The
Sarbanes–Oxley Act of 2002 , also known as the 'Public Company Accounting Reform and Investor Protection Act' (in the
SenateThe United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
) and 'Corporate and Auditing Accountability and Responsibility Act' (in the
HouseThe United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...
) and commonly called
Sarbanes–Oxley,
Sarbox or
SOX, is a United States federal law enacted on July 30, 2002, which set new or enhanced standards for all U.S.
public companyThis is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...
boards, management and public accounting firms. It is named after sponsors U.S. Senator
Paul SarbanesPaul Spyros Sarbanes , a Democrat, is a former United States Senator who represented the state of Maryland. Sarbanes was the longest-serving senator in Maryland history, having served from 1977 until 2007. He did not seek re-election in 2006, when he was succeeded by fellow Democrat Ben Cardin...
(
DThe Democratic Party is one of two major contemporary political parties in the United States, along with the Republican Party. The party's socially liberal and progressive platform is largely considered center-left in the U.S. political spectrum. The party has the lengthiest record of continuous...
-
MDMaryland is a U.S. state located in the Mid Atlantic region of the United States, bordering Virginia, West Virginia, and the District of Columbia to its south and west; Pennsylvania to its north; and Delaware to its east...
) and U.S. Representative Michael G. Oxley (
RThe Republican Party is one of the two major contemporary political parties in the United States, along with the Democratic Party. Founded by anti-slavery expansion activists in 1854, it is often called the GOP . The party's platform generally reflects American conservatism in the U.S...
-
OHOhio is a Midwestern state in the United States. The 34th largest state by area in the U.S.,it is the 7th‑most populous with over 11.5 million residents, containing several major American cities and seven metropolitan areas with populations of 500,000 or more.The state's capital is Columbus...
).
The bill was enacted as a reaction to a number of major
corporate and accounting scandalsAccounting scandals, or corporate accounting scandals, are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations...
including those affecting
EnronEnron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
,
Tyco InternationalTyco International Ltd. is a highly diversified global manufacturing company incorporated in Switzerland, with United States operational headquarters in Princeton, New Jersey...
, Adelphia,
Peregrine SystemsPeregrine Systems, Inc., an enterprise software company, was founded in 1981 and sold enterprise asset management, change management, and ITIL-based IT service management software. Following an accounting scandal and bankruptcy in 2003, Peregrine was acquired by Hewlett-Packard in 2005...
and WorldCom. These scandals, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation's
securities marketsA capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
.
The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the
Securities and Exchange CommissionThe U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
(SEC) to implement rulings on requirements to comply with the law.
Harvey PittHarvey Pitt was the 26th chairman of the U.S. Securities and Exchange Commission , serving from 2001-2003. He led the SEC in restoring the U.S...
, the 26th chairman of the SEC, led the SEC in the adoption of dozens of rules to implement the Sarbanes–Oxley Act. It created a new, quasi-public agency, the
Public Company Accounting Oversight BoardThe Public Company Accounting Oversight Board is a private-sector, non-profit corporation created by the Sarbanes–Oxley Act, a 2002 United States federal law, to oversee the auditors of public companies. Its stated purpose is to 'protect the interests of investors and further the public interest...
, or PCAOB, charged with overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies. The act also covers issues such as auditor independence,
corporate governanceCorporate governance is a number of processes, customs, policies, laws, and institutions which have impact on the way a company is controlled...
,
internal controlIn accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization's...
assessment, and enhanced financial disclosure.
The act was approved by the
HouseThe United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...
by a vote of
423 in favor, 3 opposed, and 8 abstaining and by the
SenateThe United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
with a vote of
99 in favor, 1 abstaining. 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. RooseveltFranklin Delano Roosevelt , also known by his initials, FDR, was the 32nd President of the United States and a central figure in world events during the mid-20th century, leading the United States during a time of worldwide economic crisis and world war...
."
Debate continues over the perceived benefits and costs of SOX. 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. Proponents of the measure say that SOX has been a "godsend" for improving the confidence of fund managers and other
investorAn investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s with regard to the veracity of corporate financial statements.
Outlines
Sarbanes–Oxley 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 (PCAOB)
- 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 ("auditors"). It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits, inspecting and policing conduct and quality control, and enforcing compliance with the specific mandates of SOX.
- Auditor Independence
- Title II consists of nine sections and establishes standards for external auditor independence, to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients.
