Sarbanes-Oxley Simplified
By Mike Morley
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About this ebook
Ignorance is no longer an excuse. The Sarbanes-Oxley Act of 2002 makes CEO's and CFO's personally responsible, not only for the accuracy of their financial statements, but also for reporting on the effectiveness of their company's internal controls.
This fast and easy-to-read revised 2nd edition of this book describes, in plain language, what the U.S. Sarbanes-Oxley Act says, it explains why the Act came into effect, and shows what companies, and company executives, need to do to ensure that they are in compliance with the Act. This book will help you to understand your obligations under the Act, and will enable you to establish and maintain financial controls using simple, common-sense guidelines that every company, private as well as public, should follow.
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Sarbanes-Oxley Simplified - Mike Morley
Sarbanes-Oxley Simplified
Revised 2nd Edition
by
Mike Morley, CPA
Smashwords Edition
Published by Nixon-Carre Ltd. on Smashwords
Copyright © 2011 by Mike Morley
Smashwords Edition, License Notes
This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each person you share it with. If you're reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the author's work.
All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system without written permission from the author, except for brief passages quoted in a review.
Published by Nixon-Carre Ltd. Toronto, ON
www.learnancientwisdom.com
www.mikemorley.com
Disclaimer: Nixon-Carre Ltd. does not participate in, endorse, or take any responsibility for any private business transactions between the author and the public. This publication is sold with the understanding that the publishers are not engaged in rendering legal, medical or other professional advice. The information contained herein represents the experiences and opinions of the author, but the author or the publisher are not responsible for the results of any action taken on the basis of information in this work, nor for any errors or omissions.
Table of Contents
Introduction
Chapter 1 - The Birth of Sarbanes-Oxley
Chapter 2 - The PCAOB
Chapter 3 - Corporate Responsibilities
Chapter 4 - The Events that Preceded Enron
Chapter 5 - Enhancing Investor Confidence
Chapter 6 - Conflict of Interest
Chapter 7 - The Compliance Process
Chapter 8 - Information Technology
Chapter 9 - Inventory
Chapter 10 - Accounts Receivable
Chapter 11 - Accounts Payable
Chapter 12 - Assets
Chapter 13 - Bill 198 in Canada
Chapter 14 - Internal Reporting
Chapter 15 - Living with Sarbanes-Oxley
About the Author
Introduction
The Sarbanes-Oxley Act of 2002, which makes company executives personally and criminally responsible for the financial disclosures of their US publicly traded companies, has been with us for a number of years. This second edition of this book is intended to update you on changes and to give you some pointers about how the SEC is enforcing the Act.
The SEC has given itself a lot of leeway when it comes to enforcing Sarbanes-Oxley. This unfortunately makes it more difficult for executives and auditors to know where the line they must not cross actually is. Although the SEC is working hard to improve its due diligence, their limited resources make it difficult to be watching every company. It has been helped to a certain extent by the current economic downturn which has exposed many fraudulent schemes that counted on increasing sales and apparent revenue growth to succeed.
Sarbanes-Oxley’s limited success in reducing the number and extent of fraud cases since its enactment is proof that the resourcefulness and ingenuity of human nature will always win out.
Mike Morley
www.mikemorley.com
Chapter 1: The Birth of Sarbanes-Oxley
A Simple Solution to A Complex Problem
Sarbanes-Oxley is a U.S. law that came into effect July 30, 2002 to strengthen corporate governance and restore investor confidence. Sponsored by Maryland Senator Paul Sarbanes and Ohio Congressman Michael Oxley, the Act is intended to provide a strong deterrent to those individuals who might be tempted to manipulate corporate financial data for their own gain. The penalties imposed by the Act include substantial fines and significant prison terms.
Ignorance is no longer an excuse. The Act makes CEO’s and CFO’s personally responsible not only for financial statements that accurately reflect the financial condition of the company, but also makes them responsible for setting up and maintaining systems that ensure that they actually know the truth about what is going on in the company. This requirement is a brilliantly simple solution to the ever present problem of fraud.
