difficult to go public considering the Sarbanes-Oxley Act. The foley(2007) study reports that the average cost of compliance for companies with under $1 billion in annual revenue has increased more than $1.7 million to approximately $2.8 million since the enactment of the Sarbanes-Oxley Act. This represents a 171 percent overall increase between fiscal years 2001 and 2006. From these data, we can conclude that going public becomes higher cost after the Sarbanes-Oxley Act was enacted. The costs of compliance with the Sarbanes-Oxley Act are really a huge number for the smaller privately held companies. The smaller privately held companies become reluctant to register on American stock exchanges. This can be easily understood when one considers the costs Sarbanes-Oxley imposes on businesses.

the low number of Initial Public Offerings in U.S.

The costs of complying with the Sarbanes-Oxley Act are resulting in a trend where companies choose to go public on foreign rather than in the American stock market. In 2005, a report by the London Stock Exchange cited that about 38 percent of the international companies surveyed said they had considered issuing securities in the United States. Of those, 90 percent said the onerous demands of the new Sarbanes-Oxley corporate governance law had made London listing more attractive. A research study published by Joseph Piotroski(2008) and Suraj Srinivasan(2008) titled "Regulation and Bonding: Sarbanes Oxley Act and the Flow of International Listings" found that following the act's passage, smaller international companies were more likely to list in stock exchanges in the U.K. rather than U.S. stock exchanges. There were no public offerings of Silicon Valley venture capital-backed companies in the second quarter of 2008, a phenomenon not seen since 1978. Sarbanes-Oxley has had a direct negative effect on venture capital.

the legal challenges

In the wall street journal of 2006, a lawsuit (Free Enterprise Fund v. Public Company Accounting Oversight Board) was filed challenging the legality of the PCAOB. The complaint argues that because the PCAOB has regulatory powers over the accounting industry, its officers should be appointed by the President, rather than the SEC. Further, because the law lacks a "severability clause," if part of the law is judged unconstitutional, so is the remainder. If the plaintiff prevails, the U.S. Congress may have to devise a different method of officer appointment.

3.2 Identify and discuss the arguments for regulation

Improve the investor confidence

The Sarbanes-Oxley Act definitely enhances the transparency of the public companies, as well as the trustworthiness of financial disclosures. The enactment of the Sarbanes-Oxley Act resulted in a huge number of restatements by a number of public companies, which was impossible before the Sarbanes-Oxley Act was signed into law. These facts tell the investors that the Sarbanes-Oxley Act have really made a difference. And the trust was restored in the stock market of U.S. The investors have the tender to believe that the scandals like what happened at Enron won't happen again with the regulation of the Sarbanes-Oxley Act.

More accurate, reliable financial statements

The reliability of financial reports is also enhanced by the fact that the Board of Directors and the management of a company, as well as the external auditors, are made responsible for their statements and their actions. In the Section 302 of the Act, it mandates a set of internal procedures designed to ensure accurate financial disclosure. The signing officers must certify that they are "responsible for establishing and maintaining internal controls" and "have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared."

Improve the internal control

The Sarbanes-Oxley Act requires the documentation of internal control processes. The documentation result in the reorganization of such processes in order to be more efficient. In the Section 404 of the Sarbanes-Oxley Act, it requires management and the external auditor to report on the adequacy of the company's internal control over financial reporting. The management is required to produce an "internal control report" as part of each annual Exchange Act report and the report must affirm "the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting." Though this is the most cost part for companies to implement the Sarbanes-Oxley Act, it really helps to improve the internal control of the public companies.

making audits more independent

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Before the Sarbanes-Oxley act, auditing firms, also known as the primary financial "watchdogs" for investors, were self-regulated. They also performed consulting work for the companies they audited. However, these kinds of consulting agreements were far more profitable than the auditing. This presented at least the appearance of a conflict of interest. For example, challenging the company's accounting approach might damage a client relationship, conceivably placing a significant consulting arrangement at risk, damaging the auditing firm's bottom line. So this definitely influences the independence of the external audits. With the enactment of the Sarbanes-Oxley act, the auditing firms are no longer self-regulated and the audit firms can't audit and consult the same company at the same time, which absolutely improves the independence of the auditing firms.

