The Sarbanes Oxley Act of 2002

Summary

The Sarbanes-Oxley Act, also known as SOX, was enacted in 2002 to address accounting frauds by companies like WorldCom and Enron. It mandated CEOs and CFOs to certify financial statements, introduced strict penalties for document destruction, and required companies to assess internal controls for fraud prevention. SOX also overhauled audit firm regulations, including quality control, partner rotation, and the prohibition of non-audit services for audit clients. A key outcome was the establishment of the PCAOB, which now oversees auditors, sets standards, and enforces compliance, ending the era of self-regulation in the auditing industry.

Takeaways

• 📜 The Sarbanes-Oxley Act (SOX) was enacted in 2002 in response to accounting frauds by companies like WorldCom, Enron, Global Crossing, and Tyco.
• 🏛️ SOX introduced new rules for publicly traded companies and their executives, including the requirement for CEOs and CFOs to certify the accuracy of financial statements.
• 👮‍♂️ The Act established criminal penalties for executives and audit firms involved in document destruction or fraudulent activities.
• 🔄 SOX mandated companies to assess and report on the effectiveness of their internal controls to prevent fraud and ensure accurate financial reporting.
• 🔄 Audit firms are required to implement quality control measures and are subject to more oversight, including the rotation of lead and reviewing partners every five years.
• 🔄 The Act stipulates that audit firms must assess and report on the internal controls of their publicly traded clients, separate from the company's own assessment.
• 💼 Section 404 of SOX has been criticized for being costly due to the increased workload for companies and audit firms in assessing and reporting on internal controls.
• 🚫 Audit firms are prohibited from providing non-audit services to their audit clients to avoid conflicts of interest and maintain the integrity of the audit process.
• 🛡️ The creation of the Public Company Accounting Oversight Board (PCAOB) marked the end of self-regulation in the auditing industry, introducing external oversight and standard setting.
• 👀 The PCAOB acts as a watchdog, monitoring registered auditors, evaluating their work, and enforcing compliance with auditing standards.
• 🛑 The overarching goal of SOX is to restore trust in financial statements and prevent future waves of accounting frauds.

Q & A

What is the Sarbanes-Oxley Act, and why was it enacted?

The Sarbanes-Oxley Act, also known as SOX, was enacted by the U.S. Congress in 2002 in response to a series of major corporate and accounting scandals involving companies like WorldCom, Enron, Global Crossing, and Tyco, as well as the collapse of the accounting firm Arthur Andersen.

What are the key responsibilities of a company's CEO and CFO under the Sarbanes-Oxley Act?

Under SOX, the CEO and CFO, as the principal officers of a company, must sign off and certify the accuracy of the financial statements. They are held liable for any inaccuracies, and criminal penalties can apply if they are found to be destroying documents or involved in fraudulent activities.

How does the Sarbanes-Oxley Act address the issue of internal controls within a company?

The Act requires companies to establish and maintain internal controls to prevent fraud and ensure accurate financial reporting. They must also assess the effectiveness of these controls and issue a report on their findings, including any material weaknesses or issues identified.

What changes did the Sarbanes-Oxley Act bring to audit firms?

Audit firms are now subject to more stringent regulations, including the requirement for a second partner to review and approve all audit reports for publicly traded clients. They must also implement quality control measures and are prohibited from providing non-audit services to their audit clients.

What is the significance of the five-year rotation rule for audit partners under SOX?

The five-year rotation rule mandates that the lead and reviewing partners on an audit engagement for a publicly traded client must rotate out every five years to prevent them from becoming too familiar with the client's management, which could compromise the audit's independence and objectivity.

Why has Section 404 of the Sarbanes-Oxley Act been a point of contention among companies?

Section 404 has been criticized for its costliness, as it requires companies to assess and report on the effectiveness of their internal controls. This additional work often leads to increased audit fees and has been seen as a burden for companies, despite its intent to prevent accounting fraud.

