Can the Sarbanes Oxley Act remedy deficiencies in financial regulations


In the recent past the accounting profession has undergone a radical transformation stamping from the Worldcom and Enron Scandals which led to the collapse of the largest accounting firm. The USA formulated the Sarbanes Oxley Act to pre-empt further problems. Review the financial regulation issues posed by the Worldcom and Enron scandals and discuss the extent to which the Sarbanes Oxley Act remedies any deficiencies in the financial regulations and will avoid or not avoid future problems.


Recent corporate collapses of Enron, HIH, World Com, One Tel and others on the international arena has focused attention on company failures and the role that strong corporate governance needs to play to prevent them. The corporate collapses demonstrate a need for corporate governance reform. This has seen increasing production of voluntary or mandatory corporate governance codes and policy documents such as the OECD Principles of Corporate Governance, Sarbanes-Oxley Act, and Corporate Law Economic Reform Program Number 9 (CLERP 9).

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Concerns about the impact of enterprises on society are a global one. The expectations of consumers, employees, investors, business partners and local communities as to the role of businesses in society are increasing. Guidelines, principles and codes of conduct are being developed for corporate conduct. Government's, Non Government Organizations (NGO's) and local communities are demanding increased transparency and accountability, not only in the enterprises' daily business operations but also with regard to how those operations affect society (United Nations, 2004).

Furthermore essential that the regulatory framework for corporate governance is strengthened so that organizations are able to demonstrate transparency, responsibility and accountability beyond the area of financial performance. With the corporate collapses corporate governance is becoming a key policy issue now.

"Corporate governance has become one of the most commonly used terms in the current local and international business language. It is a term now universally invoked wherever business and finance are discussed. This raises the question, "is corporate governance a vital component of successful business or is it simply another fad that will fade away over time" (Solomon, 2004).

Good corporate governance contributes to growth and financial stability of entities by strengthening market confidence, financial market integrity and economic efficiency. Bad governance practices revealed by the recent corporate scandals have focused the minds of governments, regulators, companies, investors and the general public on weaknesses in corporate governance systems and the need to address this issue. This view is consistent with Kirkpatrick (2009), who concludes that "financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements which did not serve their purpose to safeguard against excessive risk taking". Accounting standards and regulatory requirements have also proved insufficient in some areas.

The meltdown of Enron and WorldCom has sent disbelief throughout the international business community. The Accounting profession came under the spotlight and saw the downfall of Arthur Andersen and placed uncertainty on the effectiveness of existing accounting, auditing and corporate governance practices.

This paper highlights auditor's misstatement detection and reporting process. What appears from a re-evaluating of these collapse cases is that the failure point in the misstatement detection and reporting process differs among these cases, signifying the need for various ways to improve the process

The enactment of Sarbanes Oxley Act in 2002 covering corporate governance and disclosure reporting was because of the reasons underpinning Enron's collapse. (CPA108, 2009)

"The Sarbanes-Oxley Act, passed largely as a result of the Enron failure, attempts to improve the audit process for public companies in the US. The relationship of the act's provisions to the misstatement detection and reporting process, and their potential efficacy in preventing cases similar to the recent frauds are addressed' (Cullinan. C, 2002)


Enron was a Houston-based energy company which was created in 1985 after the merger of two US based gas pipeline companies. Over the period of 16 years the company was transformed from a comparatively small concern, involved in gas pipelines, and oil and gas exploration, to the world's largest energy trading company (The Economist, 28 November 2002).

The deregulation of the American energy market saw Enron creating a market of natural gas allowing energy providers to become more competitive and allowed producers and buyers to trade and hedge gas supplies. New merchants came in to the market and competition increased. The free market trading saw the price of gas becoming unstable. The fluctuations of prices saw Enron taking the opportunity to make more money.

