Sarbanes-Oxley

Late December 1999, Robert Furst, Daniel Bayly and James Brown of Merrill Lynch were approached by Andrew Fastow, of Enron, with a deal too good to pass up. Enron, at the time one of the largest companies in the world, had offered to sell Merrill Lynch their ownership stake in three barges located off the coast of Nigeria. The offered price was not all that enticing for Merrill Lynch, but Enron’s promise to purchase back the barges at a 22% mark up after six months was. The transaction was in effect a six month loan from Merrill Lynch to Enron using the three barges as collateral, however, Enron recorded the transaction as a sale. On the surface, the Nigerian Barge deal is not the most egregious misuse of accounting standards perpetrated over the course of human history, however, the charge stemming from the deal would be only one of the 109 charges brought against Fastow in the aftermath of Enron’s collapse. [1]

Enron’s accounting inconsistencies and fraudulent activity extended past Fastow. Over-zealous estimates and an ambitious management team led to one of the most infamous accounting scandals in modern history. The awe-inspiring depth of the fraudulent activity cannot be overstated; Enron’s documentation of their usage of SPE (special purpose entities) eclipsed three million pages, all public information at the time. A summary of a sample of these disclosures was created by Steven Schwarz of Duke Law School. Schwartz, averaging 40 single spaced pages per summary, estimated that a summary of all of the SPE’s would come to over one hundred twenty thousand pages. A summary of the summaries would come to a thousand pages. A summary of the summary of the summary would come to two hundred pages that was created with, as Schwartz stated, “the benefit of hindsight and with the assistance of some of the finest legal talent in the nation.”

One of the unique facts about Enron’s fraudulent activity was that it was (for lack of a better term) publicly disclosed through SEC filings for years. Jonathan Weil of the Wall Street Journal, in part credited with bringing Enron’s fraud to light, was able to find their financial irregularities through no information past the annual and quarterly filings, public information. Two years before Weil, students at Cornell in an “advanced financial-statement analysis” class were able to arrive at the conclusion that “Enron may be manipulating its earnings” through analysis of public filings. [2] Despite the information being made available to the general public Enron’s fraudulent activity went virtually unnoticed for years and resulted in catastrophic loses to the financial community, which begs the question, how?

Enron’s disclosure of their operations and financial activity was presented in a format virtually indecipherable to the financial statement user. Jonathan Macey, professor of Law at Yale wrote, “in order for an economy to have an adequate system of financial reporting, it is not enough that companies make disclosures of financial information.” [2] Financial information made public serves no purpose if the public cannot reasonably understand the information.

In the aftermath of Enron and the subsequent WorldCom scandal, the United States Government was forced to step in and enact accounting reform to prevent future cases of fraud. On July 30th, 2002, President George W. Bush signed the Sarbanes-Oxley act, considered to be the most significant accounting and internal control reform since the Securities Act of 1933 and 1934. [3] The Sarbanes-Oxley Act (SOX) created the Public Company Accounting Oversight Board (or PCAOB) which is charged with the regulation of independent auditors of public companies. Additionally, under SOX, auditing firms are forbidden to provide certain management consulting services to their audit clients. Other important provisions of SOX include the requirement of the CEO and CFO to certify that the company’s financial statements are fairly presented and disallows incentive-based compensation to CEO’s and CFO’s for twelve months upon discovery of “material noncompliance.” [4]

Even after over a decade the merit of Sarbanes-Oxley and its effectiveness is still debated. Many have criticized the law as being too hastily enacted while others claim the law does not go far enough. There is no debate however that Sarbanes-Oxley has had a dramatic effect on the financial statement reporting process and its users.

Audit committees of public boards of directors are considered to be one of the first lines of defense in the fight against fraudulent activity and the inappropriate influence upon independent auditors by management. Sarbanes-Oxley provided clear regulations and requirements for audit committees for publicly traded companies. Specifically, independent audit committees must be established and are responsible for the appointment, compensation and oversight of the outsider auditor. The fundamental purpose of this regulation is to create a mandatory separation between the auditors and executive influence.

In addition to audit committee oversight, the committee members need to be “independent” themselves. “The term “independent” under SOX means that the person, other than in his or her capacity as a director, a member of the audit committee or any other board committee, cannot (1) accept any consulting, advisory or other compensatory fees from the company, or (2) be an affiliated person of the company or any of its subsidiaries. Disallowed payments to audit committee members include indirect payments, such as payments to spouses or immediate family members and payments accepted by an entity in which the committee member is a partner, member or executive officer and which provides accounting, consulting, legal, investment banking or financial advisory services to the listed company or any subsidiary.”[5] This requirement actually did not differ significantly from pre-SOX regulations regarding US-based audit committees, but it did play a role on foreign companies which traded publicly through US markets.

It can be argued that these requirements do not go far enough to ensure independence and eliminate influence in the auditing process. This does not alleviate the pressures on auditors to maintain a client-service relationship with important clients nor does prevent audit committee members from inserting undue influence in the auditing process. The separation between auditor, audit committee and executive is important and SOX does not provide new regulations to further separate and prevent influence.

Executives, particularly CEO’s and CFO’s, are often singled out in Sarbanes-Oxley. Per The Journal of Accountancy, “According to a 1999 COSO research paper, at least 83% of 200 financial statement frauds were engineered by the CEO, CFO or both. These control