What is the role of the Public Company Accounting Oversight Board (PCAOB) established by SOX?

The PCAOB acts as a watchdog for auditors, overseeing and monitoring audit firms that have at least one publicly traded client. It sets auditing standards, conducts inspections of audits, and enforces compliance to ensure the integrity of financial reporting.

How does the Sarbanes-Oxley Act restrict the provision of non-audit services by audit firms to their audit clients?

The Act prohibits audit firms from providing a range of non-audit services, such as investment banking, consulting, valuation services, internal auditing, and designing financial information systems, to their audit clients. This is to prevent conflicts of interest and ensure the independence and objectivity of the audit process.

What was the state of the auditing industry before the establishment of the PCAOB, and how did SOX change that?

Before SOX, the auditing industry was largely self-regulated. The establishment of the PCAOB under SOX introduced external oversight, ensuring greater accountability and standardization in the auditing process for publicly traded companies.

What are the potential consequences for audit firms that fail to comply with the Sarbanes-Oxley Act's requirements?

Non-compliance with SOX requirements can lead to severe consequences for audit firms, including penalties, loss of clients, damage to reputation, and in extreme cases, the revocation of their right to conduct audits for publicly traded companies.

Outlines

00:00

📋 Sarbanes-Oxley Act: Enhancing Financial Accountability

The Sarbanes-Oxley Act, also known as SOX, was enacted in 2002 by the US Congress in response to a series of high-profile accounting scandals involving companies like WorldCom, Enron, and Global Crossing. The Act introduced stricter rules for publicly traded companies and their executives, particularly the CEO and CFO, who are now required to personally certify the accuracy of financial statements. This was a significant shift, as previously executives could distance themselves from the specifics of financial reporting. SOX also mandated that companies assess and report on the effectiveness of their internal controls to prevent fraud, a process that has been criticized for its costliness, particularly under Section 404. Additionally, the Act led to the creation of the PCAOB, which oversees the auditing profession.

05:00

🔍 SOX Impact on Audit Firms and Internal Controls

The Sarbanes-Oxley Act brought about substantial changes for audit firms, including the requirement for a second partner review on audits of public companies, ensuring a check and balance on the auditing process. This partner must approve all audit reports, and both the lead and reviewing partners are subject to a five-year rotation policy to prevent conflicts of interest. Furthermore, audit firms are now tasked with assessing and reporting on the internal controls of their clients, adding to the workload and costs associated with audits. The Act also prohibited audit firms from providing non-audit services to their audit clients, which had been a source of potential conflicts of interest. The PCAOB was established to register and monitor audit firms, setting standards and enforcing compliance, thus ending the era of self-regulation in the auditing industry.

10:03

🛡️ PCAOB: The Watchdog of the Auditing Industry

The Public Company Accounting Oversight Board (PCAOB) is a critical outcome of the Sarbanes-Oxley Act, serving as the regulatory body overseeing auditors of public companies. The PCAOB's responsibilities include registering audit firms, conducting inspections of their work, setting auditing standards, and enforcing compliance. This has led to greater accountability and transparency in the auditing profession, ensuring that auditors maintain high standards of quality and integrity in their work. The establishment of the PCAOB marked a significant shift from the previous self-regulatory approach, introducing an external and authoritative body to monitor and evaluate the performance of auditors.

Keywords

💡Sarbanes-Oxley Act

The Sarbanes-Oxley Act, often referred to as SOX, is a U.S. federal law enacted in 2002 in response to a series of major corporate and accounting scandals. The Act is designed to improve corporate accountability, financial reporting, and prevent fraudulent activities. In the video, it is the central focus, as it introduced new rules for publicly traded companies and their executives, as well as for audit firms.

💡Accounting Frauds

Accounting frauds refer to the intentional misrepresentation of financial information in order to deceive stakeholders. The video script mentions companies like WorldCom, Enron, and Global Crossing, which were involved in such fraudulent activities, leading to the enactment of SOX to prevent future occurrences.

