The Sarbanes Oxley Act

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  • 1:15 Independent Auditors
  • 3:18 Corporate Responsibilities
  • 4:46 Financial Disclosures
  • 6:30 Conflict of Interests
  • 7:54 Fraud & Records
  • 8:30 Criminal Penalties
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Lesson Transcript
Instructor: Shawn Grimsley
One of the most important laws governing publicly traded companies is the Sarbanes-Oxley Act of 2002. In this lesson, you'll learn what the law is and some of its most important provisions. You'll also have a chance to take a short quiz.

The Law at a Glance

The purpose of The Sarbanes-Oxley Act of 2002 can clearly be discerned by examining the law's long title: The Public Company Accounting Reform and Investor Protection Act of 2002. In a nutshell, the Act is designed to improve the quality of financial reporting and corporate governance and increase the responsibility of publicly traded companies to protect investors. More specifically, the Act provides for the following reforms:

  • It reforms auditing and accounting procedures of publicly traded companies
  • It defines the oversight responsibilities of directors and officers of publicly traded companies
  • It regulates conflicts of interests and insider dealings of directors and officers
  • It regulates conflicts of interest of stock analysts
  • It reforms disclosure requirements of information on anything that may influence a company's financial health and results
  • It criminalizes inappropriate conduct regarding document handling, disclosures and interference with investigations
  • It requires personal certification of financial results and income tax documents by the chief executive officer

Let's take a quick look at some of the key provisions of the Act.

Independent Auditors Are Required

The Act severely limits the ability of auditors to do anything other than provide auditing services for their auditing clients. Auditing involves a process of verifying the accuracy of a company's financial records and supporting documents by a professional, such as a certified public accountant.

An audit needs to be unbiased. If a CPA firm provides other services to a company, or wants to do so, then there is an incentive for the CPA firm to be biased in its audit for the company. This can lead to incorrect information for shareholders, potential investors and regulators. Preventing auditors from performing non-auditing work for the companies they audit helps reduce the chance of this bias. Let's look at an example.

Allan is a partner at Big Accounting Firm, LLC, which is a firm of certified public accountants that provides independent auditing services for Mega Corp. A director of Mega Corp. approaches Allan wondering if his firm would like to provide consulting services that would be worth about five million dollars a year to Allan's firm. Allan probably cannot accept the offer because that five million dollars a year may provide an incentive for Allan to be biased in his auditing to keep Mega Corp. happy and keep that five million-dollar-a-year consulting gig.

The Act also created the Public Company Accounting Oversight Board (PCAOB) that is responsible for overseeing auditing firms that audit publicly traded companies. In other words, its job is to make sure that auditors are doing their jobs correctly. Accounting firms that perform audits of public companies will have to register with the PCAOB. The board develops auditing standards and rules of ethics that accounting firms must follow.

The PCAOB also has the ability to investigate and sanction firms that violate these rules. In our example above, Allan's firm would be subject to investigation and sanctions by the board if it found that the consulting job violated the board's standard and ethical rules.

Corporate Responsibilities

Sarbanes-Oxley also outlines major changes to a publicly traded corporation's responsibilities relating to financial and accounting activities. The Act requires publicly traded companies to establish audit committees whose members must consist of independent board members, which means that they cannot have any financial connection to the company.

Board members and officers may not attempt to influence auditing results. For example, let's say that Tom is a director of a Mega Corp. It's a great gig. He gets paid well, and it's a high-status position. He also gets easy access to powerful people in business and politics. Since Tom is also a president of a different company, these contacts are very helpful for his business. He doesn't want to lose his position by getting voted out at the next shareholders' meeting because of poor company performance, so he tries to pressure his company's auditing firm to be creative in their analysis to yield a favorable result. In fact, he convinces the president of the company to offer the accounting firm we discussed above that five million-dollar contract. This is a no-no under Sarbanes-Oxley, and Allan respectfully declines because he doesn't want any trouble with the PCAOB.

Of course, insider trading is prohibited. Insider trading is making trades based upon information not available to the general public, such as being aware of a new product line that will blow away the competition.

Increase of Financial Disclosures

The Act enhances the disclosures that a publicly traded company must make. One of the most important provisions is Section 404 of the Act. This section requires that management establish, maintain, evaluate and report on the internal controls it has over financial reporting. It must submit an internal control report with all annual reports it files with the SEC.

An internal control system helps ensure that the company's financial reporting follows the generally accepted accounting principles. The Act also requires that an outside auditor give an independent evaluation of the company's internal controls. Maintaining internal controls and compliant financial reporting will help regulators, shareholders and investors make sound decisions.

Sarbanes-Oxley requires other disclosures that were not necessarily made prior to its enactment. Some of these include reporting of transactions that are not recorded on the balance sheet and dealings with unconsolidated entities that may affect the company's finances. An unconsolidated entity is one that is either directly or indirectly controlled by the company but not consolidated with the parent company for purposes of the parent's financial statements.

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