- 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. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports. It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance. For example, Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...
and Chief Financial OfficerThe chief financial officer or Chief financial and operating officer is a corporate officer primarily responsible for managing the financial risks of the corporation. This officer is also responsible for financial planning and record-keeping, as well as financial reporting to higher management...
) certify and approve the integrity of their company financial reports quarterly.
- Enhanced Financial Disclosures
- Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance-sheet
Off-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
transactions, pro-forma figures and stock transactions of corporate officers. It requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates both audits and reports on those controls. It also requires timely reporting of material changes in financial condition and specific enhanced reviews by the SEC or its agents of corporate reports.
- 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. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest.
- Commission Resources and Authority
- Title VI consists of four sections and defines practices to restore investor confidence in securities analysts. It also defines the SEC’s authority to censure or bar securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer.
- Studies and Reports
- Title VII consists of five sections and requires the Comptroller General
The Comptroller General of the United States is the director of the Government Accountability Office , a legislative branch agency established by Congress in 1921 to ensure the fiscal and managerial accountability of the federal government...
and the SEC to perform various studies and report their findings. Studies and reports include the effects of consolidation of public accounting firms, the role of credit rating agencies in the operation of securities markets, securities violations and enforcement actions, and whether investment banks assisted EnronEnron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
, Global CrossingGlobal Crossing Limited was a telecommunications company that provides computer networking services worldwide. It maintained a large backbone and offered transit and peering links, VPN, leased lines, audio and video conferencing, long distance telephone, managed services, dialup, colocation and...
and others to manipulate earnings and obfuscate true financial conditions.
- Corporate and Criminal Fraud Accountability
- Title VIII consists of seven sections and is also referred to as the “Corporate and Criminal Fraud Accountability Act of 2002”. It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations, while providing certain protections for whistle-blowers.
- 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.” This section increases the criminal penalties associated with white-collar crime
Within the field of criminology, white-collar crime has been defined by Edwin Sutherland as "a crime committed by a person of respectability and high social status in the course of his occupation" . Sutherland was a proponent of Symbolic Interactionism, and believed that criminal behavior was...
s and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense.
- Corporate Tax Returns
- Title X consists of one section. Section 1001 states that the Chief Executive Officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...
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”. It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties. This enables the SEC to resort to temporarily freezing transactions or payments that have been deemed "large" or "unusual".
History and context: events contributing to the adoption of Sarbanes–Oxley
A variety of complex factors created the conditions and culture in which a series of large corporate frauds occurred between 2000–2002. 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. In a 2004 interview, Senator Paul Sarbanes stated:
- Auditor conflicts of interest: 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. 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.
- Boardroom failures: Boards of Directors, specifically Audit Committees, are charged with establishing oversight mechanisms for financial reporting in U.S. corporations on the behalf of investors. These 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.
- Securities analysts' conflicts of interest: The roles of securities analysts, who make buy and sell recommendations on company stocks and bonds, and investment bankers, who help provide companies loans or handle mergers and acquisitions, provide opportunities for conflicts. Similar to the auditor conflict, issuing a buy or sell recommendation on a stock while providing lucrative investment banking services creates at least the appearance of a conflict of interest.
- Inadequate funding of the SEC: The SEC budget has steadily increased to nearly double the pre-SOX level. In the interview cited above, Sarbanes indicated that enforcement and rule-making are more effective post-SOX.
- Banking practices: Lending to a firm sends signals to investors regarding the firm's risk. In the case of Enron, several major banks provided large loans to the company without understanding, or while ignoring, the risks of the company. Investors of these banks and their clients were hurt by such bad loans, resulting in large settlement payments by the banks. Others interpreted the willingness of banks to lend money to the company as an indication of its health and integrity, and were led to invest in Enron as a result. These investors were hurt as well.
- Internet bubble: Investors had been stung in 2000 by the sharp declines in technology stocks and to a lesser extent, by declines in the overall market. Certain mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
managers were alleged to have advocated the purchasing of particular technology stocks, while quietly selling them. The losses sustained also helped create a general anger among investors.
- Executive compensation: Stock option and bonus practices, combined with volatility in stock prices for even small earnings "misses," resulted in pressures to manage earnings. Stock options were not treated as compensation expense by companies, encouraging this form of compensation. With a large stock-based bonus at risk, managers were pressured to meet their targets.
