Sarbanes—Oxley Act of 2002

In 2001 and 2002, the discovery of financial irregularities in financial statements of nearly two dozen companies—notably Enron, Global Crossing, and WorldCom—led to the bankruptcy of some companies, cost investors billions of dollars, and contributed to the bear stock market of 2001 and 2002. While many ordinary investors lost a lifetime of savings, corporate insiders received and profited from lucrative stock options, bonuses, and favorable loans that were sometimes not repaid.

Consequently, Congress passed the Sarbanes—Oxley Act of 2002 (SOX), which was designed to restore integrity to corporate financial statements and revive investor confidence in the securities markets. The Sarbanes—Oxley Act attempts to accomplish these objectives by imposing a wide array of new responsibilities on public corporations and their executives and auditors. All the provisions result from the crisis of ethics, in which some corporate officers and auditors preferred their selfish interests over those of the corporation and its shareholders, creditors, and other stakeholders.

Because some public companies were manipulating their balance sheets by omitting liabilities of certain affiliate entities, SOX requires that 10-Ks and 10-Qs filed with the SEC disclose material off-balance-sheet transactions. To increase the likelihood that auditors will not give in to corporate executives’ pressure to account improperly for corporate transactions, SOX requires greater independence between the auditor and the corporation by prohibiting the audit firm from performing most types of consulting services for the corporation. Moreover, officers and directors are prohibited from coercing auditors into creating misleading financial statements. To ensure that auditors are serving the interests of shareholders and not those of corporate managers, SOX requires auditors to be hired and overseen by an audit committee whose members are independent of the CEO and other corporate executives.

In addition, the CEO and CFO of a public company must certify that the corporation’s financial reports fairly present the company’s operations and financial condition. To eliminate the CEO and CFO’s incentive to manipulate earnings, the CEO and CFO must disgorge bonuses, other incentive-based compensation, and profits on stock sales that were received during the 12-month period before financial statements are restated due to material misstatements or omissions. Public corporations are also generally prohibited from making loans to officers and directors. To encourage the use of ethics codes, SOX requires public companies to disclose whether they have ethics codes for senior financial officers.

Finally, SOX gives the SEC several new powers, including the authority to freeze payments to officers and directors during any lawful investigation. The SEC may also bar “unfit” persons from serving as directors and officers of public companies. The previous standard was “substantial unfitness.”

SOX Section 404

The most controversial part of the Sarbanes—Oxley Act has been Section 404, which requires that annual reports include an “internal control report” acknowledging management’s responsibility to maintain “an adequate internal control structure and procedures for financial reports.” The benefits of Section 404 are evident and substantial, yet the costs are as well. The benefits include more active participation by the board, audit committee, and management in internal controls; increased embedding of control concepts including a better understanding by operating personnel and management of their control responsibilities; improvements in the adequacy of audit trails; and a revival of basic controls, such as segregation of duties and reconciliation of accounts, that have been eroded as businesses downsized and consolidated.

The cost of initial compliance with Section 404 averaged about $3 million per company in 2004. That cost included an increase in employee hours, averaging about 26,000, when the SEC had estimated that only 383 staff hours would be required. In addition, companies paid higher fees to auditors, who have the additional Section 404 burden of attesting to the assessment made by management. One study concluded that the total private cost of Section 404 compliance was $1.4 trillion. Another study found that only 14 percent of firms believed that the benefits of Section 404 exceeded the up-front costs of Section 404 compliance.

In 2010, a study by Protiviti reported that executives found that the cost of complying with SOX had declined on average 50 percent from the first year of SOX compliance and that most executives found the benefits of SOX outweighed its costs. Protiviti’s 2020 survey found that the compliance cost for large companies had increased 30 percent or more over the previous year, and 51 percent of companies reported that the hours spent on SOX compliance increased. However, 14 percent of large companies reported that they have plans in place to automate IT processes and controls, creating a substantial opportunity for future cost and manpower reductions.

Nonetheless, a study by Dr. Ivy Zhang of the University of Minnesota raises concerns about SOX. Dr. Zhang concluded that SOX contributed significantly to wiping $1.4 trillion off the value of the stock market. Zhang says some indirect costs of SOX compliance were not included in budgets by managers. “While SOX likely imposed significant direct compliance costs on firms, the indirect costs could be even greater. Executives have complained that complying with the details of the rules diverts their attention from normal business practices. Also, as SOX increases the litigation risks for executives, managers are likely to behave more conservatively than shareholders would prefer. These changes could have long-lasting and far-reaching influence on business practices.”

Based on what you know about SOX, what are the three strongest pros and cons for the controversial Act?