Fraud Discussion
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Chapter 11: Financial Statement Fraud: Appendix A Laws and Corporate Governance Changes Following the Sarbanes-Oxley Act Book Title: Fraud Examination Printed By: Weicheng Han (hanweicheng0513@gmail.com) © 2019 Cengage Learning, Inc.
Chapter Review
Appendix A Laws and Corporate Governance Changes Following the Sarbanes- Oxley Act
As described in the chapter, the period 2001–2003 marked the discovery of some of the largest financial statement frauds in U.S. history and some of the most significant legislation regarding the auditing profession and corporate governance since the 1933–1934 SEC acts. These events followed a very prosperous decade that saw the NASDAQ grow 10 percent per year from 1987 to 1995 and then from an index of 1,291 on January 1, 1997 to 5,049 on March 10, 2000 for a 391 percent increase in three years. The Dow Jones Industrial Average, while not quite so dramatic, rose from 6,448 on January 1, 1997 to a high of 11,723 on January 14, 2000 for an increase of 81 percent in three years. Much of this growth came from individual investors who found they could invest on the Internet by paying only small fees ($8 to $10 per trade).
When the first financial statement frauds, including Enron and WorldCom, were revealed, there was near panic in the market. The NASDAQ fell from its high of 5,049 on March 10 to 1,114 on October 9, 2002, leaving it at only 22 percent of its peak value. Similarly, the Dow Jones Industrial Average (NYSE) fell from its high of 11,723 on January 15, 2000 to a low of 7,286 on October 9, 2002, leaving it at only 62 percent of its previous value. The total decline in worldwide stock markets was $15 trillion. These sharp declines meant that nearly everyone’s 401(k) and other retirement plans and personal wealth suffered tremendous losses. Worse yet, several well-known companies that were involved in financial statement fraud declared bankruptcy. At the time when the Sarbanes-Oxley Act was passed in July 2002, many of the companies that were found to have committed fraud around this time period were among the largest bankruptcies in U.S. history, including WorldCom (largest), Enron (second largest), Global Crossing (fifth largest), and Adelphia (seventh largest).
The Sarbanes-Oxley Act
Because of the pressure brought by constituents, Congress was quick to act. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act, which had been quickly passed by both the House and the Senate. The law was intended to bolster public confidence in U.S. capital markets and impose new duties and significant penalties for noncompliance on public companies and their executives, directors, auditors, attorneys, and securities analysts.
The Sarbanes-Oxley Act is comprised of 11 separate sections or titles. You can read the full text of the act on several Web sites, but the highlights of each section are discussed here.
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(1)
(2)
(3)
(4)
(5)
Title I: Public Company Accounting Oversight Board
One of the concerns of legislators was that the auditing profession was self-regulating and set its own standards and that this regulation had fallen short of what it should have been. As a result, this part of the act established a five-member Public Company Accounting Oversight Board (PCAOB), with general oversight by the SEC, to:
Oversee the audit of public companies;
Establish audit reporting standards and rules; and
Inspect, investigate, and enforce compliance on the part of registered public accounting firms and those associated with the firms.
Title I requires public accounting firms that participate in any audit report with respect to any public company to register with the PCAOB. It also directs the PCAOB to establish (or modify) the auditing and related attestation standards, quality control, and ethics standards used by registered public accounting firms to prepare and issue audit reports. It requires auditing standards to include (among other things):
a seven-year retention period for audit work papers,
a second-partner review and approval of audit opinions,
an evaluation of whether internal control structure and procedures include records that accurately reflect transactions and disposition of assets,
that receipts and expenditures of public companies are made only with authorization of senior management and directors, and
that auditors provide a description of both material weaknesses in internal controls and of material noncompliance.
Title I also mandated continuing inspections of public accounting firms for compliance on an annual basis for firms that provide audit reports for more than 100 issuers and at least every three years for firms that provide audit reports for 100 or fewer issuers. Based on these inspections, it empowered the board to impose disciplinary or remedial sanctions upon registered accounting firms and their associates for intentional conduct or repeated instances of negligent conduct. It also directed the SEC to report to Congress on adoption of a principles-based accounting system by the U.S. financial reporting system and funded the board through fees collected from issuers.
With the passing of this act, control over auditing firms and auditing standards shifted from the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA) to this new quasi-governmental organization called the PCAOB. Some people have argued that this part of the law relegated the AICPA to a trade organization.
