The Sarbanes-Oxley Act of 2002 - Research Paper Example

The Sarbanes-Oxley Act of 2002 Making Sure Enron Does Not Happen Again: The Sarbanes-Oxley Act of 2002 In the fall of 2001, corporate giant Enron collapsed. The corporation, which had started making a name for itself in the 1980s by trading in gas futures, was imploding from the inside out. It was brought down by accounting and auditing errors and internal discrepancies that had, in fact, been going on for some time. In the weeks that followed, it became clear to the public that the devastating trail of mismanagement of funds and deniability by the top leaders of the corporation would haunt Enron forever and make it a sterling example of what not to do in the accounting and finance sector. The collapse of the corporate giant brought about a startling reality to the world of business: the corporate giant (and their auditors) had lied. As a direct result of the collapse of Enron and the subsequent meltdown of its auditing firm Arthur Andersen, the Sarbanes-Oxley Act was proposed. It quickly became apparent to all as soon as the scandal became public that both it and the cause behind it could have been avoided. To try to prevent other corporate scandals and collapses from happening, President George W. Bush signed into law the Sarbanes-Oxley Act, named for its sponsors, which would establish measures for corporate oversight and promise stiff punishments for those that even attempted, knowingly or unknowingly, to engage in corporate fraud (Bumiller, 2002). Promising to hold the top echelon of corporate executives accountable, and overhauling auditing and recording practices, the Sarbanes-Oxley Act was declared to be the most far-reaching reform of the United States of America since the time of Franklin Delano Roosevelt (Bumiller, 2002). Enron: From Start to Scandal The story of what would be one of the largest scandals in history started in 1985, when Enron came into existence as Kenneth Lay combined his company, Houston Natural Gas, with InterNorth Corporation to form Enron (National Public Radio, 2002). Hoping to gain further profits and showcase its new status as not just a business but a competitor, Enron started to market what was known as futures contracts or the delivery of natural gas to buyers for a certain price at some point in time in the future (National Public Radio, 2002). Like a giant game of Monopoly, Enron worked the boards buying and selling, building profits while growing the business larger and larger, expanding its business. Unfortunately, the investments and contracts that Enron had become known for by 2001 did next to nothing in terms of earning money. The investments that were made and secured largely were not turning a profit, or even earning a return (National Public Radio, 2002). Enron had invested sums of its own corporate funds in operations that, it had hoped, would provide even more money with which to run the business, thus creating a cycle of profit (National Public Radio, 2002). That money never materialized, though this was kept secret until Enron filed for bankruptcy. The ensuing scandal brought about major reforms in the way accounting practices and audits were conducted, starting with the Sarbanes-Oxley Act. Enron and GAAP Violations Above all, the biggest question posed to Enron was, what exactly happened? By all accounts, it appeared to be doing well. Even its own employees did not suspect wrongdoings within the company (Cruver, 2003). Unfortunately, Enron also violated Generally Accepted Accounting Principles (GAAP), or guidelines set out for the preparation of financial statements, in a number of ways (Cunningham & Harris, 2006). While this was not the entire reason for the collapse of the giant that left many without jobs and executives heading to jail for their actions, the ignorance and violation of GAAP principles may well have been the starting point. Enron, and its auditing partner Arthur Andersen, violated GAAP in a number of ways, but most importantly, by incorrect accounting for their separate entities, unfair financial reporting, and failure to provide full financial disclosure (Cunningham & Harris, 2006). Violation Number One: Accounting For Special Purpose Entities Incorrect accounting methods were used when dealing with Special Purpose Entities that Enron had set up. Under GAAP, the equity method of accounting must be used when one company has over 20% control of another company, which is sometimes the case when talking about Special Purpose Entities (SPEs) (Cunningham & Harris, 2006). Enron had created a SPE for literally every venture and sub-venture that it had poured money into. At the time of its demise, Enron held over 3000 SPEs, far more than any other company (Cunningham & Harris, 2006). Enron also violated GAAP principles in that it did not report any debt from the SPEs on the balance sheet; it treated the entities as separate entities that did not hold any purpose. As required by GAAP, Enron