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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, CPA, CIRA

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 account?


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.


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 report.

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 influence auditors.

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.

Avoiding Conflicts

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.

Audit Committee

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.

Whistleblower Protection

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.

Criminal Penalties

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 who choose 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.

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