Sarbanes — Oxley Act – Canadian Response
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Sarbanes-Oxley Act
Introduction
Sarbanes-Oxley (also known as Public Company Accounting Reform and Investor Protection Act of 2002) is not the first act of its kind. The 1920’s was the first time the general public began to purchase stocks-before then the stock market was a rich person’s game. The average investor was uninformed and uneducated, which lead to wild manipulation of stock prices by speculators. The end result was that $50 billion of new securities issued during that time had become worthless, causing the crash of the stock market and the loss of many people’s life savings, eventually leading to the great depression. This lead to one of the most significant regulatory acts passed in the United States-Securities and Exchange act of 1934 (which first introduced the Securities and Exchange Commission-the SEC-that we know of today).
Leading up to the 1990’s, there was a growing concern on the quality of corporate financial accounting. This concern was fueled during the 1990’s when many accounting irregularities had been occurring, causing many companies to restate their financial statements up to as much as $3.5 billion. Earnings management was a part of this problem. Although the Securities and Exchange act of 1934 required firms to have outside auditors audit their financial statements, these auditors would earn several times in consulting fees what they would for audit fees, causing auditors to look the other way on questionable accounting practices. This is what led to the Enron scandal. Enron set up several off-balance sheet partnerships to hide the debt of the company, and make it look more profitable. It eventually declared bankruptcy in 2001.
Even though it was known action needed to be taken, republicans and democrats were split on their opinions of what should be included in a bill, causing it to be constantly delayed. Then came WorldCom. It had admitted to $3.8 billion worth of errors in its accounting. What it had done is classified a massive amount of operating expenditures as capital expenditures, causing its stock price to go from $60 to less than $1! This was the “final straw” that had changed everything. Republicans and Democrats had decided to unite to get the much needed bill completed. Even president Bush recognized the urgency and declared he would “sign any bill put before him”.
The result was the most significant corporate regulatory reform since the Securities and Exchange act of 1934. Passed with an overwhelming vote of 424 to 3-, the Sarbanes-Oxley act of 2002 (SOX)-named after one representative of each of the parties-Paul Sarbanes (a democrat) and Michael G. Oxley (a republican) was created which made it much harder for companies to get away with fraudulent or misleading accounting and enabled regulators to severely punish those who tried. (See page 3 for a summary of the consequences of SOX).
The concern is that not everyone is content with SOX. Michael Paese, the senior counsel to the House Committee on Financial Services, believes that “80% of the act is right. 20% I think is really rough on corporate America, and there may not be a demonstrable benefit”.
Summary of Sox Consequences:
Background of Bill 198 (C-Sox)
Bill 198 is an Ontario legislative Bill that became effective October 1, 2003. It was imposed to maintain investor confidence and protect the integrity of the Canadian Capital Market through a set of instruments that mirror some of the prominent provisions of the Sarbanes-Oxley Act (Sox). These instruments were introduced by the Canadian Securities Administrators (CSA) referred to as Multilateral Instruments or MIs and National Instruments or NIs. Much of this reform is not yet put into legislation, due to the fact that Canada had yet to experience corporate fraud of the same magnitude as in the United States (U.S.). Therefore, there is a less sense of urgency to place emphasis on the rules and regulations set out by Bill 198 in Canada. A significant portion of Bill 198 deals with the disclosure of internal controls. Bill 198 requires Canadian public companies to describe the process they used to test internal financial controls in Management Discussion and Analysis (MD&A) reports (Gambrill, David p: 2). Many public companies are already reporting internal controls in MD&A because they believe in transparency. Transparency is one of two principles that the CSA certification regulations are based on.
The transparency principle is applied at three levels:
Content Level: Refers to the degree to which the information enables the reader to reliably assess and interpret the financial condition of the company(Goodfellow, Jim and Willis, Alan p:3)
Process Level: Refers to the reliability of disclosure controls and procedures (DC&P) (Goodfellow, Jim and Willis, Alan p:3)
Process Level: Is another process level that addresses the design of internal controls over financial reporting (ICFR) and any changes in the control environment (Goodfellow, Jim and Willis, Alan p:3)
Internal Controls
In Canada internal controls is described as “A process to provide reasonable assurance”. In 2006 the Canadian Institute of Chartered Accountants (CICA) released a publication about undertaking a “top-down, risk based approach” in assessing and certifying the design of ICFR. To be effective this approach requires at least two conditions. First, the main focus must be the interaction between the board of directors and the CEO in establishing the control environment. Second, there must be a sound process for identifying principle business risks, including financial reporting and disclosure risks (Goodfellow, Jim and Willis, Alan p: 2). The assessment of ICFR provides management, board of directors and the audit committee with the opportunity to reassess what ICFR is intended to achieve, which is control over financial reporting and disclosure risks. Therefore, a top-down, risk based approach is more favorable than the approach currently used in the U.S. for satisfying section 404 “Management assessment of internal controls” of the Sox act, because the objective of ICFR is achieved in a more effective manner.
Materiality is an important aspect of internal controls, which should be considered in evaluating a weakness in the design of ICFR. There are three levels of disclosure that should be assessed when evaluating a weakness in the design of ICFR: