Is it enough? Does the Sarbanes-Oxley Act do what it was intended
to do? In a publication titled, “Reforming Corporate America,” Larry Bumgardner, JD, compares the SOX legislation to the Securities Act of 1933. There are certainly some parallels, including the drama relating to choosing the people in charge.
    The Securities Act of 1933 was created as the government’s response to the stock market crash in 1929. It wasn’t an immediate response –there were congressional hearings, investigations, and discussions regarding all sorts of activities that inflated company’s stock prices (sound familiar?) There was an assortment of naughty things going on, including corporate family members selling stock to each other and paying publicists to make everything look good.  After the presidential elections in 1932 and talk of high salaries and no interest loans to executives and selling cheap shares to a select few before the company went public, Legislators passed the Securities Act of 1933. 
    At that time, the government was hesitant to be too heavy handed and the Act simply didn’t do enough. A year later the Securities Exchange Act was passed. The new Act required companies to continuously disclose pertinent information and gave the government the right to prosecute for market manipulation. It also created the Securities and Exchange Commission (SEC).     
    There was a little drama concerning the staffing of the SEC; the President selected Joseph Kennedy, father of the future president, as Chairman. Kennedy was criticized for being a part of the manipulation of the market that the SEC was designed to prevent. The SOX version of that drama involved Harvey Pitt, the 2002 Chairman of the SEC, and his selection of key members of the PCAOB. His initial choice for Chairman, John Biggs, was eventually rejected as being too close to the market industry (he managed a large pension fund) and a second choice, William Webster, was made.  It then came out that Webster had been on the audit committee of a company having its accounting practices investigated by the SEC. Both Biggs and Webster resigned over the issue. Looks like another situation of the fox guarding the henhouse!
     It only took a year to realize the Securities Act of 1933 didn’t pack enough punch. What about the Sarbanes-Oxley Act? There seems to be quite a bit of wiggle room if you know where to look for it. There are lots of rules and regulations intricately defined in the Act and the punishment threat has been greatly increased; some sentencing maximums for CEO and CFO convictions have increased as much as ten times. But will these new tough guidelines be enforced? The PCAOB and SEC have the right to allow exceptions. Some of these “new” rules aren’t new at all, but were outlined in the Securities Exchange Act of 1934; what changed are the sentencing guidelines. 
    If there can be exceptions to the disclosure rules and the newly empowered audit committees only have to review processes, not actual documents, and the
prosecution has the burden to prove “knowingly”, does the Sarbanes-Oxley Act
pack enough punch? Was this whole thing just a feel good project to restore confidence in the stock market or are companies really changing the way the audit and present their financials?

   The first order of business for the Sarbanes-Oxley Act was to establish the Public Company Accounting Oversight Board - PCAOB. The PCAOB, more commonly referred to as "the Board", was created to oversee the audit of public
companies, establish audit report standards and rules, and inspect, investigate and enforce compliance on the part of registered public accounting firms and those associated with the firms. Twenty-two pages of the sixty-eight page Act are devoted to the creation of this board and explaining in painful detail how it works.
    In February of 2005, two and a half years after the Board's inception, Peter J. Wallison wrote an essay titled Reign in the Public Company Accounting Oversight Board.   According to Wallison, Congress handed the SEC free reign and an unlimited budget by way of an organization that doesn't have the usual checks and balances that hold government agencies accountable. In this work, Wallison calls for Congress to put an end to the Board before it gets out of control. 
    What did the SOX Act set up? In reaction to the "accountants gone wild" scandals relating to Enron, WorldCom, and Tyco, Congress created an organization that has no limits to its budget, authority, and regulatory reach. Talk about having the government's fingers in the business pie!
    The PCAOB is  a Washington D.C. not-for-profit corporation rather than a government agency. Because of this, it does not present its budget before an appropriations committee for funding. There is not the usual accountability to the man with the check book. Normally a self-regulating organization is funded by the industry it is set up to serve; in this case, the accounting industry. Congress set this one up so that it is funded by charging fees to all public companies. There are about 8,400 of them, making this is effectively a tax on the entire economy. With this funding method, if the Board needs more money, it only has to raise its fees. The businesses that are footing the bill have no choice in the matter; if they want to be publicly traded, they have to pay the fee.
    Who is in charge of the Board? Who is regulating the regulators? Our government is set up with a system of checks and balances with Congress controlling the funding. If an agency is overstepping its bounds, tightening the financial belt tends to be an effective control. But the PCAOB isn't a government agency.  Technically, its budget is evaluated by the SEC. The SEC also has the right to install and remove board members. On the surface that arrangement implies that the SEC is regulating the Board. The fine print of the SOX Act directs the Board to establish, inspect, investigate, enforce, and anything else the SEC assigns it to do. Why would the SEC reduce funding for the PCAOB? The SEC, who has to go before the Appropriations Committee for funding, limit the resources for an organization that can take on some of the pet projects its own budget can't afford? The industry it serves has no leverage because it has no control over the fees it pays and the SEC has no motive to limit those fees so there is no controlling financial belt. 
    With an unlimited budget and the authority to investigate, discipline, and penalize, what happens when the regulators go wild?

