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Fraudulent Financial Reporting

• Effectiveness and efficiency of operations CORPORATE SCANDALS AND THE
SARBANES-OXLEY ACT
The COSO framework identified five interrelated compo- A series of business failures and financial scandals that
nents of internal control:
began with Enron’s disclosures of fraudulent behavior in
1. The control environment that sets the tone of an second half of 2001 caused a serious decline in investor
organization confidence in the capital markets. In an attempt to restore
public investor confidence, the federal government passed
2. Risk assessment that identifies and analyzes poten-
the Sarbanes-Oxley Act of 2002, which amended the
tial risks
Securities Exchange Act of 1934 and expanded rules con-
3. Control activities that are policies and procedures to cerning corporate governance. Sarbanes-Oxley improved
ensure that management objectives are carried out the oversight of external auditors and focused the atten-
tion of companies and auditors on internal control; it also
4. Information and communication that identify and
increased penalties for noncompliance. The intent of these
process information which enable people to carry
out responsibilities elements of Sarbanes-Oxley is to reduce the likelihood
that material fraud will go undetected.
5. Monitoring that assesses compliance with control
The Sarbanes-Oxley Act includes the following major
procedures
provisions affecting both management and external audi-
The framework provides only reasonable assurance tors:
because there are inherent limitations in any system of • The creation of the Public Companies Accounting
internal control.
Oversight Board (PCAOB)
• Rules designed to increase auditor independence
STUDY OF SEC ACCOUNTING AND
• New responsibilities for corporate directors, chief
ENFORCEMENT RELEASES
executive officers, and chief financial officers
In 1999 COSO issued the results of a study of SEC
accounting and enforcement releases between 1987 and • Enhanced financial disclosures
1997. This study attempted to gain an understanding of
The PCAOB is a five-member board of financially
the participants and the extent and duration of fraudulent
literate members. The board has the authority to establish
behavior. Because of the limitations of the study, the use-
auditing standards, quality control standards, and inde-
fulness of the findings were at best tentative and primarily pendence standards for audits of public companies. In
suggestive of the nature of the behavior of auditors and
addition, the PCAOB has the authority to inspect the
company officials.
work of public company auditors. The PCAOB’s deliber-
ations result in the adoption of rules that are submitted to
BLUE RIBBON COMMITTEE the SEC for approval. Prior to Sarbanes-Oxley, the
REPORT AICPA’s ASB was responsible for many of these functions
At the request of the SEC chairman, the New York Stock on a self-regulatory basis.
Exchange (NYSE) and the National Association of Secu- The Sarbanes-Oxley Act strengthened auditor inde-
rities Dealers (NASD) formed the Blue Ribbon Commit- pendence by making it unlawful for an auditor to perform
tee, which was charged with recommending ways to audit services for a public company and to also perform
enhance the effectiveness of audit committees. The Blue nonattest services such as bookkeeping and other consul-
Ribbon Committee, in its 1999 report, Report and Recom- tative services for the same audit client.
mendations of the Blue Ribbon Committee on Improving the The Sarbanes-Oxley Act increased penalties imposed
Effectiveness of Corporate Audit Committees, which was on the managements of public companies found to be
addressed to the heads of the two sponsoring organiza- responsible for false and misleading financial statements.
tions—NYSE and NASD—recommended stronger audit Included in the act is a provision requiring a public com-
committee oversight responsibilities relating to financial pany’s chief executive officer and chief financial officer to
reporting. Among the recommendations were the clarifi- certify the appropriateness of the financial statements and
cation of the relationship of the external auditor with disclosures contained in the company’s annual report.
management and the audit committee, improvement in Section 404 of the Sarbanes-Oxley Act and Auditing
oversights of the financial reporting process, and enhanc- Standard No. 2 issued by the PCAOB require corporate
ing communications about accounting reporting management and the company’s independent auditor to
processes between the external auditor and the audit com- issue two reports that must be included in the company’s
mittee. annual report filed with the SEC. These two reports

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 335