Sarbanes-Oxley: Its effect on the accounting profession Signed into law on July 30, 2002 Response to highly publicized corporate scandals Provisions affect corporate governance, accounting, and auditing Purpose is to restore investor confidence

2002—the year of the Corporate Scandal Enron – Material misstatements due to fraud: off-balance sheet financing, abuse of fair value accounting rules – Outcome: $3 billion in required restatements. Largest bankruptcy in history. Auditor Arthur Andersen convicted (later overturned) of obstruction of justice. Big 5  Big 4 – Key Players: Ken Lay, Jeff Skilling, Andrew Fastow, David B. Duncan – Whistleblower: Sherron Watkins WorldCom – Material misstatements due to fraud: capitalization of expenses, improper use of reserves – Outcome: First 4 billion then 11 billion in restatements. WorldCom bought out by Verizon – Key Players: Bernard Ebbers, Scot Sullivan, David Meyers, Betty Vinson, Buddy Yates – Whistleblower: Cynthia Cooper Other Frauds: Global Crossing, Adelphia, Qwest, Tyco

Public Company Accounting Oversight Board Prior to PCAOB the profession was self- regulating. The PCAOB is a private nonprofit organization with members appointed by the SEC Responsible for setting audit standards for audits of public companies Composed of 5 members, three non-CPAs Funded by firms that audit public companies Sets standards for quality control Conducts inspections to ensure that performance is up to standards. Has authority to discipline members for wrongdoing.

Audit Practice Issues--Independence Specified non-audit services are prohibited – bookkeeping, information systems design and implementation, appraisals, actuarial services, internal audit, human resources, investment banking, unrelated legal services Audit partner rotation Cannot serve as partner for more than 5 years Concurring partner review Cooling-off period

Audit Committees Auditors report to the audit committee. Audit committee hires and approves all services Scope of items reported to the Audit committee is expanded. Majority of members are independent (no other compensation from company) Members must be expert and financially literate

Audit Practice Issues—Professional Standards Role of PCAOB—responsible for issuing standards for audits of publicly held companies Role of ASB (of the AICPA) – Past – Future Role of the IFAC and IAPC Convergence PCAOB Audit Standards, SASs, ISAs

Criminal Penalties Certain acts now carry federal penalties: – Workpaper retention – Document destruction Securities fraud penalties are increased Fraud discovery statute of limitations increased Loans to executives and insider trading during blackout periods Whistleblower protections

Audit Process Management assessment of ICS – SOX 404—This is the most significant provision of the Act Auditors now report on internal control structure.

SOX 404 Applicable to registrants of the PCAOB (public companies) Requires management assessment of internal control over financial reporting Requires auditor opinion on effectiveness of IC over financial reporting

Key ProvisionsNot Directly Related to Auditors CEO and CFO certifications—SOX 302 – Another major provision of the act CEO and CFO certify that: – They have reviewed all disclosures in 10k and other docs filed with SEC – They are not aware of any untrue statements or omissions – Reports present fairly in all material respects – They are responsible for internal controls – Internal controls are designed to provide them with the information they need. – trickle down Codes of ethics and disclosure of waivers for executives Ban on loans to executives Increased disclosure of stock-options compensation

Accounting Issues Pro-forma financial statements – Before SOX, companies were taking great liberties with reporting only information that they wanted to report in their “unofficial” earnings reports. There was a general feeling in the investment community that GAAP was outdated and that it was too restrictive. The feeling was that these “pro-forma” disclosures were more relevant because they reported earnings “as if” certain GAAP based disclosure requirements were not made. It was very difficult to reconcile these pro-forma financial statements with the GAAP-based statements that were filed with the SEC later. – After SOX, any pro-forma disclosures had to provide clear information as to how these disclosures differ from GAAP-based results. Pro-forma financial information was not banned, but pro-forma disclosures had to be reconciled to GAAP. Form 8-K disclosures--changes to financial position Off-Balance Sheet Arrangements--explained in section of MD&A

What does it take to have fire/Fraud? The Fire Triangle Incentive/ Pressure Opportunity Fraud Rationalization The Fraud Triangle Heat Oxygen Fire Fuel

Fraud Triangle Influences on SOX The Fraud Triangle Incentive. Pressure Opportuni ty Fraud Rationali zation SOX Initiatives Counteract Incentives Reduce Opportunities SOX Encourage Character