personal paper on Sarbanes-Oxley Act

ETHICS  &  SOX  IN  THREE  MANAGERIAL  ACCOUNTING  TEXTBOOKS     Professor  Jay  Kang’s  Introduction  for  his  SFSU  students   Fall  semester,  2016    

1. CODE  OF  ETHICAL  STANDARDS  [Weygandt,  et  al.  p.19]    

In  response  to  corporate  scandals,  the  U.S.  Congress  enacted  the  Sarbanes-­‐Oxley  Act   (SOX)  to  help  prevent  lapses  in  internal  control.  One  result  of  SOX  was  to  clarify  top   management’s  responsibility  for  the  company’s  financial  statements.  CEOs  and  CFOs   are  now  required  to  certify  that  financial  statements  give  a  fair  presentation  of  the   company’s  operating  results  and  its  financial  condition.  In  addition,  top  managers   must  certify  that  the  company  maintains  an  adequate  system  of  internal  controls  to   safeguard  the  company’s  assets  and  ensure  accurate  financial  reports.   Another  result  of  SOX  is  that  companies  now  pay  more  attention  to  the  com-­‐   position  of  the  board  of  directors.  In  particular,  the  audit  committee  of  the  board  of   directors  must  be  comprised  entirely  of  independent  members  (that  is,  non-­‐   employees)  and  must  contain  at  least  one  financial  expert.  Finally,  the  law  sub-­‐   stantially  increases  the  penalties  for  misconduct.     2.   SOX  of  2002  [Braun,  et  al.  p.17]   As a result of corporate accounting scandals, such as those at Enron and WorldCom, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX). The purpose of SOX is to restore trust in publicly traded corporations, their management, their financial statements, and their auditors. SOX enhances internal control and financial reporting requirements and establishes new regulatory requirements for publicly traded companies and their independent auditors. Publicly traded companies have spent millions of dollars upgrading their internal controls and accounting systems to comply with SOX regulations.

As shown in Exhibit 1-7 [omitted by J Kang], SOX requires the company’s CEO and CFO to assume responsibility for the financial statements and disclosures. The CEO and CFO must certify that the financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the company. Additionally, they must accept responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. The company must have its internal controls and financial reporting procedures assessed annually. SOX also requires audit committee members to be independent, meaning that they may not receive any consulting or advisory fees from the company other than for their service on the board of directors. In addition, at least one of the members should be a financial expert. The audit committee oversees not only the internal audit function but also the company’s audit by independent CPAs.

To ensure that CPA firms maintain independence from their client company, SOX does not allow CPA firms to provide certain non-audit services (such as bookkeeping and financial information systems design) to companies during the same period of time in which they are providing audit services. If a company wants to obtain such services from a CPA firm, it must hire a different firm to do the non-audit work. Tax services may be provided by the same CPA firm if pre- approved by the audit committee. The audit partner must rotate off the audit engagement every five years, and the audit firm must undergo quality reviews every one to three years.

Why is this important? “ SOX puts more pressure on companies, their managers , and their auditors to ensure that investors get financial

information that fairly reflects the company’s operations. ” SOX also increases the penalties for white-collar crimes such as corporate fraud. These penalties include both monetary fines and substantial imprisonment. For example, knowingly destroying or creating documents to “impede, obstruct, or influence” any federal investigation can result in up to 20 years of imprisonment.8 8 Go to [no longer online] www.AICPA.org to learn more about SOX. SOX also contains a “clawback” provision in which previously paid CEO and CFO incentive-based compensation can be recovered if the financial statements were misstated due to misconduct. The Frank-Dodd Act of 2010 further strengthens the clawback rules, such that firms must recover all incentive compensation paid to any current or former executive, in the three years preceding the restatement, if that compensation would not have been paid under the restated financial statements. In other words, executives will not be allowed to profit from misstated financial statements, even if the misstatement was not due to misconduct.9 9 [no longer online] www.pepperlaw.com/publications_update.aspx?ArticleKey=1868 Since its enactment in 2002, SOX has significantly affected the internal operations of publicly traded corporations and their auditors. SOX will continue to play a major role in corporate management and the auditing profession.

3. Corporate Wrongdoing [Sawyers, et al. p.13]

Although companies establish ethics programs to en- courage employees to act with integrity, some individuals engage in behaviors that are not only unethical but also fraudulent. The case of Enron is one example where an ethics program was not effective. In late 2001, the once high-flying company filed for bankruptcy protection. Investigations into the company’s failure revealed a series of questionable transactions designed by the company’s top officials to enrich them- selves. The company’s former chief financial officer and two former chief executive officers were found guilty of fraud. Though the actual cost of

Enron’s collapse will never be known, estimates are that shareholders and creditors lost more than $60 billion.

Sarbanes–Oxley Act of 2002

As a response to the rash of corporate scandals and frauds that began in the early 2000s with the implosion of Enron in late 2001, the U.S. Congress passed

the Sarbanes–Oxley Act. Sarbanes–Oxley includes a number of significant provisions. For example, the law requires management to assess whether internal controls over financial reporting (ICFR) are effective. In addition, the company’s external financial statement auditor is required to audit ICFR and assess whether those controls are effective in preventing and detecting financial misstatements. These assessments are part of the so-called Section 404 report called for under the law. Because Congress wanted to include a significant deterrent, Sarbanes–Oxley also increases the criminal penalties associated with financial statement fraud to a maximum fine of $5 million and imprisonment for 20 years. Another provision of the law requires companies to establish procedures to allow employees to lodge complaints about accounting and auditing matters directly with members of the audit committee. Furthermore, companies must ensure that employees who make such complaints are not harassed or otherwise discriminated against by others within the organization. In sum, the Sarbanes–Oxley Act has increased the level of scrutiny of public companies’ financial statements. Many observers believe that the law has improved the quality of financial reporting in the United States and helped to rebuild the public’s trust in the nation’s financial markets.

References:

Braun, Karen Wilken and Wendy M. Tietz. 2015. Managerial accounting. Fourth edition. Pearson Education, Inc. Weygandt, Jerry, Paul D. Kimmel and Donald E. Kieso. 2015. Managerial Accounting, 7th Edition. John Wiley & Sons.

Sawyers, Roby B., Steven R. Jackson, and J. Gregory Jenkins. 2013. Managerial ACCT2, Student Edition. South-Western, Cengage Learning.