Sarbanes-Oxley Act: A Necessary Evil

The Sarbanes-Oxley Act was introduced in July, 2002 as a reaction to the internet bubble, auditing failure of Arthur Andersen and a number of major accounting scandals such as Enron, and Worldcom in order to restore the confidence of domestic and foreign investors by improving the accuracy and reliability of corporate disclosures. The bill, supported by all senators with the exception of the abstaining Jesse Alexander Helms, Jr (Senate. Gov, 2002), detailed additional responsibilities and accountability of a public corporation’s board of directors, increased the severity of penalties for fraud and misconduct, and enabled the SEC to enforce stricter regulations and introduce the Public Company Accounting Oversight Board (PCOAB) to ensure the independence and compliance of auditing firms.

The economic consequences of the introduction of the act such as increased compliance cost (Eldridge et al 2004), de-registration and re-privatization of listed US companies (Engel et al 2007), increased auditing fees, loss of business focus and the increased political and regulatory implications has exposed the Act to large criticism and condemnation. Some of these arguments include the existence of markets for corporate takeover and managers (Jensen, 1986). They are stipulated to work by incentivizing the efficacy of corporate governance rules, and facilitate greater accountability of directors to their investors. In addition the market for lemons (Akerlof,1970), assume that the market would punish those corporations that withdraw financial disclosures. Another argument is the classic free-rider problem that ensues due to the availability of a public good (Baumo,1952), this might lead to oversupply of information as consumers do not bear the cost. In addition, the market is viewed as efficient (Fama, 1969) therefore the invisible hand (Smith, 1776) is assumed to ensure that optimal provision of accounting information is attained through supply and demand. Finally, the introduction of the Sarbanes-Oxley act is thought to limit companies from choosing the most representative accounting methods for their operations

Other researches tend to view the act as a necessity, they debunk the possibility of an oversupply of accounting information as free markets historically tend to provide suboptimal information (Beales et al 1988). Furthermore, free-markets tend to support those with resource power at the expense of the vulnerable. The argument that the market is efficient on average ignores the right of those that may lose everything and those vulnerable to fraudulent organizations. Lastly, the Sarbanes-Oxley act enhances uniformity and comparability of accounting information.

The benefits of the Act to individual investors and corporations is difficult to accurately quantify due to their indirect and preventive nature however, studies from Butler/Ribstein (2006) assert that investors could diversify their stock investments, efficiently managing the risk of a few catastrophic corporate failures, whether due to fraud or competition and when each company is required to spend a significant amount of money and resources on SOX compliance, this cost is borne across all publicly traded companies and therefore cannot be diversified away by the investor. A number of senators have expressed that the at SOX was an unnecessary and costly government intrusion into corporate management that places U.S. corporations at a competitive disadvantage with foreign firms, driving businesses out of the United States (Paul & Huckabee , 2005) . It can however be expected that the constant revision of SEC and PCAOB requirements and technological improvement would drive down the compliance cost and the corresponding reduction in cost of equity across the capital market would justify the enactment of the act.