The Sarbanes-Oxley Act (SOX) was passed in 2002 in the wake of scandals that received significant coverage in the media. WorldCom and Enron were two scandals that resulted in losses of retirement income as well as heavy stock market losses; these scandals were attributed to a lack of oversight and accounting rules that allowed questionable transactions to take place without scrutiny. In the years since its passage, SOX has come under considerable criticism as being expensive, ineffective and even causing some companies to go out of business or go private. A recent article in The Economist takes issue with this commonly held view, and suggests that SOX is neither as onerous as it is often portrayed, nor as ineffective. This analysis considers the article and its evaluation of SOX.
According to “Smelly old SOX,” Sarbanes-Oxley is considered expensive government interference by boards of directors throughout the United States. It is also credited with causing companies to become increasingly risk averse with predictably poor results. Critics of SOX suggest that capital is seeking other, more friendly capital markets—including London—and that SOX has caused a number of formerly public firms to be taken private. This, in turn, reduces the transparency that SOX and other regulations require and thus the Act has resulted in less visibility with regard to corporate behavior rather than more visibility in some cases (“Smelly,” 2007).
The article acknowledges that there are significant problems with Sarbanes-Oxley. It notes that the Act was written quickly and passed in haste, and thus did not take into account safeguards that might have been more effective than those that were actually included. Of particular interest to the author is Section 404, which requires that senior management is accountable for a company’s internal risk controls. Section 404 also mandates that outside auditors “attest” to the quality of a company’s annual report; this can be prohibitively expensive for smaller organizations (“Smelly,” 2007).
Overall, though, the article concludes that despite its shortcomings—and some of these are being addressed, according to the authors—Sarbanes-Oxley has resulted in benefits. The figures received from business units are considered more reliable by management, and the Act may have boosted confidence among shareholders, as well. The article ultimately hedges by saying that it may be too soon to pass final judgment on the Act, however (“Smelly,” 2007).
Much of what the article discusses is supported by other analysts. For example, companies are paying increased attention to the composition of the boards of directors. The New York Stock Exchange and the NASDAQ require that companies have boards where at least 51 percent of the membership is independent. In a 2005 survey, 82 percent of companies indicated that their boards are 80 percent independent, and 96 percent of the responding companies indicated that their boards are at least 60 percent independent (Hemphill, 2005). It is generally assumed that independent boards are better able to provide independent oversight of the company compared with boards composed primarily of insiders.
In addition, companies are increasing evaluating their boards much in the same way that employees and managers are also evaluated. In 2002, it was estimated that only 33 percent of boards were independently evaluated; that rose to 50 percent in 2003 and 73 percent in 2004. Companies are also becoming more demanding of their board members’ time, with many directors restricted as to the number of boards on which they can serve concurrently (Hemphill, 2005).
As for the costs associated with compliance, according to one survey, only 23 percent of companies estimated that their compliance costs totaled less than $5 million. Another 29 percent indicated that their compliance costs were between $5 million and $10 million while fully 47 percent estimated that their 2005 compliance costs were in excess of $10 million. This is up from 22 percent in 2004. The increase in compliance costs is not surprising since companies have been refining their auditing and documentation procedures since the Act went into effect, and since some of the Act’s provisions were not effective until 2004—including some of the provisions of Section 404 (Hemphill, 2005).
The article mentions that some companies may be taking “better” risks than before SOX; that idea is borne out by some analysts, as well. Since the Act was passed, more companies than in the past have exceeded analysts’ per-share expectations, suggesting that the companies are purposely setting expectations low in order to avoid negative publicity and also to remain within compliance of Sarbanes-Oxley (Marshall & Heffes, 2005).
During the years immediately following passage of Sarbanes-Oxley, companies also restated their earnings more than in the past. In 2005, 42 financial services companies—including banks—were among the more than 450 companies that announced earnings restatement plans. In 2004, 44 companies in the financial services industry announced such plans and in 2003, the number was 48. In 2001, only 30 companies in the financial services industry announced earnings restatements. This upturn in earnings restatements in the financial services industry is similar to earnings restatement announcements across corporate America (Davis, 2005).
Companies generally prefer to avoid earnings restatements because of the lack of trust that may result among investors, employees and other stakeholders. Since Sarbanes-Oxley is a new Act subject to different rule interpretations, the restatements have come about largely as companies attempt to comply with the Act while interpreting the Act in the most beneficial light to the organization. Commonly-used devices such as hedging instruments—including derivatives—have had their accounting rules changed as a result of the Act, and companies are responding to those changes as best they can. However, when new interpretations are introduced, the companies must go back and restate their earnings accordingly (Davis, 2005).
The article mentions that some provisions of Section 404 have been reworked to make them less onerous to smaller companies. Specifically, the SEC’s Advisory Committee on Smaller Public Companies voted to recommend that the SEC consider exempting small publicly traded companies from some or all of the Act’s Section 404 provisions in late 2005. These provisions required that the top executives within the organization certify that the companies have procedures in place to ensure that their financial reporting is accurate. These provisions also required that outside auditors are hired to verify the conclusions of company management. The Advisory Committee’s recommendations were not binding, but the committee noted that smaller companies have indicated that the costs associated with compliance can be onerous and are not conducive to building their business.
Under the recommendation, which was implemented, companies with a market capitalization of less than $125 million and revenues also less than $125 million are exempt from Section 404 completely. Companies whose capitalization is between $125 million and $750 million and whose revenues are less than $250 million are exempt from having outside auditors attest to the adequacy of internal controls (Kuehner-Hebert, 2005).
The article does not address the issue of prosecutions under the Act, but that might be because there have been remarkably few prosecutions that have arisen. This might be due to the relatively short period of time that it has been in place. Enforcement agencies may require additional time in order to build cases against those who they believe to be in violation. At this point, the most well-known executive prosecuted is probably Weston Smith, former chief financial officer of HealthSouth, who pleaded guilty to charges that he conspired to inflate the company’s earnings and also that he falsely certified the company’s financial statements (Gincel, 2005).
It is unlikely that a single act of Congress could eliminate corporate financial and accounting scandals forever. However, the Act was written in response to specific situations—Enron and WorldCom, and its provisions are likely to ensure that these types of scandals are more rare in the future. In addition, by requiring greater outside oversight of companies and encouraging greater involvement by senior executives, the Act may have brought about changes in corporate operations that will benefit business as a whole. It should be noted, however, that organizations must now balance the cost of complying with Sarbanes-Oxley with the benefits that it provides, and that some companies will choose to go private—eliminating not only the costs of compliance, but the need to comply at all. From this standpoint, the authors’ position that it may be too soon to accurately judge the overall effectiveness of the Act may indeed be appropriate.