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Title II: Auditor Independence
Another concern of legislators was that the work of independent auditors of public companies had been compromised by some of the other types of consulting they had been doing for their audit clients. As a result, the next section of the Sarbanes-Oxley Act prohibits an auditor from performing specified nonaudit services contemporaneously with an audit. In addition, it specifies that public company audit committees must approve allowed activities for nonaudit services that are not expressly forbidden by the act. The prohibited activities include the following:
Bookkeeping services.
Financial information systems design and implementation.
Appraisal or valuation services.
Actuarial services.
Internal audit outsourcing.
Management functions or human resources.
Broker or dealer, investment advisor, or investment banking.
Legal services and expert services.
Any other service that the board determines is impermissible.
In addition, this section of the act prohibits an audit partner from being the lead or reviewing auditor on the same public company for more than five consecutive years (auditor rotation). It requires that auditors report to the audit committee each of the following:
Critical accounting policies and practices used in the audit.
Alternative treatments and their ramifications within GAAP.
Material written communications between the auditor and senior management of the issuer.
Activities prohibited under Sarbanes-Oxley.
Title II places a one-year prohibition on auditors performing audit services if the issuer’s senior executives had been employed by that auditor and had participated in the audit of the issuer during the one-year period preceding the audit initiation date and encourages state regulatory authorities to make independent determinations on the standards for supervising nonregistered public accounting firms and to consider the size and nature of their clients’ businesses audit.
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Title III: Corporate Responsibility
The first two titles of the act were directed at auditors of public companies, but the next section targeted public companies, especially their board of directors and its committees. Specifically, this part of the act involves the following provisions:
Requires each member of a public company’s audit committee to be a member of the board of directors and be independent (no other compensatory fees or affiliations with the issuer).
Confers upon the audit committee responsibility for appointment, compensation, and oversight of any registered public accounting firm employed to perform audit services.
Gives audit committees authority to hire independent counsel and other advisors and requires issuers to fund them.
Instructs the SEC to promulgate rules requiring the CEO and CFO to certify that the financial statements provided in periodic financial reports:
Do not contain untrue statements or material omissions.
Present fairly in all material respects the financial conditions and results of operations.
Establishes that the CEO and CFO are responsible for internal controls designed to ensure that they receive material information regarding the issuer and consolidated subsidiaries and that the internal controls have been reviewed for their effectiveness within 90 days prior to the report and makes them identify any significant changes to the internal controls.
Title III also deals with abuses and penalties for abuses for executives who violate the Sarbanes-Oxley Act. Specifically, it makes it unlawful for corporate personnel to exert improper influence upon an audit for the purpose of rendering financial statements materially misleading. It requires that the CEO and CFO forfeit certain bonuses and compensation received if the company is required to make an accounting restatement due to the material noncompliance of an issuer. It amends the Securities and Exchange Act of 1933 to prohibit a violator of certain SEC rules from serving as an officer or director if the person’s conduct demonstrates unfitness to serve (the previous rule required “substantial unfitness”). It provides a ban on trading by directors and executive officers in a public company’s stock during pension fund blackout periods. Title III also imposes obligations on attorneys appearing before the SEC to report violations of securities laws and breaches of fiduciary duty by a public company or its agents to the chief legal counsel or CEO of the company, and it allows civil penalties to be added to a disgorgement fund for the benefit of victims of securities violations.
Title IV: Enhanced Financial Disclosures
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Another concern addressed by the act was that public company financial statements did not disclose certain kinds of problematic transactions properly and management and directors didn’t act as ethically as they should have. As a result, Title IV:
Requires financial reports filed with the SEC to reflect all material correcting adjustments that have been identified.
Requires disclosure of all material off-balance-sheet transactions and relationships that may have a material effect upon the financial status of an issue.
Prohibits personal loans extended by a corporation to its executives and directors, with some exceptions.
Requires senior management, directors, and principal stockholders to disclose changes in securities ownership or securities-based swap agreements within two business days (formerly 10 days after the close of the calendar month).
Requires annual reports to include an internal control report stating that management is responsible for the internal control structure and procedures for financial reporting and that they have assessed the effectiveness of the internal controls for the previous fiscal year. This Section 404 request is probably the most expensive and debated part of the act. As a result of this requirement, most companies have spent millions of dollars documenting and testing their controls.
