Corporate Management Scrutinized Worldwide: Closer Oversight, Stricter Regulations
by Adolf Enthoven

T he collapse of Enron Corporation (see Transition, "The Enron Crisis: Some Lessons for Transition Economies," January-February 2002, pp. 1-4) and other scandals involving Worldcom, Tyco, Global Crossing, and other companies have drastically shaken the accounting profession, financial intermediaries and analysts, stock exchanges, and the legal community. The ethical and managerial conduct of many major corporations and the organizations that were supposed to protect public interests have induced concerned citizens to demand stricter provisions for corporate governance. The new Corporate Responsibility Act in the United States is a first result of this trend.

The new Corporate Responsibility Act of 2002, also known as the Sarbanes-Oxley Act, has undoubtedly brought with it the most radical changes since the 1933/34 securities and exchange acts that followed the 1929 stock market crash. The new legislation has the following major provisions, to be implemented by the Securities and Exchange Commission (SEC):

• Executive compensation and related corporate governance reform. Requires chief executive officers (CEOs) and chief financial managers (CFOs) to give up incentive-based compensation and trading profits if the company’s accounting statement is not accepted and a restatement is required. During investigation the company also has to freeze extraordinary payments to directors, officers, and controlling persons. Public companies are prohibited from extending most types of credit to any director or executive officer. The SEC has been empowered to prohibit individuals from serving as directors or officers of public companies.

• CEO/CFO certification. Requires CEOs and CFOs of public (listed) companies to certify that their companies’ annual and quarterly reports with the attached financial statements are appropriate and fair. This implies increased liabilities, and in the case of improprieties, even lawsuits and jail terms.

• Audit committees. Directs all public companies to set up audit committees with extended responsibilities comprised solely of independent directors, including one financial expert who oversees the activities of a company’s accounting firm.

• Corporate codes of ethics. Mandates that public companies must disclose whether they have adopted a corporate code of ethics for senior financial officers.

• Accelerated reporting of insider transactions. Requires that insider transactions within U.S. public companies must be reported within two business days.

• Benefit plan blackouts. Prohibits a public company’s directors and executive officers from trading the company’s stock during any blackout period if the company’s other employees are also prohibited from trading those stocks they hold in company benefit plans. [Editor’s note: These blackout days relate mostly to the period preceding earnings statements in order to prevent speculation.]

• Attorneys’ professional responsibility. Requires attorneys representing public companies to adhere to professional conduct standards, including reporting evidence of material violations of securities law or breaches of fiduciary duty to the CEO or general counsel and, if the CEO or general counsel does not respond appropriately, to the audit committee of the board of directors.

• Whistleblower protection. Provides job protection to employees of public companies who provide information to investigators, Congress, or their supervisors regarding violations of securities or antifraud laws.

• Disclosure of off-balance sheet transactions. Will set rules requiring the disclosure of all material off-balance sheet transactions and the conduct of a study within one year of so-called special purpose entities to close existing loopholes. (Enron used off-the-books special partnerships and set up fake companies to disguise debt and inflate profits, supposedly acting within the rules.)

• Increased frequency of SEC review. Requires the SEC to review all public companies’ filings at least every three years.

• Real-time disclosure. Requires "rapid and current" public disclosure of material changes to public companies’ financial condition or operations as may be required by future SEC rules.

• Auditor independence and rotation. Prohibits auditors of public companies from providing specified nonaudit services to the companies they audit, requires the rotation of audit partners, and requires the comptroller general to conduct a study of mandatory rotation of audit firms.

• Auditor oversight board. Creates a self-regulatory organization to establish auditing standards and regulate accounting firms that audit public companies. This organization has been established under the auspices of the SEC and is known as the Public Company Accounting Oversight Board.

• Principles-based accounting. Directs the SEC to study the adoption of a principles-based accounting system versus a rules-based system. The intent is to prevent companies from issuing distorted results that nonetheless comply with accounting rules.

• Conflicts of interest. Requires the adoption of rules to prevent conflicts of interest on the part of securities analysts.

• Document retention. Provides criminal penalties for destroying audit records and for destroying or falsifying any documents in order to impede a federal investigation.

• Enhanced criminal penalties for securities fraud. Defines new criminal offenses involving conspiracy and attempts to violate federal antifraud rules, increases criminal penalties for willful violation of federal securities laws, and directs the U.S. Sentencing Commission to review sentencing guidelines for certain white-collar and other crimes.

Foreign companies operating in the United States are also affected, as are international accounting firms operating outside the United States for American clients. U.S. legislation has, however, antagonized certain foreign regulators, especially those in the EU, by broadening U.S. securities regulation of foreign entities as follows:

• By applying several provisions to so-called foreign private issuers (foreign private issuers are public companies and the word "private" distinguishes them from governments), the legislation changed the SEC’s general policy of allowing these entities to continue to follow home country practices on a variety of accounting, corporate governance, and securities law issues.

• By mandating that foreign accounting firms would have to subject themselves to new U.S. registration requirements, adding to their existing home country (and for EU firms, EU-wide) regulations with which such firms must already comply.

Whether the new rules will be compatible with Generally Accepted Accounting Principles in the United States or with International Accounting Standards is questionable. Under these principles and standards, the "earnings game" that was underlying the various scandals (corporations trying to maximize their profits by using loopholes in the rules) have not abated. It may require new accounting, disclosure, and reporting standards in a move away from the pure accountability concept toward the notion of greater economic relevance. The debate about whether a more principles-based approach versus a rules-based approach is needed for accounting standards is already raging, with the latter undoubtedly giving greater protection to accountants and auditors, while the former is more relevant in economic terms. The focus will gradually be more on the economic substance instead of the historical financial accuracy of balance sheet items and income/expense transactions.

We are witnessing a global trend toward stricter provisions for corporate governance, although the requirements still vary greatly. In the EU the legislative approach to be followed is in close harmony with the Corporate Responsibility Act’s requirements. The expected implementation of the use of International Accounting Standards in Russia and the EU in 2004 will undoubtedly also require greater corporate transparency and concomitant corporate governance. In Russia, companies will be required to disclose corporate governance practices for the first time this year in accordance with the Corporate Governance Code approved last year.

For transition economies in general, the challenge is to step in with legislation and other procedures to prevent similar manipulations without killing the entrepreneurial spirit. Close international oversight on corporate governance codes and regulations would channel the legislation and rules in the right direction.

The author is director of the Center for International Accounting Development, University of Texas at Dallas, 2601 N. Floyd Road, Richardson, Texas 75083-0688; tel.: 972-883-2320, fax.: 972-883-2192, email: intacctg@ utdallas.edu