Are Your Publicly Traded Customers' Financial Statements More
Reliable In Light of New Federal Legislations?
A Review of the Sarbanes-Oxley Act of 2002 and What It Means To The Credit Professional
By Scott Blakeley, Esq and Maryellen K. Sebold,
Headlines of corporate fraud within public companies, from Enron to
Adelphia to WorldCom, has prompted the U.S Congress to overwhelmingly
pass federal legislation providing for accounting reform and requiring
more accurate financial disclosure and reporting from public companies.
This new federal legislation penetrates the area of corporate governance,
which traditionally had been left to the states. President Bush has
stated that corporate officers must be accountable and the integrity
of financial reporting must return.
The Sarbanes-Oxley Act of 2002 (SOA) was signed into law on July 30, 2002,
to combat the wave of accounting and financial reporting scandals and corporate
bankruptcies. SOA focuses on the conduct of corporate officers and public accounting
firms and adequate disclosure in public company financial statements. How will
the law affect credit professionals and their publicly traded customers? Will
the law change the way corporate officers, accountants and lawyers deal with
financial disclosures? Will financial information reported by public companies
become more reliable, thereby reducing credit risk for vendors selling on open
FEDERAL GOVERNMENT OVERVIEW
SOA provides that the Security and Exchange Commission (SEC) enforces
the legislation and has earmarked $766 million for SEC enforcement.
Much of this enforcement comes through SOA's creation of the Public
Company Accounting Oversight Board ("Board"). The SOA grants the Board
supervisory, investigative, disciplinary, and enforcement powers over
public accounting firms. The board will enforce mandatory registration
of firms that prepare audit reports for public companies and establish
auditing, quality control, ethics and independence standards relating
to preparation of audit reports. The Board must also enforce other
standards that it, or the SEC, determines are "necessary and appropriate." The
Board will consist of five members two CPA's and three non-CPA's.
PUBLIC COMPANY'S DUTIES
SOA imposes a number of duties and restrictions on officers and manage
ment of publicly traded companies.
Attempting to Hold Officers Accountable
The CEO and CFO must sign a certification that the company's periodic reports
do not contain untrue statements of a material fact. All financial information
must accurately present the company's financial conditions and results of operations
for the period.
Certifying officers must establish internal controls to ensure that employees
provide material information regarding the company and its subsidiaries. Signing
officers must also acknowledge that they have evaluated the company's internal
financial controls within the 90 days before the filing of the report. The
report must include conclusions of their evaluation. Certification must also
state that the CEO and CFO have reported to the auditors and audit committee
of the company all information regarding significant deficiencies in internal
controls that could adversely affect the company's ability to provide an accurate
The CEO must sign the company's tax returns. An officer or director that knowingly
makes a false certification may be fined up to $5 million and jailed for up
to 20 years.
SOA also prohibits officers and directors from taking any action to fraudulently
SOA prohibits personal loans to officers and directors. A corporate insider
must disclose stock sales of the company within two days. SOA requires that
transactions involving management and principal stockholders must be disclosed
to the public immediately.
Under SOA, if a company is required to make an accounting restatement due to
material noncompliance with any of the reporting requirements, the CEO and
the CFO must reimburse the company for any bonus or other incentive-based or
equitybased compensation during the 12 month period following first public
issuance or filing with the SEC and any profits realized from the sale of securities
of the company during that 12-month period.
Reporting "Material" Information
SOA attempts to address the recent "failure to disclose" raised in
the Enron debacle by requiring public companies to disclose material
off-balance sheet transactions, as well as immediately present material
adjustments to financial statements.
Current Financial Disclosure
A company is required to immediately disclose information about its
financial condition or operations that is necessary or useful to investors.
An Independent Board of Directors
SOA states that each member of the company's audit committee shall
be a member of the board of directors and shall be independent. The
SEC has recently shown its aggressiveness in pursuing officers of corporations
where there is alleged corporate fraud.
Part of the focus of SOA is to eliminate overly close ties a company
may have with its auditors. Enron is an example where its auditor,
Arthur Andersen, had former employees in influential positions within
Enron. With SOA, the company's officers cannot have been employed by
its audit firm and worked on the audit of the company within a year
preceding the audit.
The public company must have an audit committee. The company's auditor
should report to the committee regarding accounting policies to be
used, and the audit committee has the power to hire and fire the auditor.
SOA provides whistle-blower protection to those who assist investigations
being conducted by a federal regulatory or law enforcement agency.
Civil Liability: Securities Fraud Claims Expanded
SOA expands the time to commence private securities fraud claims
from two years from discovery or five years from violation.
White Collar Crime Enhancements
The crime of financial fraud is added and the statute of limitations
to bring such action is five. Mail and wire fraud penalties are increased
to 20 years.
SOA imposes a number of duties and restrictions on the auditors of
publicly traded companies, including federal government oversight through
an accounting board, independence rules and disclosure requirements.
An Auditor's "Questioning Mind"
SOA imposes on the auditor that it reviews its clients' financial
statements with a critical eye and independence. Public auditors must
maintain audit work papers for a minimum of seven years, provide for
a concurring or second-partner review of each audit report, and describe
in each audit report the scope of the auditor's testing of the internal
control structure and procedures of the company.
Partners in charge of conducting a company's audit must be rotated every five
years. Accounting firms may not perform audits for a company if the company's
CEO, controller, chief accounting officer, or any person of such standing was
employed by the accounting firm within one year of the audit.
Splitting the Business OSA prohibits accounting firms from offering "non-audit" services
to companies for whom they perform audits. Nonaudit services include bookkeeping
or other services related to accounting and financial statements, financial
information systems design and implementation, appraisal or valuation services,
fairness opinions or contribution- in-kind reports, actuarial services, internal
audit outsourcing services, management functions or human resources, broker,
dealer, investment adviser or investment banking services, legal services and
expert services unrelated to the audit, and any other services determined by
board to be impermissible.
If a company wishes to employ their public accounting firm to perform non-audit
functions not described above, the audit committee of the company must give
the company advance approval.
Disclosure of Off-Balance Sheet Transactions
Enron's notoriety surfaced with belated disclosure of billions of
dollars in off-balance sheet liabilities. SOA addresses this by requiring
auditors to disclose a company's material off-balance sheet transactions.
Pro Forma Financials
Pro forma financial information shall be presented in a manner that
does not contain an untrue statement of a material fact or omit to
state a material fact necessary to make the financial statements not
misleading and follow generally accepted accounting principals.
An accountant's failure to maintain all work papers for five years
may be punishable by a fine and jail of up to 10 years. An accountant
that willfully impedes a federal investigation or bankruptcy may be
punished by a fine or jail up to 10 years.
Earlier we raised the following questions:
How will the law affect credit professionals and their publicly
traded customers? In our opinion, the OSA attempts to force publicly
traded companies to report their financial information more responsibly,
emphasizing full disclosure.
Will the law change the way corporate officers, accountants and
lawyers deal with financial disclosures? There are significant
penalties for those corporations and their accounting professionals
not to adequately disclose.
Will financial information reported by public companies become
more reliable, thereby reducing credit risk for vendors selling
on open account? We believe that the current environment has brought
to the limelight the abuses of select corporate officers. The focus
is now on curbing abuse and making financial statements more reliable
for the benefit of all those who rely on them.