Introduction
Since the formation of the 1934 Securities and Exchange Commission, the Sarbanes Oxley Act (SOA) is perhaps the most important and instrumental piece of financial legislation in the Accounting field to emerge in the last century. It birthed significant reforms in the accounting sector by redefining how different professionals in the financial and accounting system should relate (Holt 48). This paper provides a contextual analysis regarding the factors that led to the development of the Act and the main characteristics of the reform movement. This background should allow us to understand the main steps taken by the SOA to improve financial accountability and accuracy. Lastly, this paper highlights why accountability and accuracy are important to the society.
What were the Corporate Scandals that Led to the Creation of the Sarbanes Oxley Act?
The Sarbanes Oxley Act emerged from a background of corporate accounting scandals. Hanna (1) puts this issue in perspective by saying that the 2002 Act emerged during the tech-burst period (2000-2002), when financial fraud cases were rampant. For example, Enron and WorldCom “bred” financial impropriety through conflicts of interest and fraudulent incentive compensation schemes (Holt 67). Conflicts of interest emerged when auditing firms received money for performing non-audit tasks (Holt 67).
They often made money from undisclosed and lucrative financial agreements. Conflicts of interest also emerged when auditors colluded with company managers to defraud companies (lack of independence between auditors and managers) (Leonard 87). Besides these incidents of financial impropriety, prevalent banking practices also failed to understand the financial risk that different companies had. For example, Enron received loans from different banks, although the financial institutions did not understand the nature and complexity that characterized the energy company (Leonard 87). Consequently, investors suffered huge losses from poor financial evaluation, by the banks.
One US legislator summed these problems by saying they amounted to “inadequate oversight of accountants, lack of auditor independence, weak corporate governance procedures, stock analysts’ conflict of interests, inadequate disclosure provisions, and grossly inadequate funding of the Securities and Exchange Commission” (Ryde 92). The tech bubble burst did not improve matters because investors were disappointed by declining stock values and, by extension, the overall decline of the financial markets (Ryde 92). Here, financial impropriety happened when mutual fund owners encouraged people to buy such stocks, but secretly sold them for a profit.
In this regard, dishonesty was a common practice in the financial markets (Ryde 92). Although the SOA aimed to correct some of these market failures, some people did not support the introduction of the Act. Instead, they viewed it as a political tool for artificially influencing market activities (Hanna 1). In this regard, they feared that the tool would prevent risk-taking and competitiveness (two ingredients they deemed important for business success).
What were the Important Characteristics of the Reform?
Among the most important goal of the SOA was to boost investor confidence in the financial sector by improving accountability and accuracy in financial reporting (Ryde 92). Important legislative subsets of the Act contain these goals. They also characterize its nature. For example, a key issue that characterized the reform movement was a greater oversight of accounting practices. As outlined in later sections of this paper, the legislation also demanded a greater independence of auditors during the preparation of financial documents (Leonard 87).
Since many companies took part in financial impropriety, with impunity, the legislation also outlined a raft of measures for increasing penalties for corporate crime. Lastly, the SOA outlined stringent accounting controls to prevent insider trading in the financial sector (Ryde 92). These issues outline the main factors that characterized the reform movement, which birthed the SOA.
What Steps Improved Accounting Accuracy?
Accuracy in financial accounting has always been a big problem for most financial experts (Ryde 92). However, the SOA helped to improve accuracy in accounting by introducing new and stringent laws of financial reporting. Section 302 of the Act contained these provisions. They promoted accurate financial reporting by outlining a set of internal procedures designed to eliminate immaterial issues in financial reports (Leonard 88).
These regulations made sure that all company stakeholders gained access to important financial information whenever they wanted (Ryde 92). Additionally, the SOA required companies to evaluate the effectiveness of their internal controls, at least three months before they reported their financial statements. Sections 304 and 402 gave power to the Security Exchange Council (SEC) to enforce these regulations (Leonard 88). Comprehensively, they helped to improve accounting accuracy.