Requires issuers to disclose whether they have adopted a code of ethics for their senior financial officers and whether their audit committees consist of at least one member who is a financial expert.
Mandates regular, systematic SEC review of periodic disclosures by issuers, including review of an issuer’s financial statement.
Title V: Analyst Conflicts of Interest
In addition to concern over auditors, board members, management, and financial statements, legislators were also concerned that others (investment bankers and financial institution executives) also contributed to the problems. Accordingly, this section of the act:
Restricts the ability of investment bankers to preapprove research reports.
Ensures that research analysts in investment banking firms are not supervised by persons involved in investment banking activities.
Prevents retaliation against analysts by employers in return for writing negative reports. Establishes blackout periods for brokers or dealers participating in a public offering during which they may not distribute reports related to such offering.
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Enhances structural separation in registered brokers or dealers between analyst and investment banking activities.
Requires specific conflict of interest disclosures by research analysts making public appearances and by brokers or dealers in research reports including:
Whether the analyst holds securities in the public company that is the subject of the appearance or report.
Whether any compensation was received by the analyst, broker, or dealer from the company that was the subject of the appearance or report.
Whether a public company that is the subject of an appearance or report is, or during the prior one-year period was, a client of the broker or dealer.
Whether the analyst received compensation with respect to a research report, based upon banking revenues of the registered broker or dealer.
Title VI: Commission Resources and Authority
Title VI of the act gave the SEC more budget and more power to be effective in its role of overseeing public companies in the United States. Specifically, this part:
Authorized a 77.21 percent increase over the appropriations for FY 2002 including money for pay parity, information and technology, security enhancements, and recovery and mitigation activities related to the September 11 terrorist attacks.
Provided $98 million to hire no less than 200 additional qualified professionals to provide improved oversight of auditors and audit services.
Authorized the SEC to censure persons appearing or practicing before the commission if it finds, among other things, a person to have engaged in unethical or improper professional conduct.
Authorized federal courts to prohibit persons from participating in penny stock offerings if the persons are the subject of proceedings instituted for alleged violations of securities laws.
Expanded the scope of the SEC’s disciplinary authority by allowing it to consider orders of state securities commissions when deciding whether to limit the activities, functions, or operations of brokers or dealers.
Title VII: Studies and Reports
This section of the Sarbanes-Oxley Act specified that certain reports and studies should be made, including the following:
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A study of the factors leading to the consolidation of public accounting firms and its impact on capital formation and securities markets.
A study of the role of credit rating agencies in the securities markets.
A study of the number of securities professionals practicing before the commission who have aided and abetted federal securities violations but have not been penalized as a primary violator.
A study of SEC enforcement actions it has taken regarding violations of reporting requirements and restatements of financial statements (as referred to earlier in the chapter).
A study by the Government Accountability Office (GAO) on whether investment banks and financial advisers assisted public companies in earnings manipulation and obfuscation of financial conditions.
Title VIII: Corporate and Criminal Fraud Accountability
Title VIII was the part of the Sarbanes-Oxley Act that imposed criminal penalties upon violators, extended the statute of limitations for financial crimes, and provided protection for whistle-blowers in fraud cases. Specifically, this part of the act:
Imposed criminal penalties for knowingly destroying, altering, concealing, or falsifying records with intent to obstruct or influence either a federal investigation or a matter in bankruptcy and for failure of an auditor to maintain for a five-year period all audit or review work papers pertaining to an issuer of securities (penalty: 10 years in prison).
Made nondischargeable in bankruptcy certain debts incurred in violation of securities fraud laws.
Extended the statute of limitations to permit a private right of action for a securities fraud violation to no later than two years after its discovery or five years after the date of the violation.
Provided whistle-blower protection to prohibit a publicly traded company from retaliating against an employee because of any lawful act by the employee to assist in an investigation of fraud or other conduct by federal regulators, Congress, or supervisors, or to file or participate in a proceeding relating to fraud against shareholders.
Subjected to fine or imprisonment (up to 25 years) any person who knowingly defrauds shareholders of publicly traded companies.
