Will New Auditing Reporting Standards Help Protect Investors from Fraud?

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Sarbanes-Oxley — “an act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes” — was enacted in 2002 in response to a series of corporate and accounting scandals at the turn of the century that cost investors billions of dollars.

These scandals include those at Enron, which, among other things, used mark-to-market accounting to hide financial losses; MCIformerly WorldCom, which used fraudulent accounting methods to dress up declining earnings; and Peregrine Systems, which was charged with conspiracy to commit a multibillion-dollar securities fraud and lost more than $4 billion in shareholder equity.

Broadly speaking, these scandals all pointed to the same thing: that the regulatory framework established by the Securities Exchange Act of 1933, the Securities Act of 1933, and others did not create sufficient accountability and transparency — two things without which fraud and corruption will occur. Sen. Paul Sarbanes (D-Md.) and Rep. Michael Oxley (R-Ohio) recognized this and championed the 2002 act, which has done a tremendous amount to protect stakeholders and preserve the overall stability of securities markets.

The Sarbanes-Oxley Act does several things that are directly relevant to the investing public. Title I established the Public Company Accounting Oversight Board, which registers auditors, curates procedural guidelines, and enforces compliance with the act as a whole. Title II established the framework in which auditors operate and outlines things like reporting requirements, helping ensure that companies can’t cloud reality via discretionary application of accounting rules. Title III mandates that senior executives assume some degree of responsibility for the accuracy of financial statements, increasing accountability and therefore reducing the likelihood of executive-level fraud. Title IV increased reporting standards for items like off-balance-sheet transactions and stock sales by corporate officers, reducing the opacity on insider trading.

These guidelines and more — there are 11 titles in the act — go a long way toward ensuring that the financial information shareholders receive about a company they are invested in is both accurate and complete. Transparency and competent enforcement of reporting standards is essential to maintaining the objectivity that is the substrate of the entire securities industry. When this objectivity is compromised, catastrophe can follow. This has been evident in the numerous individual corporate accounting scandals and was also an issue at the heart of the late 2000s financial crisis, when banks and ratings agencies misrepresented the risk of securities whose true value was masked by financial voodoo magic.

One of the most recent and visible examples of the damage that can be caused by fraudulent and/or incompetent accounting is Hewlett-Packard’s (NYSE:HPQ) $8.8 billion impairment charge associated with the acquisition of Autonomy Corp. As much as $5 billion of the charges have been attributed to accounting errors, and HP’s internal investigation unit has accused the company’s management of using “accounting improprieties, misrepresentations and disclosure failures to inflate the underlying financial metrics of the company.”

On Tuesday, in order to try to address some of the problems still haunting auditor reporting, the Public Company Accounting Oversight Board proposed a new auditing standard for public comment.

“These proposed changes will make the auditor’s report more relevant to investors,” James R. Doty, the organization’s chairman, said in a statement. “More robust audit reports that demonstrate the strength and value of the audit also should lead to better public awareness of, and appreciation for, auditors’ skill and insight.”

According to a press release, the proposed auditor reporting standard would require:

  • The communication of critical audit matters as determined by the auditor.
  • The addition of new elements to the auditor’s report related to auditor independence, auditor tenure, and the auditor’s responsibilities for — and the results of — the auditor’s evaluation of other information outside the financial statements.
  • Enhancements to existing language in the auditor’s report related to the auditor’s responsibilities for fraud and notes to the financial statements.

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