Archives for posts with tag: Sarbanes-Oxley

by Merlin Hernandez

Ethical dilemmas in corporate governance can arise from the need for truth in reporting. Issues of whether notional income from projected sales should be included on the income statement, the pressure to demonstrate financial health to stakeholders, or issues of social responsibility and the prevention of job loss if reports should illustrate a need for cut backs all have the potential to compromise a company’s ethical perspective and integrity. The Enron experience in the evolution of the US business regulatory environment was pivotal in that it brought business ethics and conflicts of interest into sharp focus. It was more than organizational malfeasance at one company but a systemic failure of the legal and regulatory structure that would provide the framework for corporate behavior and financial reporting.

Before the Enron debacle, the regulatory climate allowed an organizational culture that was inevitably self-destructive. Large firms like Enron contracted consulting services and allowed these same firms to audit both financial statements and processes – the consultants were signing off on their own work – while internal audits were conducted by employees of the firms. All possible avenues for preventing, detecting, and correcting failures in accountability were effectively contained within a management elite who were essentially laws into themselves. Against this backdrop, many businesses conducted their operations in a manner where fiscal controls and transparency were sacrificed in order to conceal inefficiencies and fraudulent activity, and to manipulate stock prices.

With the collapse of Enron, a maze of corporate fraud revealed inventive manipulations of partnerships with subsidiaries created to conceal huge debts and heavy losses, while published financial statements revealed robust fiscal health. The accounting firm, Arthur Andersen, operating as both financial consultant and external auditor, was implicated in what is now known as one of the largest frauds in corporate history. In response to the financial fall-out that resulted from Enron’s bankruptcy, the Sarbanes-Oxley Act was enacted in 2002 to provide a body of rules for Corporate Governance and to legislate accuracy and reliability in corporate disclosures for public companies. Violations can bring fines up to $500,000.00 and/or 20 years in prison. The Act mandates the company CEO and CFO to make an assessment of the internal controls they have in place while an external auditor must attest to the efficiency of those controls and issue a separate report to the SEC.

Both financial statements and process systems are auditable. CEO/CFO assessments involve documentation and implementation of the control environment. External auditors engage in the testing and reporting (attestation) of processes and transactional cycles, tracking all transactions back to the financial statement. The rules are designed to make all financial activity of publicly traded companies accurate, subject to checks and balances, made a part of the public record available for public scrutiny. But many privately held companies have embraced these rules to guide their corporate ethics.

Businesses, however, remain challenged by issues of corporate social responsibility, company loyalty, and the personal self-interest of managers, all of which can serve to blur the lines between what is ethical and what is expedient.


by Merlin Hernandez

Earlier this year, it was revealed that the Chesapeake Energy CEO and founder profited enormously from personal investments in company wells through bonuses that were part of his board-approved compensation package. The bonuses may not be quite illegal. However, they bare a fundamental weakness in governing regulations and may yet face mandated clawbacks. But the issue does reflect a corporate governance culture that was not broad enough to be congruent with emerging values in the society. Taking wider stakeholder value into consideration in the face of high unemployment, displaced military veterans, mortgage foreclosures, and the mangled American dream, corporate America has come under more scrutiny than ever. Even with record profits, executive compensation is still expected to bear some relationship to wages across the board in order to be seen as morally appropriate.

And then there is that slippery slope from practices that may be viewed as unethical to those that may be downright illegal. A few months later the Chesapeake CEO was stripped of his chairmanship by a board more responsive to the tide of ethical expectations amidst revelations of personal loans to the CEO from a firm that also finances the company. This was a direct contravention of Sarbanes-Oxley restrictions and a major conflict of interest. All of this while there are reports that capital spending has exceeded cash in operations in every quarter since 2003 – not necessarily a sign of impropriety but a red flag in terms of efficient stewardship nonetheless. The Chesapeake head was also accused of collusion and bid-rigging in suppressing land prices in Michigan in violation of anti-trust laws. The IRS, DOJ, and SEC launched investigations.

A brief study of Chesapeake’s core values explains a lot. There is an almost missionary emphasis on a commitment to “environmental excellence.” Business philosophy, operational values, commitment of resources, and regulatory compliance are focused on environmental protection in a myopic view of the company’s social responsibility. To this extent, Chesapeake appears to validate its values by its actions. But the overarching constructs that would comprise organizational ethics and fiscal responsibility have not been given prominence within those values. This is especially important for a publicly traded company as it leaves clear gaps for questionable, unethical, and perhaps illegal behavior by members of the corporation.

Inadequate governance policies remain a fundamental flaw in risk management. It can expose a business to legal liability, cause damage to the corporate image, and result in loss of public confidence in the stock. Contemporary business is slowly coming to the realization that sound ethics and a keen sense of social responsibility are more than elements of good corporate citizenship. It is indeed good business.

by Merlin Hernandez

Many analysts refer to the potential conflict of interest when auditing firms provide additional consulting services. I agree that the same accounting firm providing auditing and consulting services to a client can present some conflict of interest based on the notion that a more organic relationship can serve to compromise objectivity. But expanded auditor consulting services may not necessarily run afoul of Sarbanes-Oxley and its non-audit service restrictions. Consulting services have traditionally been provided by large accounting firms to expand the utility and applications of the technical expertise they provide. Auditing firms have a unique perspective that businesses find valuable. They bring an informed external perspective to business challenges for which their work offers deeper insights. A ban on non-audit services (like tax services, and some management consultancies) to audit clients will effectively subvert audit quality and effectiveness of the services. Total restriction will reduce the cumulative knowledge needed to identify problems and would limit auditor verification of information necessary to understand and evaluate a firm’s activities.
To strike some balance between conflict of interest and the integrity of the auditor/client relationship, the SEC has identified nine audit services that are unlawful for an auditor to provide. These include client financial statements, legal services, investment advice or services, SME services, and actuarial work, among others. A registered accounting firm may provide any non-audit service not listed as long the service is approved in advance by the audit committee of the issuer. This is a provision to ensure that non-restricted services are subject to careful scrutiny under the aegis of fiduciary responsibilities and ethical governance before being contracted.