The Influence of the Sarbanes-Oxley Act on the Auditing Profession

This year has marked seventeen years of passing Sarbanes-Oxley (SOX) Act of 2002, this act was passed due to the fact that investors had lost their confidence on stock markets; in the late 90s, there were a lot of fraudulent financial statements were presented and investors were relied on them to make their decisions in stock market. Now, seventeen years have been passed, have the act win back the investors’ confidence? Besides, did the corporation had a better governance structure? What else had influenced by the Act? To answer all these questions, we will have to start with the background of auditing, what events have lead to passing this Act and what has changed after this Act.

Auditing usually refers to a financial audit, which is an objective to examine the corporations’ financial statements to ensure the financial records are accurate presented (Tuovila, 2019). The auditing concept was started during the Industrial Revolution. Firms were aware of fraud detection, financial accountability, and how the investors relied on the financial report on those corporations that participate in the stock market. However, auditing was not becoming an obligation process until after the stock market crash in 1929 (Byrnes, et al., 2012). In the early 30s, The Securities and Exchange Act of 1934 has passed, which had also created Securities and Exchange Commission (SEC). This act provided SEC authority to publish accounting standards and oversees auditors' function. Under this act, publicly-held companies must submit various reports to the SEC in a timely fashion. In order to assist the SEC in ensuring the reports are complying Generally Accepted Accounting Principles (GAAP), public accounting firms were required to assure the reports (Byrnes, et al., 2012).

In the early 90s, the failure of corporate governance had reflected in the changes of the incentives of the managers. In 1997, there were 116 firms had to restate their earnings; in 2001, the number was increased to 270. In addition, it is also the time where the auditing firms became “client-focused”, by selling the clients the non-audit services, which had created a conflict of interest in the auditing firm. The non-audit services provide the service that towards more on the clients’ interest instead of financial statements users’ in-between, which should be the primary responsibility of an auditor and the auditing firm (Staff, 2003). It is not surprising that cases like Enron and WorldCom that were later discovered having misstatements of their financial statements.

Enron was formed in 1985 by the merge of Houston of Natural Gas and InterNorth, was a successful natural gas company back in the late 1980s and early 1990s. In the year of 1992, Enron became the largest merchant in North America (Healy & Palepu, 2003). To maintain this image and keep the growth of Enron, Jeff Skilling, the chairman of Enron, proposed the idea of “Gas Bank,” which is the mark-to-market accounting. This type of accounting allowed Enron to book the revenue immediately after a long-term contract was signed. The problem with this type of accounting, Enron needed to estimate the future market value (Mintz & Morris, 2017). Furthermore, this type of accounting “hadn’t persuaded gas producers to sell Enron their reserves” because Enron did not have the cash on hand (Mintz & Morris, 2017). Andy Fastow, the CFO of Enron, began to create special-purpose entities (SPEs) to solve the reserve problem. By creating the SPEs allowed Enron to get the fund to the gas producers for a portion of their gas reserves. In return, the SPEs would receive revenues from the sale of reserves. In order to keep the SPEs nonconsolidated with Enron’s book, as FASB required, only 3% of those SPEs owned by the outside investor(s).

By the year of 2001, Enron had created and used over hundreds of SPEs due to the pressure of maintaining the expectation of shareholders on the earnings. These SPEs creation were not only designed to fund the purchase of gas reserves, but they were also created for hiding the debt that Enron had, which helped to inflate its revenue and to understate its debts. Furthermore, Enron also used those SPEs to “get rid of” assets that were decreasing the value by transferring those assets to the SPEs (Thomas, 2002). However, creating all these SPEs did not help Enron in the long-run, especially the purpose of them was for hiding the debt that Enron had and getting rid of decreased value assets. In November of 2001, Enron tried to avoid filing bankruptcy by agreeing on the acquisition from Dynergy, a smaller competitor of Enron (Healy & Palepu, 2003) Furthermore, Enron admitted that it had overstated its earnings by $586 million since 1997 (Mintz & Morris, 2017). In late November of 2001, Enron’s public debt became junk bonds, and Dynergy withdrew on acquiring Enron. Enron filed bankruptcy in December the same year, became the largest bankruptcy in history at that time (Albrecht, Albrecht, Albrecht, & Zimbelman, 2019). In January of 2002, the Department of Justice confirmed that Enron is under investigation. In 2006, Jeff Skilling was sentenced to a 24-year term in jail time, which reduced to 14 years in 2013 (Morris, 2018).