What Steps Improved Accountability?
As we will see in the subsequent section of this report, Accountability is an important part of a country’s financial growth. This is because investor perceptions influence economic performance. The SOA recognized this fact by understanding the economic ramifications of poor investor confidence, especially emerging from poor accountability standards (Ryde 92). To eliminate this fear, the Act limited opportunities for seeking public funds. Stated differently, companies had to demonstrate that they had elaborate accounting standards to gain access to public funds.
Section 404 of the SOA also helped to improve accountability by demanding that all companies give a report on the adequacy of their internal controls of reporting (Leonard 22). By doing so, the company should produce an internal control report. The document outlines the responsibility of the management in promoting accountability in the organization and assessing the effectiveness of the company’s internal control structure (Leonard 22).
Section 404 is perhaps the most contentious part of the SOA. It gives an opportunity for investors to understand off balance-sheet items by requiring them to disclose such information in their annual financial publications (Leonard 22). This provision emerged from the financial impropriety of Enron when the company used off-balance sheet items to portray an exaggerated financial position. The Lehman Brothers Bankruptcy case also drew attention to this provision (Ryde 106).
The company used a little-known financial instrument to move its assets and debts. By doing so, investors thought the company’s financial position was favorable. However, this was not the case. Such incidences of financial impropriety led to the development of section 401 of the SOA, which required companies to disclose off-balance sheet items (Leonard 88). These measures helped to improve the accountability of American companies.
Why Accountability and Accuracy are Important to the Society
Based on the details surrounding this paper, authoritatively, one could say the SOA was mainly concerned with the accountability and accuracy of American companies. These components are not only important in the accounting field, but to the society as well. For example, accountability is important in promoting economic productivity and efficiency. In this regard, societies are likely to benefit from increased employment opportunities, fairness in the workplace, and greater socioeconomic growth (Hanna 1). Accuracy in financial reporting is equally important to social and economic growth because it builds trust between people.
For example, people are bound to lose trust in a company that reports inaccurate financial statements. This view resonates with the findings of Leonard (36) who says companies are bound to lose their credibility from inaccurate financial reporting. The SOA helped to boost investor confidence through improved accountability and accuracy (Hanna 2). A Forbes survey of more than 83 Company Financial Officers (CFOs) showed that more than 80% of the respondents agreed that the act helped to improve investor confidence in the economy (Hanna 2). Similarly, about 33% of the professionals agreed that the legislation helped to reduce fraud in the financial sector (Hanna 2).
Conclusion
This paper shows that the SOA was an elaborate financial legislation that aimed to improve accountability and accuracy in financial reporting. The Act reduced financial impropriety by introducing stringent regulations in financial reporting and promoting the independence of auditors. It also reduced incidences of conflicts of interest in the same regard. Although the legislation has helped to promote financial prudence in the accounting sector, its continued adoption requires that all people and stakeholders in the sector understand the lawmaking process that preceded its adoption and then perform a continuous performance evaluation process to comprehend if the legislative piece works for the economy, or not.
Nonetheless, based on its contribution to the accounting field, safely, one could say the SOA has been instrumental in promoting “financial sobriety” in the US. Therefore, it is unsurprising that most of the institutions created after the inception of the SOA have remained operational.
Works Cited
Hanna, Julia. The Costs and Benefits of Sarbanes-Oxley. 2014. Web.
Holt, Michael. The Sarbanes-Oxley Act: costs, benefits and business impacts, New York, NY: Butterworth-Heinemann, 2007. Print.
Leonard, Barry. Study of the Sarbanes-Oxley Act of 2002 Section 404: Internal Control Over Financial Reporting Requirements, New York, NY: DIANE Publishing, 2011. Print.
Ryde, Robin. Never Mind the Bosses: Hastening the Death of Deference for Business Success, London, UK: John Wiley & Sons, 2012. Print.