Lyn Spooner
Email:
George Lekatis
President of the President of the Sarbanes-Oxley Compliance Professionals Association (SOXCPA)
1200 G Street NW Suite 800, Washington DC 20005, USA - Tel: (202) 449-9750
Email:
An act aimed at protecting investors by making corporate disclosures more accurate
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.
Major Provisions
The SOX Act consists of eleven elements (or sections). The following are the most important sections of the Act:
Section 302
Financial reports and statements must certify that:
- The documents have been reviewed by signing officers and passed internal controls within the last 90 days.
- The documents are free of untrue statements or misleading omissions.
- The documents truthfully represent the company’s financial health and position.
- The documents must be accompanied by a list of all deficiencies or changes in internal controls and information on any fraud involving company employees.
Section 401
Financial statements are required to be accurate. Financial statements should also represent any off-balance liabilities, transactions, or obligations.
Section 404
Companies must publish a detailed statement in their annual reports explaining the structure of internal controls used. The information must also be made available regarding the procedures used for financial reporting. The statement should also assess the effectiveness of the internal controls and reporting procedures.
The accounting firm auditing the statements must also assess the internal controls and reporting procedures as part of the audit process.
Section 409
Companies are required to urgently disclose drastic changes in their financial position or operations, including acquisitions, divestments, and major personnel departures. The changes are to be presented in clear, unambiguous terms.
Section 802
Section 802 outlines the following penalties:
- Any company official found guilty of concealing, destroying, or altering documents, with the intent to disrupt an investigation, could face up to 20 years in prison and applicable fines.
- Any accountant who knowingly aids company officials in destroying, altering, or falsifying financial statements could face up to 10 years in prison.
Benefits to Investors
After the implementation of the Sarbanes-Oxley act, financial crime and accounting fraud became much less widespread than before. Organizations were deterred from attempting to overstate key figures such as revenues and net income. The cost of getting caught by the United States Securities and Exchange Commission (SEC) had exceeded the potential benefit that could result from taking liberties with the way that financial documents were presented.
Thus, investors benefited from access to more complete and reliable information and were able to base their investment analyses on more representative numbers.
Costs to Businesses
While the Sarbanes-Oxley act benefited investors, compliance costs rose for small businesses. According to a 2006 SEC report, smaller businesses with a market cap of less than $100 million faced compliance costs averaging 2.55% of revenues, whereas larger businesses only paid an average of 0.06% of revenue. The increased cost burden was mostly carried by newer companies that had recently gone public. A more granular view of the compliance costs experienced by businesses can be found in the chart below:
Repercussions
Due to the additional cash and time costs of complying with the Sarbanes-Oxley Act, many companies tend to put off going public until much later. This leads to a rise in debt financing and venture capital investments for smaller companies who cannot afford to comply with the act. The act faced criticism for stifling the U.S. economy, as the Hong Kong Stock Exchange surpassed the New York Stock Exchange as the world’s leading trading platform for three consecutive years.
Additional Resources
CFI is the official provider of the global Financial Modeling & Valuation Analyst certification program, designed to help anyone become a world-class financial analyst. The following CFI resources will be helpful in furthering your financial education:
- Income Statements
- Balance Sheet
- Types of Liabilities
- Deferred Revenue
The Sarbanes-Oxley Act (SOX) is a federal act passed in 2002 with bipartisan congressional support to improve auditing and public disclosure in response to several accounting scandals in the early-2000s. The act was named after the bill sponsors, Senator Paul Sarbanes and Representative Michael Oxley, and is also commonly referred to as SOX. Find the statutory text here: at: Pub.L.107–204.
Background:
In the early-2000s, accounting scandals at major firms shook financial markets, calling on Congress to increase investor protection. Enron was one of the major firms embroiled in such accounting scandals, as the firm’s stock price dropped from $90.75 at its peak in the fall of 2000 to $0.26 by the time it filed for bankruptcy in 2002. The drastic drop in stock prices occurred when a whistleblower exposed Enron’s practice of hiding debts and losses using accounting techniques, such as hiding toxic debt and assets from investors and creditors in off-balance-sheet special purpose vehicles. This blow to investors, along with similar scandals at major public corporations such as WorldCom and Tyco International, led Congress to strengthen disclosure and auditing requirements for public corporations to try to restore investor confidence in U.S. capital markets by passing the Act in 2002.
Provisions:
In enacting SOX, one of Congress’s primary aims was to prevent a firm’s management from interfering with an independent financial audit. Section 302 and 303 seek to enhance the independence of audits through regulating internal procedures and management actions. Section 302, codified 15 U.S.C. § 7241, requires public companies to adopt internal procedures for ensuring accuracy of financial statements and makes the CEO and CFO directly responsible for the accuracy, documentation, and submission of the financial reports and internal control structure.
Section 101–109, codified 15 U.S.C. §§ 7211–7220 with amendments to various sections of the Securities Act, created the Public Company Accounting and Oversight Board (PCAOB) to oversee public audit companies and promulgate auditing standards to ensure quality reporting and independent auditing. In 2009, the U.S. Supreme Court in PCAOB v. Free Enterprise Fund found the PCAOB removal provision—that the President may not remove a PCAOB commissioner but may only influence their tenure through the SEC commissioners, whom the President can only remove for cause, who may remove PCAOB commissioners only for cause—to be unconstitutional. However, the Court only severed the provision requiring the SEC to have cause to remove PCAOB commissioners, leaving PCAOB intact.
Congress also sought to ensure the Act’s effectiveness by providing for robust enforcement and oversight provisions. Section 301, codified 18 U.S.C. § 1350 which imposes criminal liability on any officer, i.e. a CEO and CFO, who knowingly or willfully submits non-complying financial statements. Section 303, codified 15 U.S.C. § 7242, which makes it unlawful for any officer or director to exercise improper influence on audits, such as through coercion, manipulation, or fraud. Section 404, codified 15 U.S.C. § 7262, which requires management to establish adequate internal control structure and procedures for financial reporting. It also requires management to submit an end-of-the-year assessment on the effectiveness of the internal control structure.
Particularly in response to the Enron accounting scandal, Congress sought to regulate certain types of public disclosures used to cover losses. Section 401 amended 15 U.S.C. § 78m(j) to require disclosure of off-balance sheet transactions. Also, in recognition of the role of whistleblowers in exposing the accounting scandals of the early-2000s, Congress passed Section 806, codified 18 U.S.C. § 1514A, which prohibits public companies from retaliating against whistleblowing employees. The U.S. Supreme Court in Lawson v. FMR extended the whistleblower protections in § 1514A to employees of a public company’s private contractors and subcontractors.
Impact:
One major criticism of SOX is the cost that greater disclosure and internal control requirements poses on smaller firms seeking to raise public funds. A Columbia Law Review Article, Sarbane-Oxley’s Effects on Small Firms: What is the Evidence?, found a degree of support in the argument that SOX disproportionately affected smaller firms and decreased the number of Initial Public Offerings (IPOs). A Financial Executives International study found net benefits to SOX, however, in net decreases in compliance costs and increased accuracy in financial statements. Overall, the cost of SOX’s greater internal control and disclosure requirements balanced with the benefit of greater financial statement accuracy is a matter of policy still subject to debate.
[Last updated in April of 2021 by the Wex Definitions Team]