Timeline and passage of Sarbanes–Oxley
The House passed Rep. Oxley's bill (H.R. 3763) on April 24, 2002, by a vote of 334 to 90. The House then referred the "Corporate and Auditing Accountability, Responsibility, and Transparency Act" or "CAARTA" to the
SenateThe United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
Banking Committee with the support of President
George W. BushGeorge Walker Bush is an American politician who served as the 43rd President of the United States, from 2001 to 2009. Before that, he was the 46th Governor of Texas, having served from 1995 to 2000....
and the SEC. At the time, however, the Chairman of that Committee, Senator
Paul SarbanesPaul Spyros Sarbanes , a Democrat, is a former United States Senator who represented the state of Maryland. Sarbanes was the longest-serving senator in Maryland history, having served from 1977 until 2007. He did not seek re-election in 2006, when he was succeeded by fellow Democrat Ben Cardin...
(D-MD), was preparing his own proposal, Senate Bill 2673.
Senator Sarbanes’ bill passed the Senate Banking Committee on June 18, 2002, by a vote of 17 to 4. On June 25, 2002, WorldCom revealed it had overstated its earnings by more than $3.8 billion during the past five quarters (15 months), primarily by improperly accounting for its operating costs. Sen. Sarbanes introduced Senate Bill 2673 to the full Senate that same day, and it passed 97–0 less than three weeks later on July 15, 2002.
The House and the Senate formed a
Conference CommitteeA conference committee is a committee of the Congress appointed by the House of Representatives and Senate to resolve disagreements on a particular bill...
to reconcile the differences between Sen. Sarbanes's bill (S. 2673) and Rep. Oxley's bill (H.R. 3763). The conference committee relied heavily on S. 2673 and “most changes made by the conference committee strengthened the prescriptions of S. 2673 or added new prescriptions.” (John T. Bostelman, The Sarbanes–Oxley Deskbook § 2–31.)
The Committee approved the final conference bill on July 24, 2002, and gave it the name "the Sarbanes–Oxley Act of 2002." The next day, both houses of
CongressThe United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
voted on it without change, producing an overwhelming margin of victory:
423 to 3 in the House and
99 to 0 in the Senate. On July 30, 2002, 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. RooseveltFranklin Delano Roosevelt , also known by his initials, FDR, was the 32nd President of the United States and a central figure in world events during the mid-20th century, leading the United States during a time of worldwide economic crisis and world war...
."
Analyzing the cost-benefits of Sarbanes–Oxley
A significant body of academic research and opinion exists regarding the costs and benefits of SOX, with significant differences in conclusions. This is due in part to the difficulty of isolating the impact of SOX from other variables affecting the stock market and corporate earnings. Conclusions from several of these studies and related criticism are summarized below:
Compliance costs
- FEI Survey (Annual): Finance Executives International (FEI) provides an annual survey on SOX Section 404 costs. These costs have continued to decline relative to revenues since 2004. The 2007 study indicated that, for 168 companies with average revenues of $4.7 billion, the average compliance costs were $1.7 million (0.036% of revenue). The 2006 study indicated that, for 200 companies with average revenues of $6.8 billion, the average compliance costs were $2.9 million (0.043% of revenue), down 23% from 2005. Cost for decentralized companies (i.e., those with multiple segments or divisions) were considerably more than centralized companies. Survey scores related to the positive effect of SOX on investor confidence, reliability of financial statements, and fraud prevention continue to rise. However, when asked in 2006 whether the benefits of compliance with Section 404 have exceeded costs in 2006, only 22 percent agreed.
- Foley & Lardner
Foley & Lardner LLP is an international law firm started in 1842. According to The American Lawyer, the firm ranked 39th on The American Lawyer's 2011 AmLaw 100 rankings of U.S. law firms, with $633,000,000 in gross revenue in 2010. Foley & Lardner has been in The American Lawyer's annual AmLaw 100...
Survey (2007): This annual study focused on changes in the total costs of being a U.S. public company, which were significantly affected by SOX. Such costs include external auditor fees, directors and officers (D&O) insurance, board compensation, lost productivity, and legal costs. Each of these cost categories increased significantly between FY2001-FY2006. Nearly 70% of survey respondents indicated public companies with revenues under $251 million should be exempt from SOX Section 404.
- Zhang (2005): This research paper estimated SOX compliance costs as high as $1.4 trillion, by measuring changes in market value around key SOX legislative "events." This number is based on the assumption that SOX was the cause of related short-duration market value changes, which the author acknowledges as a drawback of the study.