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Enron operated as a broker that conducted business of electricity, gas and other commodities such as packaged high-speed Internet capacity. The company produced a huge, over the counter market for contract priced against diverse energy products. "Enron entered into a contract with the sellers and signed a contract with the buyer, earning operating profits on the margin between the selling and buying prices. Therefore, Enron acted much like a bank would in dealing with it customers in the foreign exchange or money markets, except that the company tended to operate in markets involving more exotic commodities such as weather derivatives" (CPA108, 2009).

In the eyes of investors Enron was seen as a company with secured reputation for exceeding earnings prospect. "The stock price performance of Enron indicated that investors were pleased with the ever-increasing operating profits that the company was reporting. Its share price rose from $20 at the start of 1998 to a peak of $90 in September 2000" (CPA108, 2009).

During this time it is possible that Enron embark on to utilize complicated accounting method to keep its share price soaring, increased investment aligned with its own assets and stock and retained the thought of a highly thriving company.

On the other hand, the company's share price commence to decline from late 2000 onwards as the market became increasingly disturbed about the quality of Enron's reported earning's the impact of volatile energy markets on Enron's operating profitability, and sudden resignations of key staff (CPA108, 2009).

"As Enron's share price began to fall, its capacity to hide its losses began to diminish. In October 2001, Enron disclosed non-recurring charges of US$1.1billion, a reduction in shareholders' equity of US$1.2billion and a US$700 million loss, thereby revealing to the markets the significance of these shadowy SPE (Special Purpose Entities) companies. Six weeks later, Enron which had US$62 billion in assets, filed for bankruptcy" (CPA107, 2009).

"Enron's bankruptcy was remarkable not only for the sheer magnitude and extent of the disaster, but also because it hit such a model corporation, one which had adopted all of the management norms in vogue at the time; the creation of shareholder value, permanent re-engineering, e-business, derivations trading, and so on" (Aglietta, Reberioux , 2005).

Some of the Accounting methods use by Enron to misunderstand the financial statements was complex combination of many complicated strategy.

One of the strategies that were used by Enron was creation of Special Purpose Entities (SPE's). This SPE's was used by Enron to conceal debts, so that company would look more profitable in the eyes of shareholders.

"Enron's inordinate growth was due less to its choice of investments than to its policy of covering up the inevitable losses inherent in this type of activity. Its policy essentially consisted of transferring the most devalued assets, a priori unmarketable, to companies which appeared at first glance to be autonomous, but which were in fact controlled by Enron" (Aglietta, Reberioux , 2005).

Most of SPE's that was used by Enron was not consolidated in the Enron's group's accounts as a result misleads the shareholders of the full scope of the Enron group's liabilities and associated financial risk profile. Consequently applying of off balance sheet accounting led Enron to undervalued its debts and dispose of troublesome assets that were falling in value. Like many other companies Enron make the most of SPE's to access capital or hedge risk.

One of the examples stated by Aglietta, Reberioux (2005) is that of an assets valued at $33 million was sold to an SPE for $100 million, in this transaction Enron made a profit of $67 million. It was a classic example of Enron's practices, making a fictitious capital gain by passing off depreciated assets onto affiliates at arbitrarily fixed prices.

According to Thomas (2002) Enron used SPE's such as limited partnership with outside parties, a company is permitted to increase leverage and Return on Assets (ROA) without having to report this in its financials. The entity provides hard assets and associated debt to an SPE in exchange of interest. The SPE then borrows large sums of money from financial institution to obtain assets or perform other business without the debt or assets appearance on the company's financial statement. The company can sell leveraged assets to SPE and make a profit.

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Another strategy that Enron make use of marked to market principle that is when value of assets increased Enron increased its assets value in its balance sheet but on the other hand when value of this assets decreases Enron did not adjust this asset to current/ lower values. Enron took the opportunity to revalue all of its assets, the management used marked-to-market in order to increase the values.

As stated by Thomas (2002) Enron incorporated 'mark-to-market accounting" for the energy trading business in the mid 1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market whenever companies have outstanding energy-related or other derivative contract oh their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of that period.

Enron's weak internal control was another contributing factor that led to its collapse. Textbooks and Media reports also states that Arthur Anderson being the external auditors was also involved in internal audit works and this is in breach of Auditing policy.

