Recapitulation of SOX (Sarbanes Oxley Act, 2002) and Auditors Precautions

In India nowadays during auditing time always listening; about Clause-49, of listing Agreement, Internal Financial Control (IFC), Fraud Risk Management, Whistleblower system  and USA Sarbanes Oxley Act, 2002 etc. USA Sarbanes Oxley Act, 2002 was come based on a few major corporate financial scandals. Given below brief summary of major 3 corporate financial scandals, those were purported by top management.  Similar accounting failures occurred at Bausch and Lomb, Rite Aid, Cendant, Sunbeam, Waste Management, Superior Bank, and Dollar General etc.  Following case laws will give eye opening about weakness of Audit Process and it will give good learning to the young Audit Professional (Statutory Auditors and Internal Auditors both). In India Companies Act, 2013, IFC, Fraud Risk Management, Whistleblower systems and Clause-49, of listing Agreement are equivalent and parallel to SOX. 

SOX came in to force in July, 2002 and derives its name from its Architects Mr. Senator Paul Sarbanes and Representative Mr. Michael Oxley.

ENRON: [Understating of Debt by transferring of debt to Associates Partnerships and Venture companies; also done overstating of Income by long term futuristic income showing as current financial Income. Statutory Auditors Arthur Anderson and CEO Jeffrey Skilling and founder Kenneth Lay were responsible for this fraud.]

Enron was founded in 1985, and as one of the world's leading electricity, natural gas, communications and pulp and paper companies before it bankrupted in late 2001, its annual revenues rose from about $9 billion in 1995 to over $100 billion in 2000. Enron started life as a regional natural gas pipeline company, the result of a merger between Houston Natural Gas and Inter North in 1985. Mr. Ken Lay was credited with transforming Enron into the world's largest energy trading company and America's seventh-biggest corporation.Throughout the late 1990s, Enron was almost universally considered one of the country's most innovative companies. The company continued to build power plants and operate gas lines, but it became better known for its unique trading businesses. Besides buying and selling gas and electricity futures, it created whole new markets for such oddball "commodities" as broadcast time for advertisers, weather futures, and Internet bandwidth.

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron undoubtedly is the biggest audit failure. It is ever the most famous company in the world, but it also is one of companies which fell down too fast. 401,000 employees saw their pension funds vanish almost overnight, and the company's stock crashed from $90.75 to $0.67. Estimated losses  $74 billion. May 25, 2006 - The jury in the Enron case finds former CEO Jeffrey Skilling and founder Kenneth Lay guilty of conspiracy and fraud. Lay is convicted of all six counts against him and Skilling is found guilty of conspiracy, fraud, false statements and insider trading.

Key Enron Executives' Penalties:

Former chief executive Jeffrey Skilling Age: 53, Convicted  for conspiracy, fraud and insider trading. Sentenced to 24 1/2 years.

Kenneth L. Lay Enron founder and former chairman Age: Died in July at age 64.  Convicted in May,2006  for fraud, conspiracy and false statements to banks. Died before sentencing. His convictions were later vacated citing legal precedent.

Andrew S. Fastow Former chief financial officer Pleaded guilty  for conspiracy, Sentenced to six years.

Richard A. Causey Former chief accounting officer  Age:46 Pleaded guilty  for securities fraud  Sentenced to 5 1/2 years.

Michael J. Kopper Former top aide to Fastow Age: 41 Pleaded guilty for conspiracy, Sentenced to three years and one month.

