Sarbanes Oxley Act Key Components

Introduction

From the onset, it would be prudent to note that the Sarbanes-Oxley Act remains a rather instrumental law in efforts to reign in corporate fraud and further enhance reliability in the realm of financial reporting. The said act was passed in the year 2002. This text concerns itself with not only the significance of this particular piece of legislation, but also the reason as to why it was passed. Amongst other things, the paper will also consider how knowledge of the various provisions of the act would enable one to promote corporate governance in an organization.

Discussion

Why the Sarbanes-Oxley Act was Passed

Fletcher and Plette (2008) make an observation to the effect that this particular act was necessitated by the numerous financial scandals that appeared commonplace following our march into the 21st century. Some of the most prominent scandals in this case involved firms that were publicly traded, including but not limited to; WorldCom, Tyco International PLC, and Enron Corporation (Wheelen, Hunger, Hoffman, and Bamford, 2018). Some of the said companies were focused on either ignoring or bending the regulations that had in the past been formulated to ensure that the interests of shareholders were secured (Wheelen, Hunger, Hoffman, and Bamford, 2018). It is for this reason that as Fletcher and Plette (2008) further indicate, the said scandals had a massive negative impact on investor confidence – especially in relation to the extent to which they could rely on corporate financial statements. As a consequence, there were calls from diverse quarters on the need to revamp the regulatory standards in place at the time. This is more so the case that to some, the existing standards had not been overhauled for decades, and were hence largely ineffective in combating modern-day corporate fraud. It would be instrumental to note that it was also at around this time that technology was gaining root in the realm of business – especially following the advent of the internet. To gain a sneak preview of the prevailing situation prior to the enactment of the passing of the Sarbanes-Oxley Act, there would be need to briefly highlight some of the scandals alluded to above in greater detail.

To begin with, when it comes to the Enron scandal, it is important to note that according to Kieff and Paredes (2010), this was a rather brazen accounting scandal. Indeed, as the authors further indicate, alongside Tyco and WorldCom frauds, it could easily be one of the most complex scandals of its kind in history. In essence, this particular scandal – which essentially surfaced in the year 2001 – involved massive accounting fraud and corporate corruption. As Kieff and Paredes (2010) observe, the company managed to make extensive use of accounting practices that were largely off-the-books and deploy fake holdings in a bid to fool regulators. Further, the company also managed to ensure that creditors and investors did not get to know of its worsening debt situation. To accomplish this, it utilized special purpose entities (SPEs) as well as special purpose vehicles (SPVs). According to Kieff and Paredes (2010), Enron’s troubles were further deepened by embezzlement from its top executives who also actively participated in the misrepresentation of the company’s earnings reports. The company had significant connections to the nation’s political establishment – which meant that it could largely operate without being subjected to significant government scrutiny. It is important to note that at the peak of its performance, the company’s stock had reached a high of $90.75 (Kieff and Paredes, 2010). However, at the point of collapse, the company’s stock had loss massive value – trading at only $0.26 (Kieff and Paredes, 2010). Thus, some of those who were most impacted by Enron’s fall are inclusive of its employees, investors, as well as creditors.

The Tyco scandal, which has famously come to be referred to as the 2002 Tyco scandal, involved massive embezzlement of company funds by two top company executives – its CEO and CFO (Kieff and Paredes, 2010). In essence, the two engaged in a fraudulent scheme that ended up costing the company hundreds of millions of dollars. As Kieff and Paredes (2010) indicate, in addition to expense accounts falsification, the said executives also took unauthorized bonuses and partook in stock fraud. Also roped in into this scheme was the company’s general counsel who also took part in Tyco financial records’ falsification. It is important to note that although Tyco continued its operations following the discovery of this racketeering scheme, the top executives found to have taken part in the same were replaced and charged.

In the year 2002, yet another company went bankrupt as a result of accounting fraud. The said scandal involved one of the biggest telecommunication companies in the U.S. at the time, i.e. WorldCom. It is important to note that as Kieff and Paredes (2010) point out, news that “WorldCom had cooked its books came on the heels of the Enron and Tyco frauds, which had rocked the financial markets… the scale of the WorldCom fraud put even them in the shade” (211). WorldCom had engaged in well-coordinated efforts to falsify its financial statements with the intention of significantly enhancing its position in relation to profit-and-loss. This it managed to accomplish by falsifying data crucial accounting books and records including the balance sheet, income statement, as well as Form 10-K filing. The company’s top executives deployed a number of strategies to hoodwink both investors and the relevant regulatory agencies. The said strategies were inclusive of, but they were not limited to, having payments made for the utilization of other companies’ communication networks as capital expenditures (Kieff and Paredes, 2010). This had the effect of inflating the company’s earnings. As a consequence of management’s massive tampering with financial records in an effort to paint a picture that was largely inaccurate and manage Wall Street expectations, the company was eventually unable to cover the irregularities. It filed for bankruptcy in the year 2002.

Significance of the Sarbanes-Oxley Act

As has been indicated elsewhere in this text, the Sarbanes-Oxley Act came by as a consequence of the numerous scandals that had plagued the American corporate scene in the years preceding the early 2000s. Following the suffering visited upon various stakeholders after the discovery of the said scandals – specifically those highlighted in this text – there was need to restore sanity in the financial markets. Anand (2011) points out that few laws have had the impact that the Sarbanes-Oxley Act had on the country’s corporate governance. In basic terms, this particular act calls upon public companies to partake in a number of activities and engagements so as to further protect against financial schemes such as those witnessed during the early 2000s. More specifically, in the words of Anand (2011), this particular act calls upon “public companies to strengthen audit committees, perform internal control tests, make directors and officers personally liable for the accuracy of financial statements, and strengthen disclosure” (89). As the authors further observe, the said law also spells our harsher penalties for those found guilty of engaging in securities fraud. It would also be prudent to note that the Sarbanes-Oxley Act also adapts the operations of public accounting entities (Anand, 2011). There would be need to discuss the unique areas that this particular act focused on and the significance of its various provisions.