💡Arthur Andersen

Arthur Andersen was one of the five largest accounting firms at the time, which was implicated in the wave of accounting frauds. The firm was charged criminally for destroying documents and ultimately went out of business. This example is used in the script to highlight the severity of the accounting scandals that led to SOX.

💡PCAOB

The Public Company Accounting Oversight Board (PCAOB) is a result of the SOX Act. It was created to oversee the audits of public companies in order to prevent accounting frauds and improve the accuracy and reliability of financial statements. The PCAOB acts as a watchdog for auditors and sets auditing standards.

💡CEO and CFO

The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are the principal officers of a company. According to SOX, they are required to sign off and certify the veracity of the financial statements, ensuring their accuracy and integrity. The script emphasizes the personal responsibility of these executives in maintaining financial transparency.

💡Internal Controls

Internal controls are mechanisms within a firm designed to prevent fraud and ensure the accuracy of financial reporting. The script explains that companies must assess the effectiveness of their internal controls and report any material weaknesses, which is a key requirement introduced by SOX.

💡Audit Firms

Audit firms are organizations that examine and verify the accuracy of a company's financial records. The script discusses how SOX imposed new rules on audit firms, including the requirement for a second partner review and the prohibition of providing non-audit services to audit clients.

💡Quality Control

Quality control in the context of audit firms refers to the processes and procedures they must implement to ensure the accuracy and reliability of their audits. The script mentions that SOX requires audit firms to have quality control systems in place, especially for audits of publicly traded clients.

💡Partner Rotation

Partner rotation is a practice mandated by SOX where the lead and reviewing partners on an audit must change every five years to prevent conflicts of interest and maintain audit independence. The script uses the example of a partner auditing Walmart to illustrate this concept.

💡Non-Audit Services

Non-audit services are any professional services provided by an audit firm to its audit clients outside of the audit function, such as consulting or advisory services. SOX prohibits audit firms from providing these services to their audit clients to avoid potential conflicts of interest, as explained in the script.

💡Section 404

Section 404 of the SOX Act is a specific provision that has been criticized for its costliness. It requires companies to assess and report on the effectiveness of their internal controls over financial reporting. The script mentions that this section has led to increased work and costs for both companies and audit firms.

Highlights

The Sarbanes-Oxley Act (SOX) was enacted in 2002 in response to accounting frauds by companies like WorldCom, Enron, and Global Crossing.

One of the five largest accounting firms, Arthur Andersen, was implicated in the frauds and went out of business.

SOX introduced new rules for publicly traded companies and their executives, including CEO and CFO, who must now certify the accuracy of financial statements.

The Act mandates that CEOs and CFOs are subject to criminal penalties if found destroying documents or involved in fraudulent activities.

Companies are now required to assess and report on the effectiveness of their internal controls to prevent fraud.

Audit firms face increased regulations under SOX, including the implementation of quality control and oversight for public clients.

A second partner review is required for all audits of publicly traded clients, ensuring a check on the audit process.

Partner rotation is mandated every five years to prevent auditors from becoming too close to the client's management.

Audit firms are prohibited from providing non-audit services to their audit clients to avoid conflicts of interest.

SOX has been criticized for its costly Section 404, which requires companies to assess and report on internal controls.

The Act has led to an increase in accountants' workload and hiring due to SOX compliance requirements.

The intention of SOX is to prevent future waves of accounting frauds and restore trust in financial statements.

The creation of the Public Company Accounting Oversight Board (PCAOB) is a key component of SOX, acting as a watchdog for auditors.

The PCAOB is responsible for monitoring, standard-setting, and enforcement within the auditing industry.

SOX ended the self-regulation of the audit industry, increasing accountability and transparency.

Audit firms must register with the PCAOB if they have at least one publicly traded client.

The PCAOB evaluates a sample of audits to ensure auditors are performing their duties effectively.

