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The Sarbanes Oxley Act of 2002 was established after there was a huge outcry from the investors who had lost their invested funds. The Act was meant to protect the investors by ensuring that the audit reports are independent and fair.
Why was the Public Company Accounting Oversight Board (PCAOB) created?
The Public Company Accounting Oversight Board (PCAOB) is a non governmental, non profit corporation that was established under Title I of the Sarbanes Oxley Act of 2002.The main reason why this board was created was to protect the investors by ensuring that the audit reports are fair and independent. It has five members, all of whom are appointees of the Securities and Exchange Commission. Two of the board’s members must be or must have been certified public accountants.
The Sarbanes Oxley Act of 2002 was enacted in July 30, 2002 after the investors lost billions of their funds invested in Enron and WorldCom. It was alleged that the auditors’ independence in these scandals had been compromised with the companies paying excessive audit fees to the auditors. (Holt Michael F. 2008).
The duties of the PCAOB are: to register public accounting firms that carry out audit of issuers, to establish rules related to the ethics and independence of auditors, to set the standards required for preparation of audit reports, and to inspect of registered public accountants. The board performs any other duties as the SEC may deem necessary for promotion of high professional standards (Spillane Dennis K. 2009).
The powers of PCAOB are set out in Section 101 of the Sarbanes-Oxley Act. These powers include: investigating the public audit firms and taking disciplinary action against the firms and staffs that fail to comply and taking necessary disciplinary action against registered public companies and auditors who fail to comply with the set standards. No firm or individual is permitted to carry out an audit on a public company unless that auditor is registered with the board. While carrying out its investigations, the PCAOB may require that an audit firm produces, as documentary evidence, notes and other materials in its possession. Failure to do so would lead to automatic deregistration. According to Siegel Joel G., et al. (2005):
National audit firms will be subjected to inspection annually; other firms will be inspected every three years. The PCAOB is empowered to impose disciplinary action (including sanctions on accepting new audit clients) on firms that have unsatisfactory inspections. (p.595)
The board inspects the non-audit services such as advisory services on tax management provided by the audit firms to their clients. However, the audit firms can appeal to the decisions taken by the PCAOB and the Securities and Exchange Commission (SEC) may overturn the decisions reached by the board. The board also has powers to hire staffs, accountants and other professionals, as it may deem fit, to help it accomplish a certain mission. It also collects the fees that support it. The board has powers to act as a legal person. It can sue, be sued and represent itself in defense in any federal or state court of law. It also has powers to enter into legally binding contracts, execute instruments and perform any other act that may be necessary, appropriate and incidental to its activities as spelt out in the Sarbanes-Oxley Act. (Welytok Gilbert Jill. 2008).
Disclosure is defined as the providing of all significant information by a company to the third parties (owners, prospective investors, or government) in accordance with the standards set out by the regulatory bodies or by the terms of the agreement between the company and the third parties. The specific disclosures required by the Sarbanes-Oxley Act are: Disclosure of all material off-balance sheet transactions in Periodic Reports, Enhanced conflict of interest disclosures, disclosures of transactions involving management and principal stockholders, disclosures on the management assessment of internal controls, disclosure on whether the issuer has adopted the required Code of Ethics for senior financial officers, disclosure on whether the audit committee has a financial expert, and disclosures on any material changes that are likely to affect the issuer.
The first disclosure is detailed out in Section 401 of the Act. It relates to the disclosures in periodic reports. This section requires that all the financial reports should follow the generally accepted accounted principles. The Act requires the SEC to ensure that all the financial statements prepared either quarterly or annually do not contain material misstatements (untrue statements) or fail to disclose any material item.
The Enhanced Conflict of interest Provision requires an issuer to disclose all the loans that are advanced to its directors and executives. The law prohibits a company to give credit or loans to its directors unless the ordinary activity of the issuer is to advance loans to clients. In such a case, the company should give credit to its directors under the same terms and conditions as the other clients.
