Basics of Sarbanes-Oxley Act of 2002

Sarbanes-Oxley Act

Historical Timeline of Laws that Precedes Sarbanes-Oxley Act of 2002

In 1911, Kansas enforced a comprehensive securities law in response to agents that sell interests that had no financial backing. Several years down the line, the 1929 market crash acted as the turning point for the institution of preventive measures on business proceedings.

Consequently, the Securities Act of 1993 was enacted. Through this, investors were required to thoroughly disclose their financial information and were prohibited from engaging in shady, fraudulent, and misleading business transactions, which involved securities.

The implementation of the Securities Exchange Act of 1934 resulted to the formation of the Securities and Exchange Commission. According to Law Library – American Law and Legal Information, the agency is “responsible for supervising and regulating brokerage firms, transfer agents, clearing agencies, and securities self-regulatory organizations (SROs) in the country.”

A dispute between Otis & Co. and Pennsylvania Railroad Company in 1944 ensued the inference of the basis of the Business Judgment Rule wherein executives and directors are not subject to liabilities if they act in good faith, unless proven otherwise. Thereupon, several amendments and bills were passed and enacted that led us to Sarbanes-Oxley Act (SOX) of 2002.

Legislation of SOX

The eruption of the Enron scandal made investors to become doubtful and uncertain regarding the U.S. market. According to Forbes, there were 21 more scandals, aside from Enron from 2001 to 2002. Investigations revealed that auditing firms provided auditing and consulting services to the same entities, which is clearly a conflict of interest. These events are the ones that led to the legislation of SOX.

The Sarbanes-Oxley Act is a combined proposed bill of Senator Paul Sarbanes and Congressman Oxley. Sarbanes proposed the Public Company Accounting Reform and Investor Protection Act while Oxley introduced the Corporate and Auditing Accountability and Responsibility Act. The intention of SOX is to safeguard investors by improving the veracity and trustworthiness of corporate disclosures. In addition, the law will guarantee that the board of directors of public companies is responsible in receiving rigorous information relative to the financial status of the company and in disclosing it scrupulously to the public.

Main Components of SOX

❖ Establishment of Public Companies Accounting Oversight Board

Under the Sarbanes-Oxley Act of 2002, an independent oversight body is responsible for inspecting and supervising financial statement audits of public companies and in the institution of auditing guidelines in the country. This therefore led to the establishment of the Public Companies Accounting Oversight Board (PCAOB).

The Securities and Exchange Commission designates five members of the committee. Their duties and responsibilities include institution of auditing guidelines for external audits of public companies, overseeing accounting firms that offer auditing services and probing for possible transgressions or infractions of SOX regulations, rules, and guidelines in professional accounting. In addition, PCAOB release practice alerts so that auditors can address potential issues or risks.

The frequencies of PCAOB’s inspection on accounting firms depend on its auditing capacity. For instance, firms that conduct yearly audits to more than 100 public companies are subjected to annual PCAOB inspection. In so doing, audit professionals will know the areas that need further practice reminders or audit guidance in order to better their performance.

If and when PCAOB discovers irregularities and violations, the auditors and/or the firm will face fines, revocation of the firm’s registration with PCAOB, or proscription from the association.

Corporate Responsibility

Consequent to the implementation of SOX, the company’s Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are now held liable and accountable for the transparency and accuracy of their company’s’ financial statements. Before the financial reports are submitted to SEC, the CEO and CFO must first attest that these reports adhere to the provisions of the Securities Exchange Act of 1934 and are not misrepresented and misstated.

In confirming the veracity of the reports, the CEO and CFO must certify that:

❏ They have examined the financial reports and found them accurate and properly presented.
❏ They have assured and maintained a satisfactory internal control policy that will provide a reliable financial report.
❏ They have gauged the efficacy of the internal control.
❏ They have reported, to the company’s auditing body and external auditors, any fraudulent activities involving executives or employees who play an important part in the implementation of the internal controls.
❏ They have reported to the company’s auditing body and external auditors relevant shortcomings and inadequacies determined during their assessment.

Furthermore, SOX directs corporations to form independent audit committees whose duties include culling, compensating, and supervising their external auditors. Services carried out by external auditors that are not relevant to financial audit must first be authorized by the audit committee.

Corporations are compelled to report all material off-balance sheet undertakings and activities, which may influence their present or eventual financial health. In addition, material changes in the company’s financial status and code of ethics for its top executives must also be disclosed.

❖ Autonomy and Responsibility of Auditors

External auditors are expected to provide up-to-date information on significant accounting practices and regulations employed by the corporate management to the audit committee. In addition, any dialogues or talks between the management and the auditor regarding other possible schemes or protocols should also be reported.

To avoid conflict of interest, SOX forbids external auditors from providing certain services to their clients. These services encompass the following: bookkeeping, devising and realizing financial information systems, actuarial services among others. The auditor must not be associated, linked, or have ties with the client firm in any way whatsoever.

The auditor is responsible for substantiating and reporting the company’s internal controls. In addition, he/she is tasked with assessing the entity’s internal control system and to validate if the system can provide accurate and reliable financial reports.

At the end of an audit, the auditor will express an opinion established on the outcome of the auditor’s assessment. This will be a part of the company’s audited financial statements.