Ethics: Enactment of Sox

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Ethics: Enactment of Sox


Congress enacted the Sarbanes–Oxley Act (SOX) on July 30, 2002 in response to corporate and accounting failures in several major companies (Orin, 2008). These failures eroded public confidence in the US financial markets and harshly affected the public trust in corporate reporting practices and ethical behaviors of organizations (Mitchell, 2012). Therefore, Congress passed SOX to restore public confidence in the reliability of financial reporting. The Act led to a comprehensive revision of the regulatory framework for the public accounting and auditing profession and laid out guidance for strong corporate governance (Fischer, Gral, & Lehner, 2014). However, the Act contains some highly contentious provisions (Fischer et al., 2014). This paper reviews the major ethical components of SOX, social responsibility implications with respect to the compulsory publication of corporate ethics, and controversies therein. Moreover, it describes the opportunities for the future improvement of the Act.

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History of the SOX Enactment

As mentioned earlier, Congress enacted SOX in 2002 against the backdrop of fraudulent accounting activities by major US corporations. Mega scandals in Enron, WorldCom, and Tyco weakened the confidence of investors in financial reporting (Orin, 2008). Furthermore, there was an urgent requirement to overhaul regulatory standards to protect investors and restore confidence in financial markets (Orin, 2008). Subsequently, SOX came into force and introduced major changes in financial practice and corporate governance. It required strict mandatory reforms to improve disclosures in financial reporting from public companies and prevent accounting fraud. The Act is named after Senator Paul Sarbanes and Michael Oxley, and it spelled out several non-negotiable timelines for compliance (Fischer, Gral, & Lehner, 2014).

The Key Ethical Components of SOX

Establishment of Independent Oversight of Public Company Audits

SOX created the Public Company Accounting Oversight Board (PCAOB), which brought to an end over 100 years of self-regulation by the company audit profession. The creation of the PCAOB is considered the most fundamental change brought by SOX (Fischer et al., 2014). Currently, the PCAOB regulates auditing companies, lays out auditing and ethics standards, and performs audit quality inspections with the aim of identifying issues pertaining to audit quality (Turley & Howe, 2012). Furthermore, the PCAOB is also mandated to investigate allegations and discipline auditors of publicly trading firms and broker-dealers (Turley & Howe, 2012).

Stronger Audit Committees and Corporate Governance

SOX expanded the responsibilities of audit committees, a move that substantially strengthened corporate governance. It requires the boards of firms listed on the United States exchanges to create audit committees constituted of only board members that are independent of management (Mitchell, 2012). Due to requirement, audit committees, rather than management, are directly responsible for the appointment, compensation, and monitoring of work of external auditors. The latter should evaluate fair representation of financial statements prepared by management (Mitchell, 2012).

Improved Transparency, Executive Accountability, and Investor Protection

SOX clearly defines and allocates the responsibilities for the firm’s financial statements with its CEO and CFO. SOX also requires the two executives to certify a number of items for every quarterly and annual report (Turley & Howe, 2012). These items include:

  1. Reviewing the report.

  2. Ensuring that the report represents the financial information fairly.

  3. Confirming that the report does not contain any false statement of material fact or omission of a material fact that would render the financial statements misleading.

  4. Acknowledging their responsibility for creating and maintaining proper internal controls on financial reporting and other disclosures

  5. Evaluating the effectiveness of the firm’s internal controls, presenting a conclusion regarding the effectiveness, and disclosing any significant changes in the controls.

SOX has the mandate to impose stiff penalties on executive officers who knowingly certify that financial reports comply with the regulatory frameworks while they do not (Turley & Howe, 2012). Further, SOX requires companies to have auditors to validate the effectiveness of the firm internal controls on financial reporting to restore investor’s confidence (Fischer et al., 2014).

Greater Auditor’s Independence

SOX enhanced auditor independence and defined several types of non-audit services in which audit public companies should not engage (Turley & Howe, 2012). Furthermore, the independent audit committee of a public company should approve in advance any acceptable non-audit services carried out by the external auditor (Turley & Howe, 2012). SOX also requires a compulsory rotation of the lead engagement member every five years, instead of seven years required under previous professional standards. The five-year rotation requirement also extends to the concurring audit partner (Turley & Howe, 2012).

