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The Sarbanes-Oxley Act: An Introduction

Sarbanes-Oxley for Entrepreneurs

The Sarbanes-Oxley Act: An Introduction

Written by Bennet Grill for Gaebler Ventures

The Sarbanes-Oxley Act was passed in 2002 after a number of corporate scandals including Tyco International, WorldCom, and most notably, Enron. While this legislation does not apply to private firms, it is important information for entrepreneurs to know what Sarbanes-Oxley is.

We are all aware of the corporate accounting scandals which plagued Wall Street in 2000 and 2001.

Faulty accounting practices and dishonest business procedures robbed the public of its trust in corporate America and cost the economy thousands of jobs.

Public dismay grew into outrage and soon the executive officers of these companies were summoned before congress to testify about their involvement in the illegal business activities which robbed shareholders of billions of dollars.

These companies performed a number of dishonest and unlawful actions in order to falsely manipulate their stock price, hide their losses and project a façade of profitability, and cover up insider trading and options granted to executives.

Enron's Downfall

The two largest contributors to the Enron downfall were its use of mark-to-market accounting and the creation of special purpose entities.

Mark-to-market accounting is a method of valuating assets at their current value; for example, if you purchase 100 shares of a company at $1, but the share is now worth $2, its mark or book value would be 100 x $1 = $100, while its market value would be 100 x $2 = $200. Mark-to-market accounting would allow for the valuation of the 100 shares at $200, which makes sense in this relatively simple example.

Enron, however, employed this accounting method to valuate its assets at ridiculously inflated levels. One example includes recording millions of dollars of profit from a power plant in India that was actually losing many times the stated profit; this was rationalized claiming that future earnings would compensate for the initial losses, which were never in fact disclosed to the public.

In addition to greatly inflating its profits and assets, Enron was incredibly manipulative in the manner in which it concealed its losses. The company created special purpose entities, which were special private companies run by Enron's CFO Andrew Fastow (in and of itself a major conflict of interest), to which it transferred its losses. Essentially billions of dollars of losses were conveniently left off Enron's accounting statements because they had been transferred to the "special purpose entities" created and controlled by the company's chief financial officer. Enron's share price ultimately fell from $90 to zero as the company filed for bankruptcy.

More Bad Actors: Tyco and WorldCom

Tyco International and WorldCom used more simple methods of deceit and fraud but nevertheless successfully produced a façade of higher earnings and profit.

Tyco executives deceived shareholders by failing to report stock options and compensation and also issued themselves zero interest loans from the company which they subsequently forgave.

In the case of WorldCom, the company underreported many of its operating costs by not including them in its operating expenses and fabricated sources of revenue to inflate its earnings statements. In the end, WorldCom's assets had been inflated by an estimated $11 billion dollars.

During the course of WorldCom's legal proceedings, its accounting firm Arthur Andersen lost its privileges to perform accounting services due to felony charges stemming from its activities with Enron. The accounting firm, considered one of the "Big Five," was revealed to have willfully participated in the fraud and deception of both Enron and WorldCom and was never able to recover to offer accounting services again.

Sarbanes-Oxley To the Rescue

The Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act, was passed in 2002 with the goal of creating a more responsible environment for the disclosure of financial information. Its passing resulted in the creation of the Public Company Accounting Oversight Board to regulate and enforce honest accounting activities.

The bill contains 11 titles, or provisions. In this series of articles on Sarbanes-Oxley, one article will be dedicated to the explanation and application of each title.

The Sarbanes-Oxley Series -- Learn More About Sarbox

The Sarbanes-Oxley Act: An Introduction
The Sarbanes-Oxley Act: Title I
The Sarbanes-Oxley Act: Title II
The Sarbanes-Oxley Act: Title III—Audit Committees
The Sarbanes-Oxley Act: Title III—Blackout Periods
The Sarbanes-Oxley Act: Title IV
The Sarbanes-Oxley Act: Title V
The Sarbanes-Oxley Act: Title VI
The Sarbanes-Oxley Act: Title VII—Accounting Firms
The Sarbanes-Oxley Act: Title VII— Past Violators
The Sarbanes-Oxley Act: Title VIII
The Sarbanes-Oxley Act: Title IX-XI