Sarbanes-Oxley Act overview and key changes

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Chapter 11: Financial Statement Fraud: Appendix A Laws and
Corporate Governance Changes Following the Sarbanes-Oxley
Act
Book Title: Fraud Examination
Printed By: Weicheng Han ([email protected])
© 2019 Cengage Learning, Inc.
Chapter Review
Appendix A Laws and Corporate Governance Changes
Following the Sarbanes-
Oxley Act
As described in the chapter, the period 2001–2003 marked the
discovery of some of the
largest financial statement frauds in U.S. history and some of
the most significant legislation
regarding the auditing profession and corporate governance
since the 1933–1934 SEC
acts. These events followed a very prosperous decade that saw
the NASDAQ grow 10
percent per year from 1987 to 1995 and then from an index of
1,291 on January 1, 1997 to
5,049 on March 10, 2000 for a 391 percent increase in three
years. The Dow Jones
Industrial Average, while not quite so dramatic, rose from 6,448

on January 1, 1997 to a
high of 11,723 on January 14, 2000 for an increase of 81
percent in three years. Much of
this growth came from individual investors who found they
could invest on the Internet by
paying only small fees ($8 to $10 per trade).
When the first financial statement frauds, including Enron and
WorldCom, were revealed,
there was near panic in the market. The NASDAQ fell from its
high of 5,049 on March 10 to
1,114 on October 9, 2002, leaving it at only 22 percent of its
peak value. Similarly, the Dow
Jones Industrial Average (NYSE) fell from its high of 11,723 on
January 15, 2000 to a low of
7,286 on October 9, 2002, leaving it at only 62 percent of its
previous value. The total
decline in worldwide stock markets was $15 trillion. These
sharp declines meant that nearly
everyone’s 401(k) and other retirement plans and personal
wealth suffered tremendous
losses. Worse yet, several well-known companies that were
involved in financial statement
fraud declared bankruptcy. At the time when the Sarbanes-
Oxley Act was passed in July
2002, many of the companies that were found to have
committed fraud around this time
period were among the largest bankruptcies in U.S. history,
including WorldCom (largest),
Enron (second largest), Global Crossing (fifth largest), and
Adelphia (seventh largest).
The Sarbanes-Oxley Act
Because of the pressure brought by constituents, Congress was
quick to act. On July 30,

2002, President Bush signed into law the Sarbanes-Oxley Act,
which had been quickly
passed by both the House and the Senate. The law was intended
to bolster public
confidence in U.S. capital markets and impose new duties and
significant penalties for
noncompliance on public companies and their executives,
directors, auditors, attorneys, and
securities analysts.
The Sarbanes-Oxley Act is comprised of 11 separate sections or
titles. You can read the full
text of the act on several Web sites, but the highlights of each
section are discussed here.
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(1)
(2)
(3)
(4)
(5)
Title I: Public Company Accounting Oversight Board
One of the concerns of legislators was that the auditing

profession was self-regulating and
set its own standards and that this regulation had fallen short of
what it should have been.
As a result, this part of the act established a five-member Public
Company Accounting
Oversight Board (PCAOB), with general oversight by the SEC,
to:
Oversee the audit of public companies;
Establish audit reporting standards and rules; and
Inspect, investigate, and enforce compliance on the part of
registered public
accounting firms and those associated with the firms.
Title I requires public accounting firms that participate in any
audit report with respect to any
public company to register with the PCAOB. It also directs the
PCAOB to establish (or
modify) the auditing and related attestation standards, quality
control, and ethics standards
used by registered public accounting firms to prepare and issue
audit reports. It requires
auditing standards to include (among other things):
a seven-year retention period for audit work papers,
a second-partner review and approval of audit opinions,
an evaluation of whether internal control structure and
procedures include
records that accurately reflect transactions and disposition of
assets,
that receipts and expenditures of public companies are made

only with
authorization of senior management and directors, and
that auditors provide a description of both material weaknesses
in internal
controls and of material noncompliance.
Title I also mandated continuing inspections of public
accounting firms for compliance on an
annual basis for firms that provide audit reports for more than
100 issuers and at least every
three years for firms that provide audit reports for 100 or fewer
issuers. Based on these
inspections, it empowered the board to impose disciplinary or
remedial sanctions upon
registered accounting firms and their associates for intentional
conduct or repeated
instances of negligent conduct. It also directed the SEC to
report to Congress on adoption
of a principles-based accounting system by the U.S. financial
reporting system and funded
the board through fees collected from issuers.
With the passing of this act, control over auditing firms and
auditing standards shifted from
the Auditing Standards Board of the American Institute of
Certified Public Accountants
(AICPA) to this new quasi-governmental organization called the
PCAOB. Some people have
argued that this part of the law relegated the AICPA to a trade
organization.

