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Investigations, Inspections, and Audits in the Post-SOX Environment Nebraska Law Review Volume 86 Issue 1 Article 3 1-2007 Investigations, Inspections, and Audits in the Post-SOX Environment Thomas C. Pearson Shidler College of Business, University of Hawaii Gideon Mark New York City Follow this and additional works at: https://digitalcommons.unl.edu/nlr Recommended Citation Thomas C. Pearson and Gideon Mark, Investigations, Inspections, and Audits in the Post-SOX Environment, 86 Neb. L. Rev. (2007) Available at: https://digitalcommons.unl.edu/nlr/vol86/iss1/3 This Article is brought to you for free and open access by the Law, College of at DigitalCommons@University of Nebraska - Lincoln. It has been accepted for inclusion in Nebraska Law Review by an authorized administrator of DigitalCommons@University of Nebraska - Lincoln. Thomas C. Pearson* and Gideon Mark** Investigations, Inspections, and Audits in the Post-SOX Environment TABLE OF CONTENTS I. Introduction to Audited Financial Information and Related Litigation ..................................... 44 II. The Impact of SOX on Financial Information and Its R eliability ............................................ 53 A. Significant Improvements in Accountability from SO X .............................................. 54 B. SOX' Significant Ripple Effects .................... 64 III. Investigations, Inspections, and Audits of Financial Inform ation ........................................... 70 A. Internal Investigations of Financial Reporting and D isclosure ......................................... 70 B. SEC's Informal Inquiries and Enforcement Division Investigations ..................................... 73 C. PCAOB's Inspections and Investigations of CPAs... 80 1. PCAOB's Inspections of CPA Firms ............ 81 2. PCAOB's Investigations, Disciplinary Processes, and Sanctions ................................. 85 D. Parallel Investigations: IRS Audits, DOJ Investigations, and Others ......................... 88 1. IRS Audits of Corporate Financial Information . 89 2. Other Parallel Investigations .................. 91 E. Pressures for Corporate Cooperation in Investigations ..................................... 93 IV. Reforms Needed for Effective and Fair Investigations of Financial Information ................................. 98 * Thomas C. Pearson, Professor of Accounting at the University of Hawaii's Shidler College of Business, earned degrees from laws schools at Vanderbilt, University of Denver, and New York University; and other degrees from Dartmouth and Vanderbilt. ** Gideon Mark, a practicing attorney in New York City, earned degrees from Bran- deis University, Columbia University, Harvard University, New York University, and the University of California. NEBRASKA LAW REVIEW [Vol. 86:43 A. Strengthening Corporate Governance and the "Tone at the Top" ..... .................................. 99 B. Improving Comprehension of Financial Reporting and Disclosure Rules .............................. 102 C. Implementing Internal Controls and Auditor "404" Work More Affordably ............................. 106 D. Assisting Enforcement through Enhancements, Efficiency, and Education .......................... 114 V . Conclusions ........................................... 118 I. INTRODUCTION TO AUDITED FINANCIAL INFORMATION AND RELATED LITIGATION Financial information for a "public company"' is comprised of a set of four financial statements 2 and "Management's Discussion & Analy- sis of Financial Condition and Results of Operation" ("MD&A").3 The unreliability of financial information for hundreds of companies be- came evident after major "financial fraud"4 was uncovered in the early 2000s,5 and significant stock market losses followed.6 To restore in- 1. Most public companies consist of hundreds of subsidiary entities and complicated joint venture arrangements. The U.S. has about 15,000 public companies, which comprise more than ninety-five percent of the U.S. market capitalization. Impact of Sarbanes-Oxley Act: Hearing Before House FinancialServices Comm., 109th Cong. 109-21 (Apr. 21, 2005) (Statement of Hon. William H. Donaldson, Chair- man of SEC) [hereinafter The Impact of SOX]. 2. 17 C.F.R. § 229.1010(a)(2) (2006); cf. Financial Accounting Standards Board, Statement of FinancialAccounting StandardsNo. 117: FinancialStatements of Not-for-Profit Organizations (June 1993), available at http://www.fasb.org/pdf/ fasll7.pdf. 3. 17 C.F.R. § 229.303 (2006); Commission Guidance Regarding Management's Dis- cussion and Analysis of Financial Condition and Results of Operation, Exchange Act Release No. 48960 [2003-2004 Transfer Binder] Fed. Sec. Law Rep. (CCH) 1 87,127, at 88,887 (Dec. 19, 2003). Since 1980, public companies must provide the MD&A. See Amendments to Annual Report Forms, 45 Fed. Reg. 63,630 (Sept. 25, 1980) (codified at 17 C.F.R. pts. 229, 231, 239, 240, 241, and 249). 4. Financial fraud consists of asset misappropriations, corruption, and fraudulent financial statements. See ASSOCIATION OF CERTIFIED FRAUD EXAMINERS, 2002 RE- PORT TO THE NATION: OCCUPATIONAL FRAUD AND ABUSE 6, available at http:ll www.securitymanagement.comlibrary/AFCEFraudll02news.pdf. Various types of financial fraud exist. For example, financial fraud through inventory valua- tion can occur by increasing asset values, such as inventory, and reducing related expenses, such as cost of goods sold. This may happen to meet corporate earnings expectations by security analysts, avoid violating debt covenants, earn profit-re- lated bonuses, increase the value of employee stock options, or meet internal budgets. See Craig L. Greene, When Employees Count Too Much: Spotting Over- stated Inventory, FRAUD MAG., Nov.-Dec. 2002, at 2, available at httpJAvww. acfe.com. 5. The SEC regularly issues various releases, such as "Accounting & Auditing En- forcement Releases" ("AAER"), which summarize enforcement actions against companies, auditors, and individuals found violating the securities law. For ex- ample, in 2002, the SEC originally charged WorldCom with a $3.8 billion fraud 20071 INVESTIGATIONS, INSPECTIONS, AND AUDITS 45 vestor confidence in the capital market, Congress quickly reacted by overwhelmingly voting to enact the Sarbanes-Oxley Act of 2002 ("SOX").7 SOX was the most significant expansion of. securities laws since the 1934 Securities Exchange Act.8 To encourage investor confidence in companies and their financial information, SOX attempted to achieve four major goals. The first goal was to improve corporate governance and "the tone at the top" of a public company. This objective stemmed from the fact that a com- pany's Chief Executive Officer ("CEO")9 or Chief Financial Officer ("CFO")1O is usually involved in any significant financial fraud."l The second goal was to strengthen financial reporting and disclosure. by capitalizing and deferring the recognition of expenses. See Sec. & Exch. Comm'n Lit. Rel. 17588, AAER 1585, SEC v. WorldCom (June 27, 2002). The SEC subsequently alleged that WorldCom overstated its net income by over $9 billion. See Sec. & Exch. Comm'n Lit. Rel. 17866, AAER 1678 (Nov. 26, 2002); Sec. & Exch. Comm'n Lit. Rel. 18277, AAER 1834; The HonorableArthur J. Gon- zales Approves Settlement of the SEC's Claim for a Civil Penalty Against WorldCom (July 23, 2004). WorldCom's former CEO was convicted of accounting fraud and sent to prison. See Steve Burkholder, Accounting Fraud:Ebbers Sen- tenced to 25 years for Fraud, 20 CORP. CouNs. