Dr. Kimberly Byrd
Ever since President George W. Bush signed the Sarbanes-Oxley Act of 2002 into existence seven years, it feels like it has been a thorn in the side of Corporate America for eons. While the United States lawmakers who created it had very good intentions, the costs for corporations to implement, maintain, and perform to the strict standards has been astronomical. The financial burden SOX has caused so many companies has many experts wondering if the benefits outweigh the heavy price tag associated with it.
The Sarbanes Oxley Act of 2002 is the product of co-sponsors Senator Paul Sarbanes of Maryland and Representative Michael G. Oxley of Ohio. The Sarbanes Oxley Act, also known in the Senate as the "Public Company Accounting Reform and Investor Protection Act" and in the House as the "Corporate and Auditing Accountability and Responsibility Act" is also commonly called Sarbanes-Oxley, Sarbox or SOX. It is a United States federal law that was enacted on July 30, 2002, which set new or enhanced standards for all U.S. public company boards, management and public accounting firms.
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The bill was enacted as a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. "A variety of complex factors created the conditions and culture in which a series of large corporate frauds occurred between 2000 and 2002. The spectacular, highly-publicized frauds at Enron, WorldCom, and Tyco exposed significant problems with conflicts of interest and incentive compensation practices. The analysis of their complex and contentious root causes contributed to the passage of SOX in 2002" (Farrell, 2005).
Corporate scandals cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation's securities markets. "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). "One consequence of these events was the passage of Sarbanes-Oxley Act in 2002, as a result of the first admissions of fraudulent behavior made by Enron. The act significantly raises criminal penalties for securities fraud, for destroying,
altering, or fabricating records in federal investigations or any scheme or attempt to defraud shareholders" (Cohen, Dey, & Lys, 2005, p. 5). The Sarbanes Oxley Act contains 11 different sections called "titles" ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law. The 11 titles are: Public Company Accounting Oversight Board (PCAOB); Auditor Independence; Corporate Responsibility; Enhanced Financial Disclosures; Analyst Conflicts of Interest; Commission Resources and Authority; Studies and Reports; Corporate and Criminal Fraud Accountability; White Collar Crime Penalty Enhancement; Corporate Tax Returns; and Corporate Fraud Accountability.
Some of the perceived problems unearthed by the Senate Banking Committee leading to the passage of SOX included: inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analysts' conflict of interests, inadequate disclosure provisions, and grossly inadequate funding of the Securities and Exchange Commission. Prior to SOX, auditing firms, the primary financial "watchdogs" for investors, were self-regulated. They also performed significant non-audit or consulting work for the companies they audited. Many of these consulting agreements were far more lucrative than the auditing engagement. This presented at least the appearance of a conflict of interest. As an example, CPAs with Arthur Anderson, continually looked the other way while auditing Enron's accounts as they did not want to jeopardize potential future consulting contracts which were worth more than the auditing fees currently being generated.
Another problem identified by the Senate Banking Committee which helped to establish the need for implementing new accounting standards concerned audit committees. Audit committees on Boards of Directors, were charged with establishing oversight mechanisms for financial reporting in U.S. corporations on the behalf of investors. The Enron, WorldCom and Tyco scandals identified Board members who either did not exercise their responsibilities or did not have the expertise to understand the complexities of the businesses. In many cases, audit committee members were not truly independent of management.
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As a result of the aforementioned conflicts, the relationship between accounting firms and their publicly held audit clients dramatically differs under the Sarbanes-Oxley Act. The following changes for auditors are as a direct result of the passage of SOX; starting with the fact that auditors will report to and be overseen by a company's audit committee. These audit committees must pre-approve all audit and non-audit services provided by their auditors. Auditors must report new information to the audit committee, including "critical accounting policies and practices to be used, alternative treatments of financial information within GAAP that have been discussed with management, accounting disagreements between the auditor and management, and other relevant communications between the auditor and management" (McDermott, 2010). The Sarbanes-Oxley Act statutorily prohibits auditors from offering certain non-audit services to audit clients. These services include: "bookkeeping, information systems design and implementation, appraisals or valuation services, actuarial services, internal audits, management and human resources services, broker/dealer and investment banking services, legal or expert services unrelated to audit services and other services the PCAOB determines by rule
to be impermissible" (McDermott, 2010). Furthermore, the lead audit partner and second or reviewing partner must be rotated every five years on public company engagements. An accounting firm will not be able to provide audit services to a public company if one of that
company's top officials (CEO, Controller, CFO, Chief Accounting Officer, etc.) was employed by the firm and worked on the company's audit during the previous year.
Sarbanes-Oxley closes two legal and ethical loopholes that have been used in the past to defraud investors. It requires financial statements to be free not only of falsehoods, but also of misleading omissions. Financial statements must also report off-balance sheet information if it is relevant to the company's financial status. Company officers are required to sign these reports, preventing them from relieving themselves of responsibility for inaccuracies and fraud by pointing to the accounting department or pleading ignorance. Issuers of financial statements must report on the internal controls designed to encourage accurate financial reporting. If there is an adverse financial change, companies are now required to report these changes soon after they occur. Under the Sarbanes Oxley Act, stiff prison sentences are now mandated for "anyone who destroys, hides, or alters documents or objects for the purpose of obstructing justice, including intentionally misfiling documents so that they are difficult to find.