"Enron also turned over to Arthur Anderson some responsibility for its internal bookkeeping, "blurring a fundamental division of responsibility that companies employ to assure the honesty and completeness of their financial figures" (Schwartz, Stephens 2006).

"Enron's board 'waived the company's conflict of interest policy to allow its CFO to invest in the corporation's special purpose entities, then failed to follow up to ensure the mandated compensating controls were being adhered to. This shows just how weak Enron's internal control system was. Enron's managers failed to identify the major risk facing their operating areas and develop control practices and procedures for employees to follow" (Locatelli, 2002).

Another issue was of conflict of interest between Enron and Arthur Anderson whereby both of them did not maintain arm's length transaction. Arthur Anderson was seen as a client pleasure and this was one of the reasons for his unwillingness to stand up to Enron management regarding accounting issues. Anderson was involved with Enron's external audits, internal audits and provided other consultancy services. From this other services provided to Enron's, Arthur Anderson was getting more revenue than just doing external audits.

" Arthur Levitt, one of the profession's leading critics, anf former head of the SEC claims that ' conflict of interest inevitably occurs when a company pays an accounting firm consulting fees that far outweigh the audit fee" (Boyd, 2004).


WorldCom was second biggest telecommunication company in USA. The corporation was founded in 1995 after it was renamed from Long Distance Discount Service to WorldCom.

"The rise of WorldCom was not through honest measures and on July 21, 2002, the company filed the biggest bankruptcy in the history of The United states at that time. The bankruptcy was a result of one the greatest corporate fraud scandals ever where the company's assets were inflated by the implausible sum of $11 billion" (Dedering,, 2009)

"Even though WorldCom's bankruptcy surpassed Enron's in scale, the latter remains symbolic of how adrift capitalism had become at the end of the twentieth century. It would be mistaken to see nothing but the hand of corrupt company executives at work in these spectacular bankruptcy" (Aglietta, Reberioux , 2005).

WorldCom was on the verge to create a merger with Sprint which would have seen share price increased. If the merger had been successful this would have made WorldCom the leading communication company in the market. The merger was unsuccessful and later saw the communication industry suffered through falling market and stock price thus led to downfall of WorldCom.

WorldCom provided loans to its staff which led Securities and Exchange Commission (SEC) to demand information from WorldCom about its accounting procedures and about the loan transaction that transpired with its staff. The SEC investigation exposed that WorldCom had lent money to its CEO to cover him loans that he took to purchase its own shares in WorldCom. This led SEC to filed charges against WorldCom for securities fraud.

"It alleged that WorldCom's top management "disguised its true operating performance' and "misled investors about its reported earnings" (Sirdhar, 2002).

An Internal Audit had found that company's financials did not follow accounting principles and thus led to overstatement of its income and profit. The company conceal its expenditure, by applying simple tricks in it balance sheet to increase revenue and profits. WorldCom was classifying expenses associate with investment as capital assets. WorldCom was able to conceal day to day expense and showed them as profit (Sirdhar, 2002).

The investors and shareholders thought WorldCom was doing well but instead the earning of the company was declining. The accounting methods used by WorldCom to portray that it was profitable was through reclassifying expenses as investments and thus underestimating its expenditure, showing false profitability to investors and to keep up the share price in the market.

"Financial experts have pointed out that WorldCom's accounting practices, particularly those relating to the gauge the performance of the company. Revisions in financial statements were thus the norm in WorldCom. While profitability was overstated, investors were misled by the opaque nature of its regular operating performance" (Sirdhar, 2002).

Arthur Andersen

Arthur Andersen's dismissal deficiency in the Enron case mostly involved an unwillingness to stand up to Enron management regarding accounting issues.

Sarbanes-Oxley Act (SOX)

The Sarbanes-Oxley Act (SOX) passed largely as a result of the corporate and accounting failure, attempts to improve the audit process for public companies in the US and to restore investors confidence. The relationship of the act's provisions to the misstatement detection and reporting process, and their possible effectiveness in avoiding cases similar to the recent frauds are addressed.