- Butler/Ribstein (2006): Their book proposed a comprehensive overhaul or repeal of SOX and a variety of other reforms. For example, they indicate that investors could diversify their stock investments, efficiently managing the risk of a few catastrophic corporate failures, whether due to fraud or competition. However, if each company is required to spend a significant amount of money and resources on SOX compliance, this cost is borne across all publicly traded companies and therefore cannot be diversified away by the investor.
- A 2011 SEC study found that Section 404(b) compliance costs have continued to decline, especially after 2007 accounting guidance.
Benefits to firms and investors
- Arping/Sautner (2010): This research paper analyzes whether SOX enhanced corporate transparency. Looking at foreign firms that are cross-listed in the US, the paper indicates that, relative to a control sample of comparable firms that are not subject to SOX, cross-listed firms became significantly more transparent following SOX. Corporate transparency is measured based on the dispersion and accuracy of analyst earnings forecasts.
- Iliev (2007): This research paper indicated that SOX 404 indeed led to conservative reported earnings, but also reduced—rightly or wrongly—stock valuations of small firms. Lower earnings often cause the share price to decrease.
- Skaife/Collins/Kinney/LaFond (2006): This research paper indicates that borrowing costs are lower for companies that improved their internal control, by between 50 and 150 basis points (.5 to 1.5 percentage points).
- Lord & Benoit Report (2006): Do the Benefits of 404 Exceed the Cost? A study of a population of nearly 2,500 companies indicated that those with no material weaknesses in their internal controls, or companies that corrected them in a timely manner, experienced much greater increases in share prices than companies that did not. The report indicated that the benefits to a compliant company in share price (10% above Russell 3000 index) were greater than their SOX Section 404 costs.
- Institute of Internal Auditors (2005): The research paper indicates that corporations have improved their internal controls and that financial statements are perceived to be more reliable.
Effects on exchange listing choice of non-US companies
Some have asserted that Sarbanes–Oxley legislation has helped displace business from New York to London, where the
Financial Services AuthorityThe Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
regulates the financial sector with a lighter touch. In the UK, the non-statutory Combined Code of Corporate Governance plays a somewhat similar role to SOX. See Howell E. Jackson & Mark J. Roe, “Public Enforcement of Securities Laws: Preliminary Evidence” (Working Paper January 16, 2007). The
Alternative Investment MarketAIM is a sub-market of the London Stock Exchange, allowing smaller companies to float shares with a more flexible regulatory system than is applicable to the main market....
claims that its spectacular growth in listings almost entirely coincided with the Sarbanes Oxley legislation. In December 2006
Michael BloombergMichael Rubens Bloomberg is the current Mayor of New York City. With a net worth of $19.5 billion in 2011, he is also the 12th-richest person in the United States...
, New York's mayor, and
Charles SchumerCharles Ellis "Chuck" Schumer is the senior United States Senator from New York and a member of the Democratic Party. First elected in 1998, he defeated three-term Republican incumbent Al D'Amato by a margin of 55%–44%. He was easily re-elected in 2004 by a margin of 71%–24% and in 2010 by a...
, a US senator from New York, expressed their concern.
The Sarbanes–Oxley Act's effect on non-US companies cross-listed in the US is different on firms from
developedA developed country is a country that has a high level of development according to some criteria. Which criteria, and which countries are classified as being developed, is a contentious issue...
and well regulated countries than on firms from less developed countries according to Kate Litvak. Companies from badly regulated countries see benefits that are higher than the costs from better credit ratings by complying to regulations in a highly regulated country (USA), but companies from developed countries only incur the costs, since transparency is adequate in their home countries as well. On the other hand, the benefit of better credit rating also comes with listing on other stock exchanges such as the
London Stock ExchangeThe London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
.
Piotroski and Srinivasan (2008) examine a comprehensive sample of international companies that list onto U.S. and U.K. stock exchanges before and after the enactment of the Act in 2002. Using a sample of all listing events onto U.S. and U.K. exchanges from 1995–2006, they find that the listing preferences of large foreign firms choosing between U.S. exchanges and the LSE's Main Market did not change following SOX. In contrast, they find that the likelihood of a U.S. listing among small foreign firms choosing between the Nasdaq and LSE's Alternative Investment Market decreased following SOX. The negative effect among small firms is consistent with these companies being less able to absorb the incremental costs associated with SOX compliance. The screening of smaller firms with weaker governance attributes from U.S. exchanges is consistent with the heightened governance costs imposed by the Act increasing the bonding-related benefits of a U.S. listing.
Sarbanes–Oxley Section 302: Disclosure controls
Under Sarbanes–Oxley, two separate sections came into effect—one civil and the other criminal. (Section 302) (civil provision); (Section 906) (criminal provision).
