When William H. Donaldson entered his cavernous corner office on the sixth floor of the Se- curities and Exchange Commission in 2003, he headed an agency at one of its lowest points since its creation nearly 70 years ago.8
Enron’s former chairman and chief executive, Kenneth Lay, received $152.7 million in pay- ments and stock in the year leading up to the company’s collapse amid revelations that it hid debt and inflated profit for years. Lay’s take in 2001 was more than 11,000 times the maxi- mum amount of severance paid to laid-off workers.
Former WorldCom CEO Bernard Ebbers borrowed $408 million from the telecommunications company that had improperly accounted for $9 billion and was forced into bankruptcy. Ebbers had pledged company shares as collateral, but with those shares, once valued at $286 million, worth- less, he was said to be considering forgoing his $1.5 million annual pension to help settle the debt.
Adelphia Communications’ founder and former CEO, John J. Rigas, allegedly conspired with four other executives to loot the company, leading prosecutors to seek the forfeiture of more than $2.5 billion.9
Hardly a day passed during 2002 without a new revelation of corporate wrongdoing. The list of companies whose executives virtually robbed the corporate treasury or whose accounting practices ranged from dubious to outrageous is unfortunately long. Throughout this excruciating disclosure process, many in the investing public began to raise two related questions:
Why didn’t the independent auditor stop these practices?
How can the SEC allow such activities to occur?
As indicated previously, a number of theories can suggest the cause of the ethical meltdown during this period, ranging from human greed to inappropriate auditing practices. In truth, as the history of this time continues to unfold, a variety of culprits share the blame for such rep- rehensible behavior on both the corporate and the individual levels.
Regardless of the reasons, drastic actions had to be taken to reduce or eliminate future abuses (actual and perceived) to begin restoring public confidence in publicly traded entities and their disclosed accounting information. A capitalistic economy needs readily accepted in- vestments, and that is possible only if investors believe they can make wise decisions to buy and sell securities based on the information available. Thus, Congress passed the Sarbanes- Oxley Act in July 200210by a virtually unanimous vote. The scope and potential consequences of this legislation are extremely broad; the actual impact will probably not be determined for decades. “The Sarbanes-Oxley Act of 2002 is a major reform package mandating the most far- reaching changes Congress has imposed on the business world since FDR’s New Deal.”11
The act is so wide ranging that this text describes only a general overview of some of the more frequently discussed statutory provisions here.
Creation of the Public Company Accounting Oversight Board
The public accounting profession has long taken pride in its own self-regulation. Through its major professional body, the American Institute of Certified Public Accountants (AICPA), the profession has established and enforced its own code of conduct and, through its Auditing Standards Board (ASB), created its own auditing standards for decades. The maintenance of public trust was often heard as a litany for the creation of such professional guidelines.
Unfortunately, self-regulation obviously was not always successful in the public auditing arena. One of the inherent flaws in the system was that the professional body, the AICPA, was considerably smaller than many of the international audit firms that it sought to control.
8Stephen Labaton, “Can a Bloodied S.E.C. Dust Itself Off and Get Moving?” New York Times,December 16, 2002, p. C-2.
9Brad Foss, “Unearthing of Corporate Scandals Exposed Market’s Vulnerabilities,” Associated Press Newswires, December 12, 2002.
10Public Law 107-204; 107th Congress, July 30, 2002.
11Richard I. Miller and Paul H. Pashkoff, “Regulations under the Sarbanes-Oxley Act,” Journal of Accountancy, October 2002, p. 33.
LO3
Understand the congressional rationale for enacting the Sarbanes-Oxley Act and the responsibilities of the Public Accounting Oversight Board.
hoy36628_ch12_533-556.qxd 1/27/10 10:27 AM Page 539
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Discipline and conformity are simply difficult to maintain when the students are many times bigger, richer, and more powerful than the principal.
The Sarbanes-Oxley Act created the Public Company Accounting Oversight Board (PCAOB) to oversee auditors of public companies. The creation of the Oversight Board—a governmental board under the control of the SEC—effectively minimizes self-regulation in the accounting profession. The board
• Has five members appointed by the SEC to staggered five-year terms.12
• Allows only two members to be accountants, past or present.13
• Enforces auditing, quality control, and independence standards and rules.
• Is under the oversight and enforcement authority of the SEC.
• Is funded from fees levied on all publicly traded companies.
