The problem of reporting results accurately is substantial. Managers in- terested in giving stockholders all that they need face a series of legal hur- dles as well as accounting complexities. In 2002, the Sarbanes-Oxley Act
The most interesting operating trends for corporations are often found not in the consolidated statements, but in a study of major operating units.
Key Point
(SOX) was passed by Congress to establish stan- dards for auditors as well as for corporations in how conflicts of interest are to be eliminated, and in how corporations must disclose financial results to stockholders and to regulators.
Under the new law, SOX, major changes were made in the following areas:
1. Public Company Accounting Oversight Board. SOX sets up a special board to regu- late auditors. In the past, the accounting industry was self-regulating; but history has shown that this was not effective. Now the SEC has the authority, through this board, to perform four specific functions: (1) set standards for audits, (2) inspect accounting firm procedures and records, (3) investigate violations, and (4) impose sanctions when needed.
2. Auditor independence. Most big accounting firms have histori- cally performed a broad range of nonaudit services for their audit clients. This has led to two types of conflict of interest. First, au- ditors are less likely to challenges improper activities of clients when large nonaudit fees are involved, out of fear of losing the client. Second, it is likely that auditors end up reviewing their own work when, for example, the same firm has designed and in- stalled internal audit systems. Under SOX, many specific nonau- dit services are prohibited if and when the firms also perform audits for the same clients. Under the same provision, a firm may not perform an audit if any senior management of the firm worked for the accounting firm within the past year.
T h e S a r b a n e s - O x l e y A c t a n d A u d i t i n g S a f e g u a r d s 65
Sarbanes- Oxley Act (SOX) a 2002 federal law regulating accountants, executives, and securities analysts in reporting to the public and in disclosing poten- tial conflicts of interest; and established to increase regula- tory funding to investigate corpo- rate practices by the Securities and Exchange Com- mission (SEC).
The provision under SOX to impose outside regulation on the ac- counting industry is incredible. The complete failure of the industry to regulate itself, alone, points out how little investors can trust in the independence of the audit.
Key Point
3. Corporate responsibility. Publicly listed companies are required to appoint audit committees, which are responsible for hiring and paying an auditing firm; overseeing the auditors; receiving and reviewing reports; and resolving disputes that arise from audits.
Senior managers cannot interact directly with auditors.
A related provision under this section makes chief executive officers (CEOs) and chief financial officers (CFOs) personally re- sponsible for certifying that financial statements are complete and accurate. Both civil and criminal penalties can be imposed for false certification. The same CEOs and CFOs are forbidden from attempting to influence the outcome of audits. The penal- ties for infractions of the SOX rules could include monetary fines, prison terms, and permanent bar from serving as officers or directors of any public companies.
4. Financial disclosure rules. The law requires companies to explain all important adjustments proposed by auditors, even when those suggestions did not end up changing the financial statements.
(The requirement extends to transactions off the balance sheet as well as those included.) An off-balance sheet transaction can in- clude an important obligation or entity that can affect future profit reporting.
5. Analyst conflict of interest. SOX requires that se- curities analysts follow specific rules and make disclosures to clients. At least four types of con- flict of interest have been chronic in the Wall Street establishment in the past, including:
a. Compensation is often based in part on how well an analyst participates in underlying a company’s stock.
b. The analyst’s firm may be compensated in part from companies on which research re- ports are published.
c. The investing banking personnel within the firm may influence analysts to issue favorable reports on companies whose stock is under- written by the company.
d. In the past, analysts issuing negative reports suffered retaliation, further pressuring those analysts to report favorably on compa- nies when investing banking relationships were in effect.
off-balance sheet
transaction any transaction of a company not shown on the balance sheet or operating state- ment. These in- clude lease obligations, con- tingent liabilities, and unconsoli- dated subsidiary company operat- ing results.
Under SOX analysts are required to disclose any interests in a company’s stock; and companies are required to separate oper- ating units between investment banking and research activities.
The new rules clarify, for example, that if an analyst’s firm is un- derwriting a stock, then the analyst cannot also recommend the stock to his or her clients.
6. Regulatory funding. SOX authorized $776 million in additional budget for the SEC to carry out oversight and enforcement du- ties under the Act. Throughout the 1990s, the SEC budget re- mained at the same level even though its obligations grew. The increased budget helped the SEC to catch up to its basic staffing and audit requirements, as well as to meet its new duties. These included salary increases for existing regulatory staff; improved technological systems; and hiring of at least 200 additional inves- tigators and staff.