Regulatory Bodies, StandardSetters, and Best Practices

Chapter VII

Chapter Objectives: • Understand the roles and responsibilities of regulators and standard setters.

• Provide an overview of fundamental provisions of SOX and their impacts.

• Provide an overview of the evaluation of SOX (cost and benefits).

• Understand why the SEC was established.

• Provide an overview of the primary functions of the PCAOB.

• Become familiar with the role of the FASB and its activities.

• Provide an overview of the GASB.

• Understand the challenges facing the IFAC.

• Identify the primary responsibilities of the Committee of European Securities

Regulators.

• Understand the role and authority of the state attorney general.

• Be aware of how state laws affect corporate governance.

• Be aware of the role of courts in corporate governance.

• Become familiar with corporate governance listing standards and best practices.

Key Terms Accounting and Auditing Enforcement Releases (AAERS)Accounting Regulatory Committee (ARC)Administrative law judgesAmerican Bar Association (ABA)American Institute of Certified Public Accountants (AICPA)AnticontractarianistsBlackout periodCalifornia Public Employees’ Retirement System (CalPERS)Committee of European Securities Regulators (CESR)ContractarianistsCouncil of Institutional Investors (CII)European Financial Reporting Advisory Group (EFRAG)Generally accepted accounting principles (GAAP)generally accepted accounting standards (GAAS)Government Accounting Standards Board (GASB)International Accounting Standards Board (IASB)investment protection principles (IPPs)Investor Task ForceOffice of Risk Assessmentself-regulatory organization (SRO)U.S. Sentencing Commission (USSC)

Regulations Regulations are aimed at protecting the investors and creating an environment for organizations to conduct their affairs in the utmost ethical, legal, and competent manner.

Regulations are typically enacted in response to specific crises and concerns or protection needed due to the failure of market based correction mechanisms. Adequate regulation creates a balance between reducing the likelihood of recurrence of the crisis and the imposed enforcement and compliance costs. Underregulation is when adequate rules are not in place to ensure long-term improvements and stability.

Sarbanes –Oxley Act of 2002 Was enacted in July 2002 in response to the economic downturn of the early 2000s, several years of steady decline in the capital markets and numerous high-profile financial scandals.

The fundamental provisions of SOX can be categorized into the following five categories: (1) corporate governance; (2) financial reporting; (3) audit functions; (4) federal securities law enforcement; and (5) others (e.g., legal counsel, financial analysts).

SOX provisions Influence on corporate governance: (1) auditors, analysts, and legal counsel who were not traditionally considered as components of corporate governance are now brought into the realm of internal governance as the gatekeepers, (2) the legal status and fiduciary duties of directors and officers, particularly the audit committee and CEO, have been enhanced significantly, (3) certain aspects of state corporate law were preempted and federalized. (e.g. Section 404 of SOX prohibits loans to directors and officers, whereas state law permits such loan), (4) SOX is considered a process whose impact on improving the effectiveness of corporate governance will continue for years to come.

Financial reporting provisions of SOX and SEC-related rules are:

1. Certification of financial statements and internal controls by CEOs and CFOs2. Disclosure of off balance sheet transactions3. Disclosure pertaining to the use of non-GAAP financial measures4. Disclosure of material current events affecting companies5. Mandatory internal control reporting by management6. A study of principles-based accounting standards7. Convergence of accounting standards8. Recognition of an adequate funding for the FASB as an accounting standard-setting body9. Oversight function of the FASB by the SEC.

SOX provisions

Provisions of SOX and SEC-related rules addressing audit functions are:

1. Creation of the PCAOB to regulate public accounting firms’ practice before the SEC2. Adoption of new rules related to auditor independence3. Establishment of auditing standards in guiding auditors to improve audit quality4. Issuance of new rules related to improper influence on auditors5. Issuance of new rules pertaining to retention of records and audit evidence relevant to reviews and audits of financial statements6. Establishment of quality control standards to protect investors from receiving misleading financial information7. Oversight function of the PCAOB by the SEC8. Attestation of and report on ICFR

SOX provisions

SOX empowered the SEC to better enforce federal securities laws to improve public trust and investor confidence in the capital markets. SOX enabled the SEC to use various means to bring enforcement actions against corporate wrongdoers, sanction them, obtain penalties and disgorgement, and compensate injured investors.