Auditors Arthur Andersen

Arthur Andersen LLP was founded in Chicago in 1913 by Arthur Andersen and partner Clarence DeLany. Over a span of nearly 90 years, the Chicago accounting firm would become known as one of the “Big Five” largest accounting firms in the United States, together with Deloitte & Touche, PricewaterhouseCoopers, Ernst & Young, and KPMG. Enron was one of Andersen’s biggest clients. Indeed, Andersen’s new CEO, Joseph Berardino, had perhaps viewed the $1 million a week in audit fees Enron paid to Andersen, along with the consulting fees it paid to Andersen’s spin-off firm, Accenture, as a significant opportunity to expand revenues at Andersen. Plus, with Enron as a client, Andersen had been able to make 80 percent of the companies in the oil and gas industry its clients. The company was one of the "Big Five" accounting firms in the United States, and it had served as Enron's auditor for 16 years.  Arthur Andersen once exemplified the rock-solid character and integrity that characterized the accounting profession. However, high-profile bankruptcies of clients such as Enron and WorldCom capped a string of accounting scandals that eventually cost investors nearly $300 billion and lost jobs for hundreds of employees. As a result, the Chicago-based accounting firm closed its doors in 2002, after 90 years of business. In August 2000, following an arbitration hearing, a judge ruled that Andersen’s consulting arm could effectively divorce the accounting firm and operate independently. By that time, Andersen’s consulting business consisted of about 11,000 consultants and brought in global revenues of nearly $2 billion. Arthur Andersen, as a whole, employed more than 85,000 people worldwide. The new consulting company promptly changed its name to Accenture the following January.

The company paid $110 million in May 2001 to settle claims brought by Sunbeam shareholders for accounting irregularities and $100 million to settle with Waste Management shareholders over similar charges a month later. In the meantime, news that Enron had overstated earnings became public, sending shock waves through the financial markets. Over the following year, many companies, a number of them Andersen clients, were forced to restate earnings. In Baptist Foundation of Arizona (BFA) case, the firm eventually agreed to pay $217 million to settle the shareholder lawsuit in 2002. In Sunbeam case In 2002, a federal judge approved a $141 million settlement in the case. In it, Andersen agreed to pay $110 million to resolve the claims without admitting fault or liability. Losses to Sunbeam shareholders amounted to about $4.4 billion, with job losses of about 1,700. In case of Waste Management Corporation The result of these cases was that Andersen paid some $220 million to Waste Management shareholders and $7 million to the SEC. Four Andersen partners were sanctioned, and an injunction was obtained against the firm. Andersen, as part of its consent decree, was forced to promise not to sign off on spurious financial statements in the future or it would face disbarment from practicing before the SEC—a promise that it would later break with Enron. After the dust settled, Waste Management shareholders lost about $20.5 billion and about 11,000 employees were laid off. In Enron Case On June 15, 2002, the jury found Andersen guilty of obstruction of justice, the first accounting firm ever to be convicted of a felony. Same issue was noted in case of WorldCom. The company agreed to stop auditing public companies by August 31, 2002, essentially shutting down the business.

One of the reasons for this confusion in its corporate culture may have been that numerous inexperienced business consultants and untrained auditors were sent to client sites who were largely ignorant of company policies. Another factor may have been its partners’ limited involvement in the process of issuing opinions. As the company grew, the number of partners stagnated. There is also evidence that Andersen had limited oversight over its audit teams and that such visibility was impaired by a relative lack of checks and balances that could have identified when audit teams had strayed from accepted policies. Audit teams had great discretion in terms of issuing financials and restatements.

WORLDCOM: [This telephone company Overstating of Income by adopting wrong accounting practices.]

WorldCo-m took the telecom industry by storm when it began a frenzy of acquisitions in the 1990s. The low margins that the industry was accustomed to weren't enough for Bernie Ebbers, CEO of WorldCom. From 1995 until 2000, WorldCom purchased over sixty other telecom firms. In 1997 it bought MCI for $37 billion. WorldCom moved into Internet and data communications, handling 50 percent of all United States Internet traffic and 50 percent of all e-mails worldwide. By 2001, WorldCom owned one-third of all data cables in the United States. In addition, they were the second-largest long distance carrier in 1998 and 2002.

WorldCom, once the second biggest U.S. long-distance phone company, filed for bankruptcy in 2002 after it revealed its executives inflated the company's assets by $11 billion through dodgy accounting. 10,000 jobs were lost because of the scandal. Bernard Ebbers, the former CEO of WorldCom, was sentenced to 25 years in prison in 2005

