Government Regulation

Research Paper 1

Crystal Carrothers

Introduction Government regulation is around us everywhere. The government needs to make sure that the public’s interests are maintained and preserved. Being an accounting student, I have heard and read about regulation in the accounting industry numerous times. There have been many major accounting scandals in history that have lead to many different kinds of government regulation. The government regulations in accounting are mostly enacted to protect investors. From 2000 to 2002 there was an abundant number of large corporate accounting frauds, which led to the Sarbanes-Oxley Act of 2002. Previous regulations were efficient to a certain extent, but scandals still happened and more regulation seemed to always be needed. Even though the new SOX regulation seems powerful and efficient, I believe that there will always be a need for additional regulation in order to prevent future scandals.
Securities Acts of 1933 and 1934
Summary of Regulation The stock market crash of 1929 resulted in the Securities Act of 1933. This act required that before a company an offer or sell securities in a public offering, they must register the securities with the Securities and Exchange Commission (SEC). The registration statement is used to notify the SEC that a sale of securities is pending and that the information needs to be disclosed to prospective buyers. This statement includes information about the issuer and its business, a description of the stock, the proposed use of the proceeds from the offering, and audited balance sheets and income statements. This registration process ensures that buyers of the security have accurate and complete information about the security before they decide to invest in it. Even though the SEC requires all of this information, they do not investigate the quality of the offering. They are mainly concerned with the accuracy of the securities, and the Securities Act of 1933 prohibits fraud in any securities transactions, whether or not they are registered (Spindler, 2006). A year later, the Securities Exchange Act of 1934 was put into place. This act requires that public companies continuously disclose annual reports, quarterly reports, and form 8-K’s, which are used to report significant events. Because most buyers do not purchase new securities from the company in an initial public offering and instead buy stock, which is secondhand because other people have already owned it, the Act’s purpose is to provide those investors with ongoing information about the companies. This disclosure policy was enacted to provide investors and speculators with enough information to enable them to arrive at their own rationale decisions and to prevent financial manipulation (Benston, 1973).
Analysis of related fraud/scandal The famous Martha Stewart scandal is a great example of fraud relating to the securities acts. Under section 17(a) of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934, insider trading is not allowed. Insider trading is trading a corporation’s stock or other securities as a result of hearing non-public information about the company. In December of 2001, Martha Stewart avoided a loss of $45,673 by selling all 3,928 shares of her ImClone Systems stock after receiving material, nonpublic information from her broker Peter Bacanovic. It turned out that the day after she sold the stock, it fell 16%. The federal court in Manhattan alleged that Stewart committed illegal insider trading when she sold the stock of the biopharmaceutical company. Not only did she commit insider trading, but her and Bacanovic created an alibi for the ImClone sales and concealed important facts during SEC and criminal investigations (Carlin, 2003). The punishment for insider trading can be fines, imprisonment, and paying three times the profit made to the SEC. Stewart was sentenced to serve a five month term and a two year period of supervised release. She also paid a fine of $30,000 and paid $137,019 for three times the loss she avoided (Carlin, 2003). This scandal may be a result of an inadequacy in these two regulations because insider trading was not the main focus of the acts and the language relating to it is found deep inside the documents. But I think that since Stewart was a stockbroker, she would have known that what she was doing was unlawful and that this scandal was a result of her own foolishness.
The Foreign Corrupt Practices Act of 1977
