Implications of the Sarbanes-Oxley Act of 2002

SOX

Review of the Sarbanes-Oxley Act of 2002

In July 2002, the Sarbanes-Oxley Act (SOX) of 2002 was enacted in order to restore confidence in corporate financial statements. This was in response to the series of financial scandals that erupted involving large corporations and accounting firms. Under SOX, accounting firms, public companies, registered foreign corporations, and specified private companies are required to comply with the requirements and rules as sanctioned by the law.

In most cases, the auditors were criticized and blamed for having a conflict of interest. Investigations showed that their income far exceeded what was supposed to be the average income in conducting an audit.

An article published on the Journal of Business and Economics Research said that the legislation of SOX resulted to “dramatic changes in the accounting industry.” These include the creation of Public Company Accounting Oversight Board (PCAOB), prohibition of certain services that an accounting firm can provide for a more independent auditing profession, delegation of more responsibilities to corporate executives, and implementation of provisions for transparent and accurate financial reports.

❏ Effect of SOX on Corporate Governance

The Harvard Law School classified the changes in corporate governance after the implementation of SOX as audit-related, board-related, and changes on disclosure and accounting rules.

❖ Changes Relevant to the Audit

Since most of the financial scandals that transpired involved accounting frauds, changes in the corporate governance is focused primarily on auditing processes and the way companies present their data. To reduce the likelihood of external auditors being used by their corporate clients for their own gain, auditors are forbidden to offer non-audit services to their clients. These include bookkeeping, internal audit outsourcing services, and legal services among others. As such, companies must employ another valuation firm for non-auditing concerns.

Corporations are also required to report the amount of money that they pay for an audit and other audit-related services versus non-audit services as allowed by the law. If and when governance rating agencies believe that the ratio between non-audit and audit services is extremely high, the rating agency will give the company a low governance grade.

The SOX compels corporations to have independent audit committees that have the authority to employ, terminate, and compensate external auditors. Furthermore, audit engagements and review partners must be replaced every five years. The law also provides guidelines on how to provide financial reports, requires financially literate and experts to be a part of the company’s audit committees, and demands validation on the efficacy of internal accounting controls.

❖ Changes Related to the Board

According to Harvard Law School, in an effort to curtail the likelihood of the occurrence of conflict of interests, SOX obliges public companies to have a majority of “independent executives” on their boards. Independent executives are those who are presently not associated with the company or have not been associated with the company for the past three years. In addition, he/she must not have any relatives on the board.

The law also requires companies to have an audit, compensation, and nominating committees that are comprised of independent directors. The members of the key committees, along with independent directors of the boards, must regularly conduct scheduled executive meetings. Moreover, they are obliged to perform periodic self-examinations and evaluations. On the part of the independent members of the committees, SOX requires them to be financially literate, competent, and proficient.

❖ Changes on Disclosure and Accounting Rules

SOX implements rules that necessitate better, quick, and different disclosures. These involve off-balance sheet arrangements, crucial accounting policies, and related party undertakings, filing requirements, and expensing stock options.

❏ Effect of SOX on U.S. Economy

The capital of foreign companies is inarguably an integral part of the country’s economy. Since the enactment of SOX, it has been reported that there had been a considerable decrease in number of non-U.S. corporations that enter the U.S. capital market. They think that the compliance cost relative to SOX far exceeds its potential merits. In effect, they invest in markets outside U.S.

According to George Washington University’s International Review, some people believe that because of SOX, an anti-competitive environment is formed wherein non-U.S. firms are prevented from having economic freedom similar to that of the U.S. corporations.

❏ Legal Implications of SOX

Mondaq Business Briefing conveyed that international administration of SOX can lead to double regulatory burdens, conflicting regulatory necessities and policies, cultural disparities, and concerns of comity and jurisdiction. In addition, a top U.S. accounting firm had expressed their concern regarding the legal impediments as a result of the enactment of SOX.

According to an article published by the Ohio State University’s Knowledge Bank, the extraterritorial application of SOX may result to major conflicts during the implementation of the law, which, in turn, affects the accounting firm’s capacity to audit the company.

❏ Impact of SOX on Public Corporations’ Information Systems

The enforcement of SOX on companies resulted to the creation of new systems and computer languages that follow, and can handle, SOX’s guidelines. However, not all companies were able to follow through. Some had “gone dark” or had to delist from stock exchanges in order to avoid costly system changes.

Based on an article published on The New York Times, smaller companies or those whose yearly incomes do not exceed $100 million have to spend more on compliance costs on IT infrastructure compared to larger companies that generate annual revenues of $2 billion or more.

Inarguably, the implementation of SOX led to some political, legal, and economical concerns. However, one cannot deny that the enforcement of the law resulted to a more credible financial information, bolstered corporate governance, and abatement on financial statement fraud.