Estimated losses: $107 billion in assets

How the Fraud Happened

So what happened? In 1999, revenue growth slowed and the stock price began falling. In an effort to increase revenue, WorldCom reduced the amount of money it held in reserve (to cover liabilities for the companies it had acquired) by $2.8 billion and moved this money into the revenue line of its financial statements. In 2000, WorldCom began classifying operating expenses as long-term capital investments. Hiding these expenses in this way gave them another $3.85 billion. These newly classified assets were expenses that WorldCom paid to lease phone network lines from other companies to access their networks. They also added a journal entry for $500 million in computer expenses, but supporting documents for the expenses were never found.  It also made WorldCom's assets appear more valuable. These changes turned WorldCom's losses into profits to the tune of $1.38 billion in 2001

TYCON INTERNATIONAL:[CEO Mr.Dennis Kozlowski, CFO Mr. Mark Swartz and General Counsel Mark Belnick  had done fraud for personal gain of multimillion dollars by way of bonuses and misuse of Employees Loan Programs.]

Tyco International has operations in over 100 countries and claims to be the world’s largest maker and servicer of electrical and electronic components; largest designer and maker of undersea telecommunications systems; the larger maker of fire protection systems and electronic security services; the largest maker of specialty valves; and a major player in the disposable medical products, plastics etc. Without Board approval scheme of employees loans with low to no interest and latter on many of them were offset as bonuses without open approval. Tyco’s corporate culture was driven by the CEO Dennis Kozlowski who admired the extravagant and lavish lifestyle lavish of the former CEO, Joseph Gaziano. CEO has used company fund for toga party for his wife’s birthday, bought millions of dollars worth of art to decorate his home. He spent $6,000 of company money on a shower curtain and $15,000 on a umbrella stand shaped like a poodle. CEO alone plundered the company of over $400 million. Total impact of fraud was $600 Million.

Penalty: Dennis Kozlowski, the former CEO of Tyco International Ltd., and former Tyco finance chief Mark Swartz were sentenced up to 25 years in prison for stealing hundreds of millions of dollars from the company.

State Supreme Court Justice Michael Obus ordered Kozlowski and Swartz to pay a total of $134 million in restitution; in addition, Kozlowski was fined $70 million, Swartz $35 million.

The sentences end a case that exposed the executives’ extravagant lifestyle after they pilfered some $600 million from the company including a $2 million toga birthday party for Kozlowski’s wife on a Mediterranean island and an $18 million Manhattan apartment with a $6,000 shower curtain.

Kozlowski, 58, and Swartz, 44, were convicted for grand larceny, falsifying business records, securities fraud and conspiracy. Kozlowski and Swartz are the latest executives sentenced to prison in a wave of white-collar scandals that shook corporate America and outraged the public after thousands of people lost their jobs and pension nest-eggs.

Penalty to Auditors :The Securities and Exchange Commission settled a case against Richard Scalzo, a partner at PricewaterhouseCoopers, by permanently barring him from conducting public company audits.

After absorbing of above case laws now question has come how Internal and Statutory Auditors will make the audit plan. In addition to routine Audit scope following critical points have to be taken under Audit testing:

1.   Balance Sheet: through review of Balance Sheet’s Architecture , Inter Company Loan Deposit , Advance, Receivable and Payable etc to be review thoroughly i.e. thought process of ICD and Related Party Transactions testing and its documentation like Contract copy, justification of rates, ACM noting and board minutes. In addition of this Bank loan and Promoters share pledging flow and total custodian and their declaration to be checked.

2.   Operating Income: Industry trend of growth and your company growth are there major gap? if yes, then check what are special drive taken for this extra mileage. Major revenue contract to be checked for its proper accounting process like income related to current year or futuristic etc. Further analysis revenue or capitalized as per GAAP and Accounting Standards.

From academic point of view like to point out that what are the reasons for overstating of incomes:

     I.       Gaining of Performance Bonus by CEO/CFO/MD

   II.       Sale of holding shares and enjoy the gain

  III.       Promoters pledging the shares and taken extra loan for new projects

 IV.       Loan taken at lower interest due to inflated better health of the organization.

   V.       Easy arrangement of fund for Working Capital.

3.   Non-Operating Income: If non-operating income abnormally high, there its contract copy and revenue recognition process to be checked in addition to board resolution.

4.   Operating Expenses: High Value major Contracts Management Process i.e. control, review, testing, noting, documentation and escalation process have to be reviewed.

5.   Cash Flow Statement: It has to be absorbed in details. Profit but Negative Cash flow, that to be thoroughly investigated.

6.   Higher Loan burden (Liability) but there is High Volume of Deposit (Assets): Deposits 100% physical checking and its genuineness to be ascertained.

7.   Receivable: Why high receivable? Credit Policy, contract and escalation practice for its collection to be checked.

8.   Incentive to the Senior Management: Is it approved by the Board? Criteria and documentation for its calculation to be checked. Sometime incentive given on project execution, there also above logic applicable.

9.   Senior Management Code of Conduct: Implementation of code of conduct and its real execution, testing, review, monitoring, action, minutes etc to be checked.

10. Share Price Sensitive Issue: Are there share price fluctuating during board meeting time/share pledging time/bond issue time etc. There to be more caution about the transparency of accounting disclosure.

11. Fraud Risk Management Practice: like policy, committee, information receiving channel, noting, documentation, meeting interval, its investigation, outcome, action and future planning minutes to be checked.

12. Auditors Fees: Rapid increase of Statutory Auditors Fees not looks good sign; it may be qualification report dropping charges. ACM members have to take issue for its justification. Further Statutory Auditors getting more consultancy services in associated company like SAP implementation, GRC implementation, Tax consultant, IFC consultant etc at higher price etc it is also like above example.

13. Restriction to Access to Books and Accounts: Some time, Auditees have some reservation about some critical transactions and also denied to share of supporting documents. Auditees try to explain that it is known to top management even it is known to Chairman etc. etc. Auditors should not compromise about this explanation. If require this points can be presented through Management letter.

14. Limited or single Staff access to large critical Transactions: If only single /limited staff only authorized for large volume of transaction, there detailed investigation have to be carried out.

15. High Value one time Transaction: 100% have to be checked for understanding of transactions’ back ground.

16. Vendors KYC [Know your customers]: Some time Related Party disclosure may not be correct, there all high value new party or specific terminology party’s KYC have to be checked.

17. Global Transactions: Project time lots of import happening, there precaution to be taken for audit testing like whether manufacturer and supplier same or difference? if difference why? Manufacturer in one country but invoice creator in another country Why?

18. Experienced SAP and IT Staff: For tracking of exceptional entry and generation of exceptional report, in audit team SAP and IT expert to be inducted.

19. Not to be dependency of Management Disclosure: As per SOX Section 302, 401 and 404 Management (CEO,CFO etc) given disclosure and certify about Financial Reports, Periodic Reports and Internal control etc. There Auditors should not rely only on this certificate. He/She have to gone through the above process with proper documentations.

20. Consultancy Charges: All major consultancy charges have to be checked and to be understood what its background of payment is. If Service receiver and approving authority same dept./person there should be taken more cautions.

21. Personal gain by Audit Executives/Partner: If Audit staff’s life style change, like frequent personal air travel and that ticket underhand paid by client. There firm have to rotate the audit staff.

22. Auditors not attended by CEO/CFO etc: If major audit findings not resolve due to over busy of CEO and CFO etc. Auditors try to meet and like to discuss the points but repeatedly it has been denied by showing their over business, there above points immediately have to bring the notice of Partner/CAE.

23. Due Diligence Process: Where Aggressive progress through new projects and multiply

acquisition; there procurement process and valuation method and quality of project to be strictly ascertained.

Suggestions: For Auditors: Considering above complexity and high quantum of liability of Auditors as per SOX Section 802 and 807(Jail upto 10 to 25 years with Monetary Penalty) there should be highly experienced (15-25 years) Senior Audit Executives. All Audit Executives should be properly trained not only auditing also complex accounting transactions and SAP exposure must.

For SEBI: SEBI should conduct quarterly audit to all listed companies and for other companies where bank and financial institution loan is more than Rs.100Cr etc. or overview of Auditors' file once a year. Unfortunately it is not expectable due to their infrastructure limitation.

Limitation of Auditors: Due to reporting relationship most of the above cases Internal Auditors don’t take these under Audit Scope. In case of Statutory Auditors due to middle level audit executives, they are unable to find about issue and/or for retention of clients a few Firms may compromise to some extent.

Note: The Author is a Senior Chartered Accountant and Strategic Management Specialist having extensive Control Assurance and Due Diligence experience over two decades.