Summary of regulation In 1977, a study was conducted by the SEC that revealed that some 400 companies had paid hundreds of millions of dollars in questionable payments to foreign officials. These payments were made for various reasons, but most were made for bribery of high foreign officials in order to secure some type of favorable action by a foreign government and for facilitating payments that allegedly were made to ensure that government functionaries discharged certain ministerial or clerical duties. The Foreign Corrupt Practices Act (FCPA) of 1977 was a result of that study (Holt, Fincher, 1981). The FCPA was an amendment to the Securities Exchange Act of 1934 and it states that it is a crime to bribe foreign officials in order to obtain business. It is not allowed for any American company to make or promise to make payments or gifts to foreign officials, political candidates, or parties in order to influence a governmental decision, even if the payment is legal under local law. The only exception is making payments to expedite a routine governmental action. Not only did the FCPA create this antibribery law, it also required that companies develop and maintain a system of internal accounting controls that would provide reasonable assurance that the corporate funds are not being used for corrupt purposes. The punishments for violations include fines of up to one million dollars for corporations and ten thousand dollars or five years for individuals (Holt, Fincher, 1981). One disadvantage of the FCPA is its hindrances to foreign trade. Many companies may simply refrain from certain activities that may possibly violate the act, which in turn causes current and future foreign trade to suffer.
Analysis of related fraud/scandal General Electric Company was charged with violations of the Foreign Corrupt Practices Act in July of 2010. GE was involved in a $3.6 million kickback scheme with Iraqi government agencies that occurred from approximately 2000 to 2003. This scheme was in order to win contracts to supply water purification equipment and medical equipment. The payments were in the form of cash, medical supplies, computer equipment, and services to the Iraqi Health Ministry or the Iraqi Oil Ministry in order to obtain valuable contracts under the U.N. Oil for Food Program, and the payments were made by GE and four of its subsidiaries. General Electric and its subsidiaries involved in the illegal kickback payments were charged with violating the books and records and internal controls provisions of the FCPA. GE agreed to pay $23.4 million to settle. This $23.4 million was composed of: $18,397,949 in disgorgement of profits, $4,080,665 in prejudgment interest, and a $1 million penalty (Scarboro, 2010). Unlike the Martha Stewart case, GE actually cooperated with the investigation. I think that the General Electric scandal was partly a result of an inadequacy in the regulation. According to Touch Ross and Company, there are no regulatory rules or guidelines on how the law should actually be applied. Auditors also cannot always give legal advice like a lawyer could. Auditors are the professionals who check the books and controls, but an auditor might see information that seems reasonable whereas a regulatory agency might disagree. There were many weaknesses in the accounting provision in the FCPA that actually led to the strong accounting provisions of the Sarbanes-Oxley Act.
Sarbanes-Oxley Act
Summary of regulation After numerous major corporate and accounting scandals, including those affecting WorldCom, Enron, and Tyco International, the Sarbanes-Oxley Act was formed. These scandals cost investors billions of dollars and shook the public confidence in the nation’s securities markets, and the Sarbanes-Oxley Act was quickly put into place to help restore that confidence. The Sarbanes-Oxley Act, commonly known as SOX, was enacted in July of 2002. It set new or enhanced standards for all U.S. public company boards, management and public accounting firms and contains 11 sections. This act created the Public Company Accounting Oversight Board (PCAOB), which provides an independent oversight of the public accounting firms that audit companies and enforces compliance with the mandates of SOX. Another important part of this regulation is auditor independence, which mainly restricts companies from providing non-audit services to the same clients that they are auditing. The purpose of auditor independence is to limit conflicts of interest, which was a major cause of the numerous scandals that led to SOX. One major requirement from this act is the individual responsibility that senior executives have for the accuracy and completeness of their corporate financial reports. Requiring a company’s CEO and CFO to certify the adequacy of the internal controls and financial reports is a main reason why the securities acts and the Foreign Corrupt Practices Act have not been as successful as everyone had hoped. Personal liability of these top officers has led to an increase in the companies reporting internal control weakness and violations of various types, including violations of the FCPA. (White, 2009). Another big impact of the Sarbanes-Oxley Act of 2002 is enhanced financial disclosures. Some of these disclosures include pro-forma figures, off-balance-sheet transactions, and stock transactions of corporate officers. The FCPA requires companies to maintain adequate internal controls, but those have shown to be insufficient in many cases. SOX requires a management letter, which the auditors send to the company after each audit addressing internal control weaknesses. Management then has to write a letter back explaining that the internal control problems either have been, are being, or will be fixed and the CEO and CFO have to certify that they are responsible for this (Wiesen, 2003). This increased awareness and responsibility has led to better internal controls and less fraud. Many opponents of SOX argue that the costs are too high, but according to Enofe (2010), numerous surveys have shown that companies who have used the SOX regulations rate the effectiveness of the compliance activities equal to or higher than the costs.
