Public Company Accounting Oversight Board Pcaob example essay topic

Wednesday, July 31, 2002 H.R. 3763 - The Sarbanes-Oxley Act of 2002 A lot has been made, perhaps without justification, of the July 30, 2002 passage of H.R. 3763, The Sarbanes-Oxley Act of 2002 ('Sarbanes-Oxley' or The Act). Having read the Act, I suspect that the great praise is unfounded. I intend to address three issues presented within the act. First, I will address stock options as considered (or neglected, as the case may be) by Sarbanes-Oxley. Second, I will address the creation of a Commission designed to oversee audits and corporate accounting practices, and the potential efficacy of this Commission.

Finally, I will address the modifications to the Federal Sentencing Guidelines as it relates to corporate fraud. The failure to directly address accounting practices as they relate to stock options and other corporate incentives in Sarbanes-Oxley indicates the flaw in Federal regulation of corporate practices. Sarbanes-Oxley was designed to address the fraudulent accounting practices undertaken by the accountants for Enron and World Com. One of the biggest problems with regard to the accounting used in preparation of financial statements by corporations has been the issue of non-salary executive compensation. Corporations, as part of a combined incentive and retention program, often offer executives stock options and enhanced performance pay. The key debate, with regard to accounting practices, has been how these incentives should be depicted on annual and quarterly corporate financial reports.

The position of the Internal Revenue Service has been that corporations, in order to fairly obtain the tax benefits often garnered on corporations based on their compensation plans, should list these compensation plans (options, in particular) as expenses on their financial reports. See Simon Kennedy and Brendan Murray, IRS Proposes Stock Options be Expensed for Some U.S. Affiliates, Bloomberg News Wire Service (Jul. 26, 2002). If corporations were to expense executive compensation plans, this would reduce their overall profits. However, there are those, including the celebrated and successful CEO of Berkshire Hathaway, Warren Buffett, who argue that this reduced profit figure is a more accurate reflection of a corporation's performance. See Warren E. Buffett, Who Really Cooks the Books, NY Times (Jul. 24, 2002). 'When a company gives something of value to its employees in return for their services, it is clearly a compensation expense.

And if expenses don't belong in the earnings statement, where in the world do they belong?' Id. Sarbanes-Oxley only indirectly addresses the problem of the inclusion of executive compensation in financial statements. Title I, Section 108 of the Act requires audits to follow generally accepted accounting practices for the preparation of corporate financial statements. It makes no judgment as to the treatment of options by corporate auditors. This leaves it to the newly created Oversight Board to determine what standards are acceptable in the treatment of options. As noted by Mr. Buffett, supra, this leaves open the loopholes created by the 1994 Securities Act.

There is no requirement that corporations accurately reflect executive compensation as an expense on their financial reports. Thus, it is still possible that earnings statements by corporations remain 3-5% higher than actual corporate earnings, even with the enactment of Sarbanes-Oxley. This can become problematic, as shareholders will not have accurate information upon which they can act to ensure accountability in their Boards of Directors. C. f., In re Walt Disney Co. Derivative Litigation (where shareholders challenged compensation programs awarding astounding amounts of money to Michael Ovi tz as part of a 'golden parachute'). The creation of the new Oversight Board fails to directly address the true problems of recent corporate fraud: direct accountability of corporate boards to their shareholders. Section 101 of the Act establishes the Public Company Accounting Oversight Board (PCAOB... why can't they pick acronyms that are pronounceable?

). PCAOB will then adopt policies and create an annual report that will be submitted to the SEC, which will, in turn, submit that report to the Senate Committee on Banking, Housing, and Urban Affairs (which should be a committee addressing torrid relationships in Chicago). Basically, the PCAOB will act as an ethics advisory committee (in New Jersey, the closest equivalent is the Supreme Court Committee on Attorney Ethics) for those accountants that engage in audits of public companies. The Board will be able to punish accountants that engage in misconduct during public audits.

The Board will (and I think this is most important and troubling) set the standard used in accounting practices. In other words, the Board decides what is an appropriate accounting formula. The first problem with the Board is simple. Yes, the Board will be able to punish 'bad' accountants. Here's a simple rhetorical question: were we not able to punish 'bad' accountants in the past? Of course not.

Fraud has been punishable going all the way back to early British common law. Why do we need a new administrative body to punish people for fraud? Is this not the purpose of the SEC and the Department of Justice? If the old agencies - SEC and DOJ - were either unwilling or unable to punish accountants and corporate officers adequately for fraudulent conduct, the sole result should have been a modification of the sentencing guidelines (which was made in the Act as well). The creation of a new administrative body will not fix the problem.

Greater, more thorough enforcement will. Second, the Board has the power to set the particular accounting standard used in public audits (simply by virtue of being able to declare what is a generally accepted accounting practice). If this is the case, the Board has the potential to stifle new developments in accounting theory. Now, I am not an accountant, and I know little about that practice, but I do know that mathematical formulae within that field change often. For example, when stock options are valued, they are assessed through the Black-Scholes Model. This model, a giant algorithm, then estimates the present value of the options if they were exercisable today.

Now, initially, Black-Scholes was based on the European form of options, which were not exercisable after a certain date specific. In America, we use the reverse format of options. Options are not exercisable until after a certain date specific (i. e., after a 'blackout period'). Thus, someone came along and later modified the Black-Scholes model to create a more accurate appraisal of an option's present worth.

If this had occurred after the creation of the Board, the board would have the power to effectively declare the use of the new Black-Scholes model to be unlawful, as the old, European model was widely accepted long before the new one. Thus, the Board would have the power to stifle the use of an accurate accounting method. This seems to be de facto a bad possibility. Instead, the Act should have focused on the creation of general, non-specific laws addressing accounting misconduct. Modifications to the Federal Sentencing Guidelines may have given the SEC more teeth, but not nearly in proportion to the profit derived from corporate fraud. There's an old story that I have neither the time nor inclination to verify.

When Michael Milken was punished for insider trading, he served five years in minimum security prison and was fined about $30 Million. At the same time, even after the fines, he earned $300 Million from his misconduct. From a cost-benefit perspective, if this story is true, crime pays quite well when your collar is white. White collar crime has notoriously been under enforced and inadequately punished. Sarbanes-Oxley attempts to rectify this as to corporate fraud by increasing, in Section 1106, the penalties for violations of the Securities Exchange Act of 1936.

Fines have been increased (the maximum possible fine is now $25 Million per violation, instead of $2.5 Million), as have prison terms (20 years maximum). Still, the problem remains: who cares if they are fined $25 Million if they make $250 Million? There needs to be stronger enforcement policies. A theory I think might be useful is to borrow from the Racketeering Influenced Corrupt Organizations Act (RICO). Fines should not be set as a constant. They should reflect the social cost of the crime.

Thus, as with RICO, fines should be set at a level three times that of the social cost of the criminal act (a. k. a., treble damages). Imagine how reluctant Milken would have been to engage in insider trading had he known that he would make -$600 Million as a result of $300 Million in social costs? Conclusion Sarbanes-Oxley is a very well-intentioned act. However, it lacks teeth in areas where it needs them, and goes too far in areas where actual enforcement of pre-existing laws would solve the present regulatory problem. The Act, I suspect, may be the source of more problems in the future. Further, it is unlikely to work as the curative salve it is intended to be for the stock market / economy..