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Accounting, Auditing and Corporate Governance: Impact of Enron Accounting Scandal and Sarbanes-Oxley Act.

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Presentation on theme: "Accounting, Auditing and Corporate Governance: Impact of Enron Accounting Scandal and Sarbanes-Oxley Act."— Presentation transcript:

1 Accounting, Auditing and Corporate Governance: Impact of Enron Accounting Scandal and Sarbanes-Oxley Act

2 Corporate Governance in the US Before Enron Accounting Scandal Shareholders Board of Directors CEO Audit Committee

3 Pre-Enron Corporate Governance Standards Listed companies must have a minimum three-person audit committee composed solely of independent directors. Existing definition of “independence” precludes any relationship with the company that may interfere with the exercise of director's independence from management and the company. Three year cooling-off period for former employees of the company and business relationships. Requires all audit committee members to be financially literate and at least one must have accounting or related financial-management expertise. Audit committee charter must provide that audit committee and board of directors have “ultimate“ authority to retain and terminate independent auditors Requires shareholder approval of equity compensation plans for directors, but broad-based plans are exempt Requires board of directors to adopt and approve a written charter for audit committee, which must be reviewed annually.

4 New Name Enron Adopted CEO Lay challenges managers to embrace deregulation and shift strategy “Asset Light” strategy is adopted. Enron begins shedding hard assets CalPERS and Enron enter into JEDI-I to invest in energy projects JEDI-II is formed. Enron needs a buyer for CALPERS interest in JEDI-I FERC issues order 636 that requires all gas transmission companies to “open up” their pipelines to unowned gas. Enron enters into gas marketing and begins energy trading CHEWCO formed to buy JEDI interests. Enron employee under CFO Fastow is the partner. Deal is all debt with Enron liable for payments Skilling becomes CEO LJM-1 and 2 formed to transfer unwanted assets and debt off Enron’s balance sheet Dynergy merger fails. Enron debt downgraded to junk status. Enron files for bankruptcy Enron restates books going back to 1997 Sherron Watson warns that Enron could “implode” Skilling resigns Analysts question Enron’s books

5 Anatomy of Enron Accounting Scandal Enron, like many other companies, used special purpose enterprises (SPEs) to access capital or hedge risk By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet Company contributes hard assets and related debt to an SPE in exchange for an interest in the partnership

6 Anatomy of Enron Accounting Scandal SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without debt or assets showing up on the company‘s financial statements Company can also sell leveraged assets and book a profit To avoid classification of SPE as a subsidiary (thereby forcing entity to include SPEs financial position and results of operation in its consolidated financial statements), FASB guidelines require that only 3% of SPE be owned by outside investor.

7 Anatomy of Enron Accounting Scandal Enron took advantage of these guidelines. –Transferred troubled assets that were falling in value to SPEs –Losses on these assets would then be kept off Enron‘s financial statements To compensate partnership investors for downside risk, Enron promised issuance of additional Enron shares As value of transferred assets fell, Enron incurred larger and larger obligations to issue more of its shares

8 Anatomy of Enron Accounting Scandal August 14, 2001 Sherron Watkins, an Enron vice-president, CPA and auditor previously with Arthur Andersen for 8 years, sends letter to Enron Chairman Kenneth Lay outlining many of the misleading accounting treatments used by Enron. In this memo, Watkins describes her reservations about the lack of disclosure of the substance of related party transactions with SPEs run by the CFO of Enron, Andrew Fastow She states: “I realize that we have had a lot of smart people looking at this and a lot of accountants including AA & Co. (Andersen) have blessed the accounting treatment. None of that will protect Enron if these transactions are ever disclosed in the bright light of day.“

9 Anatomy of Enron Accounting Scandal October 16, 2001 Enron Corporation, one of largest corporations in the world, announced the following: reduction in its after-tax net income by $544 million reduction in its shareholders‘ equity by $1.2 billion

10 Anatomy of Enron Accounting Scandal October 22, 2001 Enron announced that SEC was looking into related party transactions between Enron and partnerships owned by its CFO, Andrew Fastow