These few provisions show that this Oversight Board rather than the accounting profession is now ultimately in charge of regulating public accounting for publicly traded companies. Al- though the board itself is not a government agency, the SEC has control of it and, thus, will be a much more active participant in the work of the independent auditor. For example, the SEC is to pick the five members of the board (after consultation with the chair of the Board of Gov- ernors of the Federal Reserve System and the secretary of the U.S. Department of the Trea- sury). The act requires the board members to be prominent individuals of integrity and good reputation who must cease all other professional and business activities to help ensure inde- pendence and adequate time commitment.
One of the most interesting issues is how the Oversight Board interacts with the Auditing Standards Board to promulgate audit and attestation standards. While AICPA authorizes the ASB to issue such pronouncements, the mandate of the Sarbanes-Oxley Act requires the Over- sight Board to play a significant role in this process. Although directed to cooperate with the accounting profession, the PCAOB has the authority to amend, modify, repeal, or reject any auditing standard.14ASB standards, unless later modified or superseded by the PCAOB, are adopted for audits of issuers. The Oversight Board has since taken an active role in develop- ing its own pronouncements and many new ASB pronouncements apply only to nonissuers.
The future of the Financial Accounting Standards Board (FASB) is much less in doubt at this time. From its inception, the FASB has been a free-standing organization entirely separate from the AICPA. As we discuss later, the SEC has always held the ability to significantly impact ac- counting standards. Furthermore, the problems that led to the recent corporate scandals have been less about accounting issues and more about audit failurs. Some observers, however, contend that the rule-based orientation of U.S. generally accepted accounting principles encourages income manipulation, which also could encourage more activity by the SEC in this area.
Registration of Public Accounting Firms
Registration of public accounting firms is required only of firms that prepare, issue, or participate in preparing an audit report for an issuer—basically an entity that issues securities on a publicly traded exchange. Consequently, virtually all public accounting firms of significant size must reg- ister, but most small firms do not need to register. Even foreign firms that play a substantial role in the audit of an organization that has securities registered in the United States must register with the PCAOB and follow the rules of the Sarbanes-Oxley Act. This act has a significant impact on the activities of foreign companies that sell their securities on U.S. markets, an impact not neces- sarily appreciated outside the United States. “Under the law, CEOs are required to vouch for financial statements, boards must have audit committees drawn from independent directors, and companies can no longer make loans to corporate directors. All of that conflicts with some other countries’ rules and customs.”15
540 Chapter 12
12Sarbanes-Oxley Act of 2002, Sec. 101(e)(1).
13Ibid., at Sec. 101(e)(2).
14Ibid., at Sec. 103(a)(1).
15Louis Lavelle and Mike McNamee, “Will Overseas Boards Play by American Rules?” BusinessWeek, December 16, 2002, p. 36.
hoy36628_ch12_533-556.qxd 1/25/10 9:53 AM Page 540
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Financial Reporting and the Securities and Exchange Commission 541
The application process for PCAOB registration provides the Oversight Board a significant amount of information about the audit firms. The firms must identify each of their audit clients that qualifies as an issuer and the Oversight Board then assesses an annual fee on the issuer based on the size of its market capitalization. These fees serve, in part, as the financial support for the work of the Oversight Board.16
Other information required of the accounting firms in this application process includes the following:
• A list of all accountants participating in the audit report of any client qualifying as an issuer.
• Annual fees received from each issuer with the amounts separated as to audit and nonaudit services.
• Information about any criminal, civil, or administrative actions pending against the firm or any person associated with the firm.
• Information regarding disagreements between the issuer and the auditing firm during the previous year.
Inspections of Registered Firms
After registration, each audit firm is subject to periodic inspections by the PCAOB. This process is to eliminate the peer reviews that one firm conducted on another. Now any firm that audits more than 100 issuers per year will be inspected annually. All other registered firms will be inspected every three years. The Oversight Board has the power to take disciplinary action as a result of the findings of these inspections. In addition, deficiencies can be made public if the firm does not address them in an appropriate fashion within 12 months.
The PCAOB’s power is not limited just to reacting to the findings of annual inspections.
“The new board has a full range of sanctions at its disposal, including suspension or revoca- tion of registration, censure, and significant fines. It has authority to investigate any act or practice that may violate the act, the new board’s rules, the provisions of the federal securities laws relating to audit reports or applicable professional standards.”17Clearly, Congress pro- vided the new Oversight Board extensive powers to enable it to clean up any problems dis- covered in public accounting.
