Sarbanes-Oxley Act: Corporate Governance & Auditing

• Incorrect financial statements may arise due to errors or fraud

Reasons for financial statement errors:

• Errors are accidental mistakes in recording transactions or using accounting rules
• Fraud is intentional deception for personal gain or to harm another person
• Occupational fraud involves misusing one's job for personal enrichment

Fraud Triangle

• This illustrates the three elements present when fraud occurs Opportunity is a situation that allows fraud
• Motivation is the feeling of needing to commit fraud e.g. for money
• Rationalization is the justification of the deceptive act by the person committing the fraud

Internal controls

• Internal controls aim to remove the opportunity for fraud
• Internal controls are implemented according to plans to:
• Safeguard a company's assets
• Improve accounting information accuracy and reliability

Accounting Scandals and Congressional Response

• Managers manage resources of lenders and owners
• Managers act as stewards or caretakers of company assets
• Some managers neglected ethical responsibilities
• Top executives misused or misreported company funds

Accounting Fraud in U.S. History

• Enron avoided reporting billions in debt and losses
• WorldCom misclassified expenditures to inflate assets and profitability

Sarbanes-Oxley Act of 2002

• Also known as the Public Company Accounting Reform and Investor Protection Act of 2002
• Passed by Congress
• Applies to companies filing financial statements with the SEC
• It set guidelines for:
• Internal control procedures
• Relations between auditor and client
• Management must document and assess the internal control processes affecting financial reporting
• Company auditors must express an opinion on whether management's assessment of internal control effectiveness is fairly stated

Sarbanes-Oxley Act of 2002 Major Provisions

• Oversight board: The Public Company Accounting Oversight Board (PCAOB) establishes auditing standards, quality control, ethics, and independence
• Corporate executive accountability: Corporate executives must personally certify financial statements and disclosures and face penalties for misstatements
• Nonaudit services: Auditors cannot perform specific nonaudit services like investment advising
• Retention of work papers: Auditors must keep work papers for seven years or face prison
• Auditor rotation: The lead auditor must rotate off the company every five years
• Conflicts of interest: Audit firms cannot audit companies where executives worked for the firm in the prior year Hiring of auditor: Audit firms are hired by the audit committee, not management
• Internal control: Companies must document and assess internal control effectiveness

Components of Internal Control

• Control environment: Management's attitudes and actions impact the overall control environment
• Risk assessment: Careful consideration of internal and external risk factors
• Control activities: Using policies and procedures to protect company assets
• Monitoring: Regularly monitoring internal controls
• Information and communication: Obtaining and communicating reliable information

Control Activities - Preventative Controls

• Separation of duties: Separating employee duties for authorizing, recording transactions, and controlling assets
• Physical controls: Procedures ensuring asset and accounting record safety
• Proper authorization: Preventing improper use of company resources
• Employee management: Providing employees guidance to ensure they can perform their duties

Separation of Duties

• Important in business processes such as, purchases, inventory, payroll, cash receipts/disbursements, and IT systems
• Minimizes errors theft and fraud
• Assigning responsibilities to multiple individuals prevents sole control, which include
• Who initiates, authorizes and approves transactions executes transactions, or has custody of the involved assets
• Who accounts for transactions and maintains records

Control Activities - Detective Controls

• Reconciliations: Management should periodically determine whether the amount of physical assets of the company agree with the accounting records
• Performance reviews: The actual performance of how individuals or processes are measured against performance expectations
• Audits: An independent assessor on internal control procedures

Bank Reconciliation

• Occurs as the balance of cash in records may not equal the balance of cash in the bank's records
• Reconciles balance in the bank with the own records
• Timing differences occur when transactions are recorded by the company before/after the bank
• Errors: Made either by company or its bank and may be accidental or intentional

Responsibilities for Internal Control

• Everyone in a company impacts the effectiveness of internal controls, but top executives have the final responsibility

Limitations of Internal Control

• Financial misstatements can occur even in firms with the best control systems
• Internal control systems can be especially susceptible to collusion by two or more people
• Top-level employees can override internal control procedures and can commit fraud
• Good internal controls and good employees do not ensure a company's success or survival

Reporting Cash

• Balance sheet:
• Shows a balance of cash
• A snapshot at the end of a period
• Can be current or noncurrent asset
• Statement of cash flows:
• Inflows and outflows
• Covers a period of time
• Includes operating investing and financing

Statement of Cash Flows

• Operating activities:
• Involves cash transactions for revenues and expenses
• Cash received from customers or cash paid for rent, utilities, supplies, and salaries fall into this
• Investing activities:
• Involves cash investments in long-term assets or investment securities
• The purchase or sale of land equipment and buildings all fall into this
• Financing activities:
• Involves transactions designed to finance the business through borrowing and owner investment
• Issuing common stock or paying dividends as well as borrowing or repaying debt fall into this

Key aspects about Cash

• Includes coins checks balances in checking accounts
• Includes credit/debit card sales and cash equivalents
• Cash equivalents are investments that mature within three months from date of purchase
• This does not consider for certificates of deposit

Payment Collections

• Include cash and checks ("paper")
• Credits and debit cards ("plastic")
• Mobile payments
• Electronic Funds Transfers (EFTs)
• Prepaid Cards
• Cryptocurrencies

Receipt and Checks

• Follow these controls
• Open mail daily and log cash/checks with payer name and amount
• Designate an employee different from the first to deposit cash/check into bank account daily Have another employee record cash immediately Verifying cash by comparing the bank deposit slip to accounting records
• Accept Credit Card or Debit Card

Cash and Checks

• Follow these controls
• Use debit card or credit card or check other than very small ones
• Authorize all expenses before purchasing and accuracy of the purchase
• Make sure all checks are signed and serially numbered
• Compare amounts in debit card and credit statements with purchase receipts
• Set maximum purchase limits

Key Aspects about Cash

• Because cash is the asset of a company that is most susceptible to employee fraud, the important control over this include
• The separation of duties
• Independent verification of cash receipts
• Payment by credit card or debit card with authorization procedures

Explore the accounting scandals of Enron and WorldCom, and delve into the Sarbanes-Oxley Act of 2002. Understand its focus, consequences for fraud, auditing standards, and restrictions on auditors. Learn about the PCAOB and how internal controls address the fraud triangle.