What Does the Sarbanes-Oxley Act Do?
The Sarbanes-Oxley Act of 2002 (“the Act”) is a federal law aimed at safeguarding investors by enhancing the reliability and transparency of corporate financial disclosures required by securities laws. It was passed by Congress in response to several corporate scandals that highlighted widespread misconduct and a lack of transparency among corporate insiders.
The Act addresses fraud, conflict of interest, and financial inaccuracies, thereby protecting shareholders and the general public from unethical corporate practices. For instance, the collapse of Enron and WorldCom revealed serious gaps in financial accountability, prompting lawmakers to take immediate action with the Sarbanes-Oxley Act to restore investor trust.
Sarbanes-Oxley Whistleblower Protection
One of the key aspects of the Sarbanes-Oxley Act is its provision for whistleblower protection. It prohibits any company that is subject to the Securities Exchange Act of 1934 from retaliating against employees who cooperate lawfully with investigations regarding violations of the Act or shareholder fraud. This provision ensures that employees can report corporate misconduct without fear of retaliation.
For example, an employee at a large accounting firm may report fraudulent practices, such as improper revenue recognition, and be protected under the Act from losing their job as a result. The Act also authorizes whistleblowers to bring claims of retaliation in federal district court due to procedural issues in previous administrative proceedings.
Sarbanes-Oxley Board of Directors
To further protect investors, the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). This independent board oversees the audits of public companies to ensure compliance with securities laws. Its goal is to protect investors by improving the reliability, accuracy, and independence of audit reports for publicly traded companies.
For instance, the PCAOB’s oversight ensures that an auditor cannot simply overlook discrepancies in a company’s financials to maintain a lucrative audit contract, thus reinforcing trust in the financial statements provided to shareholders.
Powers of the Board
The PCAOB is vested with extensive powers under the Act. These powers include the ability to:
- Sue or be sued, and represent itself in federal, state, or other courts.
- Operate and maintain offices without state-imposed licensing or restrictions.
- Acquire, lease, or sell property and appoint employees or agents necessary for its operation.
- Collect fees and allocate resources for accounting oversight purposes.
- Enter into contracts, incur liabilities, and perform acts necessary to fulfill its obligations under the Act.
For example, if a registered accounting firm repeatedly fails to comply with established auditing standards, the PCAOB can use its power to impose fines and bring legal action against the firm, helping to uphold audit quality and investor protection.
Auditing, Quality Control, and Ethics Standards
The PCAOB is responsible for adopting standards for auditing, quality control, and ethics for public accounting firms. This includes modifying and altering standards as needed to serve the public interest and protect investors. The Board is also required to conduct inspections to ensure that accounting firms comply with applicable laws and standards.
For example, a PCAOB inspection might reveal a lack of adequate internal controls over financial reporting, prompting corrective action by the accounting firm. Any sanctions imposed by the PCAOB are promptly reported to the SEC.
Improper Influence on Conduct of Audits
The Sarbanes-Oxley Act makes it illegal for corporate officers, directors, or other individuals to fraudulently influence or manipulate an auditor’s performance of financial audits. This measure is intended to ensure that audit reports remain accurate and independent, protecting investors from misleading financial information.
For instance, if a CFO attempts to pressure an auditor to overlook certain accounting irregularities, this would be a violation of the Act, and both the officer and the company could face significant penalties.
Forfeiture of Certain Bonuses and Profits
If a company is found to have materially violated financial reporting requirements and must restate its accounting records due to misconduct, the Act mandates that its CEO and CFO must reimburse the company for:
- Any bonuses or equity-based compensation received during the 12 months following the initial issuance of erroneous financial statements.
- Any profits gained from the sale of company securities during that 12-month period.
These provisions hold top executives accountable for any profits gained during periods involving financial misreporting. For example, if a CEO received a large bonus based on inflated financial performance that was later restated, that bonus would need to be returned to the company.
Insider Trades During Pension Fund Blackout Periods
The Act also addresses insider trading during pension fund blackout periods. Specifically, it prohibits directors or executive officers from purchasing, selling, or transferring equity securities during these blackout periods if such securities were acquired in connection with their employment. Any profit made in violation of this rule must be returned to the company.
For instance, if an executive sells stock during a pension blackout period to avoid losses from an anticipated earnings miss, the profits from this sale would need to be forfeited. Furthermore, the Act allows shareholders to sue for recovery if the company fails to take legal action.
Auditing Requirements Under the Sarbanes-Oxley Act
The Act established new standards for corporate auditing, requiring companies to hire independent auditors to assess their financial practices. It also detailed specific duties for corporate audit committees and restricted certain non-audit services that auditors could provide, reducing conflicts of interest and fraudulent practices.
For example, a company’s auditor can no longer provide both audit services and extensive consulting services, which previously had the potential to compromise auditor independence and objectivity.
To facilitate the effective regulation of auditing practices, the PCAOB was created. All public accounting firms are required to register with the PCAOB, which sets rules for audit reports and investigates compliance at registered firms.
For instance, accounting firms that fail to comply with PCAOB standards can face sanctions, ensuring the quality of financial audits is maintained.
Criticism of the Sarbanes-Oxley Act
Despite its positive intentions, the Sarbanes-Oxley Act has faced criticism from executives who felt burdened by the new regulations. In 2008, Newt Gingrich blamed the Act for stifling business growth and for a reduction in initial public offerings. Critics argued that the Act was a reaction to high-profile corporate scandals and would ultimately hinder competition.
Many business leaders, particularly those affected by Section 404, criticized the compliance costs and time commitment required to adhere to the regulations. For example, companies have reported spending millions of dollars annually to comply with Section 404, which requires rigorous documentation of internal controls.
Benefits of the Sarbanes-Oxley Act
On the other hand, the Act has been credited with prompting better financial management practices. Some business leaders recognized that the Act helped strengthen financial controls, standardize processes, and improve board oversight.
For instance, some companies found that implementing the internal control requirements of Section 404 ultimately made their operations more efficient by identifying weaknesses and inefficiencies. Ultimately, the Act led to increased investor confidence, as subsequent studies have confirmed.
By setting standards for transparency, accountability, and independent auditing, the Sarbanes-Oxley Act has played a crucial role in improving corporate governance and investor trust in public financial disclosures.
