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Sarbanes Oxley Act

An act aimed at protecting investors by making corporate disclosures more
accurate

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What is the Sarbanes-Oxley Act?

The Sarbanes-Oxley Act (or SOX Act) is a U.S. federal law that aims to protect investors by
making corporate disclosures more reliable and accurate. The Act was spurred by major
accounting scandals, such as Enron and WorldCom (today called MCI Inc.), that tricked
investors and inflated stock prices. Spearheaded by Senator Paul Sarbanes and
Representative Michael Oxley, the Act was signed into law by President George W. Bush
on July 30, 2002.

 
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Major Provisions

The SOX Act consists of eleven elements (or sections). The following are the most
important sections of the Act:

Section 302

Financial reports and statements must certify that:

The documents have been reviewed by signing officers and passed internal controls
within the last 90 days.

The documents are free of untrue statements or misleading omissions.

The documents truthfully represent the company’s financial health and position.

The documents must be accompanied by a list of all deficiencies or changes in

internal controls and information on any fraud involving company employees.

Section 401
Financial statements are required to be accurate. Financial statements should also
represent any off-balance liabilities, transactions, or obligations.
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Section 404

Companies must publish a detailed statement in their annual reports explaining the
structure of internal controls used. The information must also be made available
regarding the procedures used for financial reporting. The statement should also assess
the effectiveness of the internal controls and reporting procedures.

The accounting firm auditing the statements must also assess the internal controls and
reporting procedures as part of the audit process.

Section 409

Companies are required to urgently disclose drastic changes in their financial position or
operations, including acquisitions, divestments, and major personnel departures. The
changes are to be presented in clear, unambiguous terms.

Section 802

Section 802 outlines the following penalties:

Any company official found guilty of concealing, destroying, or altering documents,

with the intent to disrupt an investigation, could face up to 20 years in prison and
applicable fines.

Any accountant who knowingly aids company officials in destroying, altering, or

falsifying financial statements could face up to 10 years in prison.

 
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Benefits to Investors

After the implementation of the Sarbanes-Oxley act, financial crime and accounting fraud
became much less widespread than before. Organizations were deterred from
attempting to overstate key figures such as revenues and net income. The cost of getting
caught by the United States Securities and Exchange Commission (SEC) had exceeded the
potential benefit that could result from taking liberties with the way that financial
documents were presented.

Thus, investors benefited from access to more complete and reliable information and
were able to base their investment analyses on more representative numbers.

Costs to Businesses

While the Sarbanes-Oxley act benefited investors, compliance costs rose for small
businesses. According to a 2006 SEC report, smaller businesses with a market cap of less
than $100 million faced compliance costs averaging 2.55% of revenues, whereas larger
businesses only paid an average of 0.06% of revenue. The increased cost burden was
mostly carried by newer companies that had recently gone public. A more granular view
of the compliance costs experienced by businesses can be found in the chart below:

 
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Repercussions

Due to the additional cash and time costs of complying with the Sarbanes-Oxley Act,
many companies tend to put off going public until much later. This leads to a rise in debt
financing and venture capital investments for smaller companies who cannot afford to
comply with the act. The act faced criticism for stifling the U.S. economy, as the Hong
Kong Stock Exchange surpassed the New York Stock Exchange as the world’s leading
trading platform for three consecutive years.

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst certification
program, designed to help anyone become a world-class financial analyst. The following
CFI resources will be helpful in furthering your financial education:

Income Statements

Balance Sheet

Types of Liabilities

Deferred Revenue
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Financial Analyst Certification

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Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s

online financial modeling classes and training program!

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