In the past, investors and lenders trusted executives of large, reputable public companies, investment banks, credit rating agencies, and, most of all, large auditing firms, to provide them with accurate financial information on which to make sound investing and lending decisions. Unfortunately, as we now know, many of these players traded their principles for money. Many had been profiting from unethical, if not downright illegal, practices for some time before Enron came crashing down. The collapse of Enron made it impossible for the US government to continue to ignore what was going on. Legislators were forced to take action in order to earn back the trust of investors.
Enron: The Destruction of Investor Confidence
The largest corporate bankruptcy in U.S. history (Enron) shook the very foundation upon which the securities exchange system was founded. The report card that investors and lenders used to make their decisions, the audited financial statement, could no longer be trusted. Investors and lenders lost confidence in public company senior management to tell them the truth.
Investors had trusted the accounting firm of Arthur Andersen, LLP, Enron’s auditor, to be their watchdog.
However, Arthur Andersen, LLP, was receiving significant consulting contract revenue from Enron, in addition to being their auditing firm. SEC investigators ultimately concluded that this conflict of interest contributed in large part to Arthur Andersen, LLP’s, decision not to disclose Enron’s contingent liability arising out of certain loan guarantees. The companies whose loans they were guaranteeing were Special Purpose Entities
(SPE) that happened to be owned by Enron’s CFO.
Special Purpose Entities
An SPE is a legal entity created by another entity (a sponsor) to carry out a specified purpose or activity. An SPE is often a financing vehicle that allows a sponsor entity to transfer assets to the SPE in exchange for cash, including prepay transactions
, which are transactions that involve a contract for a service or product to be delivered at a later date. In other words, the SPE would borrow money to sell
a service or product and recognize the revenue although the service had not yet been delivered.
Off-Balance-Sheet Items
Section 401 of the Act stipulates that off-balance-sheet transactions must be disclosed. In Enron’s case, because these loans were recorded on the SPE’s balance sheet instead of Enron’s, Enron appeared to be less debt ridden than it actually was, although it was still liable if the SPE defaulted on the loan. Enron used the lack of disclosure to hide the real indebtedness of the company.
In order for the scheme to work, the investment banks that provided the loans to the SPE’s had to keep quiet, and they did. The investment banks were related to the credit rating agencies that gave Enron a good rating right up to four days before its bankruptcy. As a result of this complicity on the part of all the players involved, investors no longer trusted the companies, the auditors, the investment banks, and the credit rating agencies.
Enron was by no means the only company whose questionable accounting practices illustrated the need for stronger regulations. Before Enron, especially in the high tech bubble of the 1990’s, there was an ever-growing pressure for companies to continually beat expectations.
Expectations were met and exceeded, even if it meant manipulating financial data. In addition, because stock options were a large part of executive compensation packages, manipulating financial information to produce increasing stock prices proved too tempting for some executives who became millionaires almost overnight.
Revenue Recognition
In order for public companies to continue beating expectations
and keep the stock price going up, (which allowed executives to collect big bonuses), one of the techniques they used was to manipulate the timing
of revenue. Revenue recognition is supposed to be based on GAAP (Generally Accepted Accounting Principles).
Conservatism is one of the GAAP principles. It says that, when in doubt, do not recognize the revenue until you are sure. Unfortunately, some public companies anticipated recognition of revenue by including it in their current period instead of waiting for the evidence that revenue had actually been earned. As well, some companies received asset-financing money but classified it as revenue, although there was no evidence to support this accounting treatment.
Lack of Public Confidence
Investors felt betrayed by the accountants and auditors they had depended upon to be the gatekeepers. Auditors were supposed to be disinterested third parties who could be relied upon to ring the alarm if something was not right. Investors and lenders were let down also by the investment banks and the credit rating agencies whose expertise was never in question. The lack of confidence in the established financial reporting system threatened the ability of public companies to obtain equity financing from public securities exchanges.
This lack of confidence in public company financial statements was a crisis that