Sarbanes-Oxley Act: Purpose, Provisions, and Corporate Governance

Introduction

From the outset, it is important to note that the Sarbanes-Oxley Act remains a highly significant piece of legislation in efforts to rein in corporate fraud and enhance reliability in financial reporting. The Act was passed in 2002. This paper concerns itself with both the significance of this legislation and the reasons why it was passed. Among other things, the paper also considers how knowledge of the Act's various provisions can enable one to promote corporate governance within an organization.

Why the Sarbanes-Oxley Act Was Passed

Fletcher and Plette (2008) observe that this Act was necessitated by the numerous financial scandals that became commonplace in the early years of the 21st century. Some of the most prominent scandals involved publicly traded firms, including — but not limited to — WorldCom, Tyco International PLC, and Enron Corporation (Wheelen, Hunger, Hoffman, and Bamford, 2018). Some of these companies were focused on either ignoring or bending the regulations that had previously been formulated to secure the interests of shareholders (Wheelen, Hunger, Hoffman, and Bamford, 2018). For this reason, as Fletcher and Plette (2008) further indicate, these scandals had a massive negative impact on investor confidence — particularly regarding the extent to which investors could rely on corporate financial statements. As a consequence, calls arose from diverse quarters for the existing regulatory standards to be overhauled. Many observers noted that those standards had not been significantly updated for decades and were therefore largely ineffective in combating modern corporate fraud. It is also worth noting that technology was gaining ground in the business world during this period, especially following the advent of the internet.

When it comes to the Enron scandal, Kieff and Paredes (2010) describe it as a rather brazen accounting scandal. Together with the Tyco and WorldCom frauds, it could be considered one of the most complex scandals of its kind in history. This scandal — which surfaced in 2001 — involved massive accounting fraud and corporate corruption. As Kieff and Paredes (2010) observe, the company made extensive use of largely off-the-books accounting practices and deployed fake holdings in order to deceive regulators. The company also ensured that creditors and investors remained unaware of its worsening debt situation by utilizing special purpose entities (SPEs) and special purpose vehicles (SPVs). Enron's troubles were further deepened by embezzlement carried out by 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 it could largely operate without being subjected to meaningful government scrutiny. At the peak of its performance, Enron's stock reached a high of $90.75; at the point of collapse, however, it traded at only $0.26 (Kieff and Paredes, 2010). Among those most impacted by Enron's fall were its employees, investors, and creditors.

The Tyco scandal — famously known as the 2002 Tyco scandal — involved the massive embezzlement of company funds by two top executives: its CEO and CFO (Kieff and Paredes, 2010). These two engaged in a fraudulent scheme that cost the company hundreds of millions of dollars. In addition to falsifying expense accounts, the executives took unauthorized bonuses and participated in stock fraud. The company's general counsel was also implicated in the scheme and took part in falsifying Tyco's financial records. Although Tyco continued its operations following the discovery of this racketeering scheme, the top executives found to have participated were replaced and charged.

In 2002, another major company went bankrupt as a result of accounting fraud. This scandal involved one of the largest telecommunications companies in the United States at the time — WorldCom. 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" (p. 211). WorldCom had engaged in well-coordinated efforts to falsify its financial statements in order to significantly enhance its apparent profitability. It accomplished this by falsifying data in crucial accounting books and records, including the balance sheet, the income statement, and Form 10-K filings. The company's top executives deployed several strategies to mislead both investors and relevant regulatory agencies — including recording payments made for the use of other companies' communication networks as capital expenditures (Kieff and Paredes, 2010). This had the effect of inflating the company's reported earnings. As a consequence of management's extensive tampering with financial records, the company was eventually unable to conceal the irregularities and filed for bankruptcy in 2002.