Debate continues over the perceived benefits and costs of SOX. Supporters contend the legislation was necessary and has played a useful role in restoring public confidence in the nation's capital markets by, among other things, strengthening corporate accounting controls. Opponents of the bill claim it has reduced America's international competitive edge against foreign financial service providers, saying SOX has introduced an overly complex regulatory environment into U.S. financial markets. Another concern is whether the cost of complying with regulations has driven businesses in general - and small firms in particular - to leave the public capital market and "go private." "According to a RAND Corporation report, the propensity for small public companies to be purchased by private firms, which are not subject to Sarbanes-
Oxley, increased by 53 percent during the first year. The estimate was calculated relative to similar foreign companies, which are also not subject to Sarbanes-Oxley" (Karaca-Mandic, & Kamar, 2006).
Many small business owners are concerned about the section of the Sarbanes Oxley Act which requires publicly-traded companies to hire third-party auditors. The cost of complying with SOX 404 impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment. "During 2004 U.S. companies with revenues exceeding $5 billion spent 0.06% of revenue on SOX compliance, while companies with less than $100 million in revenue spent 2.55%" (SEC.gov). Those businesses argue the law should exempt some smaller businesses, who they say can't afford the costs to comply. Randall Griffin, President of Corporate Offices Property Trust in Columbia, Maryland says, "Small publicly traded businesses deserve the [special] treatment because it takes time and resources, even additional employees, to fill in required paperwork, with total costs estimated at about $1 million" (Hopkins, 2006). "[If] It costs a company a million dollars extra; you have to be able to handle that," Griffin said. He went on to say, "It forces the smaller companies to either grow, to merge or to go private. You can't stay small and absorb those costs" (Hopkins, 2006). One of the complaints is that the law assumed too much; that all businesses will commit the same crimes absent government monitoring. "Not everyone who operates a public company is involved in accounting issues," said Lawrence Pemble, Executive Vice President of Bethesda-based Chindex International. "To impose this level of requirement on everyone, for some people it's not such a huge issue, but for us it is a huge issue. We have no option but to comply." (Hopkins, 2006).
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Strictly speaking, the requirements and prohibitions contained in Sarbanes Oxley do not impact nonprofit entities in the same manner that they impact for-profit entities. However, there are two provisions applicable to all companies across the board. They are the provisions relating to criminal liability for document destruction and for retaliation against whistleblowers. While nearly all of the provisions of the Sarbanes Oxley Act apply to publically traded corporations, the passage of the bill got the attention of the entire nonprofit community as well. "Sarbanes-Oxley has caused nonprofit leaders to focus upon "good governance" and review the practices of the nonprofit entities, including (i) the adequacy of internal controls on financial matters, (ii) the effectiveness of board committees, (iii) the understanding of fiduciary duties, and (iv) the importance of conflicts of interest policies" (DeLucia, 2004).
Several state legislatures have passed or are considering legislation containing elements of the Sarbanes Oxley Act to be applied to nonprofit organizations. Even if not mandated by law, nonprofit leaders should look carefully at the provisions outlined in the Sarbanes Oxley Act and voluntarily adopt these practices. "Regardless of the present scope of existing and potential new legislation at the state and federal level, nonprofit organizations have heard the wake-up call. For all of us in the sector, the Sarbanes Oxley Act spearheaded a renewed realization that nonprofit organizations rely on -and must protect- the indispensable and unequivocal confidence and trust
of our constituents. Self-regulation and proactive behavior will always prove more powerful than compulsory respect of laws" (Board Source, 2006).
In many instances, nonprofits have already voluntarily altered practices and adopted policies in response to SOX. Some of the recommendations for nonprofits include: conducting outside audits, establishing at least one financial committee, changing auditors every five years, following GAAP guidelines, and striving for greater disclosure and transparency. All nonprofit organizations that conduct outside audits, particularly medium to large organizations, should consider forming an audit committee and should separate the audit committee from the finance committee. Further, the audit committee should be composed of individuals who are not compensated for their service on this committee and do not have a financial interest in, or any other conflict of interest with, any entity doing business with the organization.
The implementation of the Sarbanes Oxley Act has created a new system of checks and balances that will have a significant and long-lasting impact on corporate America as well as on independent public accountants. However, it will take a mindset and attitude change to decrease the incidents of fraud. "SOA compliance will not by itself ensure that corporate scandals do not recur. Legislation rarely stops unethical acts or immoral behavior; rather, it provides a way to deal with such behavior within the legal system. Individual professionals and businesspeople have an enormous stake in preventing future corporate scandals" (Koestenbaum, Keys, & Weirich, 2005). Ideally, the Board of Directors should promote ethical conduct that permeates the corporate culture and saturates down through management to the heart of the company which is the employees. "A major determinant of such a proactive ethical environment is strong, high-
quality leadership provided by senior executives. "We need a new business model in which ethics and profitability are treated as complementary rather than as mutually exclusive" (Koestenbaum, Keys, & Weirich, 2005). Such an environment would ideally deter misconduct before it takes place rather than punishing it after the damage has been done.