Title IX: White-Collar Crime Penalty Enhancements
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Because of concern that corporate executives and directors who engage in unlawful conduct were not being penalized sufficiently, this part of the act increased penalties for mail and wire fraud from 5 to 20 years in prison. It also increased penalties for violations of the Employee Retirement Income Security Act of 1974 (up to $500,000 and 10 years in prison) and established criminal liability for failure of corporate officers to certify financial reports, including maximum imprisonment of 10 years for knowing that the periodic report does not comply with the act or 20 years for willfully certifying a statement knowing it does not comply with this act.
Title X: Corporate Tax Returns
This title expressed the sense of the Senate that the federal income tax return of a corporation should be signed by its chief executive officer.
Title XI: Corporate Fraud Accountability
This final title of the act amended federal criminal law to establish a maximum 20-year prison term for tampering with a record or otherwise impeding an official proceeding. It authorized the SEC to seek a temporary injunction to freeze extraordinary payments earmarked for designated persons or corporate staff under investigation for possible violations of federal securities law. It also authorized the SEC to prohibit a violator of rules governing manipulative, deceptive devices, and fraudulent interstate transactions, from serving as officer or director of a publicly traded corporation if the person’s conduct demonstrates unfitness to serve; and it increased penalties for violations of the Securities Exchange Act of 1934 up to $25 million and 20 years in prison.
The Public Company Accounting Oversight Board (PCAOB)
Once the PCAOB was up and running, it wasted no time in carrying out its mandate. With its authorized budget of $68 million per year, within weeks, it required that auditing firms of public companies register with the board. It hired inspectors to carry out inspections of the audits of public companies. It hired a new audit director (Douglas Carmichael) and created a board to issue auditing standards. It established offices in several cities around the United States.
It established its mission to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports. It issued its first auditing standard that articulates management’s responsibilities for evaluating and documenting the effectiveness of internal controls over financial reporting, identifies the kinds of deficiencies that can exist, states the consequences of having deficiencies, and identifies how deficiencies must be communicated.
Subsequent Changes Made by the Stock Exchanges
In response to the high-profile corporate failures, the SEC requested that the NYSE and NASDAQ review their listing standards with an emphasis on all matters of corporate
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governance. Based on that request, both the NYSE and NASDAQ conducted extensive reviews of their listing standards for corporate governance and filed corporate governance reform proposals with the SEC in 2002. In April 2003, the SEC issued Rule 10A-3, which directed all stock exchanges to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements specified in Rule 10A-3. On November 4, 2003, the SEC approved, with certain modifications, the corporate governance reforms proposed by the NYSE and NASDAQ. Here is an overview of the changes that they made.
NASDAQ Corporate Governance Changes
NASDAQ focused almost entirely upon boards of directors and executives in making governance reforms. Specifically, NASDAQ addressed the following issues:
Independence of majority of board members.
Separate meetings of independent board members.
Compensation of officers.
Nomination of directors.
Audit committee charter and responsibilities.
Audit committee composition.
Code of business conduct and ethics.
Public announcement of going-concern qualifications.
Related-party transactions.
Notification of noncompliance.
NASDAQ corporate governance reforms mandate that a majority of the board of director members are required to be independent along with a disclosure in annual proxy (or in the 10-K if proxy is not filed) about the directors, which the board has determined to be independent under NASD (formerly known as the National Association of Securities Dealers) rules. In defining what constitutes an independent director, NASDAQ’s rules state that a director is not independent under the following circumstances:
The director is an officer or employee of the company or its subsidiaries.
The director has a relationship, which in the opinion of the company’s board would interfere with the director.
Any director who is or has at any time in the last three years been employed by the company or by any parent or subsidiary of the company.
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The director accepts or has a family member who accepts any payments from the company in excess of $60,000 during the current fiscal year or any of the past three fiscal years. Payments made directly to or for the benefit of the director or a family member of the director or political contributions to the campaign of a director or a family member of the director would be covered by this provision.
The director is a family member of an individual who is or at any time during the past three years was employed by the company or its parent or any subsidiaries of the company as an executive officer.
The director is or has a family member who is employed as an executive officer of another entity at any time during the past three years where any of the executive officers of the listed company serve on the compensation committee of such entity.
The director is or has a family member who is a partner in or is a controlling shareholder or an executive officer of any organization in which the company or from which the company received payments for property or services in the current year or any of the past three fiscal years that exceed 5 percent of the recipient’s consolidated gross revenues for that year or $200,000, whichever is more.
