The Impact of the Sarbanes-Oxley Act of 2002

After a prolonged period of corporate scandals (e.g., Enron and Worldcom) in the United States from 2000 to 2002, the Sarbanes-Oxley Act (SOX) was enacted in July 2002 to restore investors' confidence in the financial markets and close loopholes that allowed public companies to defraud investors. The act had a profound effect on corporate governance in the U.S. The Sarbanes-Oxley Act requires public companies to strengthen audit committees, perform internal controls tests, make directors and officers personally liable for the accuracy of financial statements, and strengthen disclosure. The Sarbanes-Oxley Act also establishes stricter criminal penalties for securities fraud and changes how public accounting firms operate.

What Does The Sarbanes-Oxley Act Do?

One direct effect of the Sarbanes-Oxley Act on corporate governance was the strengthening of public companies' audit committees. The audit committee receives wide leverage in overseeing the top management's accounting decisions. The audit committee, a subset of the board of directors consisting of non-management members, gained new responsibilities, such as approving numerous audit and non-audit services, selecting and overseeing external auditors, and handling complaints regarding the management's accounting practices.

The Sarbanes-Oxley Act changed management's responsibility for financial reporting significantly. The act requires that top managers personally certify the accuracy of financial reports. If a top manager knowingly or willfully makes a false certification, they can face between 10 to 20 years in prison. If the company is forced to make a required accounting restatement due to management's misconduct, top managers can be required to give up their bonuses or profits made from selling the company's stock. If the director or officer is convicted of a securities law violation, they can be prohibited from serving in the same role at the public company.

The Sarbanes-Oxley Act significantly strengthened the disclosure requirement. Public companies are required to disclose any material off-balance sheet arrangements, such as operating leases and special purposes entities. The company is also required to disclose any pro forma statements and how they would look under the generally accepted accounting principles (GAAP). Insiders must report their stock transactions to the Securities and Exchange Commission (SEC) within two business days as well.

The Sarbanes-Oxley Act imposes harsher punishment for obstructing justice, securities fraud, mail fraud, and wire fraud. The maximum sentence term for securities fraud was increased to 25 years, while the maximum prison time for the obstruction of justice was increased to 20 years. The act increased the maximum penalties for mail and wire fraud from five years of prison time to 20. Also, the Sarbanes-Oxley Act significantly increased the fines for public companies committing the same offense.

The costliest part of the Sarbanes-Oxley Act is Section 404, which requires public companies to perform extensive internal control tests and include an internal control report with their annual audits. Testing and documenting manual and automated controls in financial reporting requires enormous effort and involvement of not only external accountants but also experienced IT personnel. The compliance cost is especially burdensome for companies that heavily rely on manual controls. The Sarbanes-Oxley Act has encouraged companies to make their financial reporting more efficient, centralized, and automated. Even so, some critics feel all these controls make the act expensive to comply with, distracting personnel from the core business and discouraging growth.

"On the Sarbanes Oxley Act, the overdue harsher penalties and the requirement that the CEO and CFO sign to the veracity of the balance sheets and income statements may make some think twice, though much is still avoided by deferred payment," said Michael Connolly, a Professor of Economics with the Miami Herbert Business School. "However, the higher compliance costs due to the separate audit and investment requirements penalize smaller firms and allow the big firms to get bigger"

Finally, the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board, which promulgates standards for public accountants, limits their conflicts of interest, and requires lead audit partner rotation every five years for the same public company.