Section 302 of the Act 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 controlIn accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization's...
s” and “have designed such internal controls to ensure that material information relating to the
companyA company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
and its
consolidated subsidiariesA subsidiary company, subsidiary, or daughter company is a company that is completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary's stock. The subsidiary can be a company, corporation, or limited liability company. In some cases it is a...
is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared.” . The officers must “have evaluated the effectiveness of the
companyA company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
’s internal controls as of a date within 90 days prior to the report” and “have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date.”
Id..
The SEC interpreted the intention of Sec. 302 in Final Rule 33–8124. In it, the SEC defines the new term "disclosure controls and procedures", which are distinct from "
internal controlIn accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization's...
s over financial reporting". Under both Section 302 and Section 404, Congress directed the SEC to promulgate regulations enforcing these provisions.
External auditors are required to issue an opinion on whether effective internal control over financial reporting was maintained in all material respects by management. This is in addition to the financial statement opinion regarding the accuracy of the financial statements. The requirement to issue a third opinion regarding management's assessment was removed in 2007.
Sarbanes-Oxley Section 401: Disclosures in periodic reports (Off-balance sheet items)
The bankruptcy of
EnronEnron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
drew attention to off-balance sheet instruments that were used fraudulently. During 2010, the court examiner's review of the Lehman Brothers bankruptcy also brought these instruments back into focus, as Lehman had used an instrument called "Repo 105" to allegedly move assets and debt off-balance sheet to make its financial position look more favorable to investors. Sarbanes-Oxley required the disclosure of all material off-balance sheet items. It also required an SEC study and report to better understand the extent of usage of such instruments and whether accounting principles adequately addressed these instruments; the SEC report was issued June 15, 2005. Interim guidance was issued in May 2006, which was later finalized. Critics argued the SEC did not take adequate steps to regulate and monitor this activity.
Sarbanes–Oxley Section 404: Assessment of internal control
The most contentious aspect of SOX is Section 404, which requires management and the external auditor to report on the adequacy of the company's internal control on financial reporting (ICFR). This is the most costly aspect of the legislation for companies to implement, as documenting and testing important financial manual and automated controls requires enormous effort.
Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report.
See . The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” . The report must also “contain an assessment, as of the end of the most recent fiscal year of the
CompanyA company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.” To do this, managers are generally adopting an internal control framework such as that described in
COSOThe Committee of Sponsoring Organizations of the Treadway Commission is a voluntary private-sector organization, established in the United States, dedicated to providing guidance to executive management and governance entities on critical aspects of organizational governance, business ethics,...
.
To help alleviate the high costs of compliance, guidance and practice have continued to evolve. The
Public Company Accounting Oversight BoardThe Public Company Accounting Oversight Board is a private-sector, non-profit corporation created by the Sarbanes–Oxley Act, a 2002 United States federal law, to oversee the auditors of public companies. Its stated purpose is to 'protect the interests of investors and further the public interest...
(PCAOB) approved
AuditThe general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, and energy conservation.- Accounting...
ing Standard No. 5 for public accounting firms on July 25, 2007. This standard superseded Auditing Standard No. 2, the initial guidance provided in 2004. The SEC also released its interpretive guidance on June 27, 2007. It is generally consistent with the PCAOB's guidance, but intended to provide guidance for management. Both management and the external auditor are responsible for performing their assessment in the context of a
top-down risk assessmentIn financial auditing of public companies in the United States, SOX 404 top-down risk assessment is a financial risk assessment performed to comply with Section 404 of the Sarbanes-Oxley Act of 2002 . The term is used by the U.S. Public Company Accounting Oversight Board and the Securities and...
, which requires management to base both the scope of its assessment and evidence gathered on risk. This gives management wider discretion in its assessment approach. These two standards together require 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, in sufficient detail to identify points at which a misstatement could arise;
- Evaluate company-level (entity-level) controls, which correspond to the components of the COSO
The Committee of Sponsoring Organizations of the Treadway Commission is a voluntary private-sector organization, established in the United States, dedicated to providing guidance to executive management and governance entities on critical aspects of organizational governance, business ethics,...
framework;
- Perform a fraud risk assessment;
- Evaluate controls designed to prevent or detect fraud
Fraud deterrence has gained public recognition and spotlight since the 2002 inception of the Sarbanes-Oxley Act. Of the many reforms enacted through Sarbanes-Oxley, one major goal was to regain public confidence in the reliability of financial markets in the wake of corporate scandals such as...
