Sarbanes-Oxley Act of 2002

Jadeen Service
Hampton University 2014
MBA 315
3/5/2014

Abstract
This paper will discuss the purpose, history, and causes of the Sarbanes Oxley Act of
2002. The public became aware that company controls needed to be more tightly managed. The
role of an auditors is to provide financial statement users with an opinion based on whether the
financial statements were presented fairly and to help detect fraud. Considered by many to be
one of the most important legislation affecting auditors in the past century. The law enforced
provisions that drastically changed the way publicly held accounting companies behaved as well
as the audit firms auditing them. We will investigate the contextual meaning and effects of the
law. This paper will delve into how this law has impacted industries within the corporate world.

The term Sarbanes-Oxley stems from the Senator Paul Sarbanes and Representative
Michael Oxley, who drafted the act. Sarbanes Oxley Act of 2002 was established in order to
identify accounting frauds in different public companies. This paper will examine the causes and
content/components of the Sarbanes Oxley Act. Sarbanes-Oxley has focused primarily on
reestablishing investor confidence in the financial markets. It was triggered by the bankruptcies
and alleged audit failures involving such companies as Enron and WorldCom. The Sarbanes
Oxley Act established the Public Company Accounting Oversight Board, appointed and overseen
by the SEC. The PCAOB.
The Sarbanes-Oxley Act was signed into law on 30 July 2002 by President Bush. The Act
is designed to oversee the financial reporting landscape for finance professionals. Its purpose is
to review legislative audit requirements and to protect investors by improving the accuracy and
reliability of corporate disclosures. The act covers issues such as establishing a public company
accounting oversight board, auditor independence, corporate responsibility and enhanced
financial disclosure. It also significantly tightens accountability standards for directors and
officers, auditors, securities analysts and legal counsel. The two key provisions of the SarbanesOxley Act are: 1. Section 302: A mandate that requires senior management to certify the
accuracy of the reported financial statement & 2. Section 404: A requirement that management
and auditors establish internal controls and reporting methods on the adequacy of those controls.
Section 404 had very costly implications for publicly traded companies as it is expensive to
establish and maintain the required internal controls.
The Sarbanes-Oxley Act created new standards for corporate accountability as well as
new penalties for acts of wrongdoing. It changes how corporate boards and executives must
interact with each other and with corporate auditors. It removes the defense of "I wasn't aware of

financial issues" from CEOs and CFOs, holding them accountable for the accuracy of financial
statements. The Act specifies new financial reporting responsibilities, including adherence to
new internal controls and procedures designed to ensure the validity of their financial records.
Before understanding how the Sarbanes Oxley act of 2002 effected companies going
forward there must be a comprehensive understanding of the terms used. The term audit
means an examination of the financial statements of any issuer by an independent public
accounting firm in accordance with the rules of the Board or the Commission (or, for the period
preceding the adoption of applicable rules of the Board under section 103, in accordance with
then-applicable generally accepted auditing and related standards for such purposes), for the
purpose of expressing an opinion on such statements. a committee (or equivalent body)
established by and amongst the board of directors of an issuer for the purpose of overseeing the
accounting and financial reporting processes of the issuer and audits of the financial statements
of the issuer; and (B) if no such committee exists with respect to an issuer, the entire board of
directors of the issuer. From this audit will stem an audit report.
A report prepared following an audit performed for purposes of compliance by an issuer
with the requirements of the securities laws; and (B) in which a public accounting firm either
(i) sets forth the opinion of that firm regarding a financial statement, report, or other document;
or (ii) asserts that no such opinion can be expressed.
Background and Purpose
Enron began in 1985 selling natural gas to gas companies and businesses. In the year
1996, government guidelines no longer governed what the price of energy would be. Prices
would now be driven by the competition between the energy companies within the industry.

Enron could now begin to act more as a middleman rather than just a simple energy supplier.
Enron's rapid growth created drove the stock price up and it gained the opportunity to enter into
other industries for example Internet services, and in turn resulted in the increased complication
of its financial contracts.
Looking profitable in the eyes of investors is important in the business industry. In order
to keep its steady growth at an increase, Enron started borrowing money to help them invest in
other activities. Debt would decrease their attractiveness by impacting their earnings. In realizing
this factor, Enron decided to create partnerships in which allowed them to keep their debt off of
their books. Chewco Investments, a partnership generated by Enron, allowed $600 million in
debt off the books. Because this debt was hidden, Enron claimed to have tripled its profits in two
years.
In the summer of 2001 Vice President of Enron, Sherron Watkins sent an anonymous
letter to the CEO, Kenneth Lay, listing accounting methods she felt would eventually lead up to
Enrons turn in number of accounting scandals. During that same time Kenneth Lay took time to
email his employees implying that he expected the stock prices of Enron to rise; as he sold off all
his own stock in the company. On October 22nd 2001, the SEC announced that Enron was under
investigation. On November 8th, Enron declared a statement that it had overstated earnings for
the past four years by $586 million and that it owed over $6 billion in debt by next year.
Enrons stock price plummeted which prompted Enron to act on specific agreements that
mandated it pay investors their money almost instantly. Enron clearly did not have the capital to
efficiently cover all its expenditures including repay its creditors therefore causing them to
declare Chapter 11 bankruptcy.

