The startling revelations about WorldCom underscore thenecessity to restore trust and confidence in our markets, where over 60 percent of the American public invests. It is imperative we move forward with strong accounting reform and investor protection legislation," Maryland Sen. Paul S. Sarbanes said June 30, when, following a unanimous 97-0 vote by the Senate, President Bush signed the Sarbanes-Oxley Act of 2002.
Officially known as the Public Company Accounting and Investor Protection Act, the bill comes as a response to the great multitude of corporate governance issues that have filled the news since the Enron scandal broke last December.
The bill's major provisions will create an independent oversight board, increase funding for the SEC and Financial Accounting Standards Board, strengthen corporate responsibility, form harsher criminal penalties on those who commit securities fraud, require disclosure of insider transaction and ban loan issuance.
The repercussions of the corporate scandals have reverberated throughout the financial markets and, ultimately, throughout a suffering U.S. economy already amid recession.
"The recession and the stock market problems are closely intertwined, and current fears of a double dip recession are largely due to the continuing weak stock market which is in turn at least partly due to a continuing stream of news about new corporate scandals," Economics Prof. Mary Lee Epps said.
Legislation of this magnitude will no doubt be seen as the most important change to securities law since the Securities Exchange Act of 1934, which created the Securities and Exchange Commission.
However, the main objective of this bill still remains a daunting task at this critical stage in our economy to improve market transparency and ultimately to restore investor confidence.
Among its provisions, the creation of an independent oversight board could have the most profound impact. The SEC will choose the five members of the board, two of which must be certified public accountants.
The board takes the responsibilities to establish auditing and accounting standards previously assumed by the American Institute of CPAs.
This "public accounting oversight board will have more clout and more capability for disciplinary action than the AICPA," Commerce Prof. William G. Shenkir said.
With more authority, the oversight board will be less likely to succumb to the kind of political pressure that often has been an influence in shaping accounting standards.
For example, in the 1990s, heavy opposition from senators and the Secretary of Treasury forced the FASB to drop its plan for requiring executive stock options to be expensed.
The effectiveness of the oversight board (i.e. how the board will function and how strong it will be) remains uncertain as board members have as yet to be named.
This board, however, has the appearance and the capability of making significant changes that could improve the accounting industry.
The oversight board "will serve to remind corporate executives, boards of directors and audit firms of the individual responsibilities in financial reporting," Shenkir said.
The provision that requires CPA firm independence standards also will have substantial impacts on the accounting industry. Auditor independence prohibits accounting firms from providing certain consulting and non-audit services for public company audit clients.
Auditor independence, which prohibits firms from providing certain consulting and non-audit services, serves as a crucial component of the bill because of certain inherent conflicts created by non-audit services that may prevent objectivity when examining a company's books.
For example, accounting firms' lucrative consulting contracts with their audit clients makes the auditors less inclined to make tough calls on questionable financial reporting. Such a conflict of interest grew evident when Arthur Andersen's consulting revenues for Enron exceeded its audit fees. Consequently, Andersen's focus started to shift toward the more profitable consulting business, thus pushing the firm off its established accounting course.
The component of the bill that requires CEOs and CFOs to sign off on their corporation's financial statements, complemented by harsher criminal penalties, will create an incentive for executive officers to ask tougher questions of management, which provides another safeguard against faulty judgments by management.
Despite all these provisions aimed at reforming the accounting industry and at addressing corporate governance issues, it is still management that makes the fundamental judgments in regard to measurements and disclosures in the financial statements, which may be the central problem of current corporate scandals.
Legislation of this magnitude will no doubt be seen as the most important change to
securities law since the
Securities Exchage Act of 1934.
"The danger is that when the storm blows over and public attention is lost and we will slip back into the past practice that has given management the latitude to act mostly in their own interest, rather than in that of shareholders," Economics Prof. Thomas W. Epps said.
Many hope the bill will help limit some of the freedom that management previously had held with making judgments in regard to financial statements. TheSarbanes-Oxley Act will provide the necessary measures by which CEOs and CFOs ask tougher questions to management, forces auditors to be more objective and allows the independent oversight board greater authority to oversee auditors than the weaker self-regulated AICPA.
Under any set of circumstances, this bill marks an important step forward in addressing issues of corporate governance. Whether or not the bill will succeed in restoring investor confidence depends on several factors notwithstanding the outcome or success of the bill.
Because various provisions of the bill aim at improving market transparency and fairness in financial reporting, it should help to restore some of the lost confidence in the market and to aid in regaining market efficiency, which will go hand in hand in improving the condition of our struggling economy.
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