3.3 Four practical examples

"We need to make sure the emphasis is on substance and not form. We need to make sure that innocent mistakes are not criminal."Snow said in prepared remarks to New York University Center for Law and Business.

"Even though we all know there are ways that you could tweak (Sarbanes-Oxley) this way or that, the consequences of trying to amend it to deal with those issues this early in the process would have a political backlash that would be unfortunate and counterproductive." Snow said.

"I am surprised that the Sarbanes-Oxley Act, so rapidly developed and enacted, has functioned as well as it has...the act importantly reinforced the principle that shareholders own our corporations and that corporate managers should be working on behalf of shareholders to allocate business resources to their optimum use." Former Federal Reserve Chairman Alan Greenspan praised the Sarbanes-Oxley Act.

"For all of this, we can first thank Sarbanes-Oxley. Cooked up in the wake of accounting scandals earlier this decade, it has essentially killed the creation of new public companies in America, hamstrung the NYSE and Nasdaq, and cost U.S. industry more than $200 billion by some estimates." The editorial of the wall street journal concluded.

4. The description and justification of preferred theory of regulation

4.1 A detailed description of preferred theory of regulation

The preferred theory of regulation I choose is Sarbanes-Oxley Act Section 404, which is listed under Title IV of the act. It required issuers to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting. This statement shall also assess the effectiveness of such internal controls and procedures. The registered accounting firm shall, in the same report, attest to and report on the assessment on the effectiveness of the internal control structure and procedures for financial reporting. To be specific, the section 404 requires management to:

Assess both the design and operating effectiveness of selected internal controls related to significant accounts and relevant assertions, in the context of material misstatement risks;

Understand the flow of transactions, including IT aspects, sufficient enough to identify points at which a misstatement could arise;

Evaluate company-level (entity-level) controls, which correspond to the components of the COSO framework;

Perform a fraud risk assessment;

Evaluate controls designed to prevent or detect fraud, including management override of controls;

Evaluate controls over the period-end financial reporting process;

Scale the assessment based on the size and complexity of the company;

Rely on management's work based on factors such as competency, objectivity, and risk;

Conclude on the adequacy of internal control over financial reporting.

the justification of preferred theory of regulation

The section 404 of the Sarbanes-Oxley Act focuses on the assessment of internal control. There are some comments argue that the section 404 cost too much for the public companies to completing the assessment. This is true that it has a significant fixed cost to comply with the section 404, especially for the small companies. However, what's the most important in the stock market? People maybe still remembered how terrible it is that the stock market tumbled when the scandals of Enron were brought into the light of day. So the investor confidence is the most important in the stock market, which is also the foundation of the stock market. The section 404 plays a critical role in restoring the confidence of the investors after the scandals of Enron. It makes the financial disclosure of the public companies more accurate and reliable, which means the investors can trust the annual reports of public companies again. The section 404 also helps to improve the public companies' internal control, senior management engagement in financial reporting. To be concluded, the section 404 avoids more frauds in the reports of the public companies than any other regulations in the Sarbanes-Oxley Act and contributes most to restoring the confidence of the investors, so the section 404 is the preferred theory of the regulation.

5. Conclusion

In this case, we discussed about the costs and benefits of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act was considered as the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt. However, the Sarbanes-Oxley Act was also challenged by changes in the modern time. Some rules in the Sarbanes-Oxley Act went too far so that they blocked the development of the economy and crippled the venture capital business. Thus, some sections of Sarbanes-Oxley Act have been modified to adapt to the development of the society. In a word, the Sarbanes-Oxley Act has more benefits than costs and signing it into law is a right thing.