11 Anatomy of Enron Accounting Scandal November 8, 2001 Enron announced restatement of its financial statements for 1997 thru 2000 to reflect consolidation of SPEs it had omitted as well as to book adjustments recommended by Arthur Andersen for those years, which Enron had previously “deemed immaterial” In addition to recognizing an additional $628 million in liabilities, these restatements reduced previously reported net income as follows: YearReportedRestatedDecline 1997$105$2873% 1998$703$13381% 1999$893$24872% 2000$979$9990%

12 Anatomy of Enron Accounting Scandal December 2, 2001 Enron filed for bankruptcy under Chapter 11 of US Bankruptcy Code With assets of $63.4 billion, largest US corporate bankruptcy in history Texaco, Inc., which went bankrupt in April 1977 with assets of $35.9 billion was next largest

13 Anatomy of Enron Accounting Scandal January 17, 2002 Enron fires Arthur Andersen as its independent auditor Cites document destruction and lack of guidance on accounting policy issues

14 Anatomy of Enron Accounting Scandal Enron bankruptcy of particular interest for following reasons: Transactions involving SPEs and related accounting issues Breakdown in corporate governance in relationship between Board of Directors and Audit Committee Participation of Enron‘s independent auditor, Arthur Andersen, in setting up SPEs Reveals shortcomings of rule-based US GAAP GAAP override

15 Anatomy of Enron Accounting Scandal Accounting Issues Non-consolidation of SPEs that permitted Enron to hide losses and debt from investors Sales of investments to unconsolidated (though actually controlled) SPEs as if they were arms-length transactions Recording as current income, fees for services rendered in future periods Fair-value restatements of investments that were not based on trustworthy numbers Accounting for Enron stock issued to and held by SPEs Disclosure of related party transactions and conflicts of interest, and their costs to stockholders

16 Anatomy of Enron Accounting Scandal Breakdown of Corporate Governance Many of related party transactions were brought to attention of Enron‘s BOD and were discussed in some detail with members of Audit and Compliance Committee SEC requires that exchanges (NYSE, ASE, and NASDAQ) require financial literacy for all audit committee members and financial expertise for at least one member At least 4 of 6 members had financial expertise –Robert Jaedicke, Professor of Accounting at Stanford University –Wendy Graham, PhD in Economics and former Chair of Commodity Futures Trading Commission –Lord John Wakeham, CA and British Secy of State for Energy –Paola Ferraz Pereira, President of State Bank of Rio de Janerio

17 Anatomy of Enron Accounting Scandal Breakdown of Corporate Governance Enron‘s BOD reviewed and approved creation of SPEs and assigned Audit Committee duty to review transactions BOD waived company’s code of ethics for SPE transactions Audit Committee failed to adequately understand, review, and monitor SPEs and Enron‘s accounting and reporting practices

18 Anatomy of Enron Accounting Scandal Independence of External Auditor Arthur Andersen audited and gave unqualified opinions on Enron‘s financial statements since 1985 Enron was AA‘s second largest client –In 2000, AA received $25 million in audit fees and $27 million in non-audit consulting fees from Enron –In 2000, AA had total worldwide revenues of $9 billion AA was not only Enron‘s external auditor, but also its internal auditor and kept staff on permanent assignment at Enron‘s offices Many of Enron‘s internal accountants, CFOs and controllers were former AA executives and employees

19 Anatomy of Enron Accounting Scandal Independence of External Auditor AA was consulted on and participated in setting up SPEs In conjunction with Enron employees, they set up the SPEs to conform to the letter of the US GAAP requirement that outside ownership, presumably independent, must be at least 3% of the SPE assets AA admitted it destroyed thousands of documents and electronic files related to the Enron audits for 1997 thru 2000, in accordance with “firm policy,“ supposedly before SEC issued subpoena for them On October 12, 2001, AA’s lawyers issued an internal memo reminding employees of the firm’s document retention and destruction policies