The director is or has a family member who is an executive officer of a charitable organization, if the company makes payments to the charity in excess of the greater of 5 percent of the charity’s revenues or $200,000.
The director is or has a family member who is a current partner of the company’s outside auditor.
The director was a partner or employee of the company’s outside auditor and worked on the company’s audit at any time in the past three years.
Under new governance standards, independent directors are required to have regularly scheduled meetings at which only independent directors are present (thus excluding all members of management). To eliminate sweetheart deals, the compensation of the CEO and all other officers must be determined or recommended to the full board for determination by a majority of the independent directors or a compensation committee comprised solely of independent directors.
In addition, director nominees should be either selected or nominated for selection by a majority of independent directors or by a nominations committee comprised solely of independent directors. NASDAQ changes also require each issuer to certify in writing that it has adopted a formal written charter or board resolution addressing the nomination process.
A written charter for the audit committee of the issuer must provide the following:
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The committee’s purpose of overseeing the accounting and financial reporting processes and audits of the financial statements.
Specific audit committee responsibilities and authority including the means by which the audit committee carries out those responsibilities.
Outside auditor’s accountability to the committee.
The committee’s responsibility to ensure the independence of the outside auditor.
Audit committee consists of at least three members.
Each audit committee member is required to be:
Independent under the NASD rules.
Independent under Rule 10A-3 issued by the SEC.
Someone who has not participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the last three years.
Existing NASDAQ rules already required that each audit committee member should be able to read and understand fundamental financial statements. This requirement did not change. However, under the new NASDAQ governance rules, one audit committee member must have past employment experience in finance and accounting, requisite professional certification in accounting, or any other comparable experience or background that results in the individual’s financial sophistication, including being or having been a CEO, CFO, or other senior officer with financial oversight responsibilities. Audit committee members are also prohibited from receiving any payment from the company other than the payment for board or committee services and are also prohibited from serving the audit committee in the event they are deemed to be an affiliated person of the company or any subsidiary.
Under the new NASDAQ requirements, each listed company must have a publicly available code of conduct that is applicable to all directors, officers, and employees. The code of conduct must comply with the “code of ethics” as set forth in Section 406(c) of the Sarbanes-Oxley Act and must provide for an enforcement mechanism that ensures the following:
Prompt and consistent enforcement of the code.
Protection for persons reporting questionable behavior.
Clear and objective standards for compliance.
Finally, each listed company that receives an audit opinion that contains a going-concern qualification must make a public announcement through the news media disclosing the
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receipt of such qualification within seven calendar days following the filing with the SEC of the documents that contained such an audit opinion. In addition, the audit committee of each issuer must conduct an appropriate review of all related-party transactions for potential conflicts of interest on an ongoing basis and make sure that all such transactions have been approved.
NYSE Corporate Governance Changes
Changes made by the NYSE were quite similar to those made by the NASDAQ. Specifically, the NYSE addressed the following broad categories of the proposed standards:
Independence of majority of board members.
Separate meetings of independent board members.
Nomination/corporate governance committee.
Corporate governance guidelines.
Compensation committee.
Audit committee charter and responsibilities.
Audit committee composition.
Internal audit function.
Code of business conduct and ethics.
CEO certification.
Public reprimand letter.
Like the NASDAQ, the NYSE governance changes require that a majority of the directors be independent. Under the NYSE standards, no director qualifies as an independent director unless the board affirmatively determines that the director has no material relationships with the company. Like the NASDAQ, the NYSE now requires disclosure in annual proxy (or in the 10-K if a proxy is not filed), the basis of the conclusion that the particular directors have been deemed to be independent. If an issuer fails to meet this requirement due to vacancy or due to any director ceasing to be independent due to circumstances beyond his or her reasonable control, the issuer must regain compliance by the earlier of the next annual meeting or one year from the date of occurrence.
Under NYSE guidelines, the independence of a director is impaired under the following circumstances:
The director is an employee or whose immediate family member is an executive officer of the company would not be independent until three years after the termination
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of that employment.
The director receives or whose immediate family member receives more than $100,000 per year in direct compensation from the listed company would not be independent until three years after he or she ceases to receive more than $100,000 per year.
