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UNDERSTANDING THE SARBANES-OXLEY ACT AND ITS IMPACT

- In 2002, passed by US lawmakers in the wake of several high-profile bankruptcies and the revelation of accounting
irregularities and fraud
- Created by Paul Sarbanes (Democrat senator from Maryland) and Michael Oxley (Republican member of the House of
Representatives) who wrote separate bills in an attempt to restore investor confidence in the American securities
market
- By 2008, applied to all publicly listed companies in the US and all companies registered with the SEC
- Broad goal was to increase investor confidence and reduce unethical behaviour in corporate America

Section 302: Corporate Responsibility for Financial Reports

- Enacted in 2002
- CEO and CFO must sign off on accuracy and completeness of financial statements
- Signing officers held personally responsible for designing, establishing, maintaining and evaluating internal controls
- Signing officers are responsible for the disclosure of any fraudulent activity discovered, whether material or not, to the
corporation’s BOD and external auditors

Section 404: Management Assessment of Internal Controls

- Came into effect in 2004


- One of the most controversial sections as it was responsible for a majority of the costs businesses have incurred to
implement SOX
- Requires management to produce annual “internal control report” that contains an assessment of the design and
effectiveness of the corporation’s internal controls
- Requires company’s external auditors to provide opinion on management’s internal control report
- Requires corporations to demonstrate an extra level of transparency, company must prove all of the processes it uses
to develop its financial statements work correctly with effective and complete internal controls

The Canadian Response to SOX

- Canadian securities regulators were pressured to adopt SOX-like regulations to maintain investor confidence in
Canada’s securities markets and ensure Canadian corporations continued to enjoy preferential access to US securities
markets
- Canadian regulators did not feel a strong sense of urgency to introduce SOX-like legislation as there were no Canadian
cases of accounting irregularities or corporate fraud had been experienced on as large a level as the US
- Canadian legislation was initially released as a set of draft instruments, regulators sought the input and comments of
affected parties to ensure legislation would meet regular requirements and reflect Canada’s unique business
environment

The Canadian Public Accountability Board

- Created by the Canadian Securities Administrators in 2002


- Mandate to oversee public auditors, ensuring the quality and independence of the auditing profession in Canada
- Authority to regularly inspect the auditors of public companies and set and enforce rules and guidelines regarding
auditor independence and the quality control of the auditing process
- 6 largest Canadian auditing firms immediately agreed to implement the requirements as soon as they were established

Proposed Legislation

- December 2002, Ontario government passed Bill 198, An Act to Implement Budget Measures and Other Initiative of the
Government – amended Ontario’s Securities Act and reformed several securities laws in Ontario, allowed Canadian
Securities Administrators to develop several
404 Compliance – Initial Costs

- Initially senior officials at the SEC believed that many companies would have already implemented and documented
internal controls to a large extent and therefore would have a minimal amount of work
- Regulator estimated initial compliance would cost on average $94,000 for a publicly listed company, or $1.24B in
aggregate for all corporations
- Resulting, large companies with revenues in excess of $5B spent on average $4.36M to initially comply, with smaller
companies estimated to be spending $250,000-500,000
o Costs fell disproportionately on smaller companies
- Increased costs of regulatory compliance and increased legal liability risks thought by many to have helped start a
boom in the PE industry as many smaller companies were taken private to avoid the costs

404 Compliance – Ongoing Costs

- Annual ongoing costs were estimated to be in the millions for larger companies and hundreds of thousands for smaller
companies
- Increased cost exerted downward pressure on bottom line of many corporations, affecting competitiveness

Auditing Fees

- When SOX came into effect, auditing firms immediately increased their regular audit fees by 20-40% as a result of the
increased audit work required

Other Costs

- As a result of the threat of new legal liabilities imposed on the officers and directors of companies, insurance
companies increased the premiums charged for directors’ and officers’ insurance
- Legal fees for many corporations initially increased as a result of the enactment of SOX as corporate counsel needed to
spend more time ensuring companies were complying with new legislation
o Because most companies have now gained experience regarding compliance, legal fees have decreased
- Increased tangible costs lower the profit of each complying company, affect the company’s share price and reduce the
amount of money the company can reinvest to produce future growth and returns

Intangible Costs – Board of Directors

- Because of increasing requirements for their work and increased legal liability, many business professionals questioned
the value of being a member of any corporation’s BOD
- Initially affected the quality of corporate governance as the talent pool of new directors shrunk, and individuals willing
to serve focused attention on legal liabilities and less so on taking risks and pursuing entrepreneurial activities

Intangible Costs – Decreased US Listings

- Executives of companies who had previously considered an IPO had second thoughts due to the costs of complying
with SOX
- Many non-American companies that had planned to list on a US exchange listed on a foreign stock exchange
- Decreased short-term competitiveness of American stock exchanges

Intangible Costs – Decreased Management Attention

- Due to new requirements, management time and attention was being diverted from running companies to ensuring
compliance with regulations
- Penalties for non-compliance were affecting management team’s willingness to take risks
- Turnover rate of corporate CEOs increased after implementation

Benefit of Implementation – Increased Regulation

- New and increased levels of regulatory oversight for auditing firms and corporations
- Increased power to monitor and discipline auditing firms and corporations provided a strong disincentive for
corporations to engage in questionable accounting practices or fraud and dissuade auditing firms from allowing
questionable practices to persist

Benefit of Implementation – Better Financial Reporting

- Helped restore public faith in financial reporting and its accuracy


- Enhanced reporting requirements improved the transparency of corporate financial reporting and the quality of the
financial reporting process

Benefits of Implementation – Better Management of Companies and Corporate Governance

- Introduced a new way of thinking about and managing the company’s control structure
- Many companies were forced to spend a significant amount of time and effort building a better control structure which
provided a significant benefit to the corporation in the long term
- SOX improved the reliability of the internal auditing function and minimized the potential for management interference