, including management override of controls;
- Evaluate controls over the period-end financial
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
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.
SOX 404 compliance costs represent a tax on inefficiency, encouraging companies to centralize and automate their financial reporting systems. This is apparent in the comparative costs of companies with decentralized operations and systems, versus those with centralized, more efficient systems. For example, the 2007 FEI survey indicated average compliance costs for decentralized companies were $1.9 million, while centralized company costs were $1.3 million. Costs of evaluating manual control procedures are dramatically reduced through automation.
Sarbanes–Oxley 404 and smaller public companies
The cost of complying with SOX 404 impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment. For example, 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%.
This disparity is a focal point of 2007 SEC and U.S. Senate action. The PCAOB intends to issue further guidance to help companies scale their assessment based on company size and complexity during 2007. The SEC issued their guidance to management in June, 2007.
After the SEC and PCAOB issued their guidance, the SEC required smaller public companies (non-accelerated filers) with fiscal years ending after December 15, 2007 to document a Management Assessment of their Internal Controls over Financial Reporting (ICFR). Outside auditors of non-accelerated filers however opine or test internal controls under PCAOB (Public Company Accounting Oversight Board) Auditing Standards for years ending after December 15, 2008. Another extension was granted by the SEC for the outside auditor assessment until years ending after December 15, 2009. The reason for the timing disparity was to address the House Committee on Small Business concern that the cost of complying with Section 404 of the Sarbanes–Oxley Act of 2002 was still unknown and could therefore be disproportionately high for smaller publicly held companies. On October 2, 2009, the SEC granted another extension for the outside auditor assessment until fiscal years ending after June 15, 2010. The SEC stated in their release that the extension was granted so that the SEC’s Office of Economic Analysis could complete a study of whether additional guidance provided to company managers and auditors in 2007 was effective in reducing the costs of compliance. They also stated that there will be no further extensions in the future.
On September 15, 2010 the SEC issued final rule 33-9142 the permanently exempts registrants that are neither accelerated nor large accelerated filers as defined by Rule 12b-2 of the Securities and Exchange Act of 1934 from Section 404(b) internal control audit requirement.
Sarbanes–Oxley Section 802: Criminal penalties for violation of SOX
Section 802(a) of the SOX, states:
Sarbanes–Oxley Section 1107: Criminal penalties for retaliation against whistleblowers
Section 1107 of the SOX states:
Criticism
Congressman
Ron PaulRonald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
and others such as former Arkansas governor
Mike HuckabeeMichael "Mike" Dale Huckabee is an American politician who served as the 44th Governor of Arkansas from 1996 to 2007. He was a candidate in the 2008 United States Republican presidential primaries, finishing second in delegate count and third in both popular vote and number of states won . He won...
have contended that SOX was an unnecessary and costly government intrusion into corporate management that places U.S. corporations at a competitive disadvantage with foreign firms, driving businesses out of the United States. In an April 14, 2005 speech before the U.S. House of Representatives, Paul stated, "These regulations are damaging American capital markets by providing an incentive for small US firms and foreign firms to deregister from US stock exchanges. According to a study by a researcher at the Wharton Business School, the number of American companies deregistering from public stock exchanges nearly tripled during the year after Sarbanes–Oxley became law, while the New York Stock Exchange had only 10 new foreign listings in all of 2004. The reluctance of small businesses and foreign firms to register on American stock exchanges is easily understood when one considers the costs Sarbanes–Oxley imposes on businesses. According to a survey by
Korn/FerryKorn/Ferry International, headquartered in Los Angeles, is the world's largest executive search firm, and the largest publicly-traded search firm in the United States, with 76 offices in North America, Europe, Asia/Pacific, Latin America, the Middle East and South Africa. Since the firm's...
International, Sarbanes–Oxley cost Fortune 500 companies an average of $5.1 million in compliance expenses in 2004, while a study by the law firm of Foley and Lardner found the Act increased costs associated with being a publicly held company by 130 percent."
A research study published by Joseph Piotroski of Stanford University and Suraj Srinivasan of Harvard Business School titled "Regulation and Bonding: Sarbanes Oxley Act and the Flow of International Listings" in the Journal of Accounting Research in 2008 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.
During the financial crisis of 2007-2010, critics blamed Sarbanes–Oxley for the low number of Initial Public Offerings (IPOs) on American stock exchanges during 2008. In November 2008,
Newt GingrichNewton Leroy "Newt" Gingrich is a U.S. Republican Party politician who served as the House Minority Whip from 1989 to 1995 and as the 58th Speaker of the U.S. House of Representatives from 1995 to 1999....
and co-author David W. Kralik called on Congress to repeal Sarbanes–Oxley.
