Sarbanes-Oxley Act of 2002

Jadeen Service

Hampton University 2014

MBA 315

3/5/2014

Abstract

This paper will discuss the purpose, history, and causes of the Sarbanes – Oxley Act of

2002. The public became aware that company controls needed to be more tightly managed. The

role of an auditors is to provide financial statement users with an opinion based on whether the

financial statements were presented fairly and to help detect fraud. Considered by many to be

one of the most important legislation affecting auditors in the past century. The law enforced

provisions that drastically changed the way publicly held accounting companies behaved as well

as the audit firms auditing them. We will investigate the contextual meaning and effects of the

law. This paper will delve into how this law has impacted industries within the corporate world.

The term Sarbanes-Oxley stems from the Senator Paul Sarbanes and Representative

Michael Oxley, who drafted the act. Sarbanes Oxley Act of 2002 was established in order to

identify accounting frauds in different public companies. This paper will examine the causes and

content/components of the Sarbanes Oxley Act. Sarbanes-Oxley has focused primarily on

reestablishing investor confidence in the financial markets. It was triggered by the bankruptcies

and alleged audit failures involving such companies as Enron and WorldCom. The Sarbanes –

Oxley Act established the Public Company Accounting Oversight Board, appointed and overseen

by the SEC. The PCAOB.

The Sarbanes-Oxley Act was signed into law on 30 July 2002 by President Bush. The Act

is designed to oversee the financial reporting landscape for finance professionals. Its purpose is

to review legislative audit requirements and to protect investors by improving the accuracy and

reliability of corporate disclosures. The act covers issues such as establishing a public company

accounting oversight board, auditor independence, corporate responsibility and enhanced

financial disclosure. It also significantly tightens accountability standards for directors and

officers, auditors, securities analysts and legal counsel. The two key provisions of the Sarbanes-

Oxley Act are: 1. Section 302: A mandate that requires senior management to certify the

accuracy of the reported financial statement & 2. Section 404: A requirement that management

and auditors establish internal controls and reporting methods on the adequacy of those controls.

Section 404 had very costly implications for publicly traded companies as it is expensive to

establish and maintain the required internal controls.

The Sarbanes-Oxley Act created new standards for corporate accountability as well as

new penalties for acts of wrongdoing. It changes how corporate boards and executives must

interact with each other and with corporate auditors. It removes the defense of "I wasn't aware of

financial issues" from CEOs and CFOs, holding them accountable for the accuracy of financial

statements. The Act specifies new financial reporting responsibilities, including adherence to

new internal controls and procedures designed to ensure the validity of their financial records.

Before understanding how the Sarbanes Oxley act of 2002 effected companies going

forward there must be a comprehensive understanding of the terms used. The term ‘‘audit’’

means an examination of the financial statements of any issuer by an independent public

accounting firm in accordance with the rules of the Board or the Commission (or, for the period

preceding the adoption of applicable rules of the Board under section 103, in accordance with

then-applicable generally accepted auditing and related standards for such purposes), for the

purpose of expressing an opinion on such statements. a committee (or equivalent body)

established by and amongst the board of directors of an issuer for the purpose of overseeing the

accounting and financial reporting processes of the issuer and audits of the financial statements

of the issuer; and (B) if no such committee exists with respect to an issuer, the entire board of

directors of the issuer. From this audit will stem an audit report.

A report prepared following an audit performed for purposes of compliance by an issuer

with the requirements of the securities laws; and (B) in which a public accounting firm either—

(i) sets forth the opinion of that firm regarding a financial statement, report, or other document;

or (ii) asserts that no such opinion can be expressed.

Background and Purpose

Enron began in 1985 selling natural gas to gas companies and businesses. In the year

1996, government guidelines no longer governed what the price of energy would be. Prices

would now be driven by the competition between the energy companies within the industry.

Enron could now begin to act more as a middleman rather than just a simple energy supplier.

Enron's rapid growth created drove the stock price up and it gained the opportunity to enter into

other industries for example Internet services, and in turn resulted in the increased complication

of its financial contracts.

Looking profitable in the eyes of investors is important in the business industry. In order

to keep its steady growth at an increase, Enron started borrowing money to help them invest in

other activities. Debt would decrease their attractiveness by impacting their earnings. In realizing

this factor, Enron decided to create partnerships in which allowed them to keep their debt off of

their books. Chewco Investments, a partnership generated by Enron, allowed $600 million in

debt off the books. Because this debt was hidden, Enron claimed to have tripled its profits in two

years.

In the summer of 2001 Vice President of Enron, Sherron Watkins sent an anonymous

letter to the CEO, Kenneth Lay, listing accounting methods she felt would eventually lead up to

Enron’s turn in number of accounting scandals. During that same time Kenneth Lay took time to

email his employees implying that he expected the stock prices of Enron to rise; as he sold off all

his own stock in the company. On October 22nd 2001, the SEC announced that Enron was under

investigation. On November 8th, Enron declared a statement that it had overstated earnings for

the past four years by $586 million and that it owed over $6 billion in debt by next year.

