The definition and importance of The Sarbanes Oxley Act

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The Sarbanes Oxley Act (SOX) was swiftly put into legislation during 2002 of the Bush administration after the collapse of large American companies such as Enron, WorldCom, and Tyco which rocked investor confidence significantly.  The goal of SOX was to restore and maintain investor confidence in the capital markets through accuracy of financial statements and increased corporate transparency.  SOX found several issues it wanted to correct mainly corporate accountability, reduction in misleading and fraudulent accounting, and auditor's independence.  Although still a relatively new legislation, SOX has the ability to resolve these issues, however, it must be noted that it will not completely dispose of them.

  An area of great concern when SOX followed was whether it would be able to solve the problem of misleading or fraudulent accounting practices.  The trouble with providing regulation in this area stems from the fact that accounting practices similar to legislation is in the comprehension of the individual.  Many companies were within accounting principles but were using them aggressively. 

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When an investor researches a company for potential investment, among other information gathered, much of their analysis stems from the financial statements and management's discussion and analysis as it indicates past performance, management performance, and future prospects of the company. With a large emphasis on the information presented in financial statements, one would expect that all material transactions that would affect the future of the company and its ability to continue operating at the same performance standards would be presented. Revenue would be recognized when realized and costs reported when incurred. Earnings and cash flow projections and performance are inherently important to analysts as many of the valuation techniques used in the industry to report on companies employ the use of these numbers. Prior to SOX, companies were utilizing earnings management techniques to manipulate the earnings numbers and their interpretation by users of financial statements (Ronen and Yaari, 25-38). Managers wanted to meet expectations consistently and smoothly each quarter instead of having periods of remarkable performance followed by disastrous quarters. Disclosures of possible obligations that would affect the financial structure of the company would be overlooked and kept off financial statements in order to maintain analyst expectations and covenants.

Sarbanes-Oxley addresses these issues of fraudulent accounting by requiring all material off-balance sheet items such as contingent obligations, leases, and potential claims against the company are reported within notes to the financial statements. Requiring company officers to certify financial statements with the potential to be criminally convicted if knowingly misstate statements decreases their use of aggressive accounting principles to the benefit of their needs. (Fuller, G. "Effectiveness"). It has provided stringent protocols for compliance and also monitors the compliance through independent audits. By indicating that all companies whether domestic or foreign must abide by these rules to be listed on an American stock exchange, the act increases the disclosures that must be reported to investors which may have been left out by previous foreign and domestic companies. Increasing transparency and reducing the ability to "hide" material facts off financial statements has effectively reduced the amount of misleading accounting practices.

Although SOX has been able to prevent fraudulent accounting, it does not eliminate subtle techniques that companies still engage in. Fund managers and financial advisors are facing massive layoffs in today's economy and are exposed to excessive pressure from higher management to perform beyond goals and expectations. Justification for finding shortcuts to boost sales or earnings, committing fraud and inflating numbers will still continue to within an organization despite claims of compliance and ethical reporting. Where SOX attempts to curtail these types of misstatements is within internal control procedures and corporate accountability.

 Corporate accountability involves the obligation the business has to its employees, customers, and shareholders to account for its activities.  It also includes the obligation to disclose these results in a transparent manner (businessdictionary.com).  Accountability and responsibility is a general and objective term, therefore, being able to define what needs to be in place for this to be achieved is then a difficult task as not all will agree.  Overall accountability and responsibility is mandated by a business's corporate governance.   Corporate governance in an ideal situation would not include any government protection but would come from the individuals who would incorporate best practices for their firms citing that individuals would be "scrupulous...never either to hurt or offend" (Epstein and Hanson, "Accountable").  Corporate governance defines the procedures and constraints imposed on corporate managers so that outside investors will receive the appropriate return on their invested funds (Epstein and Hanson, "Accountable").  What it attempts to do is keep management's needs and objectives in line with those of shareholders. At times those may not be the same as one is an owner and the other merely controls the company. Accountability comes from management taking full responsibility of the outcome of the business performance and trust in their statements of what to expect in the future. It expects managers to indicate internal operations are sound and effective.

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Sarbanes-Oxley addresses the issue of corporate accountability throughout each part of the Act. Before its implementation, the Securities Exchange Commission (SEC) was very lenient on corporate bodies. For instance, the Securities Act of 1933 prohibited false misrepresentation in the sale of securities and requires that the financial statement be accurate but it does not guarantee the reliability and relevance of these financial statements, and as such public companies were not accountable for omitting a very important disclosure in their books. The SOX Act aided in redefining and highlighting the responsibilities of all parties such as management, internal auditors, the audit committee and the external auditors in the preparation of a company's financial report.

For every financial statement issued by a public company, the CEO and CFO would have to certify that the financial statement reflected the true and fair value of the company, in a case that the top officials do not conform to what is stipulated in the act, they would have forfeit their bonuses or prison terms for fraud. With tying compensation to ethical behaviour and honest reporting rather than solely to performance, the Act establishes a direct link and best interest of directors to report fair and accurate financial statements. Among other rules, SOX explicitly indicates that director ignorance and destruction or alteration of pertinent documents will not be condoned. Increased penalties and statute of limitations allows the SEC to prosecute individuals for past unethical behaviour. Furthermore, this act has strengthened accountability because the CEO is now responsible for certifying the effectiveness of internal controls over financial reporting. By strengthening insider trading rules, it has required directors to be honest with shareholders on information about to come forward in regards to performance of the company. A director could no longer be spared penalties and criminal consequences for favourable public announcements followed by adverse stock trades or vice-versa.

