The Sarbanes Oxley is a federal law that was passed to create a reform in business and financial practices. Also known as the Sarbanes-Oxley Act of 2002, the reform aims at improving financial accountability and accuracy in publicly held corporations by ensuring that their financial reporting is accurate. The United States Congress passed the act on July 30, 2002, to protect investors from the possibilities of fraudulent accounting activities undertaken by corporations. The Act came about in response to accounting malpractice that took place in the early 2000s involving several large corporations. The Sarbanes Oxley Act came with strict reforms that saw an improvement in financial disclosures among corporations and a prevention of accounting fraud.
Corporate scandals that led to its creation
There were several financial scandals that led to bankruptcy and financial struggles among several companies such as WorldCom, Enron, Adelphia Communications, and Global Crossing. Enron was a new company dealing with energy and participated in the sale of gas, oil futures, and it built oil power plants and refineries. However, various misdeeds and crimes took place in Enron among its employees and officers. For instance, there were misrepresentations that produced inflated financial reports for the shareholders. There were several other instances of fraud and dishonesty which included embezzlement of funds by the Enron executives. The result of the fraudulent activities was that the company filed for bankruptcy in 2001. Many shareholders suffered devastating losses as a result of the failure of the company.
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WorldCom also experienced bankruptcy as a result of fraudulent activities undertaken by the company’s management. The financial reporting of the company was manipulated by the management to the extent that a company which was bankrupt appeared to be profitable. Even though the company had more than $100 billion in assets, it filed for protection early in 2002. It was revealed that the company had overstated its profits by as much as $11 billion in its past three years of operations. The inflated profits were as a result of reporting operating expenses as assets (Brochet, 2010). WorldCom became the largest single bankruptcy and it significantly impacted the final legislation.
Important characteristics of the reform
The Sarbanes-Oxley Act had reforms in four critical areas including corporate responsibility, accounting regulation, new protections, and increased criminal punishment. The entire act was divided into eleven sections. Section 302 mandated that the senior management should certify for the accuracy of the reports on the financial statement. This reform emphasized on corporate responsibility among the top management. Section 404 required that the management and auditors should establish adequate internal controls and report methods to ensure the adequacy of the internal controls. This ensured strict accounting regulations to establish and maintain proper internal controls (Ge and McVay, 2005).
The Sarbanes-Oxley was created to protect investors in order to improve the reliability and accuracy of corporate disclosures in financial reporting. Investors were protected by increasing the disclosure requirements of corporate executives, auditors, and public accountants. There was an increased penalty for executives that participated in accounting malpractice or any fraudulent activities. It also led to the creation of the Public Company Accounting Oversight Board (PCAOB) that saw the monitoring of corporate behavior in accounting.
Steps the reform took to improve accuracy
The reform entailed a section 302 which required financial officers and principal executives to produce a certification to file with the annual financial statements. The requirement is that officers should certify that the financial statements are accurate to the best of their knowledge. Inaccurate and false financial statements could lead to fines of up to $5 million and spending twenty years in jail.
Section 404 also requires that an independent auditor should ascertain the accuracy of the company. The auditor should attest every year to the evaluation of the company’s controls. Additionally, the auditor should assess documentation of the procedures and controls. They should also assess how competently the employees perform various control activities that they have been assigned.
Steps the reform took to improve accountability
The reform involved several changes that targeted top executives and senior management in order to improve their accountability. The reforms improved the status of corporate responsibility by holding the company CEO and CFO accountable in several accounting factors. The CEO and CFO were required to certify that the financial statements and disclosures presented are appropriate. They should also ascertain that the documents represented in the operations and finances represent a fair assessment of the company.
The reform also ensured criminal fraud and corporate accountability. The alteration, destruction, or falsification of documents and records with the aim of influencing bankruptcy can be subject to fines and up to 20 years in prison (Green, 2004). Additionally, the act established that any person that knowingly defrauded shareholders of publicly traded companies can be subject to imprisonment and fines. Putting fines and penalties ensured that everyone within the company is held accountable for the financial statements.
Opinion as to why accuracy and accountability are important
Financial accuracy and accountability are important to create a fair society that provides equal economic opportunities for everyone. Poor accuracy and accountability would lead to embezzlement of funds by top executives. This may drive the company to bankruptcy and a final collapse of the entire organization. While the top level employees benefit by keeping a large share of the company, low-level employees will suffer through the loss of jobs and poor pay. As such, poor accuracy and accountability causes an imbalance in society and increases the gap between the rich and the poor.
Poor accounting practices lead to a poor economy, drives inflation upwards, and causes a general panic. As seen in the scandal before the establishment of Sarbanes Oxley, poor accounting leads to the failure of large companies that drive economic growth. This can lead to an economic breakdown and panic in the entire economy. The economic meltdown would cause a negative ripple effect on other companies. Companies would reduce their expenses and resort to layoffs causing unemployment and general suffering of the entire population.
References
Brochet, F. (2010). Information content of insider trades before and after the Sarbanes-Oxley Act. The Accounting Review , 85 (2), 419-446.
Ge, W., & McVay, S. (2005). The disclosure of material weaknesses in internal control after the Sarbanes-Oxley Act. Accounting Horizons , 19 (3), 137-158.
Green, S. (2004). A Look at the Causes, Impact, and Future of the Sarbanes-Oxley Act. J. Int'l Bus. & L. , 3 , 33.