Analysis of related fraud/scandal As mentioned above, Enron was one of the huge accounting scandals that led to the Sarbanes-Oxley Act. The scandal was revealed in October of 2001 and led to the bankruptcy of Enron and the dissolution of Arthur Andersen. Enron’s price per share dropped from $90 to less than $1. Shareholders lost around $11 billion and revised financial statements for the previous five years indicated that there was $586 million in losses (Yuhao, 2010). Many of the actions that caused the Enron scandal are now set as regulations in the Sarbanes-Oxley Act. The management of Enron had quite a lack of truthfulness when it came to the health of the company. They believed that Enron was the best at everything they did and they wanted to protect their reputations and their compensation. Enron’s CEO told employees that the stock would probably rise, but at the same time he was selling stock to repay money he owed to Enron. The CFO also headed the special accounting entity that borrowed large sums of money from Enron and did not report the debt on Enron’s financial statements (Yuhao, 2010). Accounting rules allowed a company to exclude a SPE from its own financial statements, but only if an independent party has control of the SPE; the CFO of Enron was certainly not an independent party. These unlawful actions by the CFO and CEO are now less tempting by companies to commit because of the personally liability that they have under SOX. Also, under this new act, there are expanded financial disclosure regulations with relation to a firm’s relationship with unconsolidated entities. One of the most significant regulations of the Sarbanes-Oxley Act, conflict of interest, played a huge role in the Enron scandal and many other scandals. Arthur Andersen was not only the auditor for Enron, but also their consultant. This lack of auditor independence can often lead to conflicts of interest between their own self-interest and their professional obligation to give good advice. The Sarbanes-Oxley Act prohibits accounting firms that audit public companies from providing consulting services to their audit clients on topics such as bookkeeping, financial information systems, human resources, and legal issues that are unrelated to the audit. In the case of Enron, I do not think that the whole corporation, including shareholders, is responsible for the scandal. I believe that certain individuals, including the CEO, CFO, and the employees that helped carry out the fraud even though they knew it was wrong, are the people that would be responsible for this scandal. This Enron scandal was a result of inadequacy in previous regulations, before Sarbanes-Oxley. If they included all of the regulations that SOX includes, there would have been a much less chance, if any, for this large accounting fraud to occur.
Conclusion
The recognition of the weakness in the accounting provisions from the FCPA led to the strong accounting provisions of the Sarbanes-Oxley Act. The personal liability of the CEO and CFO has resulted in an increase in the companies reporting internal control weakness and violations of various types, including violations of the FCPA. SOX also increased the size of the penalties, which forces companies to be more concerned about violating the FCPA (White, 2009). In addition, Sarbanes-Oxley has significantly increased the responsibilities of auditors, where other acts in the past have not. The accounting profession is a reactionary profession. It reacts to changes taking place in the economy as it relates to company financial management and scandals that occur (Parles, O’Sullivan, Shannon, 2007). The Securities Acts of 1933 and 1934 seemed to do a good job of regulation, but more was needed to prevent fraud. Later came the Foreign Corrupt Practices Act, which was an amendment to the Securities Act of 1934. This amendment was needed because of scandals that previously happened and a regulation that needed to be put into place to prevent future scandals of that nature. Eventually, the Sarbanes-Oxley Act was formed as a reaction to more scandals, which created more regulations and rules that would hopefully prevent future scandals. All of these regulations were different from each other, but each one helped out by providing more regulation to prevent more future fraud. As proven in the past, more regulation has always been needed as the economy changes, which leads me to believe that there will be a need for additional regulation in the future. Sarbanes-Oxley was signed into law to improve corporate governance and change the industry from self-regulation to government regulation. The failure of the corporate giants under self-regulation was a signal to the SEC that the profession is not capable of self-regulation unless it changes its image from a reactionary to a proactive profession.

References

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