The following SEC-related rules address the conduct of gatekeepers other than directors, management, and auditors:

1. Rules governing research analysts’ potential conflicts of interest2. Rules regarding standards of conduct for attorneys practicing before the SEC3. Rules pertaining to rating agencies4. Rules concerning mutual and hedge funds5. Rules pertaining to investment banks

SOX provisions

SOX – Global Reach Several provisions of SOX have been adopted in countries worldwide, which lends credibility to SOX and its intended purpose of protecting investors.

Adopted provisions by other countries, including Australia, Canada, China, India, and Mexico, are executive certification of financial statements, mandatory audit committees consisting of all independent directors, creation of standard setting bodies similar to the PCAOB in regulating the auditing profession, the rotation of audit partners and audit firms, and executive certification of ICFR without requiring an audit opinion.

Securities and Exchange Commission The SEC has four divisions: 1) Division of Corporate Finance, which oversees corporate disclosure of public information by reviewing registration statements for newly offered securities, annually audited and quarterly reviewed filings (Forms 10-K and 10-Q)2) Division of Market Regulations, which establishes and maintains standards for fair, orderly, and efficient capital markets by regulating the major securities market participants, including broker/dealer firms and self-regulatory organizations (SROs) such as stock exchanges and the NASD3) Division of Investment Management, which oversees and regulates the investment management industry and administers securities laws relevant to investment companies (e.g., mutual funds) and investment advisors4) Division of Enforcement, which investigates possible violations of securities laws, recommends actions either in a federal court or before an administrative law judge, negotiates settlements on behalf of the commission, and publishes accounting and auditing enforcement releases (AAERs).

The SEC is regarded as an independent agency created by Congress to protect investor interests. (Securities Act of 1933 and the Securities Exchange Act of 1934)

Sec Enforcement Actions

Securities and Exchange Commission

Public Company Oversight Board

Section 101 of SOX authorizes the establishment of the PCAOB to oversee the audit of public companies under the SEC jurisdiction.Congress authorized the PCAOB to fund its expenses by imposing a fee on all public companies determined in proportion to their market capitalizations and registration fees received from public accounting firms.PCAOB .The PCAOB has appointed a standing advisory group (SAG) of thirty members with expertise in accounting, auditing, corporate governance, investments, and corporate finance to assist in carrying out its standard-setting responsibilities.

PCAOB responsibilities:

1. Prepare its budget and manage its operation.2. Register both U.S. and non-U.S. public accounting firms auditing

U.S. public companies.3. Inspect registered public accounting firms.4. Establish auditing, quality control, and ethics standards for

registered public accounting firms.5. Enforce compliance with applicable laws and regulations.6. Investigate registered public accounting firms.7. Impose sanctions for violations.8. Hold roundtables addressing emerging issues affecting the

functions and performance of registered public accounting firms to obtain the views of interested parties, including accounting firms, public companies, investor groups, standard setters, and academicians.

9. Take initiatives in addressing auditing in a small business environment.

10. Perform other duties or functions as deemed necessary.

Public Company Oversight Board (Cont)

PCAOB rule-making process looks like the following schema:

Public Company Oversight Board (Cont)

In 1984, Congress created the U.S. Sentencing Commission (USSC) with the authority to issue guidelines for punishing organizations, including companies that have committed federal crimes.

The revised guidelines are expected to have a significant impact on the effectiveness of corporate governance by requiring: (1) companies to establish and maintain an effective compliance

program; (2) boards of directors to accept accountability to ensure

compliance throughout the company; (3) companies to assign high-level individuals (e.g., executives) to

oversee the company’s compliance program.

Federal Sentencing Guidelines For Organizations

American Institute of Certified Public Accountants

The AICPA is a national professional association of more than 330,000 CPAs in public practice, industry, government, and academia.In the post-Enron and SOX era, the AICPA has introduced 6 leadership roles: 1. Standard-setting role of obtaining greater involvement of users

of financial statements in setting auditing standards2. Fraud prevention and detection liaison role3. Research role in promoting academic research in such areas as

fraud prevention 4. Educational role of developing training programs aimed at

combating fraud 5. Financial reporting role of working with other standard setters to

improve quality, reliability, and transparency of business and financial reporting

6. Corporate governance role to improve corporate governance and internal control systems.

Financial Accounting Standards Board

The SEC has delegated its accounting standard-setting authority to the FASB to issue authoritative Statements of Financial Accounting Standards (SFAS) for the measurement, recognition, and reporting ofbusiness transactions and economic events and the preparation of their financial statements.

