The Sarbanes Oxley Act of 2002

The Sarbanes Oxley Act of 2002

The collapse of Enron in 2001 heralded the start of several accounting scandals that stunned the securities market, the country, and the world. The implosion of Enron was followed by that of Global Crossing, WorldCom, Adelphia and many others. Apart from plummeting shares in the securities’ exchange, most of the executives of the companies were investigated for criminal liability. The reaction of Congress was swift with the near unanimous enactment of the Sarbanes Oxley Act of 2002. During the signing of the bill into law, President George Bush suggested that it was the most elaborate reform of American business practices since the days of former President Franklin Delano Roosevelt. The goal of the Sarbanes Oxley Act of 2002 (SOA) was to reforms seal loopholes that allowed business managers and executives to defraud investors. It was to also restore confidence in the in the management of business in the country, return confidence in the financial markets and deter future fraud.

One of the purposes of the SOA was to deter economic malpractices from employees and executives of listed companies. The collapse of large and powerful companies was a shocker to the country. It was difficult to fathom how the business owners and managers had deceived regulators for a long time with fake financial statements. Therefore, a deterrence measure was necessary and proponents of SOA proposed that it would play this role. The Act sought to use an economic deterrence theory that follows Gary Becker’s model of crime and optimal penalties. The crime model starts from the simple assumption that people are always willing to engage in crime if they can derive greater benefits than following the law. It means that the committing a crime is a process like any other decision-making system under conditions of uncertainty. Therefore, it is important to have penalties that can prohibit a person from breaking the law because the consequences would be severe.

Before committing a crime a crime, most citizens compare the expected utility to be gained from engaging in risky criminal behavior to that of riskless legitimate employment. Most people use three components to make their decisions, namely, the probability of being caught and getting a conviction. Other considerations are whether the monetary gains outweigh the consequences of convictions. Under the model, a person will avoid fraudulent activities if there is a high chance of being caught and losing everything they stole. However, the person can participate in criminal activities if they are sure that the chances of detection and conviction are low. Therefore, the duty of legislators to choose the optimal mix of enforcement resources such as the risk of detection and the severity of punishment that maximizes social welfare. The SOA uses both approaches in trying to deter future fraud and protect public investments in publicly listed firms.

SOA’s deterrent measures emanate are in the form of new crimes and enhancement of punishment to existing criminal acts. Under sections 802 and 1102, Congress legislated new laws on the obstruction of justice. Section 1102 creates a maximum twenty-year sentence for efforts of attempts to destroy documents or obstruct investigators from accessing information relevant to a case. Section 802 of the SOA provides for fines or twenty-year imprisonment for a person who knowingly falsifies, alters or destroys records to influence or obstruct federal investigations (Perino, 2002). The Act also demands that accountants maintain all audit papers for a period of five years. Individuals who violate this requirement are subject to fines or imprisonment of up to ten years.

SOA is a critical deterrence measure because it criminalizes Securities Fraud. SOA makes it easier to win securities fraud cases. It seeks to

SOA is also a deterrent measure because it enhanced criminal penalties for existing crimes. For example, under section 902 (a), the Act increases the maximum penalties for mail and wire fraud from five years to twenty (Perino, 2002). It further provides for any person who attempts to commit mail, wire, securities, or any other fraud are subject to the same penalties as for a substantive violation of the provision. At the same time, it enhances penalties and fines for crimes under the Exchange Act from ten years to twenty years and fines from $ 1 million and to $5 million (Perino, 2002). It increases the fines for organizations from $2.5 million to $25 million among other provisions that makes a person or an organization think twice before they participate in fraudulent activities.

The enhancement of penalties was essential to ensure that white-collar criminals serve prison terms to instead to getting predatory terms. The drafters of the law achieved these objectives because some individuals are serving jail terms for fraud. According to Burgess et al. (2012), SOA penalties for jail term and fines in post-2002 than before the passage of the Act.

The Sarbanes Oxley Act of 2002 was a political response to loss of public confidence in financial reporting, accounting and auditing profession, the SEC’s willingness and capacity to enforce security laws, and in the U.S. capital markets. Therefore, the purpose of the law was to restore public confidence in U.S. capital markets. The purpose was to protect investors by improving the accuracy and reliability of corporate disclosures. Therefore, SOX is aimed at enhancing public corporate governance, management & board responsibility, and transparency.

Section 404 is about reliable financial statements. It insists on effective internal control over financial reporting (ICFR) dictating that internal control report states specific aspects. It includes management taking responsibility for establishing and maintaining adequate internal control over financial reporting. It also insisted that management had to establish a framework to evaluate the effectiveness of the internal control measures over financial reporting. The internal control report states about the material weaknesses in internal control over financial reporting identified by management. It also indicates that an external auditor has attested to and reported on the management evaluation.

Material weakness means a significant deficiency or a combination of several deficiencies. An example of material weakness is failure to recognize revenue. Ineffective control environment permits managers to override certain controls. Failure to account for numerous transactions in the consolidated financial statements forces institutions to restate their historical financial statements to capture changes. In some instances, senior managers enter into the licensing agreements with third-party vendors that lack commercial and economic substances or proper supporting documentation resulting in the inappropriate capitalization of assets. Some may also authorize several sales transactions to some third parties that lack economic substance or with supporting documentation, resulting in overstating or understanding of earnings in numerous periods.

Monitoring ensures that internal control continues to operate effectively.

One of the consequences of the Act was an increase in the number of convictions for fraud. According to Burgess et al. (2012), the Act was a deterrent measure for executives and employees caught in fraudulent activities. The harsh penalties and fines provided in the Act increased the number of plea bargaining in the post-SOA era than at any other era. According to Burgess et al. (2012), there were slightly over 9 percent plea bargaining cases in the pre-SOA era compared to more than 78 per cent in the Post-SOA era. The conclusion is that the tough provisions of the Act makes it easier for prosecutors to enter plea bargaining with suspects whom there is overwhelming evidence against them and in the process win convictions.

Another consequence of the SOA Act was to increase ethical behavior by corporations. According to Burgess et al. (2012), in the post-SOA era, corporates reduced their unreasonable risk-taking behavior by reducing investments in fixed assets and research and development. As a consequence, corporations hold greater amounts of cash and cash investments that are low-risk investments. The law is making it easy for prosecutors to imprison business executives, which is a deterrent measure for others holding similar positions.

The Sarbanes-Oxley Act tried to improve organizational and individual ethics in several ways. First, it defined a code of conduct as the organizational behavior that promotes “ethical and honest conduct.” The strategy requires the firms to disclose the codes that apply to senior financial officers and encourage whistle blowing. The Securities Exchange Commission’s was to implement rules to expand the disclosure requirement on the code of ethics that apply to chief executive officers and further develop the definition of a code of ethics. The law also mandated the United States Sentencing Commission to review the Organizational Sentencing Guidelines (OSG). Following this directive, the commission codified the OSG to redefine a compliance program as one that includes efforts to promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law. Following the enactment of the Sarbanes-Oxley Act, the New York Stock Exchange and NASDAQ adopted listing requirements that compel firms to adopt and disclose codes of ethics for all directors, officers, and employees of the company.