20 Anatomy of an Accounting Scandal – Enron Corporation Shortcomings of Rule-Based US GAAP SEC has authority to establish GAAP and GAAS in US, review and disapprove as inadequate financial statements of registered companies SEC has delegated that authority to establish GAAP to FASB, a non-governmental agency Many believe that US GAAP, as structured and administered by SEC, the FASB, and the AICPA, are substantially responsible for Enron accounting scandal US model of specifying accounting rules that must be followed appears to have allowed or required AA to accept procedures that were within the letter of rule, even though they violate basic objectives of US GAAP US model allows corporate officers to view accounting requirements of US GAAP as if they were specified in a tax code

21 Example of Rules-Based US GAAP by Lessee - SPAS 13 Lease Agreement Is there transfer of ownership? Yes Is there a bargain purchase option? Yes No Is lease term equal to or greater than 75% of economic life ? Yes No Capital Lease Operating Lease Is present value of payments equal to or more than 90% FMV? Yes No

22 Anatomy of an Accounting Scandal – Enron Corporation Shortcomings of Rule-Based US GAAP Fair-value requirement of financial instruments adopted by FASB permitted Enron to increase its reported assets and net income and, thereby, hide losses AA appears to have accepted these valuations because Enron was following specific US GAAP rules

23 GAAP Override Are auditors in US allowed to override US GAAP? Auditors in other countries allowed to override GAAP Inability of auditors in US to override US GAAP may have been contributing factor in Enron accounting scandal Many believe that principles-based IAS GAAP that requires “true and fair view” of an enterprises’ financial condition is preferable to highly specified rule-based US GAAP

24 US Audit Opinion In our opinion, the financial statements of XYZ Company present fairly the financial position and results of operations for the years ended December 31, 20X1 and 20X2 in accordance with generally accepted accounting principles applied on a basis consistent with the preceding year.

25 True and Fair View Opinion In our opinion, the financial statements of XYZ Company present a true and fair view of the financial position and results of operations for the years ended December 31, 20X1 and 20X2.

26 Other Accounting Scandals WorldCom Global Crossings Tyco International Adelphia Critical Path Imclone Systems Vivendi

27 Other Accounting Scandals

28 Aftermath of Enron Accounting Scandal Sarbanes-Oxley Act of 2002 New NYSE Corporate Governance Listing Standards New Corporate Governance Rules adopted by SEC New Rules and Auditing Standards adopted or proposed by Public Company Accounting Oversight Board

29 “Last year’s Sarbanes-Oxley Act brought the most sweeping changes in corporate governance and financial disclosure for 70 years” (Financial Times, December 1, 2003) “Sarbanes-Oxley will be judged as landmark legislation. It is one of the most sweeping reforms since the 1933 Securities Reform Legislation.” (Beth Brooke, Global Vice Chair, Ernst and Young, September 15, 2003) Importance of Sarbanes-Oxley Act of 2002

30 Audit Committee Hot Seat

31 Signed into law on July 30, 2002 Applies to publicly held US companies and foreign private issuers and their audit firms Establishes Public Company Accounting Oversight Board (PCAOB) to regulate accounting professionals who audit financial statements of public companies Provides for significant corporate governance reforms regarding –audit committees and their relationship with their auditors –financial reporting and auditing process Sarbanes-Oxley Act of 2002

32 Sarbanes-Oxley Act of 2002 Listing of Titles and Sections

33 Public Company Accounting Oversight Board Section 101 Not a government agency Private sector regulatory agency subject to direct and substantial SEC oversight –previously under Public Oversight Board of AICPA Consists of five full-time members who will –Oversee and investigate audits and auditors of public companies –Sanction both firms and individuals for violations of laws, regulations, and rules

34 Public Company Accounting Oversight Board Section 101 Board Composition Two of five board members must be or have been CPAs Remaining three must not be and cannot have been CPAs Chair of Board may be held by one of the CPAs, but he/she must not have practiced accounting during five years preceding his/her appointment

35 Public Company Accounting Oversight Board Sections 102 and 109 Registration with Board Accounting firms that audit public companies must register with PCAOB and pay registration and annual fees Funding of Board PCAOB will be funded by public companies through these mandatory fees