"The Sarbanes-Oxley Act tries to address the weakness in four different areas:

Define the suitable relationship between independent auditors and the company being audited.

Specifying appropriate corporate governance practices and inappropriate corporate activities.

Decide the right regulation with respect to corporate fraud and accountability.

Establishing requirements that companies implement and document internal control systems to help ensure that integrity of financial information being reported to the public. (Schwartz, Stephens 2006).

The SOX established the Public Company Accounting Board (PCAOB), which composed of minority of audit professionals and under direct supervision of SEC.

To remedy the increased number of conflict of interest, from now on audit firms are forbidden from providing appraisal, consulting, and creation and operating of financial data processing system to the firms they are auditing (Aglietta, Reberioux, 2005).

The major contributor to the major corporate scandals was due to lack of auditor independence. Section 201 of SOX addresses this matter which limits possible auditors conflict through measure aimed to develop auditor independence. This aims to restrict auditors of public firms from providing non-audit consulting services to their clients. Tax services could be provided to the audit clients upon seeking approval from the audit committee in advance.

"SOX continued its major reforms by focusing on another key factor affecting auditor independence with the adoption of Section 203. This mandates the rotation of audit partners in charge of audit clients. Lead audit partners and audit partners who are responsible for review of the audit must be rotated off after five years" (, 2007).

SOX also address the issue of corporate governance by requiring specific actions that need to be taken by the company and certain activities that the company are banned from doing.

Section 301 requires that company have an audit committee and that each member of the audit committed be an independent member of the board of directors. SOX does not require that member of audit committee to be a financial expert but companies must disclose whether at least one member of audit committed is a financial expert (Schwartz, Stephens 2006).

Having a financial expert may help bring management and auditor on the same level of understanding as well as create transparency to disclose all the financial issue for all the stakeholders of the company.

"Other corporate governance provisions of SOX require that the CEO and the CFO certify the financial statements; require that a corporate code of ethics be in place for top management; expand required disclosures about transactions involving the company and principle stockholders, directors, or officer; and prohibit the purchase and sale of stock by officers, directors, and other insiders during the blackout periods" (Schwartz, Stephens 2006).

SOX also deal with corporate fraud and accountability and white collar crimes and also imposes criminal penalties.

"In it role of independently auditing a company's financial results; a public accounting firm is expected to function without conflict of interest or influence from any interested parties within the company. Such influence would compromise the independence of the auditor's report. To protect the outside auditor's independence, SOX makes it unlawful for any other officer or director, or other acting under their direction, to fraudulently influence, coerce, manipulate, or mislead and independent auditor engaged in auditing the company's financials (Colley J. L., 2005).

SOX through whistleblower policy also provide protection for employees who provide evidence of fraud. SOX require company to put into practice whistleblower policy for employees to have an opportunity for confidential and to remain anonymous.

"SOX section 404, which covers management assessment of internal control, has probably received the most negative publicity, due to the additional compliance cost it implies (Schwartz, Stephens 2006).

"SOX contains a rule that requires companies to disclose to the public "on a rapid and current basis" and in plain English", important changes in the financial condition or operations of the company with the purpose of protecting investors" (Colley J. L., 2005).

Since implementation of SOX the annual cost of being a public company has doubled. The majority fraction of the increased cost was related to insurance for directors and officers. As a result there have been reports that companies that have de-listed their securities or have delayed their offering of share to public. Companies listed on SEC can keep away from rules imposed by SOX by going private (Schwartz, Stephens 2006).

Benefits of SOX

Even though the cost of compliance with SOX has increased and resulted to become public company expensive, this may deter smaller companies from going public and may possibly have some effect on companies decide to withdraw from the public markets. The entrepreneurs need to know the SOX provisions to which private firms are subject, as well as the benefits of voluntary compliance with SOX (Schwartz, Stephens 2006).