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Title II: Auditor Independence
Another concern of legislators was that the work of independent
auditors of public
companies had been compromised by some of the other types of
consulting they had been
doing for their audit clients. As a result, the next section of the
Sarbanes-Oxley Act prohibits
an auditor from performing specified nonaudit services
contemporaneously with an audit. In
addition, it specifies that public company audit committees must
approve allowed activities
for nonaudit services that are not expressly forbidden by the act.
The prohibited activities
include the following:
Bookkeeping services.
Financial information systems design and implementation.
Appraisal or valuation services.
Actuarial services.
Internal audit outsourcing.
Management functions or human resources.
Broker or dealer, investment advisor, or investment banking.
Legal services and expert services.

Any other service that the board determines is impermissible.
In addition, this section of the act prohibits an audit partner
from being the lead or reviewing
auditor on the same public company for more than five
consecutive years (auditor rotation).
It requires that auditors report to the audit committee each of
the following:
Critical accounting policies and practices used in the audit.
Alternative treatments and their ramifications within GAAP.
Material written communications between the auditor and senior
management of the
issuer.
Activities prohibited under Sarbanes-Oxley.
Title II places a one-year prohibition on auditors performing
audit services if the issuer’s
senior executives had been employed by that auditor and had
participated in the audit of the
issuer during the one-year period preceding the audit initiation
date and encourages state
regulatory authorities to make independent determinations on
the standards for supervising
nonregistered public accounting firms and to consider the size
and nature of their clients’
businesses audit.

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Title III: Corporate Responsibility
The first two titles of the act were directed at auditors of public
companies, but the next
section targeted public companies, especially their board of
directors and its committees.
Specifically, this part of the act involves the following
provisions:
Requires each member of a public company’s audit committee
to be a member of the
board of directors and be independent (no other compensatory
fees or affiliations with
the issuer).
Confers upon the audit committee responsibility for
appointment, compensation, and
oversight of any registered public accounting firm employed to
perform audit services.
Gives audit committees authority to hire independent counsel
and other advisors and
requires issuers to fund them.
Instructs the SEC to promulgate rules requiring the CEO and
CFO to certify that the
financial statements provided in periodic financial reports:
Do not contain untrue statements or material omissions.
Present fairly in all material respects the financial conditions
and results of
operations.

Establishes that the CEO and CFO are responsible for internal
controls designed to
ensure that they receive material information regarding the
issuer and consolidated
subsidiaries and that the internal controls have been reviewed
for their effectiveness
within 90 days prior to the report and makes them identify any
significant changes to
the internal controls.
Title III also deals with abuses and penalties for abuses for
executives who violate the
Sarbanes-Oxley Act. Specifically, it makes it unlawful for
corporate personnel to exert
improper influence upon an audit for the purpose of rendering
financial statements
materially misleading. It requires that the CEO and CFO forfeit
certain bonuses and
compensation received if the company is required to make an
accounting restatement due
to the material noncompliance of an issuer. It amends the
Securities and Exchange Act of
1933 to prohibit a violator of certain SEC rules from serving as
an officer or director if the
person’s conduct demonstrates unfitness to serve (the previous
rule required “substantial
unfitness”). It provides a ban on trading by directors and
executive officers in a public
company’s stock during pension fund blackout periods. Title III
also imposes obligations on
attorneys appearing before the SEC to report violations of
securities laws and breaches of
fiduciary duty by a public company or its agents to the chief
legal counsel or CEO of the
company, and it allows civil penalties to be added to a

disgorgement fund for the benefit of
victims of securities violations.
Title IV: Enhanced Financial Disclosures
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Another concern addressed by the act was that public company
financial statements did not
disclose certain kinds of problematic transactions properly and
management and directors
didn’t act as ethically as they should have. As a result, Title IV:
Requires financial reports filed with the SEC to reflect all
material correcting
adjustments that have been identified.
Requires disclosure of all material off-balance-sheet
transactions and relationships
that may have a material effect upon the financial status of an
issue.
Prohibits personal loans extended by a corporation to its
executives and directors,
with some exceptions.
Requires senior management, directors, and principal
stockholders to disclose
changes in securities ownership or securities-based swap
agreements within two

business days (formerly 10 days after the close of the calendar
month).
Requires annual reports to include an internal control report
stating that management
is responsible for the internal control structure and procedures
for financial reporting
and that they have assessed the effectiveness of the internal
controls for the previous
fiscal year. This Section 404 request is probably the most
expensive and debated part
of the act. As a result of this requirement, most companies have
spent millions of
dollars documenting and testing their controls.
Requires issuers to disclose whether they have adopted a code
of ethics for their
senior financial officers and whether their audit committees
consist of at least one
member who is a financial expert.
Mandates regular, systematic SEC review of periodic
disclosures by issuers, including
review of an issuer’s financial statement.
Title V: Analyst Conflicts of Interest
In addition to concern over auditors, board members,
management, and financial
statements, legislators were also concerned that others
(investment bankers and financial
institution executives) also contributed to the problems.
Accordingly, this section of the act:
Restricts the ability of investment bankers to preapprove
research reports.

Ensures that research analysts in investment banking firms are
not supervised by
persons involved in investment banking activities.
Prevents retaliation against analysts by employers in return for
writing negative
reports. Establishes blackout periods for brokers or dealers
participating in a public
offering during which they may not distribute reports related to
such offering.
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Enhances structural separation in registered brokers or dealers
between analyst and
investment banking activities.
Requires specific conflict of interest disclosures by research
analysts making public
appearances and by brokers or dealers in research reports
including:
Whether the analyst holds securities in the public company that
is the subject of
the appearance or report.
Whether any compensation was received by the analyst, broker,
or dealer from
the company that was the subject of the appearance or report.

Whether a public company that is the subject of an appearance
or report is, or
during the prior one-year period was, a client of the broker or
dealer.
Whether the analyst received compensation with respect to a
research report,
based upon banking revenues of the registered broker or dealer.
Title VI: Commission Resources and Authority
Title VI of the act gave the SEC more budget and more power to
be effective in its role of
overseeing public companies in the United States. Specifically,
this part:
Authorized a 77.21 percent increase over the appropriations for
FY 2002 including
money for pay parity, information and technology, security
enhancements, and
recovery and mitigation activities related to the September 11
terrorist attacks.
Provided $98 million to hire no less than 200 additional
qualified professionals to
provide improved oversight of auditors and audit services.
Authorized the SEC to censure persons appearing or practicing
before the
commission if it finds, among other things, a person to have
engaged in unethical or
improper professional conduct.
Authorized federal courts to prohibit persons from participating
in penny stock

offerings if the persons are the subject of proceedings instituted
for alleged violations
of securities laws.
Expanded the scope of the SEC’s disciplinary authority by
allowing it to consider
orders of state securities commissions when deciding whether to
limit the activities,
functions, or operations of brokers or dealers.
Title VII: Studies and Reports
This section of the Sarbanes-Oxley Act specified that certain
reports and studies should be
made, including the following:
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A study of the factors leading to the consolidation of public
accounting firms and its
impact on capital formation and securities markets.
A study of the role of credit rating agencies in the securities
markets.
A study of the number of securities professionals practicing
before the commission
who have aided and abetted federal securities violations but
have not been penalized
as a primary violator.

A study of SEC enforcement actions it has taken regarding
violations of reporting
requirements and restatements of financial statements (as
referred to earlier in the
chapter).
A study by the Government Accountability Office (GAO) on
whether investment banks
and financial advisers assisted public companies in earnings
manipulation and
obfuscation of financial conditions.
Title VIII: Corporate and Criminal Fraud Accountability
Title VIII was the part of the Sarbanes-Oxley Act that imposed
criminal penalties upon
violators, extended the statute of limitations for financial
crimes, and provided protection for
whistle-blowers in fraud cases. Specifically, this part of the act:
Imposed criminal penalties for knowingly destroying, altering,
concealing, or falsifying
records with intent to obstruct or influence either a federal
investigation or a matter in
bankruptcy and for failure of an auditor to maintain for a five-
year period all audit or
review work papers pertaining to an issuer of securities
(penalty: 10 years in prison).
Made nondischargeable in bankruptcy certain debts incurred in
violation of securities
fraud laws.
Extended the statute of limitations to permit a private right of
action for a securities