Significance of the Sarbanes-Oxley Act

The Sarbanes-Oxley Act emerged as a consequence of the numerous scandals that had plagued the American corporate landscape in the years leading up to the early 2000s. Following the harm visited upon various stakeholders after the discovery of these scandals, there was an urgent need to restore confidence in the financial markets. Anand (2011) points out that few laws have had the impact of the Sarbanes-Oxley Act on the country's corporate governance. In broad terms, the Act requires public companies to undertake a number of activities and engagements in order to guard against financial schemes such as those witnessed during the early 2000s. More specifically, in the words of Anand (2011), the 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" (p. 89). The law also specifies harsher penalties for those found guilty of engaging in securities fraud. It is also worth noting that the Sarbanes-Oxley Act significantly adapted the operations of public accounting entities (Anand, 2011).

First, the Sarbanes-Oxley Act effectively strengthened the audit committees of public companies. The committees' scope was widened in terms of their oversight role — specifically in relation to deeper scrutiny of the accounting decisions of a company's top executives (Fletcher and Plette, 2008). Audit committees were granted additional powers and could now take charge of overseeing a company's external auditors. Emerging concerns about the accounting practices of top management could also now be referred directly to the audit committee.

Second, the Act significantly adapted the financial reporting responsibilities of top management at public companies. A new requirement was introduced calling upon executives to certify the accuracy of accounting reports in their personal capacity. This meant that relevant executives could be held individually and personally responsible for false certifications made willfully or knowingly, with those found guilty of fraudulent certification risking lengthy prison sentences.

Third, the disclosure requirement was greatly reinforced by the Sarbanes-Oxley Act. The Act made it mandatory for publicly traded entities to disclose all off-balance-sheet undertakings deemed material, including — but not limited to — special purpose entities and operating leases (Fletcher and Plette, 2008). Furthermore, the Act required that stock transactions undertaken by insiders be reported to the SEC within a maximum of two business days.

Fourth, stricter penalties were introduced for wire fraud, mail fraud, securities fraud, and obstruction of justice. For instance, as Fletcher and Plette (2008) indicate, the maximum term for individuals found guilty of either wire fraud or mail fraud was increased from five years to twenty years. Those found guilty of obstruction of justice could be imprisoned for up to twenty years, while those convicted of securities fraud could be imprisoned for up to twenty-five years (Fletcher and Plette, 2008).

Fifth, the 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. As discussed later in this paper, however, some critics have raised concerns that this requirement imposes a significant compliance cost on companies that have not yet fully automated their systems.

Finally, with the establishment of the Public Company Accounting Oversight Board (PCAOB), the Act further streamlined public accounting practice by limiting conflicts of interest among public accountants. A requirement for periodic rotation of the lead audit partner was also introduced (Fletcher and Plette, 2008).

Conclusion

The relevance of the Sarbanes-Oxley Act in efforts to rein in corporate fraud cannot be overstated. Passed in 2002, the Act introduced new regulations and standards designed to ensure better handling of financial reports. With more severe penalties imposed on those found in violation, the Act proved effective in deterring the misappropriation of corporate assets. Transparency in financial reporting was also significantly enhanced through strengthened disclosure requirements. It should be noted, however, that some observers remain concerned that the Act unfairly requires both large and small public companies to comply with the same reporting rules. Future adaptations to the law could be made to ensure that compliance costs are more equitably distributed.

References

Anand, S. (2011). Essentials of Sarbanes-Oxley. John Wiley & Sons.

Fletcher, W. H., & Plette, T. N. (2008). The Sarbanes-Oxley Act: Implementation, significance, and impact. Nova Publishers.

Kieff, F. S., & Paredes, T. A. (2010). Perspectives on corporate governance. Cambridge University Press.

Wagner, S., & Dittmar, L. (2006). The unexpected benefits of Sarbanes-Oxley. Harvard Business Review. https://hbr.org/2006/04/the-unexpected-benefits-of-sarbanes-oxley

Wheelen, T., Hunger, J. D., Hoffman, A. N., & Bamford, C. E. (2018). Concepts in strategic management and business policy. Pearson Education.