The Sarbanes-Oxley Act of 2002 was passed by the House of Representatives and the Senate in response to corporate misleading and fraudulent accounting practices since the 1990s (Paine and Weber, 2004). The collapse of Enron and WorldCom as a result of fraudulent accounting prompted the passage of the Act into law in 2002 (Ibid.). Enron transferred out billions of its long-term debts from its financial statements to affiliated special purpose entities, and WorldCom recognized billions of expenses as assets on its financial statements (Scott, 2009, Pp. 7-8). Both companies fraudulently inflated their earnings. The major objectives of the Sarbanes-Oxley Act (SOX) are to increase the quality and decision usefulness of financial statements, restore investors' confidence and the efficient working of capital markets, and protect investors. The regulations in the SOX can be mainly categorized into regulations that control managers in financial reporting, regulations that increase auditing quality and independence of public accounting firms, and regulations that increase the authorities of regulatory bodies to supervise and punish managers and public accounting firms that violate financial reporting or auditing standards. This paper argues that the regulations contained in the SOX allow the SOX to achieve its objectives. To support its argument, this paper explains how the regulations on managers and public auditors and the enforcement of the regulations by governmental bodies help reduce information asymmetry (to be defined in the next paragraph) between managers and investors and consequently increase decision usefulness of financial statements.
Regulations on managers reduce information asymmetry
Information asymmetry in financial reporting occurs when managers have more information on operating, investing, and financing activities of the company than investors do (Wayne, 2010). There are two types of information asymmetry: adverse selection (hidden information) and moral hazard (hidden actions) (Ibid.). Adverse selection occurs when managers have useful and undisclosed material information on operations, investments, and financing activities of the company that investors do not know such that investors cannot decide whether managers have used information available to them to make decisions that maximize investors' wealth (Ibid.). In adverse selection, managers may use information that is only known to them for their own advantages at the expense of investors. For example, in the case of insider trading, managers have information that is known to them only and use the information to buy or sell off stocks in order to make profits that will cease to exist once the information is made known to the markets. Moral hazard occurs because the separation of ownership and control makes investors unable to directly observe the actions taken by managers; therefore, investors cannot ascertain that managers have acted in the best interests of investors by maximizing investors' wealth (Ibid.). Investors have to analyze financial statements, especially net income, share profits with managers, and provide incentives to managers in order to indirectly discover how managers have safeguarded and increased the value of assets of the company. Financial statements that are fairly presented with full disclosure help reduce adverse selection and moral hazard of managers and help investors evaluate the stewardship of management. As a conclusion, accurate and complete financial statements reduce information asymmetry and conflicts between managers and investors and lead to more cooperation between managers and investors.
The SOX requires managers (CEOs and CFOs) to certify the accuracy and completeness of financial statements (Paine and Weber, 2004). The SOX also requires managers to certify the effectiveness of the company's internal control over financial reporting (Ibid.). Thus, the SOX basically requires managers to establish an adequate and properly operating internal control over financial reporting and take corrective measures on weaknesses of the internal control. When a company has a proper internal control over financial reporting, recognition, measurement, and presentation of economic transactions/events of the company becomes more reliable and less susceptible to frauds by employees and managers. A proper internal control in a company also reflects that management has established a proper corporate governance structure, including codes of ethics for employees and managers. In fact, the SOX requires a public company to have a code of ethics for senior managers such as the CFO (Ibid.). In combination with a proper internal control, managers will provide more accurate and complete financial statements to investors and regulators if manager are responsible for the financial statements. Managers realize that if they certify and supply misleading or incomplete financial statements, they are held responsible for the financial statements and subjected to punishments from regulators.
The SOX has punitive regulations that complement the requirement for managers to certify financial statements. These regulations include $5-million fines and 20-year jail time for knowingly certifying and issuing financial statements that are misleading, incomplete, or non-compliant with the generally accepted accounting principles (GAAP) and regulations (Ibid.). The SOX also requires managers to return bonuses and profits from securities sales that exist due to the issuance of misleading or incomplete financial statements (Ibid.). Managers convicted of issuing misleading financial statements are barred by the SOX to serve in the management and Board of Directors of public companies (Ibid.).
The requirement for managers to certify the accuracy and completeness of financial statements is the most important regulation in the SOX. When managers are responsible for the financial statements, managers put their competency, integrity, and reputation at stake and therefore have the burdens to (1) ensure that the internal control is adequate and properly operational so that the company's accounting system produces accurate and complete financial statements that faithfully represent the economic transactions/events of the company, (2) to issue accurate and complete financial statements in order to avoid being fined, jailed, asked to return bonuses and other performance rewards, or barred from the management and Board of Directors of public companies. When financial statements are accurate and complete, managers provide more complete and unbiased disclosure in financial statements; therefore, investors have more information quantitatively or qualitatively from managers such that information asymmetry between managers and investors is reduced.
When managers wilfully manipulate financial reporting so that financial reporting does not conform to the GAAP and regulations, the manipulation and its harmful effects on investors and capital markets may not be instantly known to investors and regulators. The SOX prevents managers from benefiting from the time lag, which can be in years, between the time of managers' manipulation of financial statements and the appearance of related harmful effects by extending the statute of limitations for securities and financial reporting frauds (Ibid.). Thus, managers who are guilty of providing misleading and incomplete financial statements can be punished long after they had committed their crimes. Moreover, the SOX accelerates the divulgence of financial reporting frauds by requiring company lawyers to report the frauds to the Board of Directors and by legally protecting whistleblowers who report fraudulent financial reporting to regulators (Ibid.). The last regulation mentioned above accelerates the divulgence of hidden information and action that are originally known only to managers so that information asymmetry is reduced faster. Lastly, the regulation that requires managers to file changes to the ownership of company's stocks with the SEC within two days is intended to reduce adverse selection, such as insider trading, and moral hazard on the part of managers (Ibid.).
