632598256894

ineffective audit committees. SOX erases classic defenses by corporate officers accused of fraud, such
as:
• “How was I to know? I‟m not an accountant or a lawyer.”
• “I trusted the auditors.”
• “The lawyers said it was okay.”
SOX strengthens existing law and significantly increases penalties for violations, including
imprisonment. Also it takes self-regulation out of the hands of the accounting profession and makes
auditors the first and only U.S. profession to be regulated by the federal government.
SOX does have a major weakness—namely, feeble encouragement and feeble protection for
whistle-blowers, who are put into the hands of the Occupational Safety and Health Administration
(OSHA), a federal agency sadly lacking in knowledge, experience, and skill in corporate finance and
financial markets.
While SOX does about as much as any law can do regarding financial reporting, it cannot assure the
validity of financial statements. And from an economic perspective, SOX has several main flaws:
• It creates substantial government interference in free financial markets, and economics
tells us that government interference in free markets is usually expensive and often
counterproductive.
• SOX adds significantly to the SEC bureaucracy, which has a very unimpressive past record
of reducing financial fraud relating to the securities markets.
• It focuses on penalties for noncompliance, but offers few, if any, positive incentives to
improve the validity of financial reporting. It seems blind to the importance of incentives in
economics and unaware of the power of self-interest and Adam Smith‟s “invisible hand.”
SOX contains little or no thinking outside the box. For example, with regard to internal control:
• Since enactment of the Foreign Corrupt Practices Act (FCPA) of 1978, public companies
have been required by law to create and maintain adequate systems of internal control.
Regrettably, the FCPA simply mandated systems of internal control, but failed to make these
systems subject to a cost-benefit test—which would have made more sense. For example, we
could design an accounting system that could keep track of every paper clip, every postage
stamp, and every eraser. But we don‟t go that far, because so precise a system would be
incredibly expensive to create and maintain, and it clearly flunks the cost-benefit test.
• SOX added the requirement for both the top management and the auditors of all public
companies to report on the adequacy of the corporate internal control systems. Again, no
provision was made for a cost-benefit test—which would have made more sense.
• To prove that they are meeting this requirement, and to protect against legal liability, top
managements have spent large amounts of corporate funds on reviewing, documenting, and
adding improvements to internal control systems—regardless of cost-benefit analysis.
• But internal control system weaknesses were not a factor in any of the major financial
reporting scandals. In Enron and all the other major financial frauds, top management simply
overrode or bypassed the corporate control systems when they perpetrated their huge financial
frauds.
• It is well-known that a corrupt top management can always defeat internal controls by
means of overriding, subverting, or bypassing any inconvenient internal control provisions. The
Journal of Accountancy reported, “According to a 1999 COSO research project, at least 83% of
200 financial statement frauds were engineered by the CEO, CFO or both. These control frauds
are most often accomplished by upper management by overriding existing internal controls.” 6