Sarbanes-Oxley Act

English 135

Instructor: Fawn-Bragg

David Ross

15 February 06

Sarbanes-Oxley Act

The "Sarbanes-Oxley Act" is a comprehensive corporate reform package that was signed into the US law on July 30, 2002. The passage of the Act has been heralded by some as a historic occasion--calling it the most significant accounting legislation since 1933, while others have severely criticized the Act either as a "too little too late measure" or as a hasty knee jerk reaction to a temporary situation. Without a doubt, the Sarbanes-Oxley Act is the single most important piece of legislation affecting corporate governance, financial disclosure and the practice of public accounting since the US securities laws of the early 1930s. And, it is clear that public companies and the accounting profession have made tremendous progress in meeting the rigorous requirements of this legislation. In this paper we shall discuss the business conditions that led to the passage of the Act, the accounting problems that caused the Act to be passed, the advantages and disadvantages of the Act and the effect of the Act on the future of the Accounting profession. In the end I shall state my personal opinion about the Act.

Between December 2001 and July 2002, four major US corporations--Enron, Global Crossing, Adelphia and WorldCom filed for bankruptcy--six of the largest corporate bankruptcies in U.S. history (Recine 1535). These companies had hidden their true financial health from creditors and shareholders until an inability to meet financial commitments forced them to restate earnings that revealed massive losses. In most cases, the top most management had also indulged in massive fraud, insider trading and cashing in of stock options. The financial collapse of such large corporations, weakened a stock market already hit by the technology bubble-burst of 2000 and the 9/11 terrorist attacks. The US public was outraged at the unethical business practices of a number of corporate executives and demanded urgent action by the government. The legislatures were forced to re-examine the regulatory environment for businesses and the accounting profession and came up with Sarbanes-Oxley Act, which was promptly passed by the two houses and signed into law.

Subsequent investigations into the bankruptcies revealed that not only was the top management of several large corporations directly involved in questionable business practices, they were actively aided by corporate accounting firms, attorneys and audit committees in the financial irregularities and cover-ups. In short, it was the unraveling of the accounting system of the US businesses.

As an example, Enron was able to hide its precarious financial position and highly risky business operations by exploiting the loopholes in the existing accounting rules. This was done mainly through the use of hundreds of Special Purpose Entities (SPEs) that enabled the company to park its losses in off-balance sheet transactions while artificially showing increased earnings in its balance sheets. The surprising aspect of the scandal was that according to the prevalent accounting rules, SPEs were legitimate instruments .(Reinstein & Weirich 22).

Another loophole in the accounting practice was the massive use of stock options, which does not have to be included in the financial statements as an expense, but can be treated as an expense by the firm for tax purpose. This allows firms to show lower to show lower payroll costs and higher figure profit figures. For example, Enron took a $625 million tax deduction for options from 1996 to 2000, yet legally included the $625 million on its earnings. (Kratz and Jones, 2002).

Another accounting problem was the widespread amalgamation of the auditing and financial consulting functions. Arthur Anderson, Enron's auditor was also its financial consultant and was paid millions of dollars in audit and consulting fees, which led to conflict of interest and impaired the auditor's independence.

The prompt passage of the Sarbanes-Oakley Act by the legislature was crucial in restoring the public's confidence in corporate governance that, for a time, was badly shaken by the accounting and financial disclosure irregularities. A strong culture, positive or negative, will directly impact a control environment. Ignoring culture is like ignoring a cancer threat. Fairlure to take responsibility for the health of the corporate culture by way of periodic checkups and the constant exercise of values can lead to apathy and a diet deficient of reinforcing procedures.

One of the provisions of Sarbanes-Oxley makes the chief executive officers (CEOs) and chief financial officers (CFOs) personally responsible for signing false accounts and financial statements. They can now get stiff jail terms for violating the law by signing false and misleading financial statements. Before Sarbanes-Oxley many CEOs and CFOs pleaded innocence when financial irregularities were revealed by claiming that they were unaware of the 'cooking' of the books by their subordinates.

Despite the fact that hundreds of billions of dollars are lost every year to white collar crimes, white-collar criminals were always less likely to serve jail terms than other criminals. The Sarbanes-Oxley takes concrete measures to set the discrepancy right as the Title IX of the White Collar Crime Penalty Enhancement Act, which is part of the Sarbanes-Oxley Act provides for much larger jail terms for frauds. This is bound to have a psychological deterrence effect on incidences of white collar crime. ("Summary of...")

The Act also prohibits the auditors from providing other services such as financial consultancy to avoid conflict of interest. It also provides for auditors to be rotated periodically, in order to avoid them from getting too friendly with the management.

Protection for 'whistle blowers' is another plus point of the Act: It would help to create a conducive corporate environment in which ethical employees would be encouraged to introduce an element of self-regulation in the work place.

The Corporate Sector in the United States is already sufficiently regulated making it one of most tightly controlled in the world. Further regulation goes against the principles of a free market economy that is one of the basic principles of the country's economy. What was needed in the wake of bankruptcy scandals was stricter enforcement of the existing laws rather than creating new ones.

The Act was a knee-jerk reaction to the accounting scandals in a tiny percentage of businesses. The new reporting requirements of Sarbanes-Oxley, such as