SOX – Sarbanes Oxley Act – Important Sections

Sarbanes Oxley Act is also known as ‘Public Company Accounting Reform and Investor Protection Act’, ‘Corporate and Auditing Accountability and Responsibility Act’, SOX & SARBOX.

The possible questions that strike our mind while studying any law are Why, Who, When, What and How. So let’s look into the affairs of the act and try to find out the answers which satisfy our want of information.

Why SOX?

Due to the myriad of the corporate scandals, SOX was brought to establish investor’s confidence in the corporate governance and financial reporting process. Some of those Scams that led to the introduction of a newer and stronger Law were –

ENRON – It was the Seventh largest US based company. Due to a whistleblower, Sherron Watkins, it was investigated for its complex network of off-shore partnerships & accounting practices. It had used Special Purpose Entities (SPEs) to move debt off the balance sheet & transfer risk for their other business ventures. On investigation, Arthur Anderson (their Auditors), Skilling and Ken Lay (the principal officers) were charged for fraud & negligence.

WorldCom – It was the second largest US long distance phone company. In 2002, SEC was suspicious for WorldCom’s increasing profits when other telecom industries were losing. On investigation it was found that it had inflated its revenue by wrong accounting practices. In 2004, finally it was declared bankrupt.

Tyco – In 1999, SEC investigated Tyco for its reporting anomalies. It was discovered that the CEO and CFO of Tyco had hoaxed multimillion dollars by way of bonuses and misuse of Employee Loan Programs.

In wake of the above scandals, SOX Act was introduced to

Strengthen the Internal Control Mechanisms
Ensure full disclosure in financial reports
Transact Corporate Governance with full transparency.

What is SOX?

The most important question is what is SOX and what are the provisions of SOX?

SOX came into force in July 2002 and derives its name from its architects i.e. Senator Paul Sarbanes and Representative Michael Oxley. It is a mandatory act & all public entities must comply with SOX.

In simple terms – SOX is a set of standards that all U.S. public companies and public accounting firms must comply & adhere with good quality financial reporting.

Important Sections of SOX

SECTION 302 – ‘Corporate Responsibility for Financial Reports’

This section makes it mandatory for the signing officers to certify that they have personally reviewed the statutory reports and are free from material misstatements and omissions. This has been included to bring an element of accountability on the part of top management, hence increasing the investors’ confidence in the reports.

Top management also needs to certify that they have reviewed the internal controls existing in the organization and that has been done within a period of 90 days before the reporting date.

SECTION 401 – ‘Disclosures in Periodic Reports’

With the Enron Scandal, attention was drawn towards the Off Balance Sheet items and how Special Purpose Entities (SPEs) were used to inflate the stock prices. So this section comes into play and requires financial statements to present true and fair view of entity’s position. It requires financial reports to include all the off balance sheet (OBS) transactions.

SECTION 404 – ‘Assessment of Internal Controls’

This section is one of the most important sections as it speaks of the detailed assessment of internal controls in financial reporting process. As per section 404, management and external auditor are required to report about the adequacy of internal controls and its operating effectiveness over financial reporting. Based on their detailed analysis “Internal Control Report” is generated annually and produced before the shareholders. They are also required to comment upon the IT issues related to accounting matters.

The costs involved with compliance of this section are very high which is justified with the long term results it brings by boosting the investors’ confidence in the entity.

SECTION 802 – ‘Criminal Penalties for Altering Documents’

SOX impose strict penalties in case of violation. Any kind of alteration of original documents can lead to imprisonment up to 10/20 years depending upon the facts of the cases. Further penalties can be levied by way of imposition of fines as well.

How SOX impacts Financial Reporting in India?

Indian SOX = Clause 49

With the coming of SOX in U.S., India also took new corporate governance norms under Clause 49 of Listing Agreement which came into effect from 31 December 2005 and is mandatory for all listed companies. Some of the important provisions are as follows-

As per the Clause 49, it is mandatory for a company with Executive Chairman, to have 50% independent directors on Board. If the company has no Executive Chairman, 1/3^rd of the directors should be independent.
CEO/CFO’s are required to assess internal controls and take corrective measures to check the deficiencies.
CEO/CFOs are also required to certify the Financial Statements.
All the companies are required to submit quarterly Compliance Reports at Stock Exchanges.
A Compliance Certificate from auditors is to be obtained and annexed with Directors’ Report.
Establishment of an Audit Committee.
Clause 49 was revised to incorporate wider definition of independent directors and increasing the responsibility of audit committee.
Whistle Blower Policy is to be set out to provide security to those who retaliate against wrong doers.
Formal Code of Conduct is to be laid down for Board of Directors and Senior Management of the organization.
Related Party Transactions are to be disclosed separately making the financial statements more transparent.

Thus, SOX is an essential law which has brought discipline in financial reporting process. The transparency brought by this act is boosting investor’s confidence that further helps building a strong capital market in the economy.

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