was obligated to report any contingent liabilities for debt that was incurred by the companies that it controlled (Cunningham & Harris, 2006). This was not done, and Enron, quite often, looked as though it was the picture of a successful company from the outside, when in fact it was incurring massive debt. In addition to the equity method of accounting, another method called consolidated financial reporting is required by GAAP when one entity owns or controls over 50% more of another entity and can control its operations (Cunningham & Harris, 2006). Enron clearly did not do this; it made no move to consolidate any SPE earnings or losses on its balance sheets. In fact, Enron sought a position from the SEC in which it could avoid consolidating its SPEs; the response was that consolidation could only be avoided if there was an outside interest and the SPE was not controlled by Enron (Cunningham & Harris, 2006). This was not the case, as all SPEs were owned in some way, shape, or form, and with significant controlling interest, by Enron, an employee of Enron, a subsidiary of Enron, or were in some other way related to Enron. Violation Number Two: Unfair Reporting Practices While every corporation is required by law to report its earnings, Enron was not honest in reporting theirs, and thus they violated GAAP by using unfair financial reporting. First, the corporation issued shares of stock to SPEs, executives, and others in exchange for notes receivable. This in and of itself is a violation of GAAP, but more importantly, they did not report these actions whatsoever (Cunningham & Harris, 2006). This led to Enron overstating its assets and equities by over $1.2 million, an amount considered to be material, even for a corporation as large as Enron was (Cunningham & Harris, 2006). Enron also manipulated its financial reports on the basis of outside investments. When the outside investments made by Enron began to incur losses, they quickly transferred ownership of said investments to an SPE, thereby having the loss show up on the balance sheet of the SPE, and not on the balance sheet of Enron (Cunningham & Harris, 2006). Not only was this unethical, it was fraudulent. Enron as the parent corporation had made the investment, not the SPE, thus the loss was not reported fairly. Perhaps Enron’s most spectacular use of unfair financial reporting came on the front of the mark-to-market principle. Though this principle is legal according to GAAP, to say that Enron used and abused a legal principle is an understatement. Because Enron traded in futures where it was necessary to estimate future earnings, Enron controlled both the estimation and the value that was assigned to the earnings themselves, as in some cases, the active markets did not exist for what the futures that were being traded (Cunningham & Harris, 2006). While Enron did not violate GAAP per say in using the mark-to-market principle, it did violate GAAP in possibly reporting fictitious earnings (Cunningham & Harris, 2006). As there were no underlying assets to support the contracts or active markets that Enron was venturing into, it is arrogant to think that earnings be calculated and reported, even based on estimates. Violation Number Three: Full Disclosure As it can be seen from the two previous examples, Enron did not come remotely close to full financial disclosure. Under United States federal law, all companies that are publicly traded are required to present financial reports in accordance with GAAP (Cunningham & Harris, 2006). Enron did not disclose specific details as required by GAAP about the nature of the relationship with its SPEs, including information about the nature of the relationships, description of transactions, dollar amounts of transactions, and amounts due to or from the related party at year end (Cunningham & Harris, 2006). In failing to do so, Enron violated a principle of GAAP by not providing full financial disclosure to anyone. While it stands to reason that some things were being done that were known only to the auditing and accounting departments, overall, the oversights were glaring enough that someone should have noticed before the company imploded and collapsed. Analysis of Accounting Practices at Enron Corporation The accounting practices put into place by Enron and overlooked by its auditing firm, Arthur Andersen, were not only wrong, they were unethical, illegal, fraudulent, and in blunt terms, stupid. Putting up a charade about net worth and assets, in the end, cost them dearly both in terms of money, loyalty, and public opinion. It would have been better for them to report honestly, and fairly, in terms of full disclosure and take the losses that occurred. The concept of full disclosure, or telling the whole truth and nothing but the truth, is not new to accounting. Whether the details in those truths are good or bad are not for the corporation, its auditors, or even its accountants to decide; the facts are the facts, and they