Thursday, March 10, 2011

Essay on Accounting

Essay on Accounting

Introduction
Over the last few years, several factors have caused concern over the reliability of corporate financial statements. The downturn in the economy put additional pressure on management to meet financial targets. The complexity of business structures and transactions and the difficult accounting standards have become too complex for the average financial statement user. The greed and dishonesty of some auditors and high-profile business failures have caused criticism and scrutiny of the relationships between accountants and their clients. The scandals surrounding the business failures have also diminished the public’s confidence in the accounting profession and company management.

Many organizations, including the Securities and Exchange Commission and the American Institute of Certified Public Accountants, have debated over the issues that led to the business failures. There have been countless suggestions of how to correct the problems that caused the failures. In an attempt to restore investor confidence in the capital markets, new rules for accountants and their clients have already been enacted. Numerous studies and proposals are also being considered to strengthen the reliability of audited financial statements.

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The rules dramatically change the accounting profession by creating a new private regulatory structure, restricting the services auditors can provide, and imposing larger fines for violators of the rules. The rules will also require public companies to enhance their audit committees and obligate their top management to certify financial statements. The new rules are intended to protect investors by improving the accuracy and reliability of financial statements. The additional costs of compliance and risk will be passed on to companies through increased audit fees, insurance, and salaries, leaving less for investors. The rules intended to protect investors will unfortunately result in additional costs for investors.

The new rules contain a multitude of provisions that will have far-reaching effects on accounting firms and their corporate clients. It seems certain the new rules will force both accountants and management to focus on their responsibility to provide objective and accurate information. The consequences of the rules will be recognized as accounting firms and their corporate clients struggle with compliance requirements, relationships, and profitability.

The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 is significant legislation affecting the accounting profession and its clients. The intention of the act is to protect investors by improving the accuracy and reliability of corporate disclosures. The Act, passed by Congress in July 2002, is a major reform package that will create a public company accounting oversight board, revise auditor independence rules, revise corporate governance standards, and increase criminal penalties for violations of securities fraud.

Public Company Accounting Oversight Board
Title I of the Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB) to regulate the accounting professionals who audit the financial statements of public companies. The PCAOB was established because the SEC felt accountants were not doing an adequate job policing their profession. Now, an independent board will monitor and discipline the profession with stricter requirements, higher costs, and harsher fines.

The PCAOB is comprised of five members. Two members must be or must have been CPAs. The remaining three members must not be or have been CPAs. Each member shall serve on the PCAOB on a full-time basis. No member can be paid a salary or profit from a public accounting firm. The SEC was required to appoint the chairperson and other initial members by October 28, 2002. It is clear the SEC was committed to finding strong leaders to fill the positions.

The founding members of the PCAOB are as follows:
  • Chair, William H Webster, former judge and head of the FBI and CIA
  • Kayla J. Gillan, former general counsel of the California Public Employee’s Retirement system
  • Daniel L Goelzer, CPA and attorney, former SEC general counsel
  • Charles D Niemeier, CPA and attorney, current chief accountant of the SEC’s enforcement division
  • Willis D. Gradison, Jr., a former Ohio congressman (AICPA)

The PCAOB must be organized and authorized by the SEC to function by April 26, 2003.
After the SEC determines the PCAOB is able to carry out its responsibilities, accounting firms will have 180 days to register with the new PCAOB, or cease all participation in audits of public companies. Applications will include the names of the companies the firm audited in the past year, those companies it expects to audit in the current year, and all fees received for services. It will include the firm’s most recent financial information. A statement of the firm’s quality control policies must be included. The application must contain a list of accountants who participate in audits, including any information relating to criminal, civil, or administrative actions against the firm, or any associated person of the firm. The PCAOB may request additional information in the application. Firms will be required to submit updated information at least annually. The PCAOB will collect a registration fee and an annual fee from the accounting firms. These fees will be enough to cover the administrative costs of processing and reviewing the applications and annual reports. An annual accounting support fee assessed on public companies will fund the balance of the costs of the PCAOB.

The PCAOB is responsible for establishing or adopting auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports. Previously, the Auditing Standards Board performed this responsibility. The new PCAOB is required to cooperate with professional groups of accountants and advisory groups when setting standards, but they can also amend, modify, repeal or reject standards suggested by these groups.

