Sarbanes-Oxley and Enron

Sarbanes-Oxley and Enron

XXXXXXXX

XXXXXXXXXXXXXXXXXXXXXXX

Managerial Accounting, spring XXXXX

XXXXXXXXXXXXXXXXXXXXXX

XXXXXXXXXXXXXXXX

Abstract

This research paper discusses Enron crisis, its causes and enactment of Sarbanes-Oxley law to control accounting related scandals. The main provisions of Sarbanes-Oxley law to provide more reliable and transparent financial reporting is included in this paper. The Sarbanes-Oxley law has increased liability of accounting environments but regained confidence of middle class investors.

Enron Crisis:

Enron Corporation was an American energy, commodities and services company based in Houston, TX. Fortune named Enron "America's Most Innovative Company" for six consecutive years. Enron had been considered a blue chip company. But Enron made it to largest corporate bankruptcy in Unites States history. Reason for Enron's massive downfall was Enron's nontransparent financial statements which did not clearly describe its operations and finances with shareholders and analysts. The complex business model of Enron and its unethical business practices forced the company to use accounting limitations as a tool to misrepresent earnings and modify balance sheets to create a favorable picture of the company's performance. Enron's accounting and financial statements were molded in a way to show bloated income and cash flows, inflated assets and minimum liabilities. Many of the Enron's debt and losses were not reported in financial statements. Chief financial officers and other executives of Enron deceived Enron's board of directors and audit committee on high-risk accounting practices.

Arthur Anderson was accounting firm based in Chicago, providing auditing, tax, and consulting services to large corporations including Enron. Enron also pressured Arthur Andersen to ignore the issues of poor financial reporting to hide billions of dollars in debt from failed deals and projects. Evidence suggested that Arthur Andersen did not fulfill its professional obligations to truly represent audits of Enron's financial statements, or its responsibility to bring to the attention of Enron's board of directors. Arthur Anderson was found guilty and surrendered CPA licenses and right to practices and no longer exists. Enron shareholders lost almost $11 billion when Enron share prices drop below 1 dollar with thousands of job losses. Due to this, faulty audits of other companies done by Arthur Anderson Company also draw attention. Such accounting malpractices and corporate scandals like Enron continued to stain American business practices. Such scandals, which cost investors and shareholders billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation's securities markets.

Sarbanes-Oxley Act

As a consequence of such corporate and accounting scandals, new regulations and legislations were enacted to develop the accuracy of financial reporting for public companies to restore public confidence in national capital market.

The new United States federal law known as Sarbanes-Oxley Act came into effect in July 2002. Sarbanes-Oxley Act is also known as ‘Public Company Accounting Reform and Investor Protection Act' and ‘Corporate and Auditing Accountability and Responsibility Act'. This act has set enhanced standards for all U.S. public company boards, management and public accounting firms. Sarbanes-Oxley Act created non profit corporation, Public Company Accounting Oversight Board (PCAOB) to oversee audits of public companies. The main purpose is to protect the interest of investors and further the public interest in the preparation of informative, fair, and independent audit reports for all publically traded companies. PCAOB registers and regulates all accounting firms. Regulation of accounting firm includes activities such as regular inspection of accounting firms, investigations and disciplinary proceedings and enforcement of compliance with professional standards. Sarbanes-Oxley act explains process of selecting competent audit committee members and ensuring accounting loopholes are taken care facilitating regulation of adequate reporting procedures. The Sarbanes-Oxley act also increased the accountability of auditing firms to remain unbiased and independent of their clients. Provisions are made in Sarbanes-Oxley act to make sure publically traded companies stick to significant new governance standards expanding role of board members supervising financial transactions and auditing procedures.

Provisions of Sarbanes-Oxley act:

Sarbanes-Oxley act requires each member of audit committee be member of the board of directors and be independent, means not being part of management team and not receiving any compensation from company as consultant for any other professional services. The Act prohibits loans to any directors or executives of the company in order to avoid conflict of interest. Audit Committee individuals should not have a financial interest in or any other conflict of interest with any entity doing business with the organization. The audit committee is directly responsible for hiring, setting compensation, and overseeing the auditor's activities. It also sets rules and processes for complaints concerning accounting and internal control practices. Company must disclose if they have at least one financial expert serving on auditing committee. Members of audit committee must have financial competency to understand financial statements, to evaluate accounting firm bids to undertake auditing, and to make sound financial decisions as part of their responsibilities. The audit committee should ensure that the auditing firm has the mandatory skills and knowledge backed by sufficient experience to carry out the auditing function for the organization and its performance is carefully reviewed. CEO, CFO, controller, and chief accounting officer of the company cannot have worked for the auditing firm they are hiring to do audit for one year preceding the audit.

The Act also requires the auditing firm to report to the audit committee all critical accounting policies and practices used by the organization and represent the preferred way management wants these policies and practices treated. The greater disclosure of these internal control practices and management's views on them, the better the transparency. Section 404 of the Act requires including management internal control report to its annual report. Such management control report states it is management's responsibility to establish and maintain an adequate internal control structure and procedures for financial reporting. Management must identify the framework used by management to carry out evaluation of effectiveness of such internal control for financial reporting with possible weaknesses. A statement from Auditor is also required in the form of an auditor's attestation report over management's assessment of internal control.