Charles Hooper

Thoughts and projects from an infrastructure engineer

Why Was the Sarbanes-Oxley Act of 2002 Created and How Does It Impact Financial Reporting Today?

This entry is part 5 of 8 in the seriesIntro to Financial Reporting

The Sarbanes-Oxley Act of 2002, also known as the SOX Act, was created in response to the series of misleading and outright fraudulent activity of big business in the 1990s (Lasher, 2008, p. 187). Essentially, multiple publicly-traded businesses jacked up their stock prices by “publishing false or deceptive financial statements” (Lasher, 2008, p. 187). The most notable company to crash was Enron, followed by Global Crossing (parent of MCI,) and Xerox; later, almost one thousand publicly traded companies restated their financial statements (Lasher, 2008, p. 187). This resulted in almost $6 trillion of stock market value disappearing (Lasher, 2008, p. 187)! In response to these events, Congress drafted and passed the Sarbanes-Oxley Act (SOX) of 2002.

Next, we look to the provisions of the Sarbanes-Oxley Act of 2002 to see how they impact the way firms prepare their financial statements. The first and most major way the SOX Act impacted financial reporting was that it ended self-regulation of the public accounting industry (Lasher, 2008, p. 190). The SOX Act achieved this by establishing the Public Company Accounting Oversight Board (PCAOB,) an independent, non-profit organization (Lasher, 2008, p. 190). The PCAOB is given authority and empowered by the Securities Exchange Commission (SEC) to regulate and enforce these regulations of the accounting industry (Lasher, 2008, p. 190). Under the regulations of the SOX Act and the PCAOB, it is now required for all accounting firms to be registered and illegal for an unregistered firm to issue audit reports for publicly-traded companies (Lasher, 2008, p. 190). The PCAOB is empowered and directed to perform investigations of questionable accounting practices, hold disciplinary hearings, and impose sanctions upon firms and individuals who auditors who are caught letting wrongdoings “slide” (Lasher, 2008, p. 190). Another way the SOX Act effectively restores the integrity of financial statements is by removing a very large conflict of interest that existed in the 1990s. This conflict of interest existed for accounting firms that also provided consulting services to their clients; under the SOX Act, these types of relationships became illegal and firms that had audit clients could no longer offer these same clients additional consulting services (Lasher, 2008, p. 190). Another major conflict of interest that was removed was the relationships between auditors and the audited firm’s CEO and CFO. Instead of reporting to the firm’s executives, auditors now reported to an “audit committee” of the firm’s Board of Directors; At least one member of which is legally required to be a financial expert (Lasher, 2008, p. 190). Finally, partners of an auditing firm can only supervise the same client for five years at a time (Lasher, 2008, p. 191). The final main problem that the SOX Act addresses is the potential conflict of interest between a firm and its executives, also known as the agency problem (Lasher, 2008, p. 192). The SOX Act achieved this by requiring CEOs and CFOs to certify that they reviewed their firm’s financial statements, that they are true to the best of their knowledge, to also certify that they are personally responsible for their firm’s internal financial controls, and by requiring that company executives repay bonuses and capital gains from stock sales if they follow within 12 months of the issue of financial statements and the gains are made as a “result of misconduct” (Lasher, 2008, p. 191).

Lasher, William R. (2008). Practical Financial Management (5th ed.). Thomson South-Western.