The enforcement authority given by Congress allows the SEC to bring civil enforcement actions against individuals or companies alleged to have com- mitted accounting fraud, provided false information, or engaged in insider trading or other violations of the securities law. The SEC also works with criminal law enforcement agencies to prosecute individuals and companies alike for offenses that include criminal violations.
As a financial accountant, your exposure to the regulatory authority of the SEC will be limited unless you work for a company whose shares of stock are publicly traded or you work for a CPA firm conducting financial statement audits for publicly traded companies.
The Sarbanes-Oxley Act of 2002 (SOX)
Beware, fraudulent companies: SOX may sound like a cuddly kitten, but it has claws! The bankruptcies of Enron Corporation and WorldCom, Inc. — and the subsequent billions of dollars of investor losses — prompted the U.S Congress to pass the Sarbanes-Oxley Act of 2002 (SOX) in an effort to renew investor confidence in the regulation of publicly traded companies. (SOX got its name because the legislation was sponsored by U.S. Senator Paul Sarbanes and U.S. Representative Michael G. Oxley.)
Abiding by SOX is mandatory for all publicly traded organizations regardless of size. SOX introduced major changes to the regulation of financial practice and corporate governance.
SOX does not apply to privately held companies; the Auditing Standards
SOX is organized into 11 titles or sections. You can read all about them at www.sec.gov/about/laws/soa2002.pdf, but here is just a quick rundown:
✓ Public Company Accounting Oversight Board (PCAOB): SOX formed PCAOB, which I discuss in the next section of this chapter. PCAOB is the watchdog of the accounting and auditing professions.
✓ Auditor independence: The legislation establishes standards for exter- nal auditor independence in order to limit conflicts of interest.
✓ Corporate responsibility: SOX lays out the responsibility senior execu- tives take for the accuracy and completeness of corporate financial reports.
✓ Enhanced financial disclosures: This part of the legislation requires enhanced reporting for financial transactions so users can make better- informed decisions.
✓ Analyst conflicts of interest: This section addresses the code of con- duct for security analysts and requires the analysts to disclose any con- flicts of interest.
✓ Commission resources and authority: SOX defines the SEC’s authority to censure or bar security professionals from practice.
✓ Studies and reports: The SEC is required to perform studies on topics such as security violations and enforcement actions and report its findings.
✓ Corporate and criminal fraud accountability: This section addresses criminal penalties for “cooking the books” and any other manipulation of financial records.
✓ White-collar crime penalty enhancements: This section beefs up crimi- nal penalties that can be assessed for white-collar crimes, including management’s failure to certify corporate financial reports.
✓ Corporate tax returns: This title states that the Chief Executive Officer should sign the company’s tax returns.
✓ Corporate fraud and accountability: SOX identifies corporate fraud and altering financial records as criminal offenses.
The Public Company Accounting Oversight Board (PCAOB)
SOX created the watchdog of the public company accounting and auditing profession: the PCAOB. The PCAOB is private, nonprofit corporation charged with bringing a halt to the financial shenanigans on the part of corporate
chief financial officers (CFOs) and chief executive officers (CEOs) for publicly traded companies. Public accountants — those doing work for companies other than their own employer — support this goal through the preparation of informative, fair, and independent financial statement (audit) reports.
The PCAOB consists of five members, including a chairman appointed by the SEC and two members who must be — or previously have been — certified public accountants (CPAs). The chairman must be one of the two CPA members, but she cannot be an active CPA; in fact, she cannot have been a practicing CPA for at least five years prior to being appointed to the position. Being a member is a full-time, five-year commitment.
The PCAOB sanctions CPA firms for not following its standards. Its authority includes the death knell of revoking the CPA firm’s license and barring its part- ners from working in public accounting. This is pretty serious stuff because it effectively closes the CPA firm’s doors and keeps the individual CPAs from plying their trade.
Getting to Know the Financial
Accounting Standards Board (FASB)
Resulting from some congressional criticism of the standard-setting work being done by the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Foundation (FAF) was established in the state of Delaware as a nonprofit corporation by accountant Teresa S. Polley in June 1972. (As of this writing, Ms. Polley serves as the organization’s president.) The FAF in turn established the Financial Accounting Standards Board (FASB), which is currently the private-sector body establishing generally accepted accounting principles (GAAP) for all nongovernmental entities.
(Governmental entities follow procedures set up by the Governmental Accounting Standards Board or GASB; see Chapter 6 for more information.) The FASB has five full-time members, who are selected by FAF. All are required to have knowledge of accounting, finance, and business. For more info about the FASB, accounting standards, and FAF, check out the FASB Web site at www.fasb.org/home.
The recognition of the FASB as an authority is contained in the Securities and Exchange Commission (SEC) Financial Reporting Release No. 1, Section 101 and reaffirmed in its April 2003 Policy Statement and the American Institute of Certified Public Accountants (AICPA) Rule 203, Rules of Professional Conduct.
I know your spoon is probably full at this point, but before I explain what GAAP are and why they matter so much, I need you to swallow just one more acronym. The FASB formed the Emerging Issues Task Force (EITF) in 1984 to help identify emerging accounting issues in need of standardization. The EITF is composed of accounting professionals who meet six times a year with non- voting members of the SEC and FASB to mull over current economic, busi- ness, and industrial developments.
Understanding generally accepted accounting principles (GAAP)
GAAP define for financial accountants the acceptable practices in the prepa- ration of financial statements in the United States. The preponderance of the information I provide in Parts III, IV, and V of this book directly ties back to GAAP. Specifically, GAAP tell financial accountants exactly how financial data has to show up on the income statement, balance sheet, and statement of cash flows.
For example, GAAP state that assets, liabilities, and equity go on the balance sheet and not on the income statement. GAAP are also pretty darn picky as to how these accounts are arranged on the balance sheet (see Part III). In addition, GAAP give specific rules for separating operating revenue (which is related to the business purpose) from non-operating revenue (non-business- related revenue, such as profit from selling a company asset), which I explain in Chapter 7.
Like most things in life, there are exceptions to the rule that all businesses must follow GAAP. Some businesses can deviate from GAAP, and I cover a few of these instances in Chapter 22. However, your financial accounting class likely won’t concern itself much with these exceptions to the GAAP rule.