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| Sarbanes-Oxley Act |
What It Is:
The Sarbanes-Oxley Act, officially named the Public Company Accounting Reform
and Investor Protection Act of 2002, became law on July 30, 2002. The law was
informally named after its sponsors, Senator Paul Sarbanes (D-MD) and
Representative Michael G. Oxley (R-OH).
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All companies (both foreign and domestic) that have registered equity or debt securities under the Securities Exchange Act of 1934 are subject to the Sarbanes-Oxley Act. Foreign public accounting firms must also comply with the Act if they perform work for companies subject to the Act.
How It Works/Example:
In general, Sarbanes-Oxley raised financial standards in three main areas:
corporate governance, securities analysis, and the performance of audit work...
NEW REQUIREMENTS FOR CORPORATE
GOVERNANCE
One of the most important goals of the Sarbanes-Oxley Act is to ensure that
company directors and officers are aware of and accountable for the financial
condition of the companies they manage.
This is most evident in the Act's requirement that the board of directors of most public companies have an audit committee. This committee must appoint, inspect, regulate, and control the actions of the company's auditing firm. The auditors in turn report directly to the audit committee. Committee members cannot be employees of the company, and firms are required to disclose which members meet the definition of "financial expert." The audit committee must be prepared to address complaints and confidential or anonymous submissions about the company's accounting practices.
Additionally, the CEO and CFO of any company subject to the Sarbanes-Oxley Act must certify in writing that the company's financial disclosures comply with the law and fairly represent the company's condition. The CEO and CFO must also certify that they have inspected the company's internal financial controls. To prevent directors and officers from issuing misleading financial statements in order to obtain personal benefits, the Sarbanes-Oxley Act makes it a federal crime for a company officer to pressure or manipulate an auditor into signing off on misleading financial statements. Further, if a company is forced to restate its financials, then in most cases the firm's CEO and CFO must give back any bonuses, compensation, or profits made on personal trades of the company's securities during the year after the faulty documents were initially disclosed.
To discourage deceptive compensation practices, the Sarbanes-Oxley Act outlaws most kinds of loans to company directors and officers, and prohibits officers and directors from trading their company's securities during periods when other employees or retirement-plan participants may not. In addition, any changes in ownership by those owning at least 10% of the company's stock must now be publicly disclosed within two business days.
NEW REQUIREMENTS FOR SECURITIES
ANALYSTS
Sarbanes-Oxley directs the SEC to subject securities analysts to stricter rules
regarding conflicts of interest. In particular, the Sarbanes-Oxley Act seeks to
improve the objectivity and independence of securities analysts by further
separating the investment banking and securities analysis functions of most
financial-services companies. This includes preventing members of a company's
investment banking division from supervising, approving compensation for, or
retaliating against members of the securities analysis division. The rules also
require analysts to make more disclosures about their personal conflicts of
interest, including the receipt of other compensation or business from the
client. Sarbanes-Oxley also prohibits analysts from hyping a client's pending
IPO by publishing research on the client before its stock has gone public.
NEW REQUIREMENTS FOR AUDITORS
The Sarbanes-Oxley Act seeks to discourage an auditor's tacit cooperation with a
company to materially misstate its financial results. In order to prevent the
entwined, dependent relationships most likely to encourage this tacit
cooperation, the Sarbanes-Oxley Act prevents auditors from providing bookkeeping
services, financial information systems design, appraisals, valuations, fairness
opinions, actuarial services, management functions, human resources,
broker/dealer, investment banking, investment advisory, legal, or other services
to clients. However, tax services are allowed. In addition, companies cannot
hire their auditors' employees as CEO, CFO, CAO, or controller if the employees
worked for the auditor during the one-year period preceding the company's last
audit.
In order to create direct governmental supervision of auditing firms, the Sarbanes-Oxley Act created the Public Accounting Oversight Board (PAOB). All companies providing audit services must register with the PAOB -- a nonprofit corporation overseen by the SEC. The PAOB's role is to register, regulate, inspect, investigate, and discipline public accounting firms. The SEC appoints all five members of the PAOB board, only two of which may be CPAs.
Sarbanes-Oxley regulations also expand the degree to which an auditor is responsible for carefully evaluating a company's financial condition. Auditors must now opine not only to the quality of the client's financial statements, but also to the quality of the client's internal financial controls. Auditors must now maintain their notes, records, and work papers on every audit for at least seven years after the work is performed, and these records must provide enough detail to support the auditor's decisions and opinions. Knowingly destroying or creating audit documents that impede a federal investigation is now illegal.
Why It Matters:
The Sarbanes-Oxley Act of 2002 came in the wake of some of the nation's largest
financial scandals, including the bankruptcies of Enron, WorldCom, and Tyco. As
such, the Act is widely considered to contain some of the most dramatic changes
to federal securities laws since the 1930s.
The Sarbanes-Oxley Act goes beyond requiring corporate boards to adopt codes of ethics. It substantially raises the standards and requirements for directors, officers, auditors, securities analysts, and corporate lawyers. As part of its eye toward reform, the Act also toughened the consequences for financial misconduct. Violations of the Act can range from censure to prison sentences and multimillion-dollar penalties. The statute of limitations on several kinds of securities fraud charges were also extended, and more provisions were made to ensure that the victims of the fraud -- frequently individual investors -- received at least some of the monetary damages paid by the violators. Importantly, the SEC now has the authority freeze any payment to an officer, director, partner, or agent during an investigation.
The Act is not without disadvantage,
however. The legal, managerial, and technological costs of compliance can total
millions of dollars, even for small companies. These high coasts have motivated
(and may continue to motivate) some companies to delist their shares from the
major exchanges, to go private or in some cases to stay private. Arguably, for
some small firms, the cost savings associated with avoiding compliance may
actually increase shareholder value.
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