To begin with, the Sarbanes-Oxley Act effectively strengthened the audit committees of public companies. This is more so the case given that the said committees’ scope was widened in as far its oversight role is concerned, i.e. in relation to deeper scrutiny of the accounting decisions of the top executives of a company (Fletcher and Plette, 2008). Further, the audit committees were granted additional powers and could now take charge in the oversight of a company’s external auditors. Also, emerging concerns touching on the accounting practices of the top management could now be referred to the audit committee – thanks to the Sarbanes-Oxley Act.

Next, this particular act also greatly adapted the responsibilities of top management of public companies in as far as financial reporting is concerned. For instance, a new requirement was introduced calling upon executives to certify accounting reports’ accuracy in their personal capacity. What this meant is that the relevant executives could now be held individually or personally responsible for false certifications made willfully or knowingly. Those found guilty of engaging in the fraudulent certification risked being sent to prison for lengthy periods of time.

Third, it is also important to note that thanks to the Sarbanes-Oxley Act, the disclosure requirement was also greatly reinforced. This is especially the case given that the act made it mandatory for entities that were publicly traded to ensure that all off-balance sheet undertakings deemed material were disclosed (Fletcher and Plette, 2008). The said undertakings could be inclusive of, but they are not limited to special purpose entities and operating leases. Further, the act required that stock transactions undertaken by insiders be reported (within maximum of 2 business days) to SEC.

Fourth, stricter penalties were introduced for not only wire fraud, but also mail fraud as well as securities fraud and obstruction of justice. For instance, as Fletcher and Plette (2008) indicate, the maximum term for individuals found to have engaged in either wire fraud or mail fraud was increased to a maximum of 20 years – up from 5 years. Those found guilty of obstruction of justice would also be sent to jail for a period of 20 years (maximum), whereas those charged and found guilty for securities fraud would be imprisoned for a period not exceeding 25 years (Fletcher and Plette, 2008).

Next, this particular act required that annual audits be accompanied by an internal control report. The performance of broader internal control measures was also made mandatory for publicly traded companies. However, as will be highlighted elsewhere in this text, there are those who have been critical of this particular requirement – indicating that it is accompanied by a huge compliance cost.

Lastly, it should also be noted that with the establishment of the Public Company Accounting Oversight Board, this particular act further streamlined the practice of public accounting by ensuring that conflict of interest among public accountants was limited. Further, a requirement that there be a rotation of the lead audit partner on a periodic basis was introduced (Fletcher and Plette, 2008).

Specific Benefits of the Sarbanes-Oxley Act

The Sarbanes-Oxley Act benefited various stakeholders in diverse formats. This is more so the case in relation to securing the interests of investors and creditors as firms were now required to be more transparent and more deliberate/focused in their deployment of specific internal controls. The most significant benefits have been condensed below.

a) Promotion of Investor Confidence

Investor confidence had been badly shaken following the scandals that rocked the corporate scene in the years 2001 and 2002. Towards this end, the Sarbanes-Oxley Act was a move in the right direction in efforts to restore investor confidence as the said act had in essence outlined clear guidelines to govern the accounting/financial activities of companies. It also spelt the severe penalties for those found to be in contravention of the act’s various provisions.

b) Enhanced Transparency

Transparency in disclosure of financial information was another key benefit of the Sarbanes-Oxley Act. This is especially the case given that the said act expanded the reporting responsibilities of organizations and listed the roles of the key officers of entities in as far as financial disclosures are concerned.

c) Internal Controls Improvement

The Sarbanes-Oxley Act also sought to promote the accuracy and safety of data by ensuring that companies not only adopted, but also implemented internal controls that could be considered effective.

d) Contractor and Employee Protection

It should also be noted that this particular act prohibited entities from punishing contractors or employees who reported contraventions or other unlawful activities to the relevant authorities, such as SEC.

Practical Application: Improving Corporate Governance

Based on the discussion above, the Sarbanes-Oxley Act could be considered a huge win for corporate governance. In basic terms, corporate governance has got to do with the policies, processes, as well as systems by which companies are directed or controlled (Wheelen, Hunger, Hoffman, and Bamford, 2018). Below, I consider how I would utilize my knowledge and understanding of the Sarbanes-Oxley Act to improve corporate governance within a company in which I serve as CEO. A number of the relevant sections of the act have been highlighted in this regard.

To begin with, I would ensure that in compliance with Section 302 of the act, I (alongside my CFO) scrutinize all the relevant accounting records with an aim of ensuring that there are no misrepresentations contained therein, and that the said reports are presented ‘fairly.’ I would also seek to ensure that alongside my CFO, we constantly review and scrutinize the internal controls in place. This is especially important given that the act requires that deficiencies on this front be reported if/and when they are identified or uncovered. Lastly, still in seeking to ensure that I comply with Section 302, I would ensure that the relevant indications are made whenever the internal control systems reflect some changes that are deemed or considered material.

In seeking to comply with Section 401, I would ensure that any obligations or financial liabilities that could have a negative impact on the financial stability of the organization are disclosed. This is more so the case in seeking to ensure that all financial dealings are transparent. It is important to note that as Fletcher and Plette (2008) point out, some of the said obligations as well as financial liabilities have in the past been left out of the general balance sheet as they are deemed ‘off-balance sheet.’