After a series of financial scandals rocked the business community and started to have a material effect on the economy, Congress in 2002 passed the Sarbanes-Oxley Act as an effort to prevent corporate fraud in the future. At the time, Sarbanes-Oxley was considered the most significant piece of banking reform legislation since the New Deal of the 1930s. Today, its legacy stands out as perhaps one of the most effective methods for changing corporate accountability, discouraging fraud, and encouraging a more transparent corporate financial reporting process. To better understand the law, consider its most essential components.
Executive Accountability: Shifting Blame to Top Corporate Leaders
One of the most significant reforms found in Sarbanes-Oxley is its dramatic change in who is held accountable for corporate fraud and accounting scandals. In eras past, mid-level accounting managers were typically the ones arrested and held accountable for significant fraud issues and corporate scandals. While those individuals can still be held accountable, government regulators increasingly target the Chief Executive Officer and the Chief Financial Officer of a large corporation. This is because Sarbanes-Oxley holds those two people responsible not only for drafting ethical reporting guidelines, but also for enforcing those guidelines and checking company reports prior to their release. Any ethical issue that is approved by the executive becomes their responsibility if the company is ever audited and investigated.
Clear Documentation of Corporate Policies and Checks
Prior to Sarbanes-Oxley, corporations didn’t have to disclose how they held managers accountable for proper and ethical financial reporting. Furthermore, every company could use their own method of checking financial statements and holding their employees accountable for their ethical preparation. That is no longer the case, according to the Public Company Accounting Oversight Board. According to the terms set forth in Sarbanes-Oxley, all corporations must use uniform procedures to create and verify the accuracy of their financial statements. Their procedures must be disclosed to the public and they must be made available to an assigned auditor at any time. If any of these procedures is ignored or performed improperly, federal investigators can hold both the accountant and the company’s top executives responsible for the lapse in proper procedure.
Independent Auditing, No Conflicts of Interest, and Other Changes
Sarbanes-Oxley forbids the use of in-house auditors to evaluate accounting and reporting practices. Instead, an independent auditor must be assigned by the government to investigate these areas of the business. This also helps to eliminate conflicts of interest between an auditor and their employer, increasing the likelihood that any irregularities will be found, reported, and corrected appropriately. The law also establishes the Public Company Accounting Oversight Board, which has the ability to review and establish new principles for ethical financial reporting in major corporations. This is a further enhancement of corporate transparency and helps with the creation of uniform reporting standards for all businesses nationwide.
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A Signature Piece of Financial Reform Legislation
Major financial scandals toppled massive corporations like WorldCom, Enron, and many others. This had a devastating effect on the economy of the early 2000s, and legislation was deemed a requirement to help stave off these financial scandals, stabilize the economy, and change the accountability equation for top executives. These goals have largely been realized by the Sarbanes-Oxley Act since it was passed, with an almost immediate stabilization of the economy and a dramatic drop in the number of major financial scandals at American corporations.