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The American reaction to Enron: Sarbanes-Oxley Act explained with its Pros and Cons

Updated on March 26, 2013
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Sarbanes-Oxley Act an introduction

The Sarbanese-Oxley Act (or Sox) was published in 2002. Since the start of 2004, all US companies have been forced to submit an annual assessment of the effectiveness of their internal control systems to Security and Exchange Council (SEC). Further, the Sarbanes-Oxley Act has forced companies' independent auditors to audit and report on the internal control reports produced by the management, in the same way as they audit the financial statements. Major Corporate collapses forced many countries to publish SOX types of acts, such as UK's Smith Report which is SOX's equivalent.



Sarbanes-Oxley Act (2002): defines Internal control over financial reporting as:

The Sarbanes-Oxley Act (2002) made substantial changes to the financial reporting process. Specifically, the legislation defined internal control over financial reporting as:

A process designed by, or under the supervision of, the registrant's principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant's board of directors,management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

  1. Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the registrant;
  2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the registrant are being made only in accordance with authorizations of management and directors of the registrant;and
  3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the registrant's assets that could have a material effect on the financial statements. (For More info Refer to: http://www.sec.gov/rules/final/33-8238.htm)



Elaboration of SOX and emphasis on disclosure and a strong internal control system

In this sense, Sarbanes-Oxley focused attention on the financial reporting aspects of internal control. In other words, the new legislation considered that the internal control was principally concerned with preparation of financial reports. Sarbanes-Oxley also required that all listed companies must have a disclosure committee with the remit of overseeing the process by which disclosures are created and reviewed. Further, the new legislation required the company's principal executive officer and principal financial officer to sign two certificates, making them personally responsible for the correctness of the financial reporting. Also, the company's external auditors are now required to audit the companies' report on the effectiveness of internal control systems. This means that, in effect, the internal control system is assessed twice: first by management, and second by the independent auditors. SOX emphasized the need for auditor independence to be assured.



Pros:

Financial information and its reliability:

The real purpose behind the effort that produced SOX was to reinstate public confidence in the financial statements prepared by public organisations. Producing reliable financial information was one of the main objectives of the internal control as the more efficient internal controls are, the more reliable the information produced will be. Maintenance of effective internal control system is one of SOX’s requirements, therefore it is expected that information produced through such a strong system will be reliable. By following SOX properly, companies can detect any financial frauds or misstatements easily.


Involving Corporate Governance in a company’s decisions:

Ethical values and a culture of business honesty can most of the times be responsible for strengthened financial performance. For example, Government Metrics International (2005) found in a research of 2500 global companies that SOX led to a 10% improvement in corporate governance performance of U.S. organisations versus their foreign counterparts. (Government Metrics Internal is an independent governance research which is responsible for rating corporate governance performance in firms, more about GMI can be learned at: http://main.governanceprofessionals.org/governanceprofessionals/member_resources/serviceproviderdirectory/allproviders/governancemetricsinternational).


Impact of SOX on Not for profit and private organisations

Sarbanes-Oxley act was never intended for not for profit and public firms, but many private and non-profit organisations have implemented SOX’s provisions as best practice. And they have greatly benefited from its provisions. PriceWaterhouseCoopers’ (2005) surveyed some fastest-growing private U.S. firms, in this survey 30% of companies indicated that they were impacted or would be impacted in the near future by SOX. Some significant results associated with SOX compliance according to these private firms were:

  • improvement of testing and documentation
  • Reinforcing of corporate governance procedures
  • Making ethics and conduct codes stronger
  • Adoption of best practices by public companies
  • Introduction of Whistleblower policies



Cons

Audit Fees and costs

Since there is a lot of emphasis on strengthening internal control systems therefore it means increased audit costs for the companies.

Some critics concluded that section 404 of Sarbanes-Oxley Act is very rigid and the cost of implementation exceeds the benefits provided. This is unanimously agreed between and among the Securities and Exchange commissions, Public company accounting oversight board, Congress, and majority of public companies. And these costs are a problem not only for the company but investors too.

The Sarbanes-Oxley Act explained in less than 5 minutes

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