The Sarbanes-Oxley Act explained: Definition, purpose, and provisions

Sarbanes-Oxley was developed in response to the loss of consumer confidence in the capital markets and corporate financial statements arising from these scandals. Congressional hearings identified a series of causes that contributed to the harm, including lax oversight of auditors, the absence of auditor independence, insufficient corporate governance practices, conflicts of interest of stock analysts, limited disclosure obligations and “grossly inadequate” funding of the SEC and its enforcement capabilities. All annual financial reports must include an Internal Control Report stating that management is responsible for an “adequate” internal control structure, and an assessment by management of the effectiveness of the control structure. In addition, registered external auditors must attest to the accuracy of the company management’s assertion that internal accounting controls are in place, operational and effective. The Sarbanes-Oxley Act (sometimes referred to as the SOA, Sarbox, or SOX) is a U.S. law to protect investors by preventing fraudulent accounting and financial practices at publicly traded companies. Passed in 2002 in the wake of a series of corporate scandals and the bursting of the dot-com bubble, Sarbanes-Oxley imposed a number of reporting, accounting, and data retention mandates to ensure that business practices at big companies remain above board.

Companies are required to disclose on a almost real-time basis information concerning material changes in its financial condition or operations. A new generation of corporate leaders has entered the boardroom since 2002, and for many of them the magnitude of the financial crisis, its root causes and the impact of the act’s provisions may have faded. As Sarbanes-Oxley’s anniversary draws near, there may be value in leadership education, and perhaps introspection, on how the commerce and governance we know today was shaped by this momentous legislation. Critics also charged that the Act was a politically motivated reaction to a few, albeit high-profile, corporate financial scandals and that the law would hinder competition and business growth.

Sarbanes-Oxley controls

For instance, in 2003, not long after the law was passed, employees from Ernst & Young were arrested for destroying documents pertaining to one of their clients. In 2014 the FEC brought charges against the CEO and CFO of a Florida computer company for misleading auditors on the state of their internal controls. It was overbroad, it represented an unnecessary intrusion of the federal government into the financial markets, it represented the federalization of corporate governance, compliance would place severe financial burdens on many smaller companies, and it would depress the IPO market. Over time, the legitimacy of almost all these criticisms faded or failed to materialize.

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• For instance, a CEO or CFO who knowingly certifies a report that violates the Act can be fined up to $5 million dollars or sent to prison for up to 20 years.
• Section 404 made managers maintain “adequate internal control structure and procedures for financial reporting.” Companies’ auditors had to “attest” to these controls and disclose “material weaknesses.”
• In addition, registered external auditors must attest to the accuracy of the company management’s assertion that internal accounting controls are in place, operational and effective.
• Federal lawmakers enacted the Sarbanes-Oxley Act in large part due to corporate scandals at the start of the 21st century.
• Senator 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.
• Section 906 addresses criminal penalties for certifying a misleading or fraudulent financial report.

Under the Act, all accounting firms that audit public companies are required to register with the PCAOB. The PCAOB investigates and enforces compliance at the registered accounting firms. Among its many requirements, the Act requires public corporations to hire independent auditors to review their accounting practices and defines the rules of engagement for corporate audit committees and external auditors. The Sarbanes-Oxley Act is a federal law that was enacted on July 30, 2002 in reaction to the major corporate scandals that were going on at that time, such as that which involved the infamous Enron. Included in the bill are responsibilities entrusted to the boards of directors for public corporations, along with the criminal penalties that can be enforced in response to certain kinds of misconduct. The Act also demands that the Securities and Exchange Commission create regulations to guide corporations in their compliance with the law.

SOX Section 302 – Corporate Responsibility for Financial Reports

Congress passed on July 30 of that year to help protect investors from fraudulent financial reporting by corporations. Also known as the SOX Act of 2002, it mandated strict reforms to existing securities regulations and imposed tough new penalties on lawbreakers. It was soon surpassed in such ignominy by the July 2002 bankruptcy of the telecommunications firm WorldCom. Next year will mark the 20th anniversary of the passage of the Sarbanes-Oxley Act, federal legislation that has had an enormous—and mostly positive—impact on the integrity and reliability of companies, their financial statements, leadership and advisors. It sparked the corporate responsibility movement, which continues to impact corporate and leadership ethics and compliance with law.

• A few provisions of Sarbanes-Oxley apply to privately held companies—the law forbids such companies from destroying records to impede a federal agency’s investigation, for instance, or from retaliating against whistleblowers.
• Such financial statements should also include all material off-balance sheet liabilities, obligations, and transactions.
• Many thousands of companies face the task of ensuring their accounting operations are in compliance with the Sarbanes Oxley Act.
• Whistleblowers can report any corporate retaliation to the Occupational Safety and Health Administration.
• Companies must publish a detailed statement in their annual reports explaining the structure of internal controls used.
• Section 302 of the Act mandates a set of internal procedures designed to ensure accurate financial disclosure.

Major Provisions

The Sarbanes-Oxley Act also created new requirements for corporate auditing practices. The whistleblower protection provision states that employees and contractors who report fraud and/or testify about fraud to the Department of Labor are protected against retaliation, including dismissal and discrimination. Title III contains several important elements of the Sarbanes-Oxley Act.

Benefits to firms and investors

Sarbanes-Oxley penalties can be quite serious—and, importantly, they apply to individuals in positions of power at companies directly, not just the companies as institutions. While corporate officers mistakenly signing off on erroneous reports can be punished for it, the worst treatment is reserved for deliberate fraud. For instance, a CEO or CFO who knowingly certifies a report that violates the Act can be fined up to $5 million dollars or sent to prison for up to 20 years. Of these sections, 404 is considered the most complex and most onerous.

Senator Sarbanes’s 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. Senator 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.

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A Lord & Benoit report, titled Bridging the Sarbanes–Oxley Disclosure Control Gap, was filed with the SEC Subcommittee on internal controls which reported that those companies with ineffective internal controls, the expected rate of full and accurate disclosure under Section 302 will range between 8 and 15 percent. A full 9 out of every 10 companies with ineffective Section 404 controls self reported effective Section 302 controls in the same period end that an adverse Section 404 was reported, 90% in accurate without a Section 404 audit. SOX addressed the corporate scandals at Enron, WorldCom, and Arthur Anderson.

Definition of Sarbanes Oxley Act

This is apparent in the comparative costs sabanes oxley act of companies with decentralized operations and systems, versus those with centralized, more efficient systems. For example, the 2007 Financial Executives International (FEI) survey indicated average compliance costs for decentralized companies were $1.9 million, while centralized company costs were $1.3 million.49 Costs of evaluating manual control procedures are dramatically reduced through automation. The Sarbanes-Oxley Act (or SOX Act) is a U.S. federal law that aims to protect investors by making corporate disclosures more reliable and accurate. The Act was spurred by major accounting scandals, such as Enron and WorldCom (today called MCI Inc.), that tricked investors and inflated stock prices. Spearheaded by Senator Paul Sarbanes and Representative Michael Oxley, the Act was signed into law by President George W. Bush on July 30, 2002.