Executives of WorldCom, once the leading telecommunications company in the United

States, were convicted of deliberately misapplying the asset capitalization rules to boost reported
pre-tax income by approximately $3.8 billion over five quarters in 2001 and 2002. WorldCom
said most of the $3.3 billion abnormality involved the manipulation of reserves. Companies set
aside reserves in order to conceal estimated losses such as uncollected payments from customers
among numerous other expected costs. Normal operating costs for connecting to other
telecommunication lines which were actually expenses were capitalized basically listed as
investments. When these specific line costs were debited to balance sheet asset accounts eager
than charged to income statement expenses were dramatically overstated. Operating expenses
should be deducted from revenue as soon as payments are made. On the other hand, the cost of
capital expenses can range over time. Inaccurately spreading operating costs exaggerated
WorldCom's profits. The hidden motive behind WorldCom's actions was to cover up their nonproficient ability to keep up with the industry capacity.
WorldCom's accountants at the time were Arthur Andersen, the same people that looked
after Enron's books as well as other companies hit by accounting issues - Tyco, Global Crossing
and Adelphia. These among other corporate fraud forced government to take a hand and enact
the Sarbanes-Oxley Act of 2002.
The Economic Impact of Sarbanes-Oxley on the Business Environment
The crucial changes resulted in the creation of the Public Company Accounting Oversight
Board, the assessment of personal liability to auditors, executives and board members and
creation of the Section 404. Section 404 refers to mandatory internal control procedures. Public
companies must now include an internal control report with their annual audit. The oversight
board is accountable for monitoring the actions of public accounting companies, and works

jointly with the SEC. Based on size, accounting forms undergo reviews every one to three years,
depending on their size. Also another regulation, is public accounting firms will now be held
personally liable for their audits.
Public companies were obligated to conform with Sarbanes-Oxley therefore gaining
additional costs directly attributed to the new regulation. Preliminary costs associated with the
act include amplified expenses for annual audits, which public accounting companies passed on
to clients to provide a sense of trust. Accounting companies also experienced additional liability
with increased due diligence. Section 404 demanded the use of internal controls causing business
to implement and purchase internal control software/programs and the up keeping of these
programs. The prices for audits and non-compliance are expensive.
SOX had a two different effects on the market for investors who must be self-assured in
their decisions. The law projected to regain the confidence of investors after the recent
conspiracies in the market and secondly it intended to curb the ability for companies to
manipulate the investors at hand. The SEC used Sarbanes-Oxley to create a barrier for foreign
companies to function within the United States. Many small-sized /medium-sized companies
chose not to go public or to re-privatize existing public companies
Costs of Compliance
Studies of compliance costs due to the Sarbanes Oxley Acct prove to increase all public
accounting firms expenses regardless of size or profit. Unfortunately, smaller firms were
affected more on the basis that auditing costs were disproportionate to their revenue made. Firms
that had less than $75 million in market investments, spending highest portion of revenues on
audit fees saw an increase at over one percent.

Total costs of first-year compliance with section 404 could possibly surpass $4 and a half
million for each of the largest U.S. companies, which are companies that generated at least $5
billion in revenues). Medium-sized and smaller companies find an increased average projected
cost of at least $2 million. The estimated number does not apply to a single audit but the
recurring event that internal systems must comply with at least once a year. The price for
enlisting suitable board members has also enlarged. A financially literate audit committee is now
required to have a designated financial expert. This may provide a hindrance for some
companies to find an appropriate member that fits all the requirements. The PCAOB has
introduced new fees that must be paid monthly to support their operations.
The Sarbanes-Oxley Act puts stricter controls on public companies. However, there are
consequences for private companies as well. The whistleblower rule is in place for both public
and private companies to protect those who wish to anonymously report potential fraud of
corporate employees. Private companies must be able to show compliance with internal control
through documentation.
Market Implications
A report from the General Accounting Office discovered that the Big Four audit around
80% of U.S. public companies. They depict the audit providers as an oligopoly of a few
businesses. And a small barrier of entry. None of the Big Four have expertise in every industry,
so some market segments are actually dominated by just one or two firms, still leaving no room
for more competitors to compete fairly.
Conclusion

In conclusion, the Sarbanes Oxley Act of 2002 set forth a number of changes for
primarily the United States but foreign countries as well. The public lost trust in the acts
committed by once such successful companies. The fraud caused investors to make decisions
based on ethics and the safety of their capital. The Act helped to restore their confidence and
have them reinvest in the market. The act caused auditors and executives to abide by new rules
that impacted their relations as well as the way they conducted business outside of the auditing
process. Sarbanes Oxley set principles for how publicly traded companies maneuver and
accurately transcript financial documents. This law has forced more responsibilities on CFO and
CEOs.

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