Overall Sarbanes-Oxley now places the accountability on management to report the financial statements in a fair manner. No longer can the blame for inaccurate financial statements be shifted towards systems or auditors. Investor confidence should be increased as who is responsible and who provides certification of the presentation of statements is now more clearly defined with significant consequences for altered statements.

Due to Arthur Anderson and their role in both Enron and WorldCom's accounting practices, the Sarbanes-Oxley Act set out to provide legislation that auditors must follow and controls between firms and companies in their independence to be fair and objective.

During the 1990's politicians such as the US Congress and the SEC have raised questions about auditor's ability to remain independent of their audit clients. SEC in particular, became very concerned about the possible impairment of auditors independence as a consequence of providing non-audit services to their audit clients (i.e. bookkeeping, accounting services). They noticed that the auditors were working closely with their clients and were frequently engaged in the design and implementation of accounting information technology in effect auditing their own work (Porter et. al., 72-73) .

Independent auditors have a key role in protecting shareholder's interests and confidence in the capital markets. As professionals, shareholders hold expectations and trust within auditors providing significant implications for accuracy on reports. Not only is it important to assess whether the financial statements are within GAAP, it is important to ensure major value and risk elements are appropriately reflected within statements and notes to the financial statements (Walker, "Accounting"). Auditors must have an unbiased viewpoint and provide impartiality in performing professional services that investors can rely on (Arens et. al., 56). However, in reality, such independence may be difficult to achieve and easy to compromise.

The Sarbanes Oxley Act addresses the issue of auditor's independence by implementing the Public Company Accounting Oversight Board (PCAOB) and made it responsible for overseeing the audit of public company and public interest in the preparation of informative, accurate and independent audit reports. It allows the PCAOB to investigate audit firms, set professional standards, and enforce compliance with the Sarbanes-Oxley Act. Auditors of public companies must register with the PCAOB. It is unlikely that the provisions such as the establishment of the PCAOB will reduce the likelihood of audit failure. (Tackett, Wolf, and Claypool, 340-50) In the past, audit failure was a result of neglect from the auditor to apply auditing rules and techniques that already existed.

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Some provisions of SOX such as restrictions on auditor-client consulting and providing non-audit services are likely to make substantive reductions in the likelihood of major audit failure. As audits generally are not income drivers for firms, since they cannot rely on cross-selling services to the client, there is no possibility for bribes, promised revenues from other services, or threats of lost client services due to dissenting opinions on the financial statements. This releases the conflict of interest that could effectively come out of deepened relationships through multiple services. Rotation of lead audit partners not only lends a new view to the financial statements of a company, but it is expected that it would also deter any misrepresentation of financial statements as eventually others will be performing the audit and breaking up the control of information.

The establishment of the independent audit committee also breaks up any relationship that may exist between the audit firm and company as they appoint and compensate the auditor further preventing any financial bribes management may attempt to provide to the auditor for a favourable unqualified report. Auditors report to the firm's audit committee directly on several matters including (i) critical accounting policies and practices to be used in the audit (ii) any deviations from GAAP (iii) any written communication with management (Boyle and Grace-Webb, 1-16). This committee cannot have relations towards the issuer and must act as an impartial board. Audit committees require a financial expert to act on the committee to review and assess the acceptance of the auditor's report. By removing management from intervening with the auditor's report, more effective controls to limit any collusive actions between management and the audit firm.

Although SOX places responsibility of the audit in the hands of the audit committee, inherent in the appointment of the committee are people who are closely tied to the company even if not a shareholder or employee. With close association to those at senior management, bias will still exist within this committee (Tackett, Wolf, and Claypool, 340-50).

It is still too early to assess the impact that Sarbanes-Oxley will have on public corporations.  Sarbanes-Oxley defines the rules and consequences that must be adopted by individual corporations; however, it does not provide the steps to implement procedures to abide by these rules (Walker, "Accounting"). Time still needs to be given to companies to adopt practices to abide effectively to all rules. Many top executives have also asserted that no corporate governance system will be effective, no matter how stringent, unless communicated from the top down. (Epstein and Hanson, "Accountable")  Without this corporations and management will rationally continue to exploit loopholes and incentives.  Auditors who do not work ethically will still remain to report sound financial statements of companies, as seen in Lehman Brothers, however, it needs to be addressed that although all may not abide by these rules, it should inherently decrease the amount that would presumably act unethically.  Anomalies should not undermine the effectiveness SOX has had as a whole.  Several research papers have been published indicating the increased transparency in financial statements, conservative reporting, improved internal controls and cost benefits to complying with the Act (Arping and Sautner, "Effect"; Iliev, "Effect"; Reilly, C3; Benoit, 2). Overall, SOX is able to solve the issues of accountability, misleading accounting, and auditor independence.  It effectively puts controls and legislation with consequences directly in the hands of senior management of the corporations and provides checks on management through independent committees and separation of relationships. Going forward, it is likely we will see more legislation as the financial scope changes, building on what the Sarbanes-Oxley Act has currently strengthened.