36 Public Company Accounting Oversight Board Section 103 Auditing Standard Setting Board will have responsibility for establishing following standards necessary to protect the public interest: –Auditing and related attestation –Quality control –Ethics –Independence Function previously performed by Auditing Standards Board (ASB) of AICPA that establishes GAAS Board required to cooperate with designated professional groups of accountants in standard setting (eg, AICPA) Board, however, has authority to amend, modify, repeal or reject any standard suggested by professional groups Thus, board may, but is not required to, continue to allow ASB to establish these standards

37 Public Company Accounting Oversight Board Sections 104 and 105 Inspection Authority Empowered PCAOB to regularly inspect registered accounting firm‘s operations Investigative and Disciplinary Authority Empowered PCAOB to investigate potential violations of: –Securities laws –Standards –Competency and conduct

38 Public Company Accounting Oversight Board Section 106 International Authority Foreign accounting firms that prepare or furnish an audit report involving US registrants will be subject to authority of PCAOB If registered US accounting firm relies on opinion of foreign accounting firm, foreign firm‘s audit work papers must be supplied upon request to PCAOB or SEC

39 Public Company Accounting Oversight Board Section 108 Accounting Standard Setting establishes criteria that must be met in order for work product of an accounting standard-setting body to be recognized as “generally accepted” may recognize as "generally accepted" any accounting principles established by a standard setting body that: –is organized as a private entity; –has, for administrative and operational purposes, a board of trustees serving in the public interest, the majority of whom are not, concurrent with their service on such board, and have not been during the two-year period preceding such service, associated persons of any registered public accounting firm; –is funded as provided in Section 109 of the Sarbanes-Oxley Act; –has adopted procedures to ensure prompt consideration, by majority vote of its members, of changes to accounting principles necessary to reflect emerging accounting issues and changing business practices; and –considers, in adopting accounting principles, the need to keep standards current in order to reflect changes in the business environment, the extent to which international convergence on high quality accounting standards is necessary or appropriate in the public interest and for the protection of investors.

40 Public Company Accounting Oversight Board Section 108 Accounting Standard Setting SEC must conduct a study on the adoption by the United States financial reporting system of a principles-based accounting system Commission must submit results of this study to Congress by July 30, 2003 Study shall include: –the extent to which principles-based accounting and financial reporting exists in the United States –length of time required for change from a rules-based to a principles-based financial reporting system –feasibility of and proposed methods by which a principles-based system may be implemented

41 Sarbanes-Oxley Act of 2002 Listing of Titles and Sections

42 Auditor Independence Section 201 New Roles for Audit Committees and Auditors New law prohibits independent auditors from offering certain non-audit services to audit clients Prohibited services include: –Bookkeeping –Financial information systems design and implementation –Appraisals or valuation services –Actuarial services –Internal audit outsourcing services –Management and human resources services –Broker/dealer and investment banking services –Legal services –Expert services unrelated to audit services Other non-audit services not banned are allowed if pre-approved by audit committee

43 Auditor Independence Section 202 New Roles for Audit Committees and Auditors Audit committee must pre-approve all services (both audit and non-audit not specifically prohibited) provided by its independent auditors Requires disclosure, in annual report, of fees paid to independent accountants for: ­Audit services ­Audit-related services ­Tax services ­Other services

44 Auditor Independence Section 203 New Roles for Audit Committees and Auditors Second partner review and approval of audit reports Lead audit partner and audit review partner must be rotated every five years on public company engagements An accountant is not independent if, at any point during audit and professional engagement period, any audit partner earns or receives compensation based on that partner procuring engagements with audit client to provide any services other than audit, review or attest services firms with fewer than five audit clients and fewer than ten partners may be exempt from partner rotation and compensation provisions, provided each engagement is subject to special review by PCAOB at least every three years

45 Auditor Independence Sections 204 New Roles for Audit Committees and Auditors Independent auditors report to company‘s audit committee, not management Independent auditor must report new information to audit committee including : –Critical accounting policies and practices to be used –Alternative treatments of financial information with GAAP that have been discussed with management –Accounting disagreements between auditor and management –Other relevant communications between auditor and management