must be shared equally with everyone. Enron, however, felt that it was somehow above these facts, and chose not to share them. Any business will suffer losses; such things are part of having a business. Some losses are acceptable and, while not being overlooked by investors, will certainly present a better picture based on honesty rather than the house of cards that the lies of Enron precipitated. In choosing to do what it did, the company sentenced itself to infamy. The Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act was proposed as a direct result of the failure and collapse of Enron Corporation, and the subsequent failure of its auditing firm Arthur Andersen. Given the scandalous and fraudulent accounting practices that came to the attention of the Securities Exchange Commission and even Congress, it was clear that reform was needed, and the SEC could no longer rely on auditors to be trustworthy when it came to financial disclosure. The Sarbanes-Oxley act states specifically that it is an act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes ("The sarbanes-oxley act," 2002). Above all else, it put into place, for the first time, serious controls on auditing firms and audits, including who could conduct a company audit and what services could be provided, both ethically and legally. It also served to place accountability on top corporate executives, in addition to making those conducting the audits responsible for their actions. In addition, it defined criminal penalties for such things as altering documents and failure to disclose financial information, along with civil liabilities and forfeiture of bonuses for the top executives. Both the broad and specific impacts of the Sarbanes-Oxley Act were felt resoundingly throughout the auditing industry. The Public Company Accounting Oversight Board (PCAOB) The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB), an independent auditing board that would serve to provide oversight to auditors engaged in the business of making sure proper financial disclosure took place. As the scandal ravaged Enron, it became apparent that serious oversight had been needed on the auditing reports of the corporation (Cunningham & Harris, 2006). Therefore, the PCAOB serves to establish auditing standards with approval by the SEC and to oversee the quality of work providing by auditing firms, in addition to overseeing the audits of broker-dealers and the resulting compliance reports (McConnell and Banks, 2003). It is also responsible for handling registration of public accounting firms with the Board as well as conducting necessary inspections and investigations, handling any disciplinary proceedings that may arise from violations, establishing and adopting quality control, ethics, independence and other standards relating to the preparation of audit reports, and imposing appropriate sanctions towards firms that do not comply with rules and laws (McConnell and Banks, 2003). The PCAOB takes power out of the hands of the Auditing Standards Board for the first time in history as well. No longer is a simple oversight appropriate, and auditors are no longer considered trustworthy on their merits and records alone. It was proved by the Enron scandal that reform was necessary, and while the PCAOB is required to cooperate on an ongoing basis with designated professional groups of accountants and advisory boards, it has the authority to amend, modify, repeal or reject any standards suggested (McConnell and Banks, 2003). Auditing firms and any business that may provide audits to corporations are now required to register with the PCAOB. The Sarbanes-Oxley Act mandated that the PCAOB prove by April 26, 2003 to the SEC that it was organized and able to carry out its duties, and gave accounting firms and any other entity 180 days after this determination by the SEC to register with it (McConnell and Banks, 2003). Most of the provisions made by the Sarbanes-Oxley Act in regard to auditing practices and services are effective upon registration; however, the PCAOB was given 45 days to act on each application and had the right to request new information from each applicant (McConnell and Banks, 2003). This meant that companies wishing to perform audits were not advised to wait until the eleventh hour to register, as such delays and requests for more information could cause a devastating loss of business. Audits, Auditors, and Auditing Practices The Sarbanes-Oxley Act, above everything else, served as an overhaul and reform of auditing practices and services in the United States. After the publicity of the Enron scandal, it came to the attention of the public that practices regarding auditing at the corporation had not been properly followed. Auditors at Enron had been far too friendly with the corporation to provide proper oversight, auditors were not doing “auditing” as much as they were “consulting”, and the internal controls in at Enron were weak, to say the least (Cunningham & Harris, 