The SOX requires public companies to have an internal audit committee that consists of members of the Board of Directors who are independent of the management (Ibid.). An independent audit committee, with at least one financial expert, verifies the accuracy and completeness of the accounting system and financial reporting under the responsibility of management. The auditing of management's financial reporting by independent internal audit committee and external auditors pushes management to supply more accurate and complete financial statements; therefore, information asymmetry between managers and investors will be reduced. The net income figure becomes more reliable, and consequently investors can more accurately evaluate the performance of managers by using the net income figure. Thus, an internal audit committee serves as a policing unit that protects the interests of investors.
2. Regulations on public auditors
The SOX limits the number of non-auditing services that a public accounting firm can offer to a public company when the public accounting firm is auditing the public company (Ibid.). This regulation aims to reduce financial conflicts of interest between a public accounting firm and its client and to increase the independence of the public accounting firm. The failure of Arthur Andersen to properly audit the financial statements of Enron and WorldCom was mainly due to the desires of partners at Arthur Andersen to keep selling lucrative non-auditing services to the two companies (Ibid.). Arthur Andersen should have known the irregular accounting practices at Enron and WorldCom and should have never missed the easily understood capitalization of expenses in WorldCom's financial statements (Ibid.). However, Arthur Andersen lost independence in its relation to WorldCom due to revenues from non-auditing services offered to WorldCom and gave an unqualified opinion to WorldCom's financial statements.
The SOX also requires public accounting firms to understand, evaluate, and give an opinion on a client's internal control as part of the audit process of the client (Ibid.). When an auditor understand the internal control of a client, the auditor can better plan and design an audit process, including an appropriate amount of evidence to collect for evaluating managers' assertions on the financial statements. This regulation provides additional information to investors such that investors can more accurately determine the quality of the financial statements based on the quality of the internal control of the company. Consequently, the auditor's opinion on the internal control reduces managers' adverse selection. The auditor's opinion on the internal control also reduces moral hazard of managers because the degree of quality of the internal control reflects how well managers have done their job in safeguarding the assets of the company.
The SOX limits a partner's audit term of a particular client to five years and prohibits a public accounting firm from auditing a public company if former executives of the public company are employed by the accounting firm within last year (Ibid.). A public accounting firm must rotate partners every five years in its audits of a public company. These regulations aim to prevent conflicts of interest from occurring between a public accounting firm and its clients and to maintain the independence of a public accounting firm from its clients.
The SOX created the Public Company Accounting Oversight Board (PCAOB) (Ibid.). The PCAOB has the authorities to issue auditing standards, inspect the auditing practices of accounting firms, and administer punishments to public accountants and accounting firms for violating auditing standards and codes of professional ethics (Ibid.). The policing of public accounting firms by the PCAOB puts pressure on accounting firms to conduct audits of public companies' financial statements according to the generally accepted auditing standards (GAAS) and to give the right opinions to financial statements and internal controls of public companies. Public companies that want to have an unqualified opinion on their financial statements must prepare their financial statements according to the GAAP, make correcting entries for errors or omissions discovered by auditors, and provide full disclosure. Hence, the representational faithfulness of financial statements will increase; and consequently, managers' adverse selection is reduced. If the PCAOB were created a few decades back, the PCAOB might have discovered improper auditing practices and GAAS violations by Arthur Andersen in its audits of Enron, WorldCom, and other companies before these companies experienced financial troubles due to fraudulent accounting practices. Thus, the PCAOB could have reduced information asymmetry between managers and investors of Enron and WorldCom much earlier before the two companies went bankrupt.
The SOX basically complements the Securities Act of 1933, which calls for managers to provide financial statements to investors for helping investors make investment decisions. The Securities Act of 1933 does not require managers to guarantee the accuracy and completeness of financial statements. The SOX goes one step further by requiring managers to certify and guarantee the accuracy and completeness of financial statements. The SOX enforces the proper application of the US GAAP, which is extensive and rule-based, by public companies in their financial reporting.
One important issue of the SOX is the cost-effectiveness of its regulations. Protecting a whistleblower is a complex and costly process that requires legal proceedings. Enforcements of SOX's regulations by the SEC and PCAOB require more public funding. However, in the case of the PCAOB, the public and private sectors share the funding of the operations of the PCAOB because public companies and public accounting firms that provide auditing services must pay fees to the PCAOB. Although there is a considerable cost involved in the execution of the SOX, this paper holds the position that the benefits to investors and capital markets through reduction of information asymmetry and fraudulent financial reporting outweigh the cost of implementing the SOX. When the SOX can prevent one large company from losing billions of dollars due to fraudulent financial reporting, the SOX has helped maintain investors' confidence in capital markets. Without the SOX, even just one large company, such as Enron, goes bankrupt; the resulting negative effects can amplify throughout global capital markets.
The main regulations of the SOX include holding managers responsible for the accuracy and completeness of financial statements and improving the auditing practices and independence of public accounting firms. The other regulations increase the power of regulatory bodies to punish managers for misleading and incomplete financial reporting and public accounting firms for lacking independence and carrying out audits without adhering to auditing standards. Thus, the SOX binds managers and public accounting firms to certain regulations and punishes them for violating the regulations. The end result of the SOX is to reduce information asymmetry between managers and investors and consequently investors can have more confidence in the usefulness of financial statements for making investment decisions.