46 Auditor Independence Section 206 New Roles for Audit Committees and Auditors Accounting firm will not be able to provide audit services to public company if one of that company‘s top officials (CEO, Controller, CFO, Chief Accounting Officer, etc) was –employed by firm and –worked on company‘s audit during previous year

47 Sarbanes-Oxley Act of 2002 Listing of Titles and Sections

48 Corporate Responsibility Section 301 Financial Reporting and Auditing Process Self-Regulatory Organizations (SROs) (NYSE and NASDAQ) must adopt listing standards for audit committees SROs must prohibit listing of any security whose issuer does not have audit committee comprised entirely of independent directors: –For a director to be deemed "independent," the board must affirmatively determine the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company) –Former employees of company or auditors of company – and their family members – may not be considered independent until five years after their employment ends.

49 Corporate Responsibility Section 301 Financial Reporting and Auditing Process Audit committee members are prohibited from receiving any compensation other than directors’ compensation fees Chair of audit committee to have accounting or related financial-management expertise. Audit committee must have sole authority to hire and fire independent auditor and approve any non-audit relationship with independent auditor Audit committee must establish procedures for receipt, retention and treatment of complaints regarding accounting, internal controls or auditing matters Issuer must provide appropriate funding for audit committee

50 Corporate Responsibility Section 301 Financial Reporting and Auditing Process several provisions included to address special circumstances of particular foreign issuers –allow non-management employees to serve as audit committee members consistent with “co- determination” and similar requirements in some countries –allow foreign government shareholder representation on audit committees

51 Corporate Responsibility Section 302 Financial Reporting and Auditing Process CEO and CFO of each issuer shall prepare statement to accompany the audit report to certify "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer.".

52 Corporate Responsibility Section 303 Financial Reporting and Auditing Process Prohibits officers and directors of an issuer or their representatives from taking actions to coerce, manipulate, or fraudulently influence the independent auditor of the financial statements if that person knew or should have known that such action, if successful, could result in rendering the financial statements materially misleading

53 Corporate Responsibility Sections 304 and 306 Financial Reporting and Auditing Process Management must return bonuses or profits from stock sales received within 12 months of a restatement of financial results caused by non-compliance with financial reporting requirements as a result of misconduct Company officers prohibited from trading shares during pension blackout periods

54 Sarbanes-Oxley Act of 2002 Listing of Titles and Sections

55 Enhanced Financial Disclosure Sections 401, 402 and 403 Requires registrant to: ­provide explanation of its off-balance sheet arrangements in separately captioned section of MD&A section ­Provide an overview of certain known contractual obligations in tabular format Prohibits companies from making loans to insiders Requires electronic filing of disclosures of insider transactions in company stock

56 Enhanced Financial Disclosure Section 404 Annual report must contain a report from management on internal controls that –States management’s responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting –Contains an assessment of the effectiveness of internal control related to financial reporting External auditor must attest to manage- ment’s assertion concerning its assessment of internal control as part of audit ­Audit report must contain opinion on assessment made by management of company‘s internal controls structures

57 Enhanced Financial Disclosure Section 404 CEO and CFO Certifications of Disclosure Controls Term is broader than internal controls over financial reporting Term includes internal controls over financial reporting but also includes controls and procedures such as those to ensure: –Timely collection and evaluation of information subject to disclosure requirements under Regulations S-X, S-K or S-B –Timely collection and evaluation of all information relevant to an assessment of the need to disclose developments and risks that pertain to the entity’s business Limited number of companies have strong disclosure controls

58 Enhanced Financial Disclosure Sections 406 and 407 Requires companies to disclose whether they have a code of ethics for CEO, CFO, and senior accounting personnel Any amendments or waivers of code of ethics for directors or executives must be disclosed Requires company to disclose: –Whether it has at least one “financial expert” serving on its audit committee –The name of the expert and whether the expert is independent of management

