Sarbanes-Oxley Act overview and compliance requirements

SOX

The Sarbanes-Oxley Act (SOX) was passed in 2002 as a response to a wave of corporate accounting scandals. To measure the effectiveness of SOX over the past ten years, the objectives of the Act must be understood. The text of the Act states that its purpose is "to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes." The accounting scandals of the late 1990s and early 2000s had undermined public confidence in the U.S. securities system, because investors were beginning to feel that the information contained in the financial statements could not be trusted. Congress felt compelled to address this situation by passing Sarbanes-Oxley, which creates more legal controls over the financial statements, creates an enforcement body (the Public Company Accounting Oversight Board) and creates new safeguards.

Small (2011) examines the effectiveness of SOX in improving the quality of internal control reporting. The findings of this study are that the "majority of sample firms and their auditors fail to report existing control weaknesses and instead report that controls are effective." The author notes that internal control reports are useful for investors because they provide advanced warning of the likelihood of misstatements in the financial reports.

Hansen (n.d.), in a study of court cases involving SOX, found that the Act "does not lead to positive governance policies enforced in the courts." This points to an issue with the implementation of the Act, in particular with the ability of the Act to be enforced in the nation's legal system. If the Act is not enforced very well, that might explain Small's finding that companies are unwilling to implement the more stringent components of the law. While a reduction in major corporate accounting scandals since the passage of SOX is certainly beneficial and restores investor faith in the financial system, any law is only as good as its enforcement, and SOX appears to have been implemented less than fully.

Based on this, SOX is not as effective as its intent. In practice, it remains a somewhat flawed piece of legislation. One way to improve SOX is to build in stronger enforcement mechanisms. Small's point about disclosing weakness is a good one, since many accounting frauds start out with a company unwilling to disclose its weaknesses -- Enron for example. If that culture still persists, then SOX has not done its job at improving the types of disclosures that investors rely on.

2.

One of the key provisions of SOX was the creation of the Public Companies Accounting Oversight Board (PCOAB). The PCOAB has jurisdiction over the auditing function at public companies, and creates standards for external auditors. This came about as the result of the failure of external auditors to correctly address issues of fraud. Conflicts of interest occurred because the external auditors would normally also have consulting relationship with their auditing clients. That the consulting business was more lucrative created an incentive to minimize the importance of the auditing function.

SOX and the PCAOB have restored the auditing function to its former role. External auditors may not have conflicts of interest with their auditing clients. The auditing role has therefore become far more important post-SOX than it was pre-SOX. The PCOAB is responsible for registering and inspecting auditing firms (Goelzer, 2004) and this function can create a higher level of investor confidence in the auditing system in general.

Auditing firms are now subject to considerably more oversight. The public accounting profession has also been strengthened by SOX. The removal of the conflict of interest with the consulting services allows for accountants and auditors to have the freedom to do their jobs without submitting to pressure from other parts of the company that want to keep clients happy. In that way, the accounting profession has been forced to take greater responsibility for its role in the economic system and has been given the tools to do this.

3.

I believe that the accounting profession is better off being government-regulated, for two reasons. The first is that the objective of accounting and auditing for public companies is to ensure that trustworthiness of the country's investment system. This objective is greater than any one accounting firm or corporate client. When confidence in the investment system is compromised, firms find it more difficult to raise the capital they need. This in turn harms growth, innovation and the economy as a whole. That confidence in the accounting system has an effect on the GDP makes it a matter of national economic policy, not simply a matter for one industry.

The other reason why the accounting profession is better off being government-regulated is that the mechanics of how the industry performs its tasks will not change. Whether the enforcement mechanism comes from within the industry or from government, accounting firms will still need to do their jobs the same way, performing due diligence and implementing controls on the accounting and auditing processes. Because functionally the accounting firms will do the same jobs the same way, and the only difference between the two alternatives is who runs the enforcement mechanism, then we need to look back to the first reason for guidance. If government regulation caused dramatic changes to the way that the accountants to their business, then there might be a downside, but with no functional downside, the ability of government to ensure that accountants are performing their duties to investors is the deciding factor.

4.

I believe that fraud will be reduced somewhat as the result of SOX. Many of the frauds that led up to the passage of SOX were outright criminal, and SOX does not directly address criminality. There will always be people who try to perpetrate such frauds. SOX removes some of the perverse incentives within the accounting system to ignore such frauds, thereby increasing the likelihood that the fraud will not only be detected but will also be dealt with.