Auditor Independence
One of the most discussed issues surrounding accounting scandals is the failure of audit firms to act independently in dealing with audit clients. Not surprisingly, a significant por- tion of the Sarbanes-Oxley Act is intended to ensure that public accounting firms are, indeed, independent. Certain services that could previously be provided to an audit client are now forbidden.18These include financial information system design and implementation as well as internal audit outsourcing. The client’s audit committee must preapprove any allowed ser- vices and disclose them in reports to the SEC.
Audit committees have long been considered an important element in maintaining an ap- propriate distance between the external auditors and the management of the client. The com- mittee has been composed of members of the company’s board of directors and served as a liaison with the auditors. However, in actual practice, the work and the composition of the audit committee tended to vary greatly from company to company. The Sarbanes-Oxley Act formalized the liaison role by making the audit committee responsible for the appointment and compensation of the external auditor. To help ensure impartiality, the committee must be made up of individuals who are independent from management. The act directs the auditor to report to the audit committee rather than to company management. To further ensure independence from management, the lead partner of the audit firm must be rotated off the job after five years.19
16Sarbanes-Oxley Act of 2002, Sec. 102(b)(2).
17Miller and Pashkoff, “Relations under the Sarbanes-Oxley Act,” pp. 35 and 36.
18Sarbanes-Oxley Act of 2002, Sec. 201.
19Ibid., at Sec. 203.
hoy36628_ch12_533-556.qxd 1/25/10 9:53 AM Page 541
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
These provisions, as well as the many other elements of the Sarbanes-Oxley Act, have changed public accounting as it was known in the past. Drastic action was needed and was taken.20This act is strengthening the independent audit to help eliminate the dubious practices that have haunted public accounting. Some of these steps may not have been necessary, but the need to reestablish public confidence in the capital market system forced the legislators to avoid any “quick-fix” solutions.
The SEC’s Authority over Generally Accepted Accounting Principles
The primary focus of the Sarbanes-Oxley Act was on the regulation of independent auditing and auditing standards. Therefore, it had little impact on accounting standards and the regis- tration of securities. Those regulations continue to evolve over time. Because financial report- ing standards can be changed merely by amending Regulation S–X,the SEC holds the ultimate legal authority for establishing accounting principles for most publicly held companies in this country. In the past, the SEC has usually restricted the application of this power to disclosure issues while looking to the private sector (with the SEC’s oversight) to formulate accounting principles. For this reason, the FASB rather than the SEC is generally viewed as the main standards-setting body for financial accounting in the United States. “Under federal law, the SEC has the mandate to determine accounting principles for publicly traded companies. But it has generally ceded that authority to private-sector accounting bodies such as the Financial Accounting Standards Board.”21
However, the SEC does retain the ability to exercise its power with regard to the continuing evolution of accounting principles. The chief accountant of the SEC is responsible for provid- ing the commissioners and the commission staff with advice on all current accounting and auditing matters and helps to draft rules for the form and content of financial statement disclosure and other reporting requirements. Because he or she is the principal adviser to the SEC on all accounting and auditing matters,22the most powerful accounting position in the United States is that of Chief Accountant of the SEC. The work of the chief accountant can lead the SEC to pass amendments as needed to alter various aspects of Regulation S–X.
The SEC issued Financial Reporting Releases (FRRs)as needed to supplement Regulation S–Xand Regulation S–K.They explain desired changes in the reporting requirements. By the end of 1998, 50 FRRs had been issued.23By 2004 this number was 72. In addition, the staff of the SEC publishes a series of Staff Accounting Bulletins (SABs)as a means of informing the financial community of its positions.
Staff Accounting Bulletins reflect the SEC staff’s views regarding accounting-related disclosure practices. They represent interpretations and policies followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.24
For example, SAB 101was released to provide guidance in connection with the recognition of revenue. The bulletin first stated that any transaction that fell within the scope of spe- cific authoritative literature (e.g., an FASB statement) should be reported based on that pronouncement. SAB 101 then established guidelines for revenue recognition situations when authoritative standards were not available. In such cases, a reporting entity should recognize
542 Chapter 12
20The Sarbanes-Oxley Act, particularly Section 404 requirements, adds a significant cost to reporting opera- tions for public companies. However, the SEC is attempting to provide “Section 404 relief” from the “multi- million-dollar expenses,” while still ensuring proper disclosure. “Getting it Right,” Journal of Accountancy, March 2007, p. 29.