Section 403 deals with the disclosure of transactions involving the management and principal stockholders. The section requires every person who directly or indirectly owns 10% of the equity shares or who is a director or officer of the issuer to file a statement, with the Securities and Exchange Commission, showing the amount of all the securities in which the person is a beneficial owner. Sub section 3 of Section 403 also requires that the person indicates the “ownership by the filing person at the date of filing, any such changes in such ownership, and such purchases and sales of the security-based swap agreements as have occurred since the most recent such filing under such subparagraph” (Public law, 107-204) .
The statements must be filed either at the time of registration of such securities, or within 10 days after such person became the beneficial owner or director. In case there has been a change in ownership or a purchase or sale of a security based agreement has occurred, the filing should be done before the end of the second day after the day on which the owner executed the transaction.
The management should also make a disclosure regarding the internal controls system. In the disclosure, the management should report on the structure of the internal controls system and also contain a self assessment report on the effectiveness of the internal controls towards accurate financial reporting. The auditors should carry out an audit to determine whether the assertions made by the management are correct and this should be considered a part of the audit and not a separate engagement.
Every issuer is required to disclose whether it has adopted a code of ethics and if no, give satisfactory reasons. The issuers are also required to disclose whether the audit committee of such an issuer is headed by a financial expert and if not, provide satisfactory reasons. The term ‘financial expert’ for the purposes of this Act is understood to mean a person who has, either through training or experience, had a thorough understanding of GAAP and is experienced in carrying out audit of financial statements and internal controls.
Finally, Section 409 requires real time issuer disclosure. This means that each issuer should disclose, in plain language, any information relating to changes in the conditions that may have tremendous effects on the issuer. This information should be disclosed by way of qualitative analysis, analysis of trends, and providing facts and figures where necessary so as to give the investors as enough information as possible. The information can also be provided, where the Securities and Exchange Commission deems necessary, in diagrammatic representations such as graphs. (thecaq.aicpa.org).
All the above disclosure requirements are very important to the investors. A strong disclosure regime ensures that all the information contained in the financial statements is free form untrue assertions or do not omit any information that is very significant. The investors can not personally run the companies they jointly own and therefore requires a management team to run the companies on their behalf. However, if this management team is left unchecked, it can defraud the investors. Therefore, the government needs to step in and resolve this agency problem by passing legislations that require the managers to disclose all the material information.
A strong disclosure regime ensures that the investors’ confidence is restored and this is a healthy thing for the growth of an economy. The investors, the government and the financial lenders rely on the financial statements when making a decision regarding the companies. When these companies discloses enough information without having to omit anything material, these third parties make informed decisions based on facts. This is very beneficial to all the involved parties because the dealings between them are made a lot fairer.
Section 404 deals with the management’s assessment of the internal controls. The internal controls are the controls, financial or non-financial, that the management team of a company puts in place to ensure that the assets of the company are not misused as well as to ensure that the accounting system captures, quite accurately, all the transactions of the company. The management is supposed to disclose on the structure of the ICS (internal controls system) and evaluate the effectiveness of the internal controls. The auditors should then attest to the assessment of these internal controls.
Agency costs are classified into the costs that are directly related to using an agent (misuse of the resources) and the costs incurred in reducing the direct costs. The costs associated with collecting, analyzing, classifying and reporting the financial information on behalf of the stockholders are the agency costs. Section 404 of the Sarbanes Oxley Act of 2002 imposes agency costs on the issuers because they will be required to disclose more information as required by the Act.
In particular, the Act requires that the management team states its responsibilities towards the internal controls and the effectiveness of the controls and also imposes an obligation on the auditors to audit the management’s assertions and verify the effectiveness of these internal controls. (Ramos Michael J. 2004).
These requirements of disclosure increases the agency costs in that the management has to evaluate the internal controls and report on how effective the internal controls have been in ensuring accurate financial statements.
In conclusion, the enactment of Sarbanes Oxley Act was a very important thing towards the protection of investors. The Act establishes the PCAOB which is an oversight board over the audit of public companies. Since the generally accepted accounting principles are not written in the law, the Act ensures that these principles are followed whenever an issuer is preparing financial statements.