   It is common that the whole group is affected by the actions of the few. This happens anytime there is a group and someone in charge. In Kindergarten, little Sammy never washes his hands before lunch, even after finding a dead bird at recess. To make sure his hands are clean, a new rule is instituted. Everyone must wash hands before lunch. The position of Washing Monitor has been created and all children are observed washing their hands before lunch, and marked on a checklist. This is then shown to the teacher who signs and dates it, filing it away as proof of the washing. Any non-washing is immediately addressed and rectified. It takes longer to get to the lunchroom and the added positions of monitors has increased the goodies and rewards budget but all hands are clean and lunch is eaten without fear of bird germs. 
    Time goes by, kids grow up, Sammy quits playing with dead birds and ends up being a relatively clean person. Scandal then rocks the business world. A couple of big companies don't quite tell all of the truth in their financial statements and their stockholders and employees are hurt because they based financial decisions on this faulty information. The companies collapsed, accountants and executives went to jail, and Justice was served. In an effort to prevent this from happening again, Congress (someone in charge) stepped in and made a rule (Sarbanes-Oxley Act) for all publicly traded companies (the group.) 
    At first glance, it seems a little over-reactive to create sweeping legislation just because there was a little fraud going on. After doing some research, it’s clear there was a lot more than a little fraud going on. Several large companies were deeply embroiled in financial scandals. For example, Tyco had a few key executives indicted for fraud. The former CEO, CFO, and General Counsel were accused of wheeling and dealing themselves millions of dollars at the stockholders expense. Between making themselves unauthorized loans for low or no interest and forgiving those loans, undisclosed bonuses, and fraudulent security sales, these three men made off with over $600 million. 
    Perhaps the most well known fraud case that brought about the legislative act is that involving Enron[i]. Talk about accounting gone wild! In a matter of a year or two, Enron went from one of the largest companies in the world, with its stock trading at $90 a share to a name synonymous with fraud and a stock price under $1 per share. How did they do that?
    There was lots of creative accounting going on but the biggest issue was the use of non-consolidated special-purpose entities (SPE’s) to buy and sell stock and commodities to itself. Moving the assets from one SPE to another and recognizing the revenue each time greatly impacted the financials, overstating revenue, net income, and stockholder’s equity. 
    In my opinion, the biggest problem with Enron wasn’t the financial shenanigans going on but that they were allowed to do it. The Board of Directors, meeting the SEC requirements of financial expertise, was aware of the dealings with the SPE’s. The Audit Committee reviewed and signed off on the accounting. The outside attorneys reviewed and approved the partnerships. The Arthur Andersen CPA firm audited and signed off on the financials every year since 1985. Arthur Anderson! This was one of the biggest and most respected accounting firms in the country! 
    No wonder Congress enacted Sarbanes-Oxley – someone needed to restore faith in the accountants and financial managers of the nation. Perhaps if the Federal Government says you have to follow the rules, the rules will be followed. Or at least make it much harder to commit fraud and get away with it.
Perhaps this is more than punishing the many for the wrongs of the few. 

 
 
 
[i] In 2002, The Journal of Accounting and Public Policy, which publishes research papers focusing on accounting and public policy, published a paper written by George Benston and  Al Hartgraves titled “Enron: what happened and what we can learn from it.” My ideas regarding Enron stem from reading this article. If you’re interested in reading it, you can find it at http://bbs.cenet.org.cn/uploadimages/200311294124115529.pdf. Also, CNN published a very informative article regarding the Tyco indictments in 2002 that is still available at http://edition.cnn.com/2002/BUSINESS/asia/09/12/us.tyco/.