The PCAOB is responsible for conducting investigations and disciplinary proceedings and imposing sanctions against firms not in compliance with their standards. Annual quality reviews must be conducted for firms that audit more than 100 public companies. All other firms must have reviews at least every three years. The SEC and the PCAOB may order special inspections at any time. The PCAOB has the authority to investigate any act or practice that may violate the Act, the rules of the PCAOB, or the provisions of the securities laws relating to audit reports or professional standards. Disciplinary sanctions may include suspension or revocation of registration, censure, and fines. The Act contains several provisions relating to penalties and criminal violations of the Act and other federal securities laws. The maximum fine for persons willfully violating the Act was increased from $1 million to $5 million. The maximum prison sentence for violators was increased from ten years to twenty years. The Act also addresses increased penalties for failure to maintain audit work papers for five years; persons who knowingly alter, destroy, or falsify records in connection with a federal investigation; and mail or wire fraud violators.

Complying with the new requirements of the SEC and other agencies will increase the costs of doing business in public accounting. The accounting firms that audit public companies will be required to pay initial registration fees, annual registration fees, and annual accounting support fees to support the PCAOB. Registering and processing the annual updates will cause internal administrative costs to rise. Public accounting firms will also see increased costs in inspections by the PCAOB and costs involved in defending any disciplinary hearings or sanctions. The SEC has the reputation of being burdened with too many cases not investigated or closed timely, due to its lack of resources, staff turnover, and low employee moral. The SEC’s poor reputation is likely to change in the near future. Nyberg claims, “During the next year, the SEC is expected to devise 24 sets of new rules, launch and complete six major studies, shepherd the formation of the new public accounting oversight board, hire 200 new employees, and review one out of three filings. To smooth the way, Congress promised $776 million, which amounts to a 77 percent year-over-year budget increase” (57). SEC Chairman, Harvey L. Pitt said, “Discipline and quality monitoring must be responsive not to the profession, but to the SEC” (McNamee, par. 3). Armed with increased funds, better strategies, and the ability to assess increased fines and penalties, the SEC is in a stronger position to monitor and regulate public companies and their accountants. It is possible many accounting firms will need an internal staff just to ensure compliance. Smaller firms, unable to bear the increase cost of compliance, will cease doing business with public companies or they will merge into larger companies. Accounting firms that continue to provide audit services to public companies will include the additional fees and costs of compliance in their audit fees, causing them to rise. The increased costs absorbed by the company will decrease earnings and dividends paid to the shareholders. The increased cost of filing audited annual and quarterly reports could also discourage small, privately owned companies from entering the public markets and cause some public companies to take their business private.

Auditor Independence
Title II of the Sarbanes-Oxley Act of 2002 addresses auditor independence. The Act states it is unlawful for a registered firm, which is issuing an audit opinion, to perform non-audit services including: bookkeeping, financial systems design and implementation, appraisals or valuations, actuarial services, internal audit outsourcing services, management functions or human resources, investment services, legal and expert services, and any other services determined by the PCAOB. Other services, including tax services, are permissible only if pre-approved by the public company’s audit committee and disclosed in their periodic reports to the SEC. The act also requires the lead audit partner and the concurring review partner rotate off the engagement if he or she had performed audit services for the company in each of the five previous years. In another effort to protect the independence of an audit, the Act makes it unlawful for accounting firms to provide audit services if the client’s CEO, CFO, controller, or chief accounting officer was employed by the auditing firm and participated in the audit of the company during one year prior to the start of the audit.

The Act ends the long debate about the appropriateness of auditors performing non-auditing services, but the rules are likely to cause the costs of conducting audits to rise. Synergies that exist when a firm provides non-auditing services to clients will now be lost because they are now considered an impairment of independence. Accountants that have a comprehensive knowledge of a company, because they perform duel services such as financial information systems design and audits, will no longer be able to capitalize on their efficiencies. Ericson states, “The Investor Responsibility Research Center surveyed more than 1,200 firms in the S&P 500, mid-cap and small cap markets during fiscal year 2000. These companies reported paying a total of $5.7 billion to their auditors, of which 72 percent related to non-audit services, on a weighted average basis” (par. 7). In the past, accounting firms could present a potential client with proposed audit fee at a discount rate because they anticipated recovering those costs in other more lucrative non-audit services. Many of the larger accounting firms have or will spin-off portions of their consulting businesses. The age of using audits as a loss leader is over. Accountants will be forced to submit the actual costs of the audit in their proposals. It is almost certain audit fees will increase if there are no anticipated profits from other services.