2006). The Sarbanes-Oxley Act takes measures to ensure that such things will not happen again. An auditor and/or auditing firm is prohibited from providing a public company auditing client with the following specific types of consulting or other non-audit services, such as bookkeeping or other services related to the accounting records or financial statements of the audit client, financial information systems design and implementation, and legal services and/or expert services unrelated to the audit itself (Bumgardner, 2003). It is interesting to note, however, that consulting services were not completely banned. Under the Sarbanes-Oxley Act, an auditor can still provide its client with tax services and any other services not specifically precluded in the act, so long as the audit committee approves the work in advance (Bumgardner, 2003). To further provide independence, a rotation of auditors for corporations has been established in the Sarbanes-Oxley Act. Both the lead and concurring audit partners for any client company are now required to rotate away from a client audit after five consecutive years, and must wait five more years before returning (Bumgardner, 2003). Auditing firms with five or few public clients and/or ten or fewer partners in the firm are considered to be exempt from the provisions enacted in Sarbanes-Oxley, though the firms must be reviewed by the PCAOB every three years to maintain oversight and compliance (Bumgardner, 2003). Once again stopping short of something such as mandatory rotation requirements, the guidelines set out by Sarbanes-Oxley and the PCAOB are nevertheless strict to provide what is now considered necessary oversight. The Sarbanes-Oxley Act has also made provisions for the auditing committees of publicly owned corporations. Certain powers were transferred from the CEO and CFO to the audit committee due to the act, as well as revisions made to the strength and scope of the work done by an audit committee (Lipman, 2006). The first and foremost responsibility of the audit committee is to put into place the internal audit function of the corporation it serves, as well as to hire an internal auditor that will act as the “eyes and ears” of the committee (Lipman, 2006). The audit committee will also be directly responsible for the appointment, compensation, and oversight of the work of the public company auditors, with its primary responsibility being to the board of directors of the corporation and the investing public (Zameeruddin, 2003). If an outside auditor must be brought in, then the accounting or auditing firm retained will report directly to the auditing committee, and while the reports will be viewed by the CEO and CFO for certification, the auditor should not be made to feel as though they are “under the thumb” of management in any way (Zameeruddin, 2003). A good example of conflict of interests occurred in the Enron Corporation: the Enron audit committee approved off-balance sheet special-purpose entities that clearly created a conflict of interest between certain members of management and the company, yet the Enron audit committee did not create adequate oversight mechanisms to verify the findings presented to it (Lipman, 2006). Thanks to the Sarbanes-Oxley Act, conflicts of interest in auditing practices are controlled. In rare situations in which the audit committee elects to approve a conflict of interest, an ongoing independent monitoring mechanism must be established, which may include more intensive or extensive audits by the independent auditor (Lipman, 2006). After the audit has been completed, the results of both the independent auditor and the internal auditor should be reported directly to the audit committee (Lipman, 2006). However, the most important word used is “rare”. It should be noted that conflicts of interest, now so highlighted by the scandals that have taken place, will most likely be avoided altogether. If an auditing firm wishes to keep itself in business, it has no choice but to follow the Sarbanes-Oxley Act. The act has also provided an amendment to The Securities Exchange Act of 1934, inserting a section on “Appearance and Practice Before the Commission”, the “Commission” in this case meaning the SEC ("The sarbanes-oxley act," 2002). In the newly added Section 4B, it is stated that the Commission has the right to deny a person or an auditing firm, temporarily or permanently, if said person or firm is found to be lacking in character, qualifications, has willfully broken the laws and provisions, or aided and abetted someone in willfully breaking the provisions of the Sarbanes-Oxley Act ("The sarbanes-oxley act," 2002). In other words, some measure of control is now in place to stop auditors who do not perform their jobs to the standards of the SEC. Unfortunately, the broader impact of the Sarbanes-Oxley Act will be felt by auditors. Though departments such as I.T. must tighten their standards of security and possibly perform more routine