Enron’s stock price plummeted which prompted Enron to act on specific agreements that

mandated it pay investors their money almost instantly. Enron clearly did not have the capital to

efficiently cover all its expenditures including repay its creditors therefore causing them to

declare Chapter 11 bankruptcy.

Executives of WorldCom, once the leading telecommunications company in the United

States, were convicted of deliberately misapplying the asset capitalization rules to boost reported

pre-tax income by approximately $3.8 billion over five quarters in 2001 and 2002. WorldCom

said most of the $3.3 billion abnormality involved the manipulation of reserves. Companies set

aside reserves in order to conceal estimated losses such as uncollected payments from customers

among numerous other expected costs. Normal operating costs for connecting to other

telecommunication lines which were actually expenses were capitalized basically listed as

investments. When these specific line costs were debited to balance sheet asset accounts eager

than charged to income statement expenses were dramatically overstated. Operating expenses

should be deducted from revenue as soon as payments are made. On the other hand, the cost of

capital expenses can range over time. Inaccurately spreading operating costs exaggerated

WorldCom's profits. The hidden motive behind WorldCom's actions was to cover up their non-

proficient ability to keep up with the industry capacity.  

WorldCom's accountants at the time were Arthur Andersen, the same people that looked

after Enron's books as well as other companies hit by accounting issues - Tyco, Global Crossing

and Adelphia. These among other corporate fraud forced government to take a hand and enact

the Sarbanes-Oxley Act of 2002.

The Economic Impact of Sarbanes-Oxley on the Business Environment

The crucial changes resulted in the creation of the Public Company Accounting Oversight

Board, the assessment of personal liability to auditors, executives and board members and

creation of the Section 404. Section 404 refers to mandatory internal control procedures. Public

companies must now include an internal control report with their annual audit. The oversight

board is accountable for monitoring the actions of public accounting companies, and works

jointly with the SEC. Based on size, accounting forms undergo reviews every one to three years,

depending on their size. Also another regulation, is public accounting firms will now be held

personally liable for their audits.

Public companies were obligated to conform with Sarbanes-Oxley therefore gaining

additional costs directly attributed to the new regulation. Preliminary costs associated with the

act include amplified expenses for annual audits, which public accounting companies passed on

to clients to provide a sense of trust. Accounting companies also experienced additional liability

with increased due diligence. Section 404 demanded the use of internal controls causing business

to implement and purchase internal control software/programs and the up keeping of these

programs. The prices for audits and non-compliance are expensive.

SOX had a two different effects on the market for investors who must be self-assured in

their decisions. The law projected to regain the confidence of investors after the recent

conspiracies in the market and secondly it intended to curb the ability for companies to

manipulate the investors at hand. The SEC used Sarbanes-Oxley to create a barrier for foreign

companies to function within the United States. Many small-sized /medium-sized companies

chose not to go public or to re-privatize existing public companies

Costs of Compliance

Studies of compliance costs due to the Sarbanes Oxley Acct prove to increase all public

accounting firms’ expenses regardless of size or profit. Unfortunately, smaller firms were

affected more on the basis that auditing costs were disproportionate to their revenue made. Firms

that had less than $75 million in market investments, spending highest portion of revenues on

audit fees saw an increase at over one percent.

Total costs of first-year compliance with section 404 could possibly surpass $4 and a half

million for each of the largest U.S. companies, which are companies that generated at least $5

billion in revenues). Medium-sized and smaller companies find an increased average projected

cost of at least $2 million. The estimated number does not apply to a single audit but the

recurring event that internal systems must comply with at least once a year. The price for

enlisting suitable board members has also enlarged. A financially literate audit committee is now

required to have a designated “financial expert.” This may provide a hindrance for some

companies to find an appropriate member that fits all the requirements. The PCAOB has

introduced new fees that must be paid monthly to support their operations.

The Sarbanes-Oxley Act puts stricter controls on public companies. However, there are

consequences for private companies as well. The whistleblower rule is in place for both public

and private companies to protect those who wish to anonymously report potential fraud of

corporate employees. Private companies must be able to show compliance with internal control

through documentation.

Market Implications

A report from the General Accounting Office discovered that the Big Four audit around

80% of U.S. public companies. They depict the audit providers as an oligopoly of a few

businesses. And a small barrier of entry. None of the Big Four have expertise in every industry,

so some market segments are actually dominated by just one or two firms, still leaving no room

for more competitors to compete fairly.

Conclusion

In conclusion, the Sarbanes – Oxley Act of 2002 set forth a number of changes for

primarily the United States but foreign countries as well. The public lost trust in the acts

committed by once such successful companies. The fraud caused investors to make decisions

based on ethics and the safety of their capital. The Act helped to restore their confidence and

have them reinvest in the market. The act caused auditors and executives to abide by new rules

that impacted their relations as well as the way they conducted business outside of the auditing

process. Sarbanes Oxley set principles for how publicly traded companies maneuver and

accurately transcript financial documents. This law has forced more responsibilities on CFO and

CEOs.

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