Accounting firms are now required to rotate the lead auditor and reviewing partner off the engagement every five years. This regulation appears to be the result of rigid opposition of a proposal to mandate audit firm rotation. Since the Act doesn’t specify the capacity in which the auditor provided services, services provided as a manager or other capacity would count toward the five-year period. The rotation requirement is especially harmful to smaller regional firms since they don’t have enough SEC audit partners to rotate each five years. The rotation requirement could force some smaller accounting firms to consolidate. Proponents of the rotation requirement argue, if auditors know their work is for a limited period and will eventually be scrutinized by a successor, they would be less likely to sacrifice accounting rules for the sake of a friendly relationship. Advocates of the regulation argue it will cause increased audit fees due to loss of accumulated audit knowledge of the client. While both sides of the argument are credible, the requirement may improve the perceived independence of auditors.

Public Company Audit Committees
Title III of the Sarbanes-Oxley Act of 2002 addresses corporate responsibility. Public companies must have an audit committee independent from company management and the auditing firm. The audit committee is responsible for auditor selection, compensation, and supervision. The Act also requires auditors to report directly to the public company’s audit committee. The audit committee must develop procedures for addressing complaints concerning audit issues. The committee must also develop procedures for employee whistleblowers to submit their concerns regarding accounting or auditing matters. The audit committee must have the authority to hire independent counsel and advisors.

Requiring auditors to report directly to the audit committee reinforces the position that the primary duty of the auditors is to the company’s board of directors and the shareholders, not to senior management. The considerable expansion of the audit committee duties and authority will require a great deal of planning and organization by the company in the beginning. A greater commitment of time and effort, by the company and the audit committee, will be needed to comply with the Act. Individuals who serve on audit committees will receive greater public scrutiny and must meet qualifications of independence and financial literacy. Public companies may discover finding qualified, independent individuals willing to accept the risks and commitment is difficult and costly. Farrell and Krantz claim, “Aggrieved investors are filing lawsuits, not just against the management of companies that admit to accounting irregularities, but against their board of directors and their audit committees. If the lawsuits are successful, audit committee members who once operated with a sense of immunity could soon find themselves liable for not catching the accounting misdeeds of others” (par.6). Due to increased risks of the position, audit committee members will not hesitate to hire advisors and independent counsel at the expense of the company. They will not hesitate to ask the auditors to do more work if problems arise. The expanded duties and the rules of conduct, now required of audit committees, will make them more vulnerable to litigation. Companies will be forced to pay larger fees to members and incur higher costs of insurance for the additional risk and commitment of audit committee members.

Corporate Responsibility for Financial Reports
Title III, Section 302, of the Sarbanes-Oxley Act of 2002 requires the principal executive officer and the principal financial officer to certify that the corporate financial statements and disclosures fairly present the company’s operations and financial conditions. Their certification must also state they are responsible for the design, evaluation, and effectiveness of the company’s internal controls. The balance of Title III addresses other issues related to directors and officers of public companies. The Act prevents CEOs and CFOs from benefiting from profits they receive as a result of misstatements of their company’s financial statements. If a company is required to restate their financial statements, the CEO and CFO must forfeit the profits and bonuses they received for that period. The Act also empowers the SEC to bar persons from serving as officers or director if they committed a securities law violation and their conduct was considered improper for an officer or director. Public companies cannot make loans to directors or executive officers, subject to limited exceptions. Additionally, companies cannot materially modify or renew any existing loans.

The certification requirement has caused mixed emotions among many executives of public companies, boards, and shareholders. The supporters of the requirement believe it will cause CEOs and CFOs to become much more involved in the internal controls of the company and more concerned with the accuracy of the financial reports. Critics of the certification requirement claim it will cause CEOs and CFOs to become too conservative and unadventurous. The same individuals that once led the company in vibrant, bold, profitable, ventures will become complacent and reject any ventures that could involve risk. This new responsibility will undoubtedly be a collaborative effort with senior management as well as most financial personnel, both inside and outside the company. Executives in large companies will have to rely on the efforts and opinions of others. This could raise questions and litigation on whether they personally met the Act’s requirements. Companies will have to pay much more for insurance to cover the risk that their executives might be sued. Reynolds claims, “Troubled companies, being most vulnerable to lawsuits, will have to pay premium salaries for the talent required to turn things around” (par. 7). The rules relating to officers and directors are results of recent high-profile misconduct. Stock options and large loans have been given to company officers to reward them for their performance. Stock options have been used for several years as an incentive for officers to increase the stock value of the company. Unfortunately, some CEOs were deceptive in driving up the value of the stock, because they could profit from selling the stock after it rose in value. The Act will prevent executives and directors from fictitiously driving up stock prices, for their own profit.