fraud violation to no later than two years after its discovery or
five years after the date
of the violation.
Provided whistle-blower protection to prohibit a publicly traded
company from
retaliating against an employee because of any lawful act by the
employee to assist in
an investigation of fraud or other conduct by federal regulators,
Congress, or
supervisors, or to file or participate in a proceeding relating to
fraud against
shareholders.
Subjected to fine or imprisonment (up to 25 years) any person
who knowingly
defrauds shareholders of publicly traded companies.
Title IX: White-Collar Crime Penalty Enhancements
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Because of concern that corporate executives and directors who
engage in unlawful
conduct were not being penalized sufficiently, this part of the
act increased penalties for mail
and wire fraud from 5 to 20 years in prison. It also increased
penalties for violations of the
Employee Retirement Income Security Act of 1974 (up to
$500,000 and 10 years in prison)

and established criminal liability for failure of corporate
officers to certify financial reports,
including maximum imprisonment of 10 years for knowing that
the periodic report does not
comply with the act or 20 years for willfully certifying a
statement knowing it does not comply
with this act.
Title X: Corporate Tax Returns
This title expressed the sense of the Senate that the federal
income tax return of a
corporation should be signed by its chief executive officer.
Title XI: Corporate Fraud Accountability
This final title of the act amended federal criminal law to
establish a maximum 20-year
prison term for tampering with a record or otherwise impeding
an official proceeding. It
authorized the SEC to seek a temporary injunction to freeze
extraordinary payments
earmarked for designated persons or corporate staff under
investigation for possible
violations of federal securities law. It also authorized the SEC
to prohibit a violator of rules
governing manipulative, deceptive devices, and fraudulent
interstate transactions, from
serving as officer or director of a publicly traded corporation if
the person’s conduct
demonstrates unfitness to serve; and it increased penalties for
violations of the Securities
Exchange Act of 1934 up to $25 million and 20 years in prison.
The Public Company Accounting Oversight Board (PCAOB)

Once the PCAOB was up and running, it wasted no time in
carrying out its mandate. With its
authorized budget of $68 million per year, within weeks, it
required that auditing firms of
public companies register with the board. It hired inspectors to
carry out inspections of the
audits of public companies. It hired a new audit director
(Douglas Carmichael) and created a
board to issue auditing standards. It established offices in
several cities around the United
States.
It established its mission to oversee the auditors of public
companies in order to protect the
interests of investors and further the public interest in the
preparation of informative, fair,
and independent audit reports. It issued its first auditing
standard that articulates
management’s responsibilities for evaluating and documenting
the effectiveness of internal
controls over financial reporting, identifies the kinds of
deficiencies that can exist, states the
consequences of having deficiencies, and identifies how
deficiencies must be
communicated.
Subsequent Changes Made by the Stock Exchanges
In response to the high-profile corporate failures, the SEC
requested that the NYSE and
NASDAQ review their listing standards with an emphasis on all
matters of corporate

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governance. Based on that request, both the NYSE and
NASDAQ conducted extensive
reviews of their listing standards for corporate governance and
filed corporate governance
reform proposals with the SEC in 2002. In April 2003, the SEC
issued Rule 10A-3, which
directed all stock exchanges to prohibit the listing of any
security of an issuer that is not in
compliance with the audit committee requirements specified in
Rule 10A-3. On November 4,
2003, the SEC approved, with certain modifications, the
corporate governance reforms
proposed by the NYSE and NASDAQ. Here is an overview of
the changes that they made.
NASDAQ Corporate Governance Changes
NASDAQ focused almost entirely upon boards of directors and
executives in making
governance reforms. Specifically, NASDAQ addressed the
following issues:
Independence of majority of board members.
Separate meetings of independent board members.
Compensation of officers.
Nomination of directors.
Audit committee charter and responsibilities.

Audit committee composition.
Code of business conduct and ethics.
Public announcement of going-concern qualifications.
Related-party transactions.
Notification of noncompliance.
NASDAQ corporate governance reforms mandate that a majority
of the board of director
members are required to be independent along with a disclosure
in annual proxy (or in the
10-K if proxy is not filed) about the directors, which the board
has determined to be
independent under NASD (formerly known as the National
Association of Securities
Dealers) rules. In defining what constitutes an independent
director, NASDAQ’s rules state
that a director is not independent under the following
circumstances:
The director is an officer or employee of the company or its
subsidiaries.
The director has a relationship, which in the opinion of the
company’s board would
interfere with the director.
Any director who is or has at any time in the last three years
been employed by the
company or by any parent or subsidiary of the company.

