Effective corporate governance enhances stockholders' confidence that a company is being run in their best interests rather than in the interests of top managers. Corporate governanceThe system by which a company is directed and controlled. If properly implemented it should provide incentives for top management to pursue objectives that are in the interests of the company and it should effectively monitor performance. is the system by which a company is directed and controlled. If properly implemented, the corporate governance system should provide incentives for the board of directors and top management to pursue objectives that are in the interests of the company's owners and it should provide for effective monitoring of performance.¹⁵ Many would argue that, in addition to protecting the interests of stockholders, an effective corporate governance system also should protect the interests of the company's many other stakeholders—its customers, creditors, employees, suppliers, and the communities within which it operates. These parties are referred to as stakeholders because their welfare is tied to the company's performance.

Unfortunately, history has repeatedly shown that unscrupulous top managers, if unchecked, can exploit their power to defraud stakeholders. This unpleasant reality became all too clear in 2001 when the fall of Enron kicked off a wave of corporate scandals. These scandals were characterized by financial reporting fraud and misuse of corporate funds at the very highest levels—including CEOs and CFOs. While this was disturbing in itself, it also indicated that the institutions intended to prevent such abuses weren't working, thus raising fundamental questions about the adequacy of the existing corporate governance system. In an attempt to respond to these concerns, the U.S. Congress passed the most important reform of corporate governance in many decades—The Sarbanes-Oxley Act of 2002.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002Legislation enacted to protect the interests of stockholders who invest in publicly traded companies by improving the reliability and accuracy of the disclosures provided to them. was intended to protect the interests of those who invest in publicly traded companies by improving the reliability and accuracy of corporate financial reports and disclosures. We would like to highlight six key aspects of the legislation.¹⁶

First, the Act requires that both the CEO and CFO certify in writing that their company's financial statements and accompanying disclosures fairly represent the results of operations—with possible jail time if a CEO or CFO certifies results that they know are false. This creates very powerful incentives for the CEO and CFO to ensure that the financial statements contain no misrepresentations.

Second, the Act established the Public Company Accounting Oversight Board to provide additional oversight over the audit profession. The Act authorizes the Board to conduct investigations, to take disciplinary actions against audit firms, and to enact various standards and rules concerning the preparation of audit reports.

Third, the Act places the power to hire, compensate, and terminate the public accounting firm that audits a company's financial reports in the hands of the audit committee of the board of directors. Previously, management often had the power to hire and fire its auditors. Furthermore, the Act specifies that all members of the audit committee must be independent, meaning that they do not have an affiliation with the company they are overseeing, nor do they receive any consulting or advisory compensation from the company.

Fourth, the Act places important restrictions on audit firms. Historically, public accounting firms earned a large part of their profits by providing consulting services to the companies that they audited. This provided the appearance of a lack of independence since a client that was dissatisfied with an auditor's stance on an accounting issue might threaten to stop using the auditor as a consultant. To avoid this possible conflict of interests, the Act prohibits a public accounting firm from providing a wide variety of nonauditing services to an audit client.

Fifth, the Act requires that a company's annual report contain an internal control report. Internal controls are put in place by management to provide assurance to investors that financial disclosures are reliable. The report must state that it is management's responsibility to establish and maintain adequate internal controls and it must contain an assessment by management of the effectiveness of its internal control structure. The internal control report is accompanied by an opinion from the company's audit firm as to whether management's assessment of its internal control over financial reporting is fairly stated.¹⁷

Finally, the Act establishes severe penalties of as many as 20 years in prison for altering or destroying any documents that may eventually be used in an official proceeding and as many as 10 years in prison for managers who retaliate against a so-called whistle-blower who goes outside the chain of command to report misconduct. Collectively, these six aspects of the Sarbanes-Oxley Act of 2002 should help reduce the incidence of fraudulent financial reporting.

¹⁵ This definition of corporate governance was adapted from the 2004 report titled OECD Principles of Corporate Governance published by the Organization for Economic Co-Operation and Development.

¹⁶ A summary of the Sarbanes-Oxley Act of 2002 can be obtained from the American Institute of Certified Public Accountants (AICPA) website www.aicpa.org/info/sarbanes_oxley_summary.

¹⁷ The Public Company Accounting Oversight Board's Auditing Standard No. 2 requires the audit firm to issue a second opinion on whether its client maintained effective internal control over the financial reporting process. This opinion is in addition to the opinion regarding the fairness of management's assessment of the effectiveness of its own internal controls.