Sarbanes-Oxley

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frauds are often accomplished by upper management by overriding existing internal controls.” Why is there such rampant corruption at the executive level? CEO and CFO compensation is often tied to stock performance or various financial statement metrics. In addition, executives are under extreme pressure to run successful companies. Sarbanes-Oxley does its best to remove incentives for such behavior.

Specific regulations pertaining to CEO and CFO within SOX include the requirement that the CEO and CFO of each US public company must certify the company’s financial statements, declaring they are fairly presented and disclose its operations and financial condition. Additionally, “if financial statements are restated due to “material noncompliance” with financial reporting requirements, the CEO and CFO must disgorge any bonus or other incentive-based or equity-based compensation received during the twelve months following the issue of non-compliant financial statements.” These requirements perform two key functions in reigning in on executive fraud; the first attaches the executives names to the financial statements and opens the executive to potential liability and the second holds the executive financially responsible for misuse.

The major criticism with SOX’s approach to curb fraud is that it doesn’t provide any meaningful regulations to remove incentives to commit fraud. There is no guarantee that these rules will be followed and most critics argue that an executive who is willing to commit fraud will also be willing to sign a representation letter. Meaningful reform would remove incentive-based and equity-based compensation entirely, remove the CEO from financial reporting responsibilities and completely remove the CFO from operation responsibilities. If the CFO is not held accountable for the financial position of the company and the CEO cannot effective the financial statements, it would add a further layer of protection.

Another group specifically singled out by Sarbanes-Oxley, and perhaps the only group that benefitted from reform, are the independent audit firms. Esteemed professor of the great Rutgers University Accounting Department, Sungsoo Kim, explored the after math of the external audit firm market post-Enron. Arthur Anderson, Enron’s auditor and member of the “Big 5” folded as a result of Enron’s scandal and the subsequent litigation. As a result, there was a new market for former Arthur Anderson clients in the new “Big 4” and a changing landscape surrounding the riskier clients. Kim discovered that riskier public companies were seeing a disproportionate increase in audit fees as accounting firms were paying more attention to avoiding unnecessary risk.[6]

It is important to look at the shift towards Big 4 accounting firms avoiding risk. This would be indicative of the Sarbanes-Oxley act performing its intended objectives. Accounting firms are no longer comfortable taking on unnecessary risk from clients. An important requirement that helped bring about this change is Section 104 of SOX requiring annual reviews of accounting firms whom provide over 100 public issuers and every three years for firms with under 100 issuers. Essentially public audits are being audited by competitors. These findings are made public information and there is a strong incentive to ensure an accounting firm’s work is performed properly. There is also additional incentive to find mistakes, short-cuts and improper methodology as an inspector because these firms are your competitors. As a result firms take a serious approach to properly performing audits for public companies.

The fundamental question surrounding Sarbanes-Oxley is “has it worked?” There is startling evidence that both has and hasn’t, depending on what the purpose of the law truly was. As a short-term reform to prevent further hemorrhaging in the US securities market, the Sarbanes-Oxley was successful in slowing the overall stock decline in the immediate aftermath of Enron. However, the greater purpose of the law was to provide greater transparency for publicly owned companies; in this regard the jury is still out. SOX has done little, if not nothing to hold executives responsible for financial irregularities. There are some circles in the financial world that blame poor accounting regulations for the financial crisis of 2008 as the risks of over-leveraged mortgages were never disclosed or properly reserved at a conservative level. Additionally, no executive was ever convicted for illegal actions during the crisis – one of the paramount goals of the Sarbanes-Oxley act.

Others have criticized SOX for the prohibitive costs associated with compliance, particularly for foreign companies and smaller firms. These companies require a significant amount of time and capital in order to comply with the regulations associated with SOX. This is particularly troubling because these companies are attempting to go public for the very reason of raising additional capital for their business. Additionally, there is still a significant amount of misstatements for public companies. In a study of 3,861 US accelerated filers, 13% had errors in their financial statements and required restatements. [7]

Sarbanes-Oxley isn’t perfect and there are a few changes that can be made to improve the effectiveness of the law. In the absolute simplest terms SOX is meant to protect investors. It can accomplish this by providing accurate financial statements for public companies, removing incentives for executives to manipulate financial information and to provide a safety net for when SOX fails in its main objective. Protecting investors can go beyond ensuring audit committees are independent and accounting firms are unbiased in their opinions. This can be achieved in several ways past that of SOX. First, audit fees should be standardized across all public accounting firms for public companies. If audit fees were tied to an algorithm (such as a factor of revenue, profit and volatility) Big 4 accounting firms would lose incentives to low-ball services or take short-cuts. This should be coupled with a maximum engagement period of five year for CPA firms on a public company. If public accounting firms lose virtually all incentive to maintain clients they will lose incentive to cave under executive pressure or manipulation. Additionally, a set rotation between accounting firms ensures that there will be a new set of eyes on financial statement every five years and work will be spread among the industry.

In addition to removing incentive for accounting firms, a greater effort needs to be made to remove incentives for executives of public companies. Specifically, CEO’s and CFO’s should no longer receive incentive-based pay or equity-based pay. This approach is only necessary if the