The director is affiliated or employed by, or whose immediate family member is employed in any professional capacity by, a present or former internal or external auditor of the company would not be independent until three years after the end of the affiliation or the employment or auditing relationship.
The director is affiliated with or employed or whose immediate family member is affiliated or employed as an executive officer of another company where any of the listed company’s present executives serve on that company’s compensation committee would not be independent until three years after the end of such service or employment relationship.
The director is an executive officer or an employee or whose immediate family member is an executive officer of a company that makes payments to or receives payments from the listed company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million or 2 percent of such other company’s consolidated gross revenues would not be independent until three years after falling below that threshold.
Immediate family member includes a person’s spouse, parents, children, siblings, mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.
Nonmanagement directors are required to have regularly scheduled executive meetings at which only nonmanagement directors would be present.
NYSE-listed companies are required to disclose a method to interested parties to communicate directly with the presiding director of such executive sessions or with the nonmanagement directors as a group. Each listed company must have a nominating/corporate governance committee comprising solely of independent directors.
Like NASDAQ-listed companies, audit committees must have written charters that should address at a minimum the following:
The committee’s purpose and responsibilities.
An annual performance evaluation of the nominating/governance committee.
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The committee would be required to identify members qualified to become board members consistent with the criteria approved by the board.
Each NYSE-listed company must adopt and disclose corporate governance guidelines that specify director qualification standards, director responsibilities, director access to management and as necessary and appropriate to independent advisors, director compensation, director orientation and continuing education, management succession, and annual performance evaluation of the board. These corporate governance guidelines and charters of the most important board committees must be disclosed on the company’s Web site.
With respect to committees, each listed company must have a compensation committee comprised solely of independent directors and a written charter that addresses at least the following issues:
The committee’s purpose and responsibilities.
An annual performance evaluation of the compensation committee.
The committee would be required to produce a compensation report on executive compensation for inclusion in the company’s annual proxy. In addition, the committee, together with the other independent directors, would determine and approve the CEO’s compensation.
Listed companies must also have an audit committee and a written charter that provides the following:
The committee’s purpose.
Annual performance evaluation of the audit committee.
Duties and responsibilities of the audit committee.
Duties and responsibilities of the audit committee as defined in the charter should include at a minimum:
Those provisions set out in Rule 10A-3 of SEC.
Responsibility to annually obtain and review a report by the independent auditor.
Discussion of the company’s annual audited financial statements and quarterly financial statements with management and the independent auditor.
Discussion of the company’s earnings press releases, as well as financial information and earnings guidance provided to analysts and rating agencies.
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Discussion of policies with respect to risk assessment and risk management.
Meet separately, periodically with management, with internal auditors, and with independent auditors.
Review with independent auditors any audit problems or difficulties and management’s response.
Set clear hiring policies for employees or former employees of independent auditors.
The audit committee, which must have at least three members, must report regularly to the full board. In addition, each audit committee member is required to be:
Independent under the NYSE rules.
Independent under Rule 10A-3 issued by the SEC.
Someone who has not participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the last three years.
Financially literate, as such qualification is interpreted by the board in its business judgment, or must become financially literate within a reasonable period of time after his or her appointment to the committee.
At least one member of the committee would be required to have accounting or related financial management expertise, as the company’s board interprets such qualification in its business judgment. One of the biggest differences between audit committees of NYSE- listed companies and NASDAQ-listed companies is that if an audit committee member simultaneously serves on the audit committee of more than three public companies, and the listed company does not limit the number of audit committees on which its audit committee members may serve, each board is required to determine whether such simultaneous service would impair the ability of such a member to effectively serve on the listed company’s audit committee. Additionally, any such determination must be disclosed in an annual proxy statement or in the annual report on Form 10-K in case the company does not file a proxy statement.
Another major difference is that NYSE governance requirements require each listed company to have an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control. Under the guidelines, companies may choose to outsource this function to a third-party service provider other than its independent auditor, but it must at least have this function.
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Like NASDAQ, each listed company must adopt and disclose a code of business conduct and ethics that is applicable to all directors, officers, and employees. The code of conduct must be available on the company’s Web site, and any waiver of the code of conduct for officers and directors must be promptly disclosed. The code of conduct must provide the following elements:
Conflicts of interest.
Corporate opportunities.
Confidentiality of information.
Fair dealing.
Protection and proper use of company assets.
Compliance with laws, rules, and regulations.