SOX regulations have impact on public or private companies SOX has provisions that deals with criminal liability for destructions document and revenge against whistleblowers, penalties for white-collar crime and securities fraud.

Investors and shareholders may see SOX compliances as a way forward for excellent practice as this may improve corporate governance issue for all companies and this may restore confidence in the companies. It would be difficult for companies to sell shares and getting loans if they are not SOX compliant.

"Currently, a private company can selectively apply some SOX provision, such as those covering its relationship with auditors, corporate governance, and financial reporting. As long as compliance is voluntary, non-publicly traded companies can weight the cost versus the benefits of SOX compliance, and pick and choose which SOX provisions to implement" (Schwartz, Stephens 2006).

With compliances with SOX the companies with provide enhanced financial disclosures which will provide more information to shareholders.

The CEO and CFO will have to certify the financial reporting of the companies and this will ensure personal accountability. This will lead to confidence in corporate responsibility and financial reporting.

SOX has improved transparency and reduced risk on corporate fraudulent practice by increasing penalties which will deter companies personal from involving in dishonest acts and misinforming public about its financial statements.

Implementation of SOX has seen companies performing risk assessments and documentation of internal control and continuous testing of controls to see that they are operating smoothly as expected. "One of the most important best practices to come out of SOX documentation is the performance of a risk assessment. The purpose of a risk assessment is to identify the major risks facing organization and to rank those risks in terms of likelihood of occurrence and impact to the organization" (Jeffrey, Lourens, 2008).

Disclosure of Conflict of interest

Will Sarbanes-Oxley Act prevent future corporate collapses

The introduction of Sarbanes Oxley Act has revolutionize the conduct of doing business as there is enhanced public assessment of all the corporate governance activities and the financial result of the public companies. This has saw more focus been put on corporate ethics and governance and improved understanding of internal control issues.

SOX attempts to deal with the issue of auditor independence and conflict of interest of auditors by restraining external auditors to provide other consultancy service to their clients which are publicly listed companies.

SOX require companies to develop a code of conduct that should be followed by management. One of the local publicly listed companies in Fiji has developed code of ethics for its directors.

"The requiring of a code of ethics is designed to strengthen investor's confidence in financial reporting and nothing else. A code of ethics would not have prevented Enron from doing anything they did, because of the cohesion between Enron's CEO and CFO. A code of ethics will not ensure that the CFO or controller is going to behave ethically. A code of ethics can function effectively only to the extent that management desires" (Eichar, 2002)

SOX would help in preventing the off balance sheet entities used by Enron to manipulate earnings and to hide it debt as it will require more disclosure of off balance entities. This disclosure will provide more information to company's stakeholders.

"SOX further require the external auditor's certification of management's review. Will this measure be effective in preventing financial statement frauds in the future? As a forensic accountant and fraud examiner, I am not convinced it will have little or no effect" (Hurley, 2005).

According to Jamal.K (2006) so far there are no cases highlighted by external auditors as major fraud. He states that financial statement auditing, as currently practiced, is rather ineffective at detecting fraud. Standardization of audit rules and risk based auditing furthermore creates auditing ineffective in detecting fraud.

The issue of mark -to-market was not address by SOX, which allowed Enron to estimate the future market value of its contract and this led to Enron to inflate its profits and share price. This issue was seen in US in recent financial crisis regarding asset bubble in which there was over valuation of asset price that mortgage by banks.

The internal control requirement of Sarbanes Oxley Act was not effective in preventing the recent financial crisis that started from USA. This was the issue of subprime mortgage. If there was good internal control structure at banking and mortgage companies, it would have required that information provided by loan applicants to be verified and ascertained that applicant could repay the loan amounts. Moreover, a proper internal control system would have make certain that this financial institutions and investment banks would have done due diligence and transparency checks before buying mortgage as investment securities.


The paper concludes that generally the audit-related provisions of the Sarbanes-Oxley Act are aimed towards strengthening of auditor independence. Since the other areas of the audit model have been blamed for various frauds, the Act may be treating the indicator of the audit collapse which emerges to have caused the Enron failure.