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The SOX: Increased accountability of the CEO and CFO

The Sarbanes Oxley Act of 2002

The Enron scandal and its collapse occurred in 2001. The scandal proved self-regulation and peer review were insufficient to maintain accounting ethics. As a result, the Sarbanes Oxley Act of 2002 was introduced. The Act came into force after a series of Congressional hearings on the Enron scandal. The scandal had shaken the public’s and investors’ confidence in the capital market, resulting in significant pressure on the Congress to act fast. Introduced in 2002, the Act brought some major changes to corporate governance and regulation of financial practice. SOX was named after the Senators Paul Sarbanes and Representative Michael Oxley who  were the most important names behind SOX.

 SOX introduced an important requirement- deadline for compliance. The entire Act is arranged into eleven titles. Of these titles, 302,401, 404, 409, 802 and 906 are of particular importance regarding compliance. The act, apart from being appreciated for its focus on accountability and compliance, has also been criticized widely. Many held that the act would lead to a loss of risk taking and competitiveness. However, whenever there is a comparison, the benefits of SOX have far outweighed its disadvantages. Some of the most important changes that the act introduced were targeted at the senior management and the top executives.

The primary aim of the Act was to improve the status of accountability inside the financial organizations. For this purpose, it was essential to target the people in the upper echelons of the organization. Particularly, the act holds the CEO and CFO accountable for several factors. The CEO and the CFO are required to officially certify the appropriateness of the financial statements and disclosures. They should also provide that these documents represent all the finances and operations of the firm fairly. The act also prohibits most types of personal loans to the CEO.

Limitations related to insider trading during certain events are also a part of the act. The Section 404 contains some of the most important requirements related to internal controls. This section requires the companies to assess the effectiveness of their internal controls related to financial reporting. Companies must report regarding this assessment in their annual fillings with the SEC. In case of the off balance sheet transactions there is a need for extra disclosure. SOX introduced certain criminal penalties related to several financial frauds. It increased the term for mail frauds from five to twenty years.

‘SOX’ has been effective and this was proved in the subsequent years. The number of ethical violations in accounting firms has reduced sharply. The condition of accountability in the finance industry has improved. However, along with these improvements the law created some pressures. SOX has also been an object of severe criticism due to it.  The internal control mandate of SOX introduced some new costs that could be burdensome for the small companies. The changes the law introduced, resulted in compliance related extra burdens. It is the primary reason that the act has been criticized heavily. Yet, the Enron scandal had already proved that the compliance related requirements could be worth it. Apart from that another major area where the law was able to bring effective changes, was related to the strengthening of the audit committees and corporate governance.

 The changes brought about by the SOX can be summed up as follows:

  • #1.   Establishing independent oversight of the public company audits.
  • –       PCAOB was established ending more than 100 years of self-regulation.
  • –       PCAOB provided with inspection, enforcement and standard setting authority.
  • #2.   Strengthening of the audit committees and  corporate governance.
  • –       Audit committees independent of management required for all listed companies.
  • –       Independent audit committee made responsible for the appointment, compensation and oversight of the external auditor instead of the management.
  • #3.   Improved transparency and investor protection as well as executive accountability.
  • –       CEO and CFO were required to certify certain financial reports.
  • –       Corporate officers and the directors prohibited from misleading auditors fraudulently.
  • –       Clawback provisions for the CEO and CFO pay after financial restatements instituted.
  • –       Protections for the whistle-blowers established.
  • –       Management required to assess the effectiveness of the internal controls regarding financial reporting.
  • –       The auditors required to attest to the management’s representations.
  • –       Fair Funds Program established at the US SEC for compensating the victims of securities fraud.
  • #4.   Improved auditor independence
  • –       Audit firms prohibited from providing certain non-auditing services.
  • –       Audit committee pre-approval of all the audit as well as non-audit services made essential.
  • –       Lead audit partner rotation required every five years.