Internal Controls, Transparency, and Corporate Governance
All three activities embody a procedural approach to self-regulation whereby companies are under increased pressure to operate in an ethical and forthcoming manner, as opposed to one in which they are able to squirrel funds away from their investors.
The overriding focus of many of the financial sector's newly enforced rulings was to mandate that companies make full, timely, and accurate disclosures of their profits, losses, and expenditures.
According to Barron's, from a financial standpoint the term "transparency" is used to indicate documents that are written in common, easy-to-understand language. Further, stockholders and investors are entitled to receive accurate information in an expedient manner so that they may use it to help form financial decisions.
Enhancing Financial Transparency Symposium
During the early part of the 2000s, to combat nefarious business dealings, the federal government held a daylong symposium entitled "Enhancing Financial Transparency."
Within this memorable session, the current state of the financial reporting process was discussed, along with ways to modify not only the financial reporting mechanisms already in place but the accounting standards upon which financial statements are based: audit opinions, credit ratings, and analyst reports.
During the symposium, core topics included ethics and compliance. A commonly held opinion was that there was a pervasive need to re-establish ethical business conduct to the point that it became a core, respected value in corporate America.
Also at the symposium, poorly produced financial reports were stated as the reason for the lack of knowledge and trust among investors. Without well-documented reports, investors found it difficult to conduct effective fundamental analysis of their stock options.
As a result of the session, it was determined that investors had a right to "insightful and targeted" information. It was also determined that corporations need to prioritize the accuracy and timeliness of reporting. And, lastly, the symposium introduced the idea that investors should receive educational resources to ensure they were familiar and comfortable with the formalities of financial statements.
Financial Transparency: Pros and Cons
Repeatedly, it has been said that accounting standards, instead being seen as a supportive aide, can actually act as a barrier to the idea of financial transparency. In some people's opinions, this is because present-day accounting standards are outdated and unnecessarily complex.
In this vein, accounting standards are seen as being incompatible to the financial industry where change and risk are core components. Thus, in order to stay up to speed, the consensus was that regulations within the financial sector needed to respond more expediently to guidelines changes.
In 2002, as an outgrowth of the symposium and in response to the mounting pressure placed upon the federal government to take action, Congress passed the Corporate and Auditing Accountability Act, which later became known as Corporate and Auditing Accountability, Responsibility, and Transparency Act (CAARTA ).
Essentially, CAARTA sought to take the following three actions:
- Create limitations indicative of the extent to which accounting firms could engage in relationships with their clients.
- Enforce stricter penalties for attempts to conduct corporate fraud.
- Establish and empower an accounting oversight body.
Such objectives were in line with then-President George W. Bush's 10-point program that sought to both increase the profile on corporate responsibility and safeguard the investor from falling prey to poorly prepared financial statements.
Overall, the underlying idea was that there exists a need for the government to monitor the accounting profession specifically with respect to financial reporting.
Following in the steps of CAARTA, on July 30, 2002, Congress signed into law the Sarbanes-Oxley Act (also known as SOA, Sarbanes–Oxley, Sarbox or SOX). Named after its chief architects, Senator Paul Sarbanes and Representative Michael Oxley, the law set a number of non-negotiable deadlines requiring corporate compliance.
At a much-needed time in the corporate sector, the SOA introduced major changes to the regulation of corporate governance and financially related practices. A straightforward and deterrent piece of legislation, SOA was intended to address issues arising from public companies attempting to either knowingly or unknowingly misrepresent financial information for the purpose of personal gain.
Thus, it was intended to employ the previously defined idea of transparency wherein all of a company's transactions need be publicly disclosed so that shareholders and potential investors may stay fully apprised of the financial status.
To ensure investors receive timely, accurate tips, SOA requires that companies disclose, on a rapid and current basis, any information that could potentially affect the status of companies in which they hold investments and/or securities.
Furthermore, to impose stricter penalties for those found guilty of committing white-collar offenses, the SOA increased the maximum jail time for white collar and wire fraud to five years per count and 20 years for those found guilty of tampering with records.
To drive home the point, the federal government stringently tightened the criminal penalty for defrauding shareholders of publicly traded companies by extending the potential sentence time to 25 years and, for anyone who knowingly signs off on information they know to be wrong, potential jail time of between 10 to 20 years, accompanied by a seven-figure fine.
Sarbanes-Oxley Act: Titles
Specifically, the SOA was arranged into 11 "titles," or sections. The consensus is that the most important sections are 302, 401, 404, 409, 802, and 906.
While we will not going into detail on each title, we will focus on several notable ones, along with their principal tenets.
Title 302: Corporate Responsibility for Financial Reports
Periodic statutory financial reports need to include such components as:
2. No knowingly false statements or obvious omission(s).
3. Accurate presentations of the company's financial status, as illustrated within financial statements and additional supporting documentation.
4. Ninety-day reports from officials charged with the establishment, monitoring, and evaluation of the efficacy of internal controls.
5. Comprehensive list of all deficiencies pertaining to the internal controls and information pertaining to any fraud involving employees working with internal activities.
6. Major changes in internal controls or associated areas with the potential to negatively impact internal controls.
Note: Companies are not permitted to reincorporate their activities or transfer their activities outside of the United States simply as a means of avoiding their internal control responsibilities.
Title 401: Enhanced Financial Disclosures
Financial statements published by companies are required to be accurate and truthful and include the following materials: off-balance sheet liabilities, obligations, and/or transactions. Studies were to be conducted on the correlation between off-balance transactions and transparent reporting.
Title 404: Management Assessment of Internal Controls
Companies are mandated to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting. This statement shall also assess the effectiveness of such internal controls and procedures.
To better understand Sarbanes-Oxley Section 404, it would be helpful to have a basic working understanding of "internal controls": what they are and how they are set up within a company.
According to the Sarbanes-Oxley Web site, the proposed rulings defined the term "internal controls and procedures for financial reporting" as controls that pertain to the preparation of financial statements for viewing by external audiences. Further, they should be "fairly" presented in adherence to generally accepted accounting principles (GAAP).
In the event a critical situation should arise, companies are required to disclose to the public, on an urgent basis, the nature of the change and/or development. Because issues can affect stockholders' value, it is the duty of the company to ensure investors are kept in the loop.
Adding an additional layer to the self-regulation concept, corporate governance applies both of the previous concepts, transparency and internal controls, to the idea of creating a system by which companies are responsible for going beyond monitoring their own dealings. In the spirit of fairness and accuracy, they also must present shareholders with options and opportunities that demonstrate their interests in socially-minded issues and other facets beyond that of just turning a profit.
By definition, corporate governance is narrowly regarded as the relationship a company has with its shareholders or, more broadly, the relationship it has with society.
A more lofty-minded definition proclaims corporate governance is "the transformation of corporations into democratic entities whereby they seek to enhance wealth creation through shareholder activism and the empowerment of boards of directors."
Thrust into the spotlight, the topic of corporate finance has garnered a wealth of attention, most of it not good. Hence, in light of such heated controversy, corporate governance has become an important issue as it deals with the two pivotal issues of accountability and fiduciary (compliance with federal policies) duty.
Essentially, the central element of both is to introduce guidelines and mechanisms to ensure companies operate within the proper boundaries, particularly with respect to sharing financial information with shareholders.