checks on such things as servers, and executives can no longer claim deniability, it is the auditors that will ultimately be held under a microscope for far longer than anyone else. Given the fact that Arthur Andersen was an auditing firm, and the fact that it was connected with one of the largest corporate scandals in history, unfortunately means that auditors will not be considered trustworthy for some time, if ever again. However, a measure of relief may now be felt by auditors as well. Due to the Sarbanes-Oxley Act, auditors will no longer feel obligated towards any corporation. Thanks to the rotation guidelines, as well as clear definitions of services that may be provided, auditors will have a clear delineation of duties, as well as what is unacceptable. They will never have to feel as though they “owe” anything to a company, or that they are too close to a situation to provide proper oversight and advice. They are now free to do their jobs as auditors in conjunction with the auditing committee to make sure that fair and accurate reporting is received by the shareholders of a corporation. Criminal Penalties for Altering Documents Several new crimes for securities laws violations have been identified and established by the Sarbanes-Oxley Act. Penalties are now provided for the destruction of documents, the failure to maintain working papers, and schemes to defraud investors. Perhaps the most famous of moments in the Enron and Arthur Anderson meltdowns was when David Duncan of Andersen publicly admitting to shredding documents that could have been considered evidence (Cunningham & Harris, 2006). It was attested to by laid-off employees of Enron that shredders were running at full tilt at the corporate offices as well as shredding trucks being hired by the firm after it filed for bankruptcy (Cruver, 2003). The Sarbanes-Oxley Act took care to make crimes with appropriate penalties out of such actions. It is now a felony to “knowingly” destroy or create documents to impede, obstruct, or influence any existing or contemplated federal investigation or bankruptcy proceeding; violations can result in up to 20 years imprisonment and/or a fine (Zameeruddin, 2003). Auditors and accountants, again, face the broader impact in the consequences: the knowing and willful failure by an accountant to maintain all audit or review working papers for a period of five years after the end of the fiscal period in which the engagement was conducted is also prohibited, and violations can result in a sentence of up to ten years and/or a fine (Zameeruddin, 2003). The current securities fraud laws have also been broadened; knowingly devising and executing a scheme to defraud investors in connection with a security is now punishable by up to 25 years in prison and/or a fine (Zameeruddin, 2003). Thanks to the scandal of Enron and other corporations, auditors, executives, IT departments, and everyone involved with a corporation faces tough choices and a mountain of paperwork and/or electronic upkeep. Corporate Certification and Executive Accountability Under the provisions of the Sarbanes-Oxley Act, both the CEO and the CFO must personally certify the validity of financial statements both criminally and civilly. In each annual (10-K) and quarterly (10-Q) report, both the CFO and the CEO of the corporation must certify that they have personally reviewed the auditing report, that the report does not contain any errors and/or omissions, based on their knowledge (Zameeruddin, 2003). Also based on their knowledge, they certify by their signature that the financial statements and other financial information included in the report fairly present in all material respects the company’s financial condition and results of operations (Zameeruddin, 2003). Stiff penalties and harsh results await an executive who dares to act ignorant about their financial balance sheets. The Sarbanes-Oxley Act imposes fines of up to $1 million USD and 10 years in prison for unknowingly certifying a false report; for knowingly falsifying a report, the penalty is 20 years in prison and a $5 million fine (Zameeruddin, 2003). With these provisions made in the Sarbanes-Oxley Act, claiming deniability is no longer an excuse; executives must certify the validity of reports, or face the consequences. Executives face consequences in other areas as well. Under the Sarbanes-Oxley Act, disclosures involving management and principal stockholders must be reported by filing a Form 4. Though this was always the case, Section 403 the Sarbanes-Oxley Act drastically cut down the filing time, reducing it to two business days following a change in stock ownership from “the tenth of the month following the transaction”, as stated in the SEC Act of 1934 (Zameeruddin, 2003). Internal Control Reporting and Auditor Attestation Internal control is defined as a process affected by an entity’s board of directors, management, and other personnel that is designed to provide reasonable assurance