SOX, Accounting Ethics Cases

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Business Finance

"The Commission" refers to the Securities Exchange Commission, which is the primary governing body for financial markets.

"The Board" is the Public Companies Accounting Oversight Board. The SEC oversees the Board. The SEC therefore approves the rules that the Board writes and implements, the SEC appoints the people who run the PCAOB and the PCAOB is accountable to the SEC.

The PCAOB is a board, of people, appointed by the SEC.

The PCAOB is charged with four main duties in relation to the capital markets. These are to "register the public accounting firms that prepare audit forms for issuers," to "establish or adopt…standards relating to the preparation of audit reports," to conduct inspections of registered public accounting firms" and to "conduct investigations and disciplinary proceedings" against public accounting firms. In essence, the PCAOB provides oversight over the accounting and in particular the auditing profession.

e. As noted above, public accounting firms must register with the PCAOB. They must do this in order to be allowed to perform auditing duties on public corporations.

f. The Board is responsible for inspecting the public accounting companies. This is described as such: "In general, the Board shall conduct a continuing program of inspections to assess the degree of compliance of each registered public accounting firm and associated persons of that firm with this Act, the rules of the Board, the rules of the Commission, or professional standards, in connection with its performance of audits, issuance of audit reports and related matters involving issuers."

g. The Board is tasked with writing the auditing standards, which will subsequently be subject to the approval of the SEC. The Board "shall establish through (sic) adoption of standards proposed by 1 or more professional groups of accountants designated…" It is actually a poorly-constructed run-on sentence at this point but the basics are that the PCAOB establishes the auditing standards that it will then assess auditors against during its inspections and investigations. This includes attestation, quality control and ethical standards.

h. SOX is applied to any company public accounting firm. This is made clear in Section 106: "Any foreign public accounting firm that prepares an audit report with respect to any issuer shall be subject to this act." Simply put, any public accounting firm is subject to the act any time it is conducting audit activities on an issuer that is traded on a U.S. exchange. There are no exceptions granted to firms just because they are foreign, as this would logically create a loophole that would circumvent the spirit of the law. So all public accounting firms are treated the same under SOX.

i. The accounting standards recognized are the generally accepted accounting principles, as noted in Section 108.

j. The Board is funded through an "annual accounting support fee." This fee is paid by issuers, and there is allowance for different classes of issuers. The FASB is funded also by issuers, through this same fee. The fees collected will be allocated "in accordance with subsection g," which is not provided. But there is an allocation formula, and the one accounting support fee finances both the PCAOB and the FASB.

k. The independent auditor is prohibited from providing other accounting services to the issuer, including bookkeeping, financial statement implementation, appraisal or valuation services, actuarial services, broker or dealer services, internal auditing, legal and other services. The idea is to ensure that there is no conflict of interest between for the company. Every issuer will basically be serviced by a minimum of two public accounting firms -- one for the auditing and one or more for everything else.

l. Title IV outlines management's responsibility with respect to internal controls. What management needs to do is publish an internal assessment over the quality of its internal controls, and write an attestation about it.

m. Section 404 has received significant criticism because it relies on management to assess its own internal controls. Where there have been major accounting fraud cases, they have typically occurred at the behest of senior management. Therefore, the same senior management who would theoretically be committing a fraud would be the same to provide an attestation as to the strength of the internal controls -- liars basically being put in a position of determining whether they are telling the truth. This creates an inherent conflict of interest. Yet at the same time, Section 404 also creates what many companies feel is a fairly significant burden on them. The creation of strong internal controls, as well as mechanisms for evaluating those controls, can be costly and time-consuming.

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This is especially a burden for smaller companies, which creates something of a barrier to them raising capital, and it also may dissuade companies from listing in the U.S., though realistically the benefits of such probably outweigh these costs.

Part II. Chapter 2

a. I cannot agree with this proposition. First, the case highlights that this is not the case, and there remains much disagreement about what constitutes moral or ethical behavior where managing earnings is concerned. There are as many different ethical philosophies as there people, so in that respect it would be impossible to make the claim that accounting activities are now restricted strictly to those activities that are ethical. The survey highlights this disagreement, which is apparently held on pretty much every issue. There are few, if any, ethical absolutes in our society, and that means that there is no conceivable way that accounting procedures are restricted to just those are that ethical. Even precisions is difficult to guarantee, and fairness is always in the eye of the beholder.

b. If most managers surveyed had a conservative interpretation of moral/ethical behavior, this can probably be explained by certain psychological phenomena of which we are aware. First, most people in general are risk-averse. In the case of business ethics, that will manifest in people who have a stake in ethical behavior avoiding anything that even seems unethical. The downside risks are too much for them to bear, so they take a conservative line on ethical issues to avoid any chance of negative outcome. Second, it is also possible that people who are inherently conservative are attracted to these types of positions. Because risk is not particularly well-tolerated in these sorts of jobs, the jobs themselves attract people who prefer to operate in a risk-free environment. Someone who is predisposed to risk-taking will probably avoid accounting or financial management as a career because such a role will simply be less-fulfilling to their personality. So both of these are probably a factor in this finding.

c. I read that managers do not have much agreement as to what constitutes ethical practice. Every manager probably agrees that they wish to pursue ethical practice, but what that is might vary considerably from one manager to another. But the case says clearly "A major finding of the survey was as striking lack of agreement. None of the respondent groups viewed any of the 13 practices unanimously as an ethical or unethical practice," which to me runs directly counter to the proposition on which this question is based that "the managers' survey exhibited a surprising agreement as to what constitutes an ethical or unethical practice." I am not sure why the question posed is directly opposite the text -- but my comment is that the question as posed stands directly opposite the case presented.

d. The five generalizations were that "on average, the respondents viewed management of short-term earnings by accounting methods as significantly less acceptable than accomplishing the same ends by changing operating decisions"; that "direction of the effect on earnings matters" such that increasing earnings is less acceptable; that materiality matters; that the time period of the effect may also affect ethical judgments, so for example it was more acceptable for quarterly earnings than annual; and lastly that the method of managing earnings also has an effect.

e. In the long run, it is much more difficult to influence earnings through financial accounting. When the company changes accounting policies, this is noted in the statements, and the notes will highlight not only the nature of the change but also the materiality of the change. As a result, if a company continually changes its accounting policies, this will be noticed by the people in the markets who follow the company. The scrutiny that comes from being a publicly-traded company means that eventually, time will reveal when a firm has been trying to manipulate its earnings. Also, in the long run bad management will be exposed anyway. The manipulation will have to get bigger and more egregious to cover up poor firm performance, and over time it becomes less likely that such activities would not be discovered and reported. Furthermore, many instances of short-run earnings manipulation, such as channel-stuffing, merely push the problem into the next quarter. Over the long run it does become increasingly difficult to continually push problems into the next quarter. So while managing earnings can be done reasonably easy in….....

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