The Sarbanes-Oxley Act of 2002 effects public accountants and management of public companies. The Public Company Accounting Oversight Board and auditor independence sections of the Act pertain to public accountants performing audits for public companies. The public company audit committees and corporate responsibility sections are aimed at public companies. All of the sections were intended to improve the accuracy and reliability of the financial statements of public companies, but have potential negative effects on accountants and their clients.

Other Rules, Proposals and Guidance
The Sarbanes-Oxley Act of 2002 mandates the completion of several studies that may result in additional rules. The Act states the Comptroller General shall conduct a study and review of the potential effects of mandatory rotation of audit firms. Mandatory rotation refers to a requirement to limit the number of years which a public accounting firm may audit a company. The study has caused many public companies to consider the advantages and disadvantages of audit firm rotation. Another study required by the Act includes a review and analysis of all SEC enforcement actions involving violations of reporting requirements during the past five years. This study will identify the areas most susceptible to fraud and manipulation. It seems clear the SEC is looking deeper into past misconduct and many of the studies will develop into additional regulations.

The Sarbanes-Oxley Act of 2002 contains the most extensive legislative changes relating to the relationships of accountants and their clients, but other organizations are also placing restrictions on those relationships. The Act directs state regulators to make independent determinations as to whether the PCAOB standards shall be applied to small and medium-sized non-registered accounting firms. Osterland noted, “The New York Stock Exchange will prohibit auditors of listed companies from serving as independent directors on the boards of former clients for five years. The “cooling-off” period will be three years for Nasdaq listed companies” (48). Even the American Institute of Certified Public Accountants (AICPA) is developing new guidance for the accounting profession. Barry Melancon, AICPA President stated, “While the new Public Company Accounting Oversight Board has broad responsibilities, CPAs have a responsibility to set standards for their own profession, just as professionals do in medicine, engineering and architecture” (Melancon, 29).

It is unlikely that we have seen the end of the new regulations. The Sarbanes-Oxley Act of 2002 is only the beginning of the process to improve corporate governance. The SEC and other organizations will develop additional rules and restrictions for accounting firms and their clients.

Conclusion
The high profile business failures of Enron and WorldCom have caused our markets to be much more volatile and have created a lack of confidence in public accounting firms and corporate management. Accountants, once known for their integrity, competence and objectivity, are now criticized for their unscrupulous deals with corporate management. There has been concern over the lack of effectiveness of the profession’s self-regulatory process. To ensure the past misconduct is not repeated, the SEC and other organizations have enacted laws regulating the accounting profession and corporate clients. The by-products of the new laws and regulations may not be as optimistic as the intentions of the new rules.

The new requirements under the Sarbanes-Oxley Act of 2002 have dramatically changed the accounting profession. The fees and the compliance requirements of the PCAOB, which has the authority to authorize, regulate, and punish auditors, will increase the costs of doing business in public accounting. The requirements to make auditors more independent will also make them less efficient. In most cases, the additional costs and lost efficiencies will be passed on to their clients through increased audit fees. Some accounting firms may be required to cease doing business with public companies or merge with other accounting firms. The past scandals and new rules have made many accountants more defensive and conservative, which means tougher audits and fewer debates over the interpretation of accounting rules, causing tension in some auditor-management relationships.

Public companies will be required to commit more time, money, and effort to comply with the Act. For some companies, a great deal of time will be spent finding qualified, independent audit committee members who are willing to commit the additional time. CEOs and CFOs will spend more of their time ensuring the accuracy of the financial disclosures and the reliability of internal controls. The additional time, money, and efforts spent on compliance with the Act could cause a material drain on important corporate resources. The recent history of corporate scandals, fear of a stronger SEC, and the concern of increased penalties could cause many companies to become passive and reject any risky ventures. The initial efforts by public companies to meet the Act’s requirements will probably result in some discovery of internal control weaknesses and previous accounting errors. Companies will be required to restate their financial statements, causing instability in the market value of the company’s stock.

The new rules primarily focus on public companies and their auditors. There is concern whether the same rules given to public companies and their auditors will be applied to non-public companies and non-registered accounting firms through state laws. This would cause severe damage to accounting firms and non-public companies, if they cannot bear the additional costs.

The SEC, the accounting profession, and corporate management have important roles in maintaining efficient and stable financial markets. More clear and comprehensive information is required from independent, objective, and honest accountants and corporate managers in order to restore confidence in the financial markets. The new rules are tough and will take much effort and expense by all organizations, but they will help to restore confidence in the relationships between accountants and their corporate clients.

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