The central theme of the Sarbanes-Oxley Act of 2002 is the measures that need to be taken to prevent accounting fraud in US corporations. Analyzing the Act’s background and main provisions help understand what regulations were adopted to assist in the prevention of accounting fraud.
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The full title of the Act is “An Act To protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.” It was enacted by the 107th United States Congress and signed by the President in July 2002. The adoption of the law was preceded by several scandals where fraudulent actions of senior executives of large public companies had been revealed. Two prominent scandals were the cases of Enron Corporation and WorldCom. The Enron scandal was one of the most heavily publicized corporate corruption stories in the early 2000s. At the end of 2001, it became known that the corporation had been continuously reporting incorrect information on its finances with the executives’ intention to misappropriate money.
The fraudulent scheme was described in the press as systematic and creative. Concerning WorldCom, the company’s executives were also involved in a series of fraudulent actions. Particularly, the CEO persuaded the board to invest in his other businesses, and the investments negatively affected the corporation. Moreover, it was further discovered that the company had been overstating its assets and revenues for several years by manipulating financial documentation. The dissolution of these two large corporations significantly affected the market. Among other cases of corporate fraud, the cases of Enron and WorldCom highlighted the need to adopt legislation that would help prevent corporate fraud.
The Sarbanes-Oxley Act was planned to become such legislation. It used a complex approach to the issue and contained provisions for various aspects of corporate regulations. The Act consists of 11 titles covering the rights and responsibilities of the board of directors, auditors, financial stuff, and corporate employees. The major provisions are widening the board’s responsibility for financial reporting, regulating the activities of auditors, restricting them from providing certain types of services to the companies they audit for and protecting employees who are willing to disclose accounting fraud if they face it.
The major provisions of the Act are contained in the titles VIII and IX. Title VIII can be separately referred to as the Corporate and Criminal Fraud Accountability Act of 2002. It defines certain criminal penalties for any manipulation of a public company’s financial documentation and for the destruction thereof. Another important part of the Title is that it provides for the protection of employees who present evidence of accounting fraud in their corporations to authorities or make it public (so-called whistle-blowers).
Title IX can be separately referred to as the White-Collar Crime Penalty Enhancement Act of 2002. This part of the law deals with the punishment for office workers of corporations who are involved in fraud, manipulation of documentation, and conspiracies. The necessity for these provisions is justified by acknowledging that accounting fraud by corporate directors is usually associated with inciting certain employees to participate in fraudulent schemes. Title IX increases penalties for such participation.
Title I of the Act provides for creating an organ that is responsible for overseeing a corporation’s finances and accounting—the Public Company Accounting Oversight Board (PCAOB). It is specified how the board should certify and monitor the company’s auditors. Title II is dedicated to ensuring auditor independence, which is a major component of financial and accounting transparency and shareholders’ confidence. In order to avoid conflicts of interest, auditors are prohibited to provide any services related to financing or accounting (e.g. bookkeeping, analysis, and consulting) to corporations, for which they audit.
Titles III to VII covers the concept of corporate responsibility, the responsibilities of security analysts, and the functions of the security exchange commission (SEC). The description of corporate responsibility in the Act requires that executives of a corporation, particularly the CEO and the CFO, bear extended responsibility for the accuracy and completeness of all the financial documentation the corporation generates, especially statements of assets and revenues.
The Act obliges corporations to disclose certain information about their finances and accounting which previously could have been kept a secret. The Act also considers that conflicts of interest can occur for securities analysts, not only for auditors. Titles V and VI establish certain procedures and rules for securities analysts which are supposed to help prevent their involvement in the fraud. Title VII states the importance and necessity of research on the subject of corporate accounting. The law requires the SEC to conduct studies on the subject and report findings for the improvement of corporate regulations.
The only provision of Title X is the requirement for the CEO to sign the federal income tax return. Title XI can be separately referred to as the Corporate Fraud Accountability Act of 2002. It assigns certain increased penalties for accounting fraud and forgery of financial documentation. This part of the law also authorizes the SEC to block transactions or payments of a corporation if they are considered by the commission’s members to be too large or otherwise suspicious.
The Act affects public companies’ executives, overseeing authorities, and finances employees. Pursuing increased transparency of corporations’ financial records and avoidance of conflicts of interests for auditors and analysts, the Sarbanes-Oxley Act required a number of serious modifications to the way a corporation operates in terms of financial reporting, auditing, and governance. It had both positive and negative outcomes.
The positive outcome of adopting the Act is creating a model of corporate interactions between the boards of directors and the auditing committees that minimized the risks of occurrence of accounting fraud. Several studies conducted in a few years after the Act had been adopted showed that the level of transparency in large US corporations had increased. Transparency is measured based on the availability of various financial data and the accuracy of financial forecasts. Another benefit is that companies who had reinforced their internal control according to the Sarbanes-Oxley Act found their operation more cost-efficient. Also, the transparency measures taken by US corporations improved investor confidence, i.e. made investors regard corporations as more reliable.
However, the Act also was considered to cause certain inconveniences for corporations. Internal procedures and practices had to be modified, and certain types of direct interactions among different organs and positions within a corporation were omitted. The restrictions imposed on auditors and analysts and the responsibilities imposed on the boards of directors made the operation more complicated, i.e. more expensive and time-consuming. Although these complications may harm corporations in terms of efficiency and competitiveness, they are the price US public companies had to pay to protect shareholders and investors from the threat of corporate and accounting fraud.