Back To CourseBusiness 111: Principles of Supervision
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The purpose of The Sarbanes-Oxley Act of 2002 can clearly be discerned by examining the law's long title: The Public Company Accounting Reform and Investor Protection Act of 2002. In a nutshell, the Act is designed to improve the quality of financial reporting and corporate governance and increase the responsibility of publicly traded companies to protect investors. More specifically, the Act provides for the following reforms:
Let's take a quick look at some of the key provisions of the Act.
The Act severely limits the ability of auditors to do anything other than provide auditing services for their auditing clients. Auditing involves a process of verifying the accuracy of a company's financial records and supporting documents by a professional, such as a certified public accountant.
An audit needs to be unbiased. If a CPA firm provides other services to a company, or wants to do so, then there is an incentive for the CPA firm to be biased in its audit for the company. This can lead to incorrect information for shareholders, potential investors and regulators. Preventing auditors from performing non-auditing work for the companies they audit helps reduce the chance of this bias. Let's look at an example.
Allan is a partner at Big Accounting Firm, LLC, which is a firm of certified public accountants that provides independent auditing services for Mega Corp. A director of Mega Corp. approaches Allan wondering if his firm would like to provide consulting services that would be worth about five million dollars a year to Allan's firm. Allan probably cannot accept the offer because that five million dollars a year may provide an incentive for Allan to be biased in his auditing to keep Mega Corp. happy and keep that five million-dollar-a-year consulting gig.
The Act also created the Public Company Accounting Oversight Board (PCAOB) that is responsible for overseeing auditing firms that audit publicly traded companies. In other words, its job is to make sure that auditors are doing their jobs correctly. Accounting firms that perform audits of public companies will have to register with the PCAOB. The board develops auditing standards and rules of ethics that accounting firms must follow.
The PCAOB also has the ability to investigate and sanction firms that violate these rules. In our example above, Allan's firm would be subject to investigation and sanctions by the board if it found that the consulting job violated the board's standard and ethical rules.
Sarbanes-Oxley also outlines major changes to a publicly traded corporation's responsibilities relating to financial and accounting activities. The Act requires publicly traded companies to establish audit committees whose members must consist of independent board members, which means that they cannot have any financial connection to the company.
Board members and officers may not attempt to influence auditing results. For example, let's say that Tom is a director of a Mega Corp. It's a great gig. He gets paid well, and it's a high-status position. He also gets easy access to powerful people in business and politics. Since Tom is also a president of a different company, these contacts are very helpful for his business. He doesn't want to lose his position by getting voted out at the next shareholders' meeting because of poor company performance, so he tries to pressure his company's auditing firm to be creative in their analysis to yield a favorable result. In fact, he convinces the president of the company to offer the accounting firm we discussed above that five million-dollar contract. This is a no-no under Sarbanes-Oxley, and Allan respectfully declines because he doesn't want any trouble with the PCAOB.
Of course, insider trading is prohibited. Insider trading is making trades based upon information not available to the general public, such as being aware of a new product line that will blow away the competition.
The Act enhances the disclosures that a publicly traded company must make. One of the most important provisions is Section 404 of the Act. This section requires that management establish, maintain, evaluate and report on the internal controls it has over financial reporting. It must submit an internal control report with all annual reports it files with the SEC.
An internal control system helps ensure that the company's financial reporting follows the generally accepted accounting principles. The Act also requires that an outside auditor give an independent evaluation of the company's internal controls. Maintaining internal controls and compliant financial reporting will help regulators, shareholders and investors make sound decisions.
Sarbanes-Oxley requires other disclosures that were not necessarily made prior to its enactment. Some of these include reporting of transactions that are not recorded on the balance sheet and dealings with unconsolidated entities that may affect the company's finances. An unconsolidated entity is one that is either directly or indirectly controlled by the company but not consolidated with the parent company for purposes of the parent's financial statements.
Moreover, the Act requires directors, officers and stockholders, who hold at least 10% of the company's stock, to make certain disclosures, including special bonuses, stock grants or large transfers of their stock. Basically, just like the internal control report, these disclosures are designed to give regulators, shareholders and potential investors a better picture of the financial situation of the company.
The Act requires measures to create rules concerning conflict of interest for analysts who research and provide information and recommend purchases of securities to the public. It's not too hard to see where the analysts may be pressured from brokers to give a favorable recommendation. Let's look at a quick example.
Zack works for a large financial company that provides both investment banking services and also provides recommendation to its clients. The public also places trust in its recommendations. Zack works as a stock analyst. His company is currently engaged in a huge initial public offering where a tech company is selling its stock to the public. The IPO is worth tens of millions to Zack's company. Zack sees some problems with the company that could negatively affect the IPO. However, Zack is being hounded by his investment banker friends at the firm to give a sterling recommendation for the stock to be offered.
However, Sarbanes-Oxley provides that rules be established to prevent such unethical behavior and help ensure unbiased ratings and recommendations. A key concept here is to build a wall between the division of a firm that performs security analysis and recommendations and the division that is actually selling stock. The 'wall' prevents the investment bankers from influencing Zack.
Sarbanes-Oxley also creates new laws relating to fraud and document retention. In fact, the Act makes it a felony to destroy records or create fraudulent documents to defeat a federal investigation. Auditors are required to keep records relating to their audits for five years. Additionally, whistle-blowers, which are people inside the company who inform outsiders about wrongdoing, are provided more protections when they disclose information in certain circumstances. Whistle-blowers 'signal' people to wrongdoing just like a whistle can serve as a signal.
The Act also creates harsher criminal penalties for white-collar criminals. For example, the Act requires that the chief executive officer and chief financial officer of the company certify that all reports filed comply with the Securities Act and include all material aspects of the company's finances. If the executive violates this provision, he will face up to five years in prison and a fine of up to $500,000. Other provisions make it a crime to interfere with official proceedings of regulators and to tamper with records.
The Public Company Accounting Reform and Investor Protection Act of 2002, commonly known by its shorter title, the Sarbanes-Oxley Act, is a complex law affecting publicly traded companies. The overall purpose of Sarbanes-Oxley is pretty much revealed in its long title. It was enacted to reform the accounting, auditing and financial reporting requirements and procedures of publicly traded companies in order to protect investors.
Sarbanes-Oxley attempts to create better corporate governance and financial reporting of publicly traded companies in several ways. The Act attempts to ensure that auditors are independent and unbiased. It expands the reporting responsibilities of upper management and enhances a public company's disclosure requirements. The Act also attempts to prevent conflict of interest with stock analysts. Provisions provide for document retention and addresses fraudulent document creation and interference with regulatory proceedings. Sarbanes-Oxley also has created new criminal provisions and enhanced criminal penalties for violations.
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Back To CourseBusiness 111: Principles of Supervision
9 chapters | 81 lessons | 8 flashcard sets