A December 21, 2008 Wall St. Journal editorial stated, "The new laws and regulations have neither prevented frauds nor instituted fairness. But they have managed to kill the creation of new public companies in the U.S., cripple the venture capital business, and damage entrepreneurship. According to the
National Venture Capital AssociationThe National Venture Capital Association is the leading trade association representing the venture capital industry in the U.S. The NVCA represents the venture industry in public policy debates in Washington, DC, and promotes high professional standards, professional development, and interaction...
, in all of 2008 there have been just six companies that have gone public. Compare that with 269 IPOs in 1999, 272 in 1996, and 365 in 1986."
Hoover's IPO Scorecard notes 31 IPOs in 2008.
The editorial concludes that: "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 (while making the London Stock Exchange rich), and cost U.S. industry more than $200 billion by some estimates."
Previously the number of IPOs had declined to 87 in 2001, well down from the highs, but before Sarbanes–Oxley was passed. In 2004, IPOs were up 195% from the previous year to 233. There were 196 IPOs in 2005, 205 in 2006 (with a sevenfold increase in deals over $1 billion) and 209 in 2007.
Praise
Former Federal Reserve Chairman
Alan GreenspanAlan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
praised the Sarbanes–Oxley Act: "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.”
SOX has been praised by a cross-section of financial industry experts, citing improved investor confidence and more accurate, reliable financial statements. The CEO and CFO are now required to unequivocally take ownership for their financial statements under Section 302, which was not the case prior to SOX. Further, auditor conflicts of interest have been addressed, by prohibiting auditors from also having lucrative consulting agreements with the firms they audit under Section 201. SEC Chairman Christopher Cox stated in 2007: "Sarbanes–Oxley helped restore trust in U.S. markets by increasing accountability, speeding up reporting, and making audits more independent."
The FEI 2007 study and research by the Institute of Internal Auditors (IIA) also indicate SOX has improved investor confidence in financial reporting, a primary objective of the legislation. The IIA study also indicated improvements in board, audit committee, and senior management engagement in financial reporting and improvements in financial controls.
Financial restatements increased significantly in the wake of the SOX legislation, as companies "cleaned up" their books. Glass, Lewis & Co. LLC is a San Francisco-based firm that tracks the volume of do-overs by public companies. Its March 2006 report, "Getting It Wrong the First Time," shows 1,295 restatements of financial earnings in 2005 for companies listed on U.S. securities markets, almost twice the number for 2004. "That's about one restatement for every 12 public companies—up from one for every 23 in 2004," says the report.
One fraud uncovered by the Securities and Exchange Commission (SEC) in November 2009 may be directly credited to Sarbanes-Oxley. The fraud which spanned nearly 20 years and involved over $24 million was committed by
Value LineValue Line is an independent investment research and financial publishing firm based in New York, New York, USA, founded in 1931 by Arnold Bernhard. Value Line is best known for publishing The Value Line Investment Survey, a stock analysis newsletter that is updated weekly and kept by subscribers...
against its mutual fund shareholders. The fraud was first reported to the SEC in 2004 by the Value Line Fund portfolio manager who was asked to sign a Code of Business Ethics as part of SOX.
Restitution totalling $34 million will be placed in a fair fund and returned to the affected Value Line mutual fund investors. No criminal charges have been filed.
Long-Term Benefits
Sarbanes Oxley Act provides a number of long term benefits. Investors' confidence is increased as SOX ensures reliable financial reporting. SOX has had a significant impact on corporate governance, as companies are no longer able to manipulate inventories or stocks of products or sales as there is a real time reporting system in place. SOX requires a standard data entry system. SOX nurtures an ethical culture as it forces top management be transparent and employees to be responsible for their acts and also protects whistle blowers.
Legal challenges
A lawsuit (
Free Enterprise Fund v. Public Company Accounting Oversight BoardFree Enterprise Fund v. Public Company Accounting Oversight Board, 561 U. S. ____ , was a case decided by the United States Supreme Court on June 28, 2010...
) was filed in 2006 challenging the constitutionality 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. Further, the other parts of the law may be open to revision.