Encouraging the reporting of any illegal or unethical behavior.
Compliance standards.
Procedures to facilitate effective operation of the code.
The CEO of each listed company must certify to the NYSE each year that he or she is not aware of any violation by the company of the NYSE’s corporate listing standards. This certification would be required to be disclosed in the company’s annual report on Form 10- K. Additionally, the CEO of each listed company would be required to promptly notify the NYSE in writing after any executive officer becomes aware of any material noncompliance with the applicable provisions of the new requirements.
The governance changes authorize the NYSE to issue a public reprimand letter to any listed company that violates NYSE governance requirements.
Has Recent Legislation Fixed the Problem?
To determine whether recent legislation has remedied the problem and will prevent future frauds, it is important to align the three elements of the fraud triangle with remedies that have been instituted. Table 11A.1 attempts to do that.
Table 11A.1
Remedies Enacted Through Recent Legislation
ELEMENT OF THE FRAUD TRIANGLE
ELEMENT OF THE PERFECT FRAUD STORM
REMEDY THAT ADDRESSES THIS FACTOR
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ELEMENT OF THE FRAUD TRIANGLE
ELEMENT OF THE PERFECT FRAUD STORM
REMEDY THAT ADDRESSES THIS FACTOR
Perceived Pressures 1. Misplaced executive
incentives
2. Unrealistic Wall Street expectations
3. Large amounts of debt
4. Greed
Recent legislation and corporate governance changes have not addressed perceived pressures. Significant stock-based compensation is still being given to executives. No decrease has occurred in EPS forecasts and the size of penalties when those forecasts are not met. Companies have taken on more, not less, debt. And, no evidence indicates that executives are less motivated by greed than before the frauds.
Perceived Opportunities 1. Good economy was
masking many problems
2. Behavior of CPA firms
3. Rules-based accounting standards
4. Educator failures
Most of the legislative and governance changes have been targeted at reducing opportunities to commit fraud. The requirement that board members be more independent from management is intended to eliminate or decrease the opportunities of management to commit fraud. Other actions that are intended to decrease opportunities are minimum sentencing guidelines, requiring executives to sign off on the accuracy of financial statements, holding management responsible for good controls, installing a whistle-blower system, inspecting auditors so that they increase the thoroughness of their audits, etc.
Rationalization 1. Moral decay in society
The one legislative action that addresses this fraud element is requiring all companies to have an executive code of conduct. However, with decreasing integrity in society, it is doubtful that requiring a code of conduct will eliminate rationalizations.
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(1)
(2)
(3)
As we described earlier in the book, fraud is like fire in that there are three elements that come together to create fire:
heat,
fuel, and
oxygen.
The more intense or pure one element, say oxygen, the less heat and fuel are required. The same is true with fraud. The more of one element you have, say pressures, the less of the other elements (i.e., opportunities and rationalizations) it takes to commit fraud. To the extent that recent legislative and governance actions have reduced fraud opportunities, the more perceived pressure and rationalization it will take to commit financial statement fraud in the future. Eliminating opportunities will make it much more difficult for executives to argue that their personal interests will be best served by fraudulent reporting. For example, with increased independence of board members, CEOs whose performance is questionable are more likely to be dismissed. This is different than it was in the past. Boeker (1992), for example, found that, historically, organizations with below-average performance and powerful chief executives failed to dismiss the chief executive. In the majority of cases, the boards were willing to take other actions to improve success but were not willing to dismiss the CEO. Legislative and governance changes make it harder to commit fraud, make it harder to conceal fraud, and impose greater penalties for those who behave dishonestly. Only when perceived pressures and the ability to rationalize increase to the point where they more than offset the decreased opportunities will future frauds occur. Our prediction, therefore, is that less corporate fraud will occur in the United States in the future, but not all of it will be eliminated. The increased pressures and rationalizations that will now be necessary will generate fraud symptoms that are more egregious than those of the past. For individuals who understand fraud, these egregious fraud symptoms will be more observable than ever before, which should make fraud easier to detect.
Chapter 11: Financial Statement Fraud: Appendix A Laws and Corporate Governance Changes Following the Sarbanes-Oxley Act Book Title: Fraud Examination Printed By: Weicheng Han (hanweicheng0513@gmail.com) © 2019 Cengage Learning, Inc.
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