Question

In the United States during the early 2000's there were a plethora of accounting scandals. Many times, the CEO was the cause of the problem. Congress passed the Sarbanes-Oxley Act in 2002. A large portion of the act was devoted to making CEO's more responsible for control over accounting. How do the actions of CEOs and upper management affect accounting and financial reporting?

Answer 1

INTRODUCTION TO THE ACT- Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 cracks down on corporate fraud. It created the Public Company Accounting Oversight Board to oversee the accounting industry. It banned company loans to executives and gave job protection to whistleblowers.The Act strengthens the independence and financial literacy of corporate boards. It holds CEOs personally responsible for errors in accounting audits.The Act is named after its sponsors, Senator Paul Sarbanes, D-Md., and Congressman Michael Oxley, R-Ohio. It's also called Sarbox or SOX. It became law on July 30, 2002. The Securities and Exchange Commission enforces it.Many thought that Sarbanes-Oxley was too punitive and costly to put in place. They worried it would make the United States a less attractive place to do business. In retrospect, it's clear that Sarbanes-Oxley was on the right track. Deregulation in the banking industry contributed to the 2008 financial crisis and the Great Recession.

Section 404 requires corporate executives to certify the accuracy of financial statements personally. If the SEC finds violations, CEOs could face 20 years in jail.The SEC used Section 404 to file more than 200 civil cases. But only a few CEOs have faced criminal charges.Section 404 made managers maintain “adequate internal control structure and procedures for financial reporting." Companies' auditors had to “attest” to these controls and disclose “material weaknesses."

Requirements ; SOX created a new auditor watchdog, the Public Company Accounting Oversight Board. It set standards for audit reports. It requires all auditors of public companies to register with them. The PCAOB inspects, investigates, and enforces the compliance of these firms. It prohibits accounting firms from doing business consulting with the companies they are auditing. They can still act as tax consultants. But the lead audit partners must rotate off the account after five years.

But SOX hasn't increased the competition in the oligarchic accounting audit industry. It's still dominated by the so-called Big Four firms. They are Ernst & Young, PricewaterhouseCoopers, KPMG, and Deloitte.

Internal Controls ; Public corporations must hire an independent auditor to review their accounting practices. It deferred this rule for small-cap companies, those with a market capitalization of less than $75 million. Most or 83% of large corporations agreed that SOX increased investor confidence. A third said it reduced fraud.

Effect On The U.S Economy ; Private companies must also adopt SOX-type governance and internal control structures. Otherwise, they face increased difficulties. They will have trouble raising capital. They will also face higher insurance premiums and greater civil liability. These would create a loss of status among potential customers, investors, and donors.

SOX increased audit costs. This was a greater burden for small companies than for large ones. It may have convinced some businesses to use private equity funding instead of using the stock market.

Why Congress Passed Sarbanes-Oxley

The Securities Act of 1933 regulated securities until 2002. It required companies to publish a prospectus about any publicly-traded stocks it issued. The corporation and its investment bank were legally responsible for telling the truth. That included audited financial statements.

Although the corporations were legally responsible, the CEOs were not. So, it was difficult to prosecute them. The rewards of "cooking the books" far outweighed the risks to any individual.

SOX addressed the corporate scandals at Enron, WorldCom, and Arthur Anderson. It prohibited auditors from doing consulting work for their auditing clients. That prevented the conflict of interest which led to the Enron fraud. Congress responded to the Enron media fallout, a lagging stock market, and looming reelections.

THE IMPACT AND EFFECT OF THE ACT;

A large portion of the act was devoted to making CEO's more responsible for control over accounting. actions of CEOs and upper management affect accounting and financial reporting.The Sarbanes-Oxley Act of 2002 was passed by Congress in response to widespread corporate fraud and failures.The Act implemented new rules for corporations, such as setting new auditor standards to reduce conflicts of interest and transferring responsibility for the complete and accurate handling of financial reports.To deter fraud and misappropriation of corporate assets, the Act imposes harsher penalties for violators.To increase transparency, the Act enhanced disclosure requirements, such as disclosing material off-balance sheet arrangements.

One direct effect of the Sarbanes-Oxley Act on corporate governance is the strengthening of public companies' audit committees. The audit committee receives wide leverage in overseeing the top management's accounting decisions. The audit committee, a subset of the board of directors consisting of non-management members, gained new responsibilities, such as approving numerous audit and non-audit services, selecting and overseeing external auditors, and handling complaints regarding the management's accounting practices.The Sarbanes-Oxley Act changes management's responsibility for financial reporting significantly. The act requires that top managers personally certify the accuracy of financial reports. If a top manager knowingly or willfully makes a false certification, he can face between 10 to 20 years in prison. If the company is forced to make a required accounting restatement due to management's misconduct, top managers can be required to give up their bonuses or profits made from selling the company's stock. If the director or officer is convicted of a securities law violation, he can be prohibited from serving in the same role at the public company.

The Sarbanes-Oxley Act significantly strengthens the disclosure requirement. Public companies are required to disclose any material off-balance sheet arrangements, such as operating leases and special purposes entities. The company is also required to disclose any pro forma statements and how they would look under the generally accepted accounting principles (GAAP). Insiders must report their stock transactions to the Securities and Exchange Commission (SEC) within two business days as well.

The Sarbanes-Oxley Act imposes harsher punishment for obstructing justice, securities fraud, mail fraud, and wire fraud. The maximum sentence term for securities fraud has increased to 25 years, and the maximum prison time for the obstruction of justice to 20 years. The act increased the maximum penalties for mail and wire fraud from five to 20 years of prison time. Also, the Sarbanes-Oxley Act significantly increases fines for public companies committing the same offense.

The costliest part of the Sarbanes-Oxley Act is Section 404, which requires public companies to perform extensive internal control tests and include an internal control report with their annual audits. Testing and documenting manual and automated controls in financial reporting requires enormous effort and involvement of not only external accountants but also experienced IT personnel. The compliance cost is especially burdensome for companies that heavily rely on manual controls. The Sarbanes-Oxley Act has encouraged companies to make their financial reporting more efficient, centralized and automated. Even so, some critics feel all these controls make the Act expensive to comply with, distracting personnel from the core business and discouraging growth.

Finally, the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board, which promulgates standards for public accountants, limits their conflicts of interest, and requires lead audit partner rotation every five years for the same public company.A large portion of the act was devoted to making CEO's more responsible for control over accounting.