The lawsuit was dismissed from a District Court; the decision was upheld by the Court of Appeals on August 22, 2008. Judge Kavanaugh, in his dissent, argued strongly against the constitutionality of the law. On May 18, 2009, the United States Supreme Court agreed to hear this case. On December 7, 2009, it heard the oral arguments. On June 28, 2010, the United States Supreme Court unanimously turned away a broad challenge to the law, but ruled 5-4 that a section related to appointments violates the Constitution's separation of powers mandate. The act remains "fully operative as a law" pending a process correction.
Legislative information
- House
The United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...
: , H. Rept. 107–414, H. Rept. 107–610
- Senate
The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
: , S. Rept. 107–205
- Law: ,
See also
- Glass–Steagall Act
- Information technology audit
An information technology audit, or information systems audit, is an examination of the management controls within an Information technology infrastructure. The evaluation of obtained evidence determines if the information systems are safeguarding assets, maintaining data integrity, and operating...
- Information technology controls
In business and accounting, Information technology controls are specific activities performed by persons or systems designed to ensure that business objectives are met. They are a subset of an enterprise's internal control...
- ISO 27001
- Richard M. Scrushy
Richard Marin Scrushy is an American business man and founder of HealthSouth Corporation, a global healthcare company based in Birmingham, Alabama....
, CEO of HealthSouthHealthSouth Corporation , based in Birmingham, Alabama, is the nation’s largest owner and operator of inpatient rehabilitative hospitals. Operating in 26 states across the country and in Puerto Rico, HealthSouth serves patients through its network of inpatient rehabilitation hospitals , outpatient...
, the first executive charged and to be acquitted under Sarbanes–Oxley
- Fair Fund
A Fair Fund is a fund established by the U.S. Securities and Exchange Commission to distribute disgorgements and penalties to defrauded investors...
s, established by Sarbanes–Oxley
- Basel Accord
The Basel Accords refer to the banking supervision Accords —Basel I and Basel II issued and Basel III—by the Basel Committee on Banking Supervision ....
- Reg FD
- Contract Management
Contract management or contract administration is the management of contracts made with customers, vendors, partners, or employees. Contract management includes negotiating the terms and conditions in contracts and ensuring compliance with the terms and conditions, as well as documenting and...
- Agency cost
An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...
- Data Loss Prevention
- Data governance
Data governance is an emerging discipline with an evolving definition. The discipline embodies a convergence of data quality, data management, data policies, business process management, and risk management surrounding the handling of data in an organization...
Similar laws in other countries
- Bill 198
In Canada, Bill 198 is an Ontario legislative bill effective April 7, 2003, which provides for regulation of securities issued in the province of Ontario. The legislation encompasses many areas. It is perhaps best known for clauses that provide equivalent legislation to the U.S. Sarbanes-Oxley Act...
— Ontario, Canada, equivalent of Sarbanes–Oxley Act
- J-SOX
The , promulgated on June 14th, 2006, is the main statute codifying securities law and regulating securities companies in Japan.The law provides for:* Registration and regulation of broker dealers and their registered representatives...
— Japanese equivalent of Sarbanes–Oxley Act
- German Corporate Governance Code (at the German Wikipedia)
- :nl:code-Tabaksblat - Dutch version, based on 'comply or explain' (at the Dutch Wikipedia)
- CLERP9
Corporate Law Economic Reform Program Act 2004, commonly called CLERP 9, is the most recent reform to the Corporations Act 2001 which governs corporate law in Australia...
— Australian corporate reporting and disclosure law
- Financial Security Law of France
The Financial Security Law of France , signed by the Minister of Finance, Francis Mer, was adopted by the French Parliament on July 17, 2003 in order to strengthen the legal provisions relating to corporate governance. The LSF was published in OJ No. 177, August 2, 2003 The Financial Security Law...
("Loi sur la Sécurité Financière") — French equivalent of Sarbanes–Oxley Act
- L262/2005 ("Disposizioni per la tutela del risparmio e la disciplina dei mercati finanziari") — Italian equivalent of Sarbanes–Oxley Act for financial services institutions
- King Report on Corporate Governance
The King Report on Corporate Governance is a ground-breaking code of corporate governance in South Africa issued by the King Committee on Corporate Governance. Three reports were issued in 1994 , 2002 , and 2009 . Compliance with the King Reports is a requirement for companies listed on the...
— South African corporate governance code
- Clause 49
Clause 49 of the Listing Agreement to the Indian stock exchange comes into effect from 31 December 2005. It has been formulated for the improvement of corporate governance in all listed companies....
- Indian equivalent of SOX
- TC-SOX 11 - Turkish equivalent of SOX
External links