Transcripts

in this video we're going to discuss the

sarbanes-oxley Act which was sometimes

referred to as Sox so Sox was passed by

US Congress in 2002 and it was passed in

response to a wave of accounting frauds

from companies like worldcom Enron

Global Crossing Tyco there was this wave

of accounting frauds and we even had one

of the five largest accounting firms

Arthur Andersen was caught up in all

this they were destroying documents they

were charged criminally they ended up

going out of business as a result of all

of this and so sarbanes actually did a

number of things first of all I've had

new rules for publicly traded companies

and their executives they also created a

lot of new rules for audit firms and it

also resulted in the creation of the

PCAOB so I want to talk about each of

these in turn because there's a lot

going on here so first of all in terms

of the rules for companies the CEO and

CFO of a company or their principal

officers which is usually the CEO and

the CFO must sign off and certify the

veracity of the financial statements now

you might think that this is obvious and

then of course what didn't this happen

to happen before shouldn't the CEO stand

by the financial statements of their

firm but the thing was when there was

that wave of accounting frauds

the Siad CEO saying hey look I'm not an

accountant I don't know what's going on

here I didn't actually put together the

financial statements I'm just kind of

managing the company and so

sarbanes-oxley made it very clear that

the CEO the CFO they have to sign off on

the financial statements and if there's

some kind of problem they're subject to

criminal penalties particularly if later

they're found to be destroying documents

or and this even applies to the audit

firm in particularly the audit firm if

they're destroying documents or

something like that they can be subject

to stiff criminal penalties so also the

company now has to assess the

effectiveness of its internal controls

so internal controls I'll make in our

video we'll talk a lot about internal

controls and auditing but internal

controls are basically things they're in

place in the firm to prevent fraud from

happening

to prevent different things to kind of

mess up the financial reporting process

and so a company has to set up these

controls to make sure that we don't have

an accounting fraud to begin with right

so they have to not only have these

internal controls in place but companies

have to go and actually assess the

effectiveness and then they have to

issue a report on the effectiveness so

if they do the assessment they find out

there's some kind of problem a material

weakness some kind of issue they have to

actually report on that now the audit

firms they have just as many changes if

not more as a result of sarbanes-oxley

first off they have to implement quality

control but if they have a publicly

treated client they're going to be

subject to a lot more oversight we're

going to talk about that but first

things first they have to have a second

partner on any audit of a publicly

traded client they have to have a second

partner review and approve all of the

audit reports right so you've got one

partner who's like the lead partner on

an audit right so let's say there's an

audit of Walmart or something like that

there's an accounting firm that's

auditing them there's a lead partner on

that audit engagement but there's a

second partner a reviewing partner where

they come in and kind of sign off and

did check on everything that has been

done now the lead partner in the

reviewing partner they have to rotate

out every five years what it means by

rotating out is let's say that Paul is

it Paul's a lead partner on the Walmart

audit and Paul can do that for five

years but after five years Paul cannot

be the lead partner on the Walmart audit

anymore Paul has obviously stay with his

accounting firm and so forth he could do

all that he doesn't have to leave his

company or something ridiculous he could

stay with a CPA firm he just can't audit

that particular client any any longer

but he can only do it for five years and

the idea behind this is we don't want

Paul to get too cozy with the management

of Walmart because if Paul has been

handling this audit for 20 years or 10

years then Paul he becomes maybe friends

with the people and so forth the client

or there's pressure that he doesn't want

do something that would somehow cost his

firm that client so every five years

Paul Paul or whoever is a lead partner

we're going to switch to somebody else

the firm has to put somebody else right

so it's the same accounting firm

it's just they switch out to a different

lead partner different reviewing

partners that's basically what's

happening okay

now in addition where we had talked

about how management of the firm so

let's say Walmart has to assess the

effectiveness of their internal controls

and issue a report the audit firm also

has to do that not of itself but of the

client okay so you've got the client

let's say Walmart they're assessing

their internal controls and issuing a

report but then the audit firm is going

to assess Walmart's internal controls

and issue a report on Walmart's internal

controls there's actually there's two