21Kevin G. Salwen and Robin Goldwyn Blumenthal, “Tackling Accounting, SEC Pushes Changes with Broad Impact,” The Wall Street Journal,September 27, 1990, p. A1.
22www.sec.gov/about/whatwedo.shtml, June 2005.
23From 1937 until 1982, the SEC issued more than 300 Accounting Series Releases (ASRs) to (1) amend Regulation S-X,(2) express interpretations regarding accounting and auditing issues, and (3) report disciplinary actions against public accountants. The SEC codified the ASRs that dealt with financial reporting matters of continuing interest and issued it as Financial Reporting Release No. 1.
24See footnote 2.
LO4
Describe the SEC’s role in establishing generally accepted accounting principles (GAAP).
hoy36628_ch12_533-556.qxd 1/24/10 1:44 AM Page 542
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com
Financial Reporting and the Securities and Exchange Commission 543
revenue when realized (or realizable) and earned. However, SAB 101then went further to establish four criteria for revenue recognition: evidence that an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or can be determined, and collectibility is reasonably assured. To help apply these criteria in actual practice, SAB 101 included nine examples to show how to judge revenue recognition in such cases as the receipt of money in layaway programs and annual membership fees received by discount retailers.
Additional Disclosure Requirements
Historically, the SEC has restricted the use of its authority (as in SAB 101) to the gray areas of accounting for which official guidance is not available. New reporting problems arise each year while no authoritive body has ever completely addressed many other accounting issues, even after years of discussion. As another response to such problems, the SEC often requires the disclosure of additional data if current rules are viewed as insufficient.
It was in the 1970s that the SEC seemed to single out disclosure as the area in which it would take the standard-setting lead, leaving measurement issues to the FASB. This was when the SEC was expanding the coverage of Management’s Discussion & Analysis (MD&A), an extensive narrative disclosure that is required to be appended to the financial statements.25
For example, in the early part of 1997, while the FASB worked on a project concerning the accounting for derivatives, the SEC approved rules so that more information would be avail- able immediately. Footnote disclosure had to include more information about accounting poli- cies used. In addition, information about the risk of loss from market rate or price changes inherent in derivatives and other financial instruments was required. By means of these dis- closures, the SEC enabled investors to have data about the potential consequences of the com- pany’s financial position.
Moratorium on Specific Accounting Practices
The commission also can exert its power by declaring a moratorium on the use of specified ac- counting practices. When authoritative guidance is not present, the SEC can simply prohibit a particular method from being applied. As an example, in the 1980s, companies utilized a va- riety of procedures to account for internal computer software costs because no official pro- nouncement had yet been issued. Consequently, the SEC
imposed a moratorium that will prohibit companies that plan to go public from capitalizing the internal costs of developing computer software for sale or lease or marketed to customers in other ways. . . . The decision doesn’t prevent companies currently capitalizing internal software expenses from continuing, but the companies must disclose the effect of not expensing such costs as incurred. The moratorium continues until the Financial Accounting Standards Board issues a standard on the issue.26
When the FASB eventually arrived at a resolution of this question and issued SFAS 86,“Ac- counting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” the SEC dropped the moratorium. Hence, the FASB set the accounting rule, but the SEC ensured appropriate reporting until that time.
Challenging Individual Statements
As described, officially requiring additional disclosure and prohibiting the application of cer- tain accounting practices are two methods the SEC uses to control the financial reporting process. Forcing a specific registrant to change its filed statements is another, less formal ap- proach that can create the same effect. For example:
Advanced Micro Devices, Inc., agreed to settle an investigation by the Securities and Exchange Commission of the semiconductor company’s public disclosures. The SEC found AMD “made inaccurate and misleading statements” concerning development of its 486 microprocessor. In 1992 and 1993, AMD “led the public to believe that it was independently designing the microcode for
25Stephen A. Zeff, “A Perspective on the U.S. Public/Private-Sector Approach to the Regulation of Financial Reporting,” Accounting Horizons,March 1995, pp. 58–59.
26“SEC Imposes ‘Software Costs’ Moratorium,” Journal of Accountancy,September 1983, p. 3.
hoy36628_ch12_533-556.qxd 1/24/10 1:44 AM Page 543
to download more slides, ebooks, and solution manual visit http://downloadslide.blogspot.com