Ethics and financial reporting in corporate governance

¶ … Law Is Likely to Affect All of the Following: Audit Committees of Public Company Boards of Directors

According to Sections 201 and 204 of the Sarbanes-Oxley Act (SOX), auditors must report "all critical accounting policies and practices" and the members of an audit committee cannot offer "non-audit services for public company audit clients" (PowerPoint, slide 6). According to SOX Section 303 and 404, company officers are prohibited from influencing auditors and "the auditor shall attest to, and report on, the assessment of internal control made by the management of the public company" (PowerPoint, slide 6).

A study of U.S. Securities and Exchange Commission (SEC) sanctions against auditors before and after the implementation of SOX up to 2010 found that common reasons for auditor failure to detect fraud include "failure to exercise due professional care;" "insufficient levels of professional skepticism;" "inadequate identification and assessment of risks;" and "failure to respond to identified risks with appropriate audit responses to gather sufficient competent audit evidence" (Beasley, Carcello & Neal 2007). Clearly, SOX did not prevent such failures from occurring after it was passed in 2002 although ensuring a separation between auditors and other firm activities by prohibiting non-audit services should at least theoretically increase the motivation for auditors to be objective and identify risks. The demand that the auditor sign off on assessments of identified control and be held responsible for failures should at least theoretically enhance the incentive to engage in vigilant oversight.

However, auditing is never simply about the numbers, and a sensitive understanding of the corporate culture is vital to understanding the potential for fraud. "Dialogue with business unit leaders about performance-based incentives and management-imposed pressures may provide the audit committee with effective information about the risk of potential management override of internal controls to fraudulently distort financial performance" (Management override of internal controls, 2005, p.11). For example, tying bonuses to demonstrated performance metrics may increase the incentive for fraud and "and whether business unit leaders have been asked by senior management to engage in questionable activities to meet those targets may provide insightful information to the audit committee about the potential presence of management override of internal controls" (Management override of internal controls, 2005, p.11). While SOX demands a more scrupulous level of investigation than practiced in the past, the extent to which rigorous questioning is needed and potential 'red flags' are being raised still lies within the subjective perceptions of the auditor. This is not to dismiss the potential valuable impact of SOX but rather to highlight that professional ethics and diligence are still needed by members of the profession to protect the public from the negative impact of potentially fraudulent financial statements.

B. If you believe that legislation can guarantee the accuracy of public company financial statements, please explain why previous laws have failed. If you believe that the reverse is true, please explain why CEOs and CFOs are paying so much attention to this law.

The reason that CEOs and CFOs are paying so much attention to SOX is simple: additional regulations demand additional paperwork to demand compliance under the law. SOX does contain some promising elements, including the creation of an independent oversight board and an end to the era of pure self-regulation but hardly means an end to the potential for fraud altogether (Livingstone 2003). SOX merely ensures that auditors are more likely to be objective and more compliant with the law; if the law is lacking in its ability to exercise adequate oversight, it will still be ineffective to inhibit the likelihood of future financial crises . This can be seen in the wake of the demise of Lehman Brothers in 2008 and the subsequent financial crisis it triggered. In the wake of the 2008 crisis, while it was agreed that "boards of directors and audit committees are entitled to rely on external auditors to serve as watchdogs -- to be important gatekeepers who provide an independent check on management," a truly accurate portrayal of company finances was not presented even when the law was observed "the controversy reflected, in part, the difficulty of determining the fair value of assets or liabilities in illiquid markets. It also reflected the concern that the accounting for problem assets held by financial institutions, including loans, was 'procyclical' and may have exacerbated the crisis (even though loan losses are generally not measured at fair value)." (Cohn 2011). A critical component of the meltdown was an abundance of subprime loans whose dubious nature was not reflected adequately in terms of their risk level in terms of the evidence available to the public.