regarding the achievement regarding effectiveness and efficiency of operations, reliability of financial reporting, and compliance with laws and regulations (Ernst and Young, 2002). In addition to the annual financial reports, an internal control report must now be submitted to the SEC as per Section 404 of the Sarbanes-Oxley Act ("The sarbanes-oxley act," 2002). This report must include a statement of management's responsibility for establishing and maintaining adequate internal controls, an assessment of the effectiveness of the internal controls, and a statement identifying the framework used by management to evaluate the effectiveness of the company's internal controls ("The sarbanes-oxley act," 2002). In addition, the registered public accounting firm that performed the audit must issue an attestation report on management's assessment of the company's internal control over financial reporting ("The sarbanes-oxley act," 2002). In filing these statements, everyone shares accountability and responsibility and no one can claim that they “did not know” if errors occurred. The Sarbanes-Oxley Act and the I.T. Department While the Sarbanes-Oxley Act sees its broadest impacts on accounting practices and auditors, several other departments of businesses are affected as well, including the I.T. department. Prior to the passage of the Sarbanes-Oxley Act, it was assumed that if no “red flags” came up, all internal controls were working perfectly in a business (Pauwels, 2006). Such was obviously not the case at Enron, or any of the number of businesses that toppled to the ground due to their accounting practices. Therefore, I.T. has two main jobs, though they have many more sideline jobs in conjunction with the Sarbanes-Oxley Act. The first job is to provide support for corporate-wide compliance with Sarbanes-Oxley Act (Pauwels, 2006). Every action taken by a corporation must have some record, and the IT department is responsible for maintaining the electronics that keep the records accurate and accessible. Secondly, the I.T. department must ensure that it has adequate and documented controls around such things as security, application deployment, change management, and other areas (Pauwels, 2006). I.T. Systems must be constantly updated, tested, checked, and re-tested. Though I.T. should not run to the latest and greatest cataloguing systems that would cost a corporation vast sums of money, the department should nevertheless shoulder as much accountability as the auditing department in making sure records are documented and kept, not falsified in any way, and that everyone that has access to them is doing so under proper measures and procedures. Conclusion The Enron scandal and the meltdown of Arthur Andersen are stains that will remain on American history for generations. The passage of the Sarbanes-Oxley Act in 2002, legislation that sought to provide oversight on auditing falsification and error for the first time since 1934, will also remain in the history books. It is too much to hope that the two will cancel each other out; scandals will continue to happen, and doubtless someone will try to sidestep the Act at one time or another. It is enough to hope that the Sarbanes-Oxley Act will instead act as a deterrent, so that less and less corporations will end up in scandals that cost employees, investors, and shareholders thousands of dollars and their sense of security for the rest of their lives. References Bumgardner, L. (2003). Reforming corporate america: how does the sarbanes-oxley act impact america?. Graziadio Business Review, 6(1), Retrieved from http://gbr.pepperdine.edu/2010/08/reforming-corporate-america Bumiller, E. (2002, July 31). Corporate conduct: the president; bush signs bill aimed at fraud in corporations. The New York Times. Retrieved from http://www.nytimes.com/2002/07/31/business/corporate-conduct-the-president-bush-signs-bill-aimed-at-fraud-in-corporations.html Cruver, B. (2003). Anatomy of greed: the unshredded truth from an enron insider. New York, NY: Carroll and Graf. Cunningham, G. M., & Harris, J. E. (2006). Enron and arthur andersen: the case of the crooked e and the fallen a. 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The history of enron: once a new-economy trailblazer, now beleaguered and bankrupt. Retrieved from http://www.npr.org/news/specials/enron/history.html Pauwels, E. (2006, August). The impact of sarbanes-oxley on i.t. and corporate governance. Retrieved from http://www.serena.com/docs/repository/products/change-governance/sarbanes-oxley-it-co.pdf U.S. Congress, (2002). The sarbanes-oxley act of 2002. Washington, D.C.: Government Printing Office. Retrieved from http://www.gpo.gov/fdsys/pkg/BILLS-107hr3763enr/pdf/BILLS-107hr3763enr.pdf Zameeruddin, R. (2003). The sarbanes-oxley act of 2002: an overview, analysis, and caveats. Business Quest: A Journal of Applied Topics in Business and Economics, Retrieved from http://www.westga.edu/~bquest/2003/auditlaw.htm Read More