Traditional Financial Statements KPI’s

Sec Rules to allow foreign companies to file their statements using IFRS without reconciliation to U.S. GAAP.

Government Accounting Standards Board (GASB)

GASB, in April 2005, issued its Concept Statement No. 3, Communication Methods in General Purpose External Financial Reports that Contain Basic Financial Statements. Concept Statement No. 3 provides: (1) A conceptual framework for determining communication

methods for improving the presentation of financial reports of governmental entities,

(2) criteria for each communication method,(3) a hierarchy for their use.

International Federation of Accountants

Challenges facing IFAC are finding ways to improve the credibility of the accounting profession worldwide, establishing globally accepted accounting and auditing standards, and developing global corporate governance guiding principles. \These challenges require IFAC to quickly move toward the global convergence of both accounting and auditing standards issued by a variety of standard-setting bodies such as the FASB, AICPA, PCAOB, and IASB.

Committee of European Securities Regulators

The EC established the Committee of European Securities Regulators (CESR) to ensure efficient functioning of the European capital market.

In May 2004, the SEC and CESR released a joint statement that specifies the terms of reference for future cooperation and coordination between the two bodies.The primary objectives of such cooperation are to: (1) identify and address emerging risks in the EU and U.S. markets at an early stage; (2) discuss potential regulatory projects to facilitate converging ways of addressing common issues; and (3) set priorities for discussion and collaboration between the two bodies, including market structure issues, the role and responsibility of credit rating agencies and analysts, and mutual fund regulation.

State Influence on Corporate Governance. Corporate

Governance and Courts. State laws generally affect corporate governance by setting requirements for companies’ directors and officers. There is no uniform body of corporate law in the United States because each state is allowed to establish its own model.

The judicial process and court decisions in several landmark cases have affected the structure of corporate governance in the United States. Many of the court cases have led to increased accountability and liability for a company’s board of directors.

Corporate Governance and Self-Regulatory Organizations

By establishing listing standards for their listed companies, SROs including stock exchanges can also influence corporate governance.

List of self-regulatory organizations

Best Practices The effectiveness of corporate governance depends on compliance with state and federal statutes and listing standards, as well as best practices recommended by investor activists and professional organizations.

Best practices of corporate governance are these of The Conference Board, American Law Institute (ALI), American Bar Association (ABA), institutional investors, Council of Institutional Investors, National Association of Corporate Directors, Business Roundtable, Public Pension Funds and etc.

Best practices can be used as benchmarks to determine the best way to improve business processes and corporate governance by following the means by which leading organizations achieve excellence performance.

• Compliance with applicable laws, regulations, rules, and standards is essential to the efficiency and integrity of the capital markets, the effectiveness of corporate governance, and the reliability of financial reports.• The fundamental provisions of SOX can be categorized into the following five categories: (1) corporate governance; (2) financial reporting; (3) audit functions; (4) federal securities law enforcement; and (5) others (e.g., legal counsel, financial analysts).• The SEC was established to protect investor interests and was given the responsibility for issuing financial reporting standards.• SOX directs the SEC to issue rules in implementing its provisions pertaining to corporate governance, financial reporting, audit activities, and others.• Section 101 of SOX authorizes the establishment of the PCAOB as an independent, nongovernmental, not-for-profit organization to oversee the audits of public companies under SEC jurisdiction.

Conclusion

• The PCAOB’s primary functions are to (1) register public accounting firms that audit public companies; (2) inspect the registered public accounting firms on a regular basis; (3) establish auditing, attestation, ethics, quality control, and independence standards; and (4) conduct investigations and disciplinary proceedings.• The PCAOB ended several decades of self-regulation and peer reviews for registered public accounting firms because both domestic and foreign public accounting firms that prepare or issue audit reports must now register with the PCAOB.• The AICPA has introduced many initiatives in the post-SOX era to improve public trust in the accounting profession and public accounting firms.• FASB has been the designated private sector not-for-profit organization for promulgating standards of financial accounting and reporting since 1973.

Conclusion