Magazine article The CPA Journal

The Sarbanes-Oxley Act and the Evolution of Corporate Governance

Magazine article The CPA Journal

The Sarbanes-Oxley Act and the Evolution of Corporate Governance

Article excerpt

Editor's Note: Second in an ongoing series

The purpose of this series of articles on the Sarbanes-Oxley Act of 2002 and the evolution of corporate governance is to determine the actions required to prevent a recurrence of the present investor confidence crisis in American financial institutions. The first step requires an analysis of the available empirical evidence on the recent corporate governance transgressions to determine their nature, the participants, and the probable causes.

During the fall of 2003, the author conducted a study of 116 of the most notorious cases of corporate governance infringements by corporations, public audit firms, and other financial market participants. The study involved over 150 public companies and their auditors. Company executives personally implicated in 39% of the infringements have been convicted, charged, plead guilty, or are being tried in court; 8% of the cases have been settled with the SEC; 27% are being investigated by the SEC, the Department of justice, or other government agencies; and the remaining cases have resulted in voluntary restatements and write-offs.

What Went Wrong?

The study revealed that the most common transgressions are related to net profit overstatements using a creative variety of fraudulent accounting records affecting revenues, costs and expenses, or special reserves accounts. The number of executives who openly tapped company funds for their personal benefit or who profited from insider trading or misleading public disclosures is not insignificant. Below are the most common deviations from accounting standards.

Revenue recognition. The most common violations of revenue recognition include anticipated recognition; sales booked without transfer of property; "round-trip" transactions; deferred accounting of discounts, rebates, or guarantees; channel stuffing; collusion with vendors; and accounting of swaps as revenues.

One of the most outrageous cases of revenue overstatement was the reduction of $6.4 billion in revenues made by Xerox in June 2002, covering the 1997-2001 period. Only $1.9 million was an early recognition of revenues that belonged in 2002 and beyond; the balance was a plain overstatement of revenues, with an earnings impact of $ 1.4 billion.

Another technique, much used in the energy industry, was the recording of round-trip trades as sales. Enron, Dynergy, Reliant Resources, El Paso, CMS Energy, and Duke Energy all inflated revenue this way.

Reserves. Manipulation of reserves is another tool used by dishonest executives to meet earnings targets. The discretionary nature of these accounts provides the opportunity to meet Wall Street forecasts by increasing or decreasing earnings at will.

An example of overstatement of earnings by keeping reserves not entirely supported by the financial reality of the company is the 2003 write-down of $1.05 billion of tax reserves by Sun Microsystems.

AOL Time Warner and JDS Uniphase each made multibillion-dollar downward adjustments to goodwill in 2002. These adjustments are another example of untimely recognition of an economic reality. The bursting of the "tech bubble" in March 2000 reduced the market value of many dot-corn companies so drastically that the prices paid to acquire these companies subsequently looked absurdly overstated.

Understatement of debt. The Enron and Adelphia cases are examples of debt understatement. In the case of Enron, special purpose entities hid billions of dollars in debt. As debt was understated, equity was overstated, giving the investment community a false impression of the company's financial soundness. With the assistance of senior finance managers, Adelphia executives fraudulently excluded over $2 billion in bank loans from the balance sheet.

Who Benefited?

Earnings per share is the most widely used measure for executive performance. Manipulation of earnings resulted not only in fraudulent financial results, but also in greater executive compensation. …

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