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The director accepts or has a family member who accepts any
payments from the
company in excess of $60,000 during the current fiscal year or
any of the past three
fiscal years. Payments made directly to or for the benefit of the
director or a family
member of the director or political contributions to the
campaign of a director or a
family member of the director would be covered by this
provision.
The director is a family member of an individual who is or at
any time during the past
three years was employed by the company or its parent or any
subsidiaries of the
company as an executive officer.
The director is or has a family member who is employed as an
executive officer of
another entity at any time during the past three years where any
of the executive
officers of the listed company serve on the compensation
committee of such entity.
The director is or has a family member who is a partner in or is
a controlling
shareholder or an executive officer of any organization in which
the company or from
which the company received payments for property or services

in the current year or
any of the past three fiscal years that exceed 5 percent of the
recipient’s consolidated
gross revenues for that year or $200,000, whichever is more.
The director is or has a family member who is an executive
officer of a charitable
organization, if the company makes payments to the charity in
excess of the greater of
5 percent of the charity’s revenues or $200,000.
The director is or has a family member who is a current partner
of the company’s
outside auditor.
The director was a partner or employee of the company’s
outside auditor and worked
on the company’s audit at any time in the past three years.
Under new governance standards, independent directors are
required to have regularly
scheduled meetings at which only independent directors are
present (thus excluding all
members of management). To eliminate sweetheart deals, the
compensation of the CEO
and all other officers must be determined or recommended to
the full board for
determination by a majority of the independent directors or a
compensation committee
comprised solely of independent directors.
In addition, director nominees should be either selected or
nominated for selection by a
majority of independent directors or by a nominations
committee comprised solely of
independent directors. NASDAQ changes also require each

issuer to certify in writing that it
has adopted a formal written charter or board resolution
addressing the nomination process.
A written charter for the audit committee of the issuer must
provide the following:
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The committee’s purpose of overseeing the accounting and
financial reporting
processes and audits of the financial statements.
Specific audit committee responsibilities and authority
including the means by which
the audit committee carries out those responsibilities.
Outside auditor’s accountability to the committee.
The committee’s responsibility to ensure the independence of
the outside auditor.
Audit committee consists of at least three members.
Each audit committee member is required to be:
Independent under the NASD rules.
Independent under Rule 10A-3 issued by the SEC.

Someone who has not participated in the preparation of the
financial statements
of the company or any current subsidiary of the company at any
time during the
last three years.
Existing NASDAQ rules already required that each audit
committee member should be able
to read and understand fundamental financial statements. This
requirement did not change.
However, under the new NASDAQ governance rules, one audit
committee member must
have past employment experience in finance and accounting,
requisite professional
certification in accounting, or any other comparable experience
or background that results in
the individual’s financial sophistication, including being or
having been a CEO, CFO, or
other senior officer with financial oversight responsibilities.
Audit committee members are
also prohibited from receiving any payment from the company
other than the payment for
board or committee services and are also prohibited from
serving the audit committee in the
event they are deemed to be an affiliated person of the company
or any subsidiary.
Under the new NASDAQ requirements, each listed company
must have a publicly available
code of conduct that is applicable to all directors, officers, and
employees. The code of
conduct must comply with the “code of ethics” as set forth in
Section 406(c) of the
Sarbanes-Oxley Act and must provide for an enforcement
mechanism that ensures the
following:

Prompt and consistent enforcement of the code.
Protection for persons reporting questionable behavior.
Clear and objective standards for compliance.
Finally, each listed company that receives an audit opinion that
contains a going-concern
qualification must make a public announcement through the
news media disclosing the
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receipt of such qualification within seven calendar days
following the filing with the SEC of
the documents that contained such an audit opinion. In addition,
the audit committee of
each issuer must conduct an appropriate review of all related-
party transactions for potential
conflicts of interest on an ongoing basis and make sure that all
such transactions have been
approved.
NYSE Corporate Governance Changes
Changes made by the NYSE were quite similar to those made by
the NASDAQ. Specifically,
the NYSE …

Sarbanes-Oxley Act overview and key changes

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