59 Sarbanes-Oxley Act of 2002 Listing of Titles and Sections

60 Corporate and Criminal Fraud Accountability White Collar Crime Penalty Criminal Penalties Failure to maintain work papers –SEC will establish rule covering retention of audit records –Board will issue standards that compel auditors to keep other documentation for seven years Document destruction –Felony to destroy documents in federal or bankruptcy investigation –Up to 20 years in prison Securities fraud –Penalties increased to 25 years in prison Fraud discovery –Statutes of limitations extended to two years from date of discovery and five years after act –Previously one year and three years

61 Sarbanes-Oxley Act Ramifications of Provisions of Act Consulting services –Other non-audit services, including tax services, require pre- approval by audit committee Implications for CPAs with tax practices –Expert services not defined in Act –Possible that tax services viewed as “expert“ services and not permitted by any firm providing audit services for publicly held audit client Cascading effect –Concern is that new legislation by US Congress may become template for parallel federal and state legislation or rules changes that directly affect both non-public companies that are subject to other regulations and the CPAs that provide services to them Additional burdens for CPAs in business and industry –CEOs and CFOs now required to certify company financial statements –Have greater duty to communicate and coordinate with corporate audit committees who now hire, compensate and oversee independent auditors

62 Aftermath of Enron Accounting Scandal New NYSE Corporate Governance Listing Standards On February 13, 2002, Chairman of SEC asked NYSE to review its corporate governance listing standards BOD of NYSE appointed Corporate Accountability and Listing Standards Committee to review current listing standards and make recommendations On June 6, 2002, Committee presented NYSE BOD with report recommending significant changes in how NYSE-listed companies are governed On August 1, 2002, NYSE approved Committee‘s recommendations On August 16, 2002, NYSE sent recommendations to SEC for approval On November 4, 2003, SEC approved new rules

63 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule Independent directors must comprise a majority of board of directors. No existing requirement. Listed companies must have audit, compensation and nominating/corporate governance committees, each composed entirely of independent directors. Listed companies must have a minimum three-person audit committee composed solely of independent directors. No existing rules requiring compensation and nominating committees Non-management directors must meet without management in regular executive sessions. No existing requirement.

64 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule For a director to be deemed "independent," the board must affirmatively determine the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Existing definition precludes any relationship with the company that may interfere with the exercise of director's independence from management and the company. Prohibit audit committee members from receiving compensation other than directors’ compensation fees No existing restrictions

65 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule Former employees of company or auditors of company – and their family members – may not be considered independent until five years after their employment ends. Three year cooling-off period for former employees of the company and business relationships. Every listed company must have an internal audit function No existing requirement. Require chair of audit committee to have accounting or related financial-management expertise. Requires all audit committee members to be financially literate and at least one must have accounting or related financial- management expertise.

66 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule Grant audit committee sole authority to hire and fire independent auditor and approve any non-audit relationship with independent auditor Audit committee charter must provide that audit committee and board of directors have “ultimate“ authority to retain and terminate independent auditors Require shareholder approval of all equity compensation plans. Requires shareholder approval of equity compensation plans for directors, but broad-based plans are exempt

67 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule Require companies to adopt and disclose corporate governance guidelines, codes of business conduct, and charters for their audit, compensation and nominations committees. Requires board of directors to adopt and approve a written charter for audit committee, which must be reviewed annually. No existing rules requiring compensation and nominating committees, corporate governance guidelines, or codes of business conduct. Any waivers of codes of business conduct for directors or executives must be disclosed. No existing requirement. Require foreign private issuers to disclose any significant ways in which their corporate governance practices differ from NYSE rules. No existing requirement.

68 Selected Final Recommendations of NYSE Corporate Accountability and Listing Standards Committee Comparison with Current Rules Final RecommendationCurrent Rule Each listed-company's CEO and CFO must certify annual financial statements No existing requirement. Each listed-company's CEO must certify annually that he/she is not aware of any violation by the company of NYSE corporate governance standards. No existing requirement. NYSE may issue a public reprimand letter for violation of a corporate governance standard, in addition to the existing penalty of delisting. No current provision for a public reprimand. The NYSE urges every listed company to establish orientation program for new board members. No such recommendation has been made previously.

