Accounting,Fraud
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Accounting Fraud, the Investor and the Sarbanes Oxley Act
Throughout the past several years major corporate scandals have rocked the economy and hurt investor confidence. The largest bankruptcies in history have resulted from greedy executives that “cook the books” to gain the numbers they want. These scandals typically involve complex methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of assets or underreporting of liabilities, sometimes with the cooperation of officials in other corporations (Medura 1-3). In response to the increasing number of scandals the US government amended the Sarbanes Oxley act of 2002 to mitigate these problems. Sarbanes Oxley has extensive regulations that hold the CEO and top executives responsible for the numbers they report but problems still occur. To ensure proper accounting standards have been used Sarbanes Oxley also requires that public companies be audited by accounting firms (Livingstone). The problem is that the accounting firms are also public companies that also have to look after their bottom line while still remaining objective with the corporations they audit. When an accounting firm is hired the company that hired them has the power in the relationship. When the company has the power they can bully the firm into doing what they tell them to do. The accounting firm then loses its objectivity and independence making their job ineffective and not accomplishing their goal of honest accounting (Gerard). Their have been 379 convictions of fraud to date, and 3 to 6 new cases opening per month. The problem has clearly not been solved (Ulinski).
When a large company commits accounting fraud and is caught the implications from their actions are very far reaching. In the worse case scenario the company will go bankrupt. Not only will the employees of the company lose their jobs but they will also possibly lose their pensions and any chance at retirement. Older employees may never even get to retire because their entire pensions will disappear. Creditors and investors will also lose a great deal of money if not all of it. When this happens it affects every publicly held company. Investors get nervous with their money and take it out of capital markets (Tate). Without investors money companies cannot take advantage of new ideas and thus cannot expand and grow. Without growth the national economy can fall into recession, unemployment will increase, and the quality of life will decline. This is the worst case scenario but with current talk of recession it would be best to keep investors happy.
Many people think that accounting fraud will not directly affect them but that is far from the truth. In the past wake of bankruptcies millions of Americans who were heavily invested through their 401(k) retirement plans in the stock market had to postpone retirement and rethink their investment strategy. According to one estimate, American workers lost $175 billion in retirement savings during this time. The losses came at a time when 401(k) plans had become very popular with employers, replacing defined benefit pension plans that guaranteed a set amount of money during an employees retirement. Any person who plans on retiring that isn’t already wealthy will have to rely on the stock market to grow their retirement (Johnstone).
There are several ways executives can “cook the books” to make a company look more profitable and stable than it actually is. Investors rely on accurately reported numbers in the financial statements to make their investment decisions. Two of the more popular ways executives use to make a company look better than it actual is, is by inflating revenue and, or deflating expenses. Decisions investors make are based on the valuation of a stock (Madura 9). The goal of every investor is simply, buy low sell high. To determine when to buy and sell investors use the two most common financial statements which are the income statement and the balance sheet. The income statement reports a companies revenue compared to its expenses over a period of time. If the difference is positive it’s a profit. The balance sheet has two components: (1) assets and (2) liabilities and stockholders equity. A higher dollar amount of assets and a lower amount of liabilities sheds a favorable light on the company (Romney, Steinbart).
To protect investors of inaccurate numbers the United States government developed the Sarbanes-Oxley Act of 2002. The Act applies publicly held companies and their audit firms. It extensively affects the accounting profession and CPAs working as an auditor of a publicly traded company. In response to high profile corporate crime such as the Enron scandal, Congress passed the Sarbanes-Oxley Act of 2002 and President Bush signed the act into law on July 30, 2002. Sarbanes-Oxley was enacted to protect investors by fighting corporate crime and improving corporate governance. Sarbanes-Oxley requires companies to apply extensive corporate governance policies to prevent fraudulent activity within the company (Rittenberg, Schwieger, Johnstone).
The Board of Directors in a company now must have at least five financially literate members which are appointed for five-year terms. Two of these members must be or have been certified public accounts, and the other three must not be, or cannot have been CPAs. This allows financially educated board members to cycle through without spending long terms in the position and also keeps a balance in the accounting knowledge within the board. The audit lead or coordinator partner and reviewing partner in audits must also rotate every five years (Tate).
The Act protects whistleblowers, those people who come forth with incriminating information about activities within their company. This becomes especially important with the increasing prosecution following Sarbanes-Oxley as those who do not want to be involved will have the responsibility to come forth with information. This section requires the company establish procedures for the receipt, retention, and treatment of complaints such as fraud and auditing abuse.
Sarbanes-Oxley provides certain blackout periods for stock trading in which officers and directors cannot purchase or sell stock. Profits resulting from sales in violation of this are recoverable by the issuer of the stock.
The SEC has a large amount of control with Sarbanes-Oxley including the ability to restrict people from serving on the Board of Directors if they have a securities fraud issue in their background and freezing payments to company officers while they investigate the transaction for illegitimate activities.
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