reports that are happening here now this

is in terms of the complaints about

sarbanes-oxley by firms this is the the

part of settings actually it's been

criticized probably the most it's called

section 404 and and the reason is that a

lot of people complain that it's very

costly for the firm to have to go and

assess its internal controls it's your

report on that and then now they're

paying the audit firm more because their

audit firm now is to do more work right

they're not just going to do that for

free they're going to want more money

so they're having the audit firm is

actually getting more business if you

think about it and so there's actually a

lot of accountants got hired because

this section 404 compliance that creates

a lot more work for the accountants but

it's and so it's been a boon for them

but for the companies they have to

comply with these internal control of

disclosure requirements but all of this

was done again to try and prevent it

from happening again where we have a

wave of accounting frauds and people say

hey can we even trust the financial

statements of firms and so forth so that

so that's the intention and then also

another really key component to sarbanes

actually is that an audit firm is now

prohibited or prevented from providing a

lot of non-audit services to the audit

clients and what do I mean by not off

non-audit services so if you don't know

a lot about audit firms other firms

don't just audit financials to

that's not the only thing they do they

also provide advisory services and if

you think about it if an auditor they're

going to look at the internal books of a

company right so as they do that we can

learn a lot about how to better do

business and they might have suggestions

about how the company can prove its

business operations and so forth so it

stands to reason that you might have the

auditor say hey client you know we could

really help you optimize your business

processes we can help you do this and so

forth in that they actually happen and

so what you had though was it turned

into a problem and the reason was that

in some cases you had a firm auditing a

client and actually the amount of money

that the audit firm was getting for

these non-audit services was actually

higher than the audit fees they were

getting right so if a company just to

think about it if you're getting if

you're an audit firm and you're getting

ten million dollars for consulting

you're getting these consulting fees

from the client and then you're maybe

getting 1 million dollars for the audit

fee and you say hey I don't know if

their financial statements are

completely legit there could be some

problems here you don't want to say hey

I don't want to sign off on this audit

because I don't know about this firms

financial accounting practices because

you're going to lose not just the 1

million dollars you're going to lose the

10 million dollars for consulting so

there's a lot of pressure on these

auditors to say to come look the other

way or say you know why hey we're

getting a lot of business from this

client we don't lose them by creating

problems with the audit and so now

they're prevented from doing non-audit

services not just in general I mean if

we so you've got your client and then

you've got some other company that does

not your audit client

so we'll say non client so you could you

could provide so you do your audit for a

client

you're just prohibited from doing the

non auditing or non-audit services for

the client okay so let's say Walmart but

then let's say there's another company

called Monsanto that you are not doing

their audits so there are non client

then you can provide whatever services

to the non client it's just when you're

actually providing you're doing the

audit of this audit client

right so you're doing an audit you can't

turn around and do non-audit services

such as investment banking consulting

valuation services you can't be their

internal auditor you can't be designing

their financial information systems

there's a bunch of not audit services

you can't provide to an audit client now

what is that one of the really lasting

effects of sarbanes-oxley it's

tremendously as important is aside from

all the rules for the companies and CEOs

and the audit firms it created something

called the Public Company Accounting

Oversight Board which is commonly causes

the PCAOB so the PCAOB does a number of

things right so but first off before I

even get into it before that we had the

PCAOB basically the the audit the

industry when I think about audit firms

they were self regulated to a large

extent they were self regulated and so

with the PCAOB that ended basically now

the PCAOB

you could think of them as the watchdog

for auditors so now if an auditor if

they have at least one publicly traded

client they have to register with the

PCAOB and then the PCAOB will monitor

them and every now and then the PCAOB

will actually go and look at a sample of

their audits and kind of evaluate and

see are they're doing a good job the

PCAOB also handers handle standard

setting for the auditing industry and

they also handle enforcement when

there's some kind of a problem the audit

firm isn't doing things right and we'll

talk more about the PCAOB in a video to

come