69 Summary of SEC Actions and SEC Related Provisions Pursuant to the Sarbanes-Oxley Act of 2002 Restoring Confidence in the Accounting Profession The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB) Section 108(b) - On April 25, 2003, recognized the Financial Accounting Standards Board as the accounting standard setter Section 108(d) - On July 25, 2003, issued a study on principles- based accounting Section The Act established an independent funding source for the FASB Title II (Sections 201, 202, etc.) - On January 22, 2003, adopted rules improving the independence of outside auditors Section On April 24, 2003, adopted rules forbidding the improper influence on outside auditors Section On January 22, 2003, adopted rules governing the retention of audit records by outside auditors

70 Summary of SEC Actions and SEC Related Provisions Pursuant to the Sarbanes-Oxley Act of 2002 Improving the "Tone at the Top" Section On August 27, 2002, adopted rules requiring CEOs and CFOs to certify financial and other information in their companies' quarterly and annual reports. Section 304 – Adopted rule requiring management to return bonuses or profits from stock sales received within 12 months of a restatement resulting from material non-compliance with financial reporting requirements as a result of misconduct. Section On January 15, 2003, adopted rules prohibiting company officers from trading during pension fund blackout periods. Section 402 – Adopted rules prohibiting companies from making loans to insiders. Section On August 27, 2002, adopted rules that accelerated deadlines and mandated electronic filing of disclosures of insider transactions in company stock. Section On January 15, 2003, adopted rules requiring companies to disclose whether they have a code of ethics for their CEO, CFO and senior accounting personnel

71 Summary of SEC Actions and SEC Related Provisions Pursuant to the Sarbanes-Oxley Act of 2002 Improving Disclosure and Financial Reporting Section 401(a) - On January 22, 2003, adopted rules requiring disclosure of all material off-balance sheet transactions. Section 401(b) - On January 15, 2003, adopted Regulation G, governing the use of non-GAAP financial measures, including disclosure and reconciliation requirements. Section On May 27, 2003, adopted rules requiring an annual management report on and auditor attestation of a company's internal controls over financial reporting.

72 Summary of SEC Actions and SEC Related Provisions Pursuant to the Sarbanes-Oxley Act of 2002 Improving the Performance of "Gatekeepers " Section On April 1, 2003, adopted rules directing the SROs to adopt listing standards for audit committees. On November 4, 2003, approved new rules proposed and adopted by NYSE and NASDAQ requiring strengthening of corporate governance statndards for listed companies Section On January 15, 2003, adopted rules requiring the disclosure about financial experts on audit committees. Section On January 23, 2003, adopted rules governing standards of conduct for attorneys appearing and practicing before the Commission. Section On July 29, 2003, approved new SRO rules governing research analyst conflicts of interest.

73 SEC Study on Principles-Based Accounting In enacting the Sarbanes-Oxley Act, Congress recognized that accounting standards that contain too many exceptions, interpretations and bright-line percentage tests might have contributed to efforts by managements and accountants to structure transactions that provide a desired accounting result and yet allow the company to avoid clear disclosure of the economic consequences of those transactions in its financial statements. On July 25, 2003, SEC staff released its study. Study found that standards reflecting only a stated principle of accounting ("principle-only standards") would present enforcement difficulties because they would provide little guidance or structure for exercising professional judgment in applying that principle.

74 SEC Study on Principles-Based Accounting also found that accounting standards that are too detailed ("rules-based standards") often provide a vehicle for circumventing the intention of the standard. Study indicates that best approach would be to develop accounting standards that: -Are based on a conceptual framework; -Clearly state the accounting objective of the standard; -Provide sufficient detail and structure so the standard may be applied on a consistent basis; -Minimize exceptions from the standard; and -Avoid the use of percentage tests that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard. study's recommendation is consistent with the approach currently being developed by the Financial Accounting Standards Board

75 SEC Study on Principles-Based Accounting Study acknowledges that FASB has begun shift to objectives-oriented standard setting and is doing so on a prospective, project-by-project basis. study expects that the FASB will continue to move towards objectives-oriented standard setting on a transitional or evolutionary basis. According to study, operationalizing objectives- oriented approach to standard setting in U.S. requires that the following key steps be taken over time: -Ensure newly-developed standards articulate accounting objectives and avoid scope exceptions, bright-lines and excessive detail; -Address deficiencies and inconsistencies in the conceptual framework; -Ensure new standards aligned with improved conceptual framework; -Address current standards that are more rules-based; -Redefine the GAAP hierarchy; and -Continue efforts on convergence of U.S., foreign, and international accounting standards.