Social Responsibility Implications Regarding Mandatory Publication of Corporate Ethics

SOX requires each company to publish a code of ethics for its top corporate officers to follow. The officers should be socially responsible to customers, employees, shareholders, and other stakeholders. Prior to its enactment, there were perpetual incidences of corrupt corporate executives harming the reputation of their companies and also hurting investors and employees. SOX aimed at protecting investors and other stakeholders from losses arising from unethical conducts of the management.

Zhang, Zhu, and Ding (2012) found that SOX has succeeded in creating an independent board of directors. Their study of more than 500 organizations representing 64 distinct industries indicated that a greater presence of external director and women directors has led to improved corporate social responsibility.

SOX has also benefited the society in numerous ways. For instance, it has established a team mentality between management, audit committee, and the external auditor. The devotion of boards to more compliance issues and reduction strategy has led to the decrease in poor risk-taking among CEO’s, thus protecting the investor’s interest (Cohen, Hayes, Krishnamoorthy, Monroe, & Wright, 2013).

On the other hand, SOX focuses too much on the board of directors and accounting rules. In this regard, the Act may miss vital clues about impending economic troubles such as the 2008 financial crisis. Too much focus on the requirements of SOX makes companies less likely to pay attention to corporate strategy and acclimatization to technological advancements and the dynamic business environment (Cohen et al., 2013). Thus, there arises the question of what ought to be the real motive of social responsibility. The motive for social responsibility is probably to make profits since they enable firms to remunerate employees and distribute dividends to shareholders. Therefore, if the best way to help the society is to empower corporates to obtain profits, then SOX has been a barrier to corporate social responsibility (Cohen et al., 2013).

Criticisms of SOX

Section 404 which deals with firm’s internal controls over financial reporting is the most controversial aspect of SOX as it presents a disproportionately heavy burden on smaller organizations. It consists of two parts: 404(a) deals with the evaluation of the effectiveness of the internal control systems over financial reports; 404(b) contains regulations for the firm’s independent auditor to attest assertions of the effectiveness of the internal control systems (Fischer et al., 2014).

The regulations contained in Section 404(a) require that corporations should install more effective internal controls and assess them. Moreover, it presupposes that management should acknowledge its responsibility in a management report (Fischer et al., 2014). The rules in Section 404(b) contribute to the improvement of the quality of auditing services because of auditors pledge to deal more intensively with internal controls over financial reporting (Fischer et al., 2014). In other words, increased reliability of the firm’s financial reports is attained through the implementation of more effective internal controls and auditing (Fischer et al., 2014). The ultimate effect is deemed to be strong investor’s confidence.

The implications of SOX Section 404 adversely affect smaller organizations in light of the high compliance costs involved. Vast literature shows that compliance costs, particularly audit fees, have risen substantially since the implementation of this section. It is remarked that the provisions of Section 404 harmfully affect small firms. It is partially attributed to the fact that small organizations were not highly engaged in internal controls prior to the implementation of SOX as compared to big ones. Subsequently, they had less experience in documentation and testing of internal controls over financial reporting (Foster, Ornstein & Shastri, 2007). According to Kessel (2011), small and mid-cap biotech firms have seen their market values fall over the years due to the perpetual disruption in the financial markets and high cost of compliance with the regulations related to SOX. Studies also indicate that small firms are more likely to report internal control failures than big ones (Fischer et al., 2014).

Suggested Improvements on SOX

The SOX can be enhanced by addressing high compliance costs associated with the implementation of Section 404. The use of audit personnel from states with low rates and the employment of programmed controls as regularly as possible can minimize the high costs (Sneller & Langendijik, 2007).

The costs could also be decreased by reducing the frequency in which internal controls are audited. After the first auditor’s reports on the status of the internal controls over financial reporting, the frequency for the requirement of a report from an external report could be reduced. Besides, there should be scaled regulations to enable small firms save costs (Foster et al., 2007).

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Senate enacted the SOX in 2002 in response to a series of numerous corporate and accounting scandals of high profile companies in the United States, which can be viewed as a repercussion of a global crisis in corporate governance. The main objective of SOX is to protect the interest of investors and boost their trust in corporations by enhancing the reliability of disclosures of companies through financial reporting. The Act is widely credited for its various investor-oriented provisions. However, Section 404, which relates to internal control over financial reporting, sparks contention, especially in relation to small corporations due to the high compliance costs associated with the section. Although SOX has succeeded in improving corporate governance, more improvement can be achieved by focusing on the reduction of compliance costs associated with Section 404 of the Act.