What is Sarbanes Oxley and why does it change everything?

The Sarbanes-Oxley Act of 2002, signed into law on July 30, 2002, is one of the most significant changes ever legislated to federal securities law.

Sarbanes-Oxley was motived by the never-ending waves of corporate financial scandals (Enron, Arthur Andersen, WorldCom, etc) and is named after the two sponsoring congressmen, Senator Paul Sarbanes and Representative Michael Oxley.

The most important provisions of Sarbanes-Oxley include:

• Accelerated reporting of trades by insiders
• Public reporting of CEO and CFO compensation and profits
• Auditor independence and a prohibition on audit firms offering value-added (read “conflict of interest”) services
• Companies are now required to have an internal audit function, which must be certified by external auditors
• Certification of financial reports by CEOs and CFOs

As is typical with financial controls, most of these rules — including my personal favorite, that Executive offices and Directors can no longer get personal loans from a corporation — are common sense and shouldn’t even have needed to be codified as law in the first place. I mean, what daft Board of Directors or CEO approves having an audit committee “fix” things?

However, we need merely glance at the financial news to see that the regulations imposed by Sarbanes-Oxley are needed in the industry. In the news right now Krispy Kreme donuts, Nortel, Shurgard Storage, Cendant, and Savient Pharmaceuticals are all busy restating their financials (muchly because of Sarbanes-Oxley).

If you’re involved with a corporation, then you might want to heed this significant change from S-O: “Requires each member of the audit committee to be a member of the board of directors, but otherwise independent.” This is not true of the Boards I’m on currently, so we need to make some changes to comply with the new regulatory laws too.

The main impact of the Act is in financial accounting and reoprting, and according to Huron Consulting Group, 414 companies amended their financial reports in 2004, a 28% increase from 2003. Why? Because there are finally some teeth in the law, teeth that are encouraging CFOs to make sure that their books are clean.

According to Huron, the three most frequent causes of financial restatements were revenue recognition, which accounted for 16.4 percent of all restatements in 2004 and 19 percent during the past five years; equity accounting (16 percent and 15.3 percent respectively); and reserves, accruals, and contingencies (14.1 percent and 14.7 percent).

So Sarbanes-Oxley is a new set of laws that dramatically changes the way that companies audit and report their financial data to the investment community and the Securities and Exchange Commission. There’s some other stuff thrown in, but that’s fundamentally what this is all about.

To the point, Sarbanes-Oxley is about disclosure, and about risk management. And it’s generated quite a bit of controversy too, for that matter. In particular, European companies that have divisions in the United States complain that Sarbanes-Oxley reporting requirements conflict with EU regulations and are also unacceptably expensive. Rumors are flying that the SEC might change some of the S-O reporting requirements for overseas firms, actually (see here, for example).

In the end, it will undoubtedly be difficult and expensive for corporations to make the changes necessary to be in full compliance with Sarbanes-Oxley, but I believe that it’s a good change and that anything that cleans up the murky and confusing world of financial reporting and financial goings-on in corporations, anything that encourages executives to take more responsibility for their reported financials, is a really good thing, and doubly so for us investors.