76 New Rules Adopted by PCAOB On April 18, 2003, announced process PCAOB will use to establish auditing and other professional standards for registered public accounting firms Pursuant to Section 103 of Sarbanes-Oxley, new Professional Auditing Standards will be established by PCAOB PCAOB decided not to exercise its authority under Section 103 to designate or recognize any professional group of accountants to propose auditing and other professional standards PCAOB would have its own standard setting process for auditing and other professional standards Rule 3700 would govern formation, composition and role of advisory group in standard setting process

77 New Rules Adopted by PCAOB On April 18, 2003, established Interim Professional Auditing Standards (IPAS) concerning: Auditing (Rule 3200T) Attestation (Rule 3300T) Quality control (Rule 3400T) Ethics (Rule 3500T) Independence (Rule 3600T) PCAOB determined that generally accepted auditing standards (GAAS) proposed by AICPA and Auditing Standards Board (ASB) should be adopted as Interim Auditing Standards These GAAS will continue to have same authority they currently have unless and until they are superceded by standards promulgated by PCAOB

78 New Rules Adopted by PCAOB Interim standards adopted on an initial, transitional basis in order to ensure continuity and certainty in standards that govern audits of public companies Interim standards will remain in effect while PCAOB conducts review of standards applicable to registered public accounting firms Objective of review will be to determine, on a standard by standard basis, whether the IPAS should become permanent Professional Auditing Standards, repealed, or modified As review of each IPAS is completed, PCAOB will adopt that standard, with or without modification, repeal the standard, or take any other appropriate action regarding that standard

79 New Rules Adopted by PCAOB On April 18, 2003, adopted rules, subject to approval by SEC, establishing accounting support fee required by Sarbanes-Oxley Act On May 6, 2003, adopted, subject to approval by SEC, a registration system for public accounting firms On June 30, 2003, adopted, subject to approval by SEC, an Ethics Code for PCAOB On June 30, 2003, adopted rule, subject to approval by SEC, that requires all registered public accounting firms to adhere to PCAOB’s auditing and related professional practice standards in connection with preparation or issuance of any audit report for an issuer and in their auditing and related attestation practices

80 New Rules Adopted by PCAOB On September 29, 2003, adopted rules, subject to approval by SEC, on investigations of registered public accounting firms On September 29, 2003, adopted rules, subject to approval by SEC, on process by which registered public accounting firm can seek to withdraw from registration On October 7, 2003, adopted rules, subject to SEC approval, relating to inspections of registered public accounting firms

81 New Rules Proposed by PCAOB On October 7, 2003, proposed new rule regarding the terminology PCAOB will use in its Auditing and Related Professional Practice Standards to describe the obligations those standards impose on registered public accounting firms On December 4, 2003, scheduled an open meeting to consider whether to propose and seek comment on rules related to inspections and investigations of non-U.S. public accounting that register with the PCAOB

82 New Auditing Standards Proposed by PCAOB On October 7, 2003, proposed new auditing standard entitled “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements” Addresses both: work that is required to audit internal control over financial reporting and the relationship of audit to the audit of the financial statements

83 New Auditing Standards Proposed by PCAOB On November 12, 2003, proposed two new auditing standards: First proposed standard would establish general requirements for documentation the auditor should prepare and retain in connection with any public company audit. Second proposed standard would require registered public accounting firms to explicitly state in each public company audit report that the audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board

84 Contact Information Professor J. Timothy Sale University of Cincinnati


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