Not too long after Enron’s scandal, WorldCom’s scandal arose, and it was worse than Enron’s, it also became one of the biggest bankruptcies in America history. WorldCom was the second largest telecommunication company that later changed its name to MCI, Inc. During the time of Bernie Ebbers being CEO, WorldCom’s net income was growing even at the peak of the dotcom bubble. However, it had restated its net profit for about $3.8 billion total for the net income of 2001 and the first quarter of 2002. What happened was that WorldCom wanted to maintain the public expectation; they created “cookie jar reserves” to avoid any negative financial results. Cookie jar reserve is a “special account” that the company set up during their profitable period, and when the financial result is not meeting the expectation, the company will transfer the reserve to create a positive and acceptable outcome, which does not confront the General Accepted Accounting Principle (GAAP).

As a result of the WorldCom scandal, Bernard Ebbers and former CFO Scott Sullivan sentenced to prison ad jail time. It also filed Chapter 11 protection (which allowed the corporation continue to operate freely while they are still on debt that the corporation cannot pay) in July 2002, a month after its accounting firm Arthur Andersen convicted on shredding documents that contained evidence for the case of Enron. Arthur Andersen had audited and reviewed both of the overstated financial statements (Kenton, 2019), and did not want to fall to the similarity of Enron's, it “wasted no time in distancing itself from WorldCom” (Hancock, 2002), in the same time, WorldCom already hired new auditing firm which was KPMG LLP and had asked KPM LLP to conduct a comprehensive audit with those overstated financial statements. (Hancock, 2002). WorldCom was able to survive from this scandal from debtor-in-possession financing from several banks and was able to settle lawsuits with the creditors, including the shareholders. However, there were lots of workers who lost their job through this scandal (Kenton, 2019).

Enron and WorldCom were just two of the hundred cases that triggered the Sarbanes-Oxley Acts to be signed; there were more cases discovered during the same period, such as Tyco, Global Crossing, etc. The similarity of all the financial statements frauds that found during the time was that the top management was under the pressure of meeting the expectation on earnings and became “creative” on the books, just like Enron and WorldCom. The difference in how these two cases are how they are discovered. In Enron’s case, the earnings dramatically dropped that triggered the SEC to do investigation; but in WorldCom, it was discovered by a tip provided by Cynthia Cooper, an internal audit committee of WorldCom. Why are the auditors from Arthur Andersen did not discover the financial fraud that Enron was committing? According to Los Angeles Times, the fee that Enron had paid Arthur Andersen for auditing its book was more than other energy companies would pay for getting their books audited, which could trigger the independence between the firm and the client (Hirsch, 2002).

SOX Act was signed in 2002 by president George W Bush after these corporation financial scandals that had affected the stock market. It was amended from the 1934 act that had created higher penalties, increased corporation regulation, and required better transparency. All of the public-held corporations and the accounting firm needed to comply with this act. SOX Act created PCAOB (Public Company Accounting Oversight Board) to oversee and inspect the audit that is done for publicly held companies. According to congress.gov, there are eleven titles in this act (H.R.3763 - Sarbanes-Oxley Act of 2002, 2001-2002). However, the most important within these eleven titles are Section 302, 401, 404, 409, 802, 806, and 906.

Sarbanes-Oxley Act Section 302 is listed under Title three of the act, and it pertains to Corporate Responsibility for Financial Reports. This section requires the signing officers have reviewed the financial report, and they have to ensure that the reports do not contain any material misstatement that could mislead financial statement users and fairly presented the financial situations. The signing officers are also responsible for the internal controls and need to evaluate them within the previous ninety days and report on the findings and the deficiencies. If there is any fraud that involves employees who are involved in the internal activities, it needed to be reported as well.

Section 401, 404, and 409 are both listed under Title Four of the act. Section 401 pertains to Disclosures in Periodic Reports. Under Section 401, the financial statements are required to be accurately reported and not contain any incorrect statements. The financial statements are required to include all the materials and obligations that were kept off the balance sheet. Section 404 pertains to the Management Assessment of Internal Controls. Under Section 404, issuers are required to publish information regarding the company’s internal control structures and procedures for financial reporting in the annual report, as well as the effectiveness of it. There were a couple of add-ons released in 2011. Section 404(b), which became part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), required the auditors of publicly-held companies to attest and report on the management’s assessment of the internal control. Under Section 989G(a) of Dodd-Frank, it amended SOX by adding section 404(c) (Levy, 2016), which provided “that Section 404(b) does not apply for an issuer that is neither an accelerated filer nor a large accelerated filer. This group of issuers is commonly referred to as ‘non-accelerated’ filers.” (Kral, 2018) Section 409 pertains to Real-Time Issuer Disclosure, which required the issuers to disclose any information on any material changes in financial conditions or operations to the public. The disclosure must be easy to understand and support by graphics if necessary.

Section 802 and 806 are listed in Title Eight of SOX; it pertains to Criminal Penalties for Altering Documents. Under this section, if one altering, destroying, mutilating, concealing, falsifying records, documents, or any objects with the intention of a legal investigation, the penalties would be fines and maybe up to 20 years of imprisonment. In addition, if any of accountant knows with one’s action and willful to violates the requirements of maintenance of all audit for a five-year period will be fined and maybe imprisonment up to 10 years. Section 806 is about the protection of whistleblowers who provided information that he or she believes the publicly-held corporation or its subsidiary had violated the regulation of the SEC or involving any frauds that could mislead the shareholders. This section also “authorizes the U.S. Department of Labor to protect whistleblower complaints against employers who retaliate and further authorizes the Department of Justice to charge those responsible for the retaliation.” (SOX Section 906: Corporate Responsibility for Financial Reports, 2019) Section 906 is listed under Title Nine of SOX “White-Collar Crime Penalty Enhancements”; it required the senior corporate officers to certify in writing that the financial statements and disclosure of the annual reports are fairly presented and fully complied with SEC requirement. If the senior corporate officers certify the financial reports knowing that it is not complying with the SEC requirement, the senior corporate officers will be fined no more than $5 million, or imprisonment of 20 years, or both (SOX Section 906: Corporate Responsibility for Financial Reports, 2019).

Prior to the time the SOX Act was passed, the investors had lost their faith in publicly-held corporations as the corporate governance had been seen failing in the 90s. According to Forbes, a survey that was conducted by Financial Executives Research Foundation in 2005 found that 83% of large-company CFOs had agreed that this act had increased investors’ confidence (Hanna, 2014). Besides, the number of corporations that registered in the SEC needed to restate their financial statement has been dropped a couple of years after SOX completely complied in the industry. According to Journal of Accountancy, a research that was conducted by professor Susan Scholz from University of Kansas, there were 1600 restatements in 2005, and 1784 in 2006, however, the number fell steadily over the next three year which was 711, 817, 810, 738 in-between years of 2009 to 2012 respectively (Tysiac, 2014).

In conclusion, the SOX Act of 2002 has changed accounting professions in certain ways. It improved both corporate governance and auditing firms that not only focus on their interests and have made the senior managements take their responsibility when they sign fraudulent financial statements and annual reports knowing that there are misstatements to boost the corporations’ earnings. This act also ensures that the victims who were affected by the misled information for their decisions get the amount they lose from the corporations. As mentioned above, Section 404 of SOX is related to a corporation’s internal control. Under this section, the auditor had to attest to the corporations’ internal control, which had increased the cost of corporations; however, in the long run, the act was benefit for the users of financial statements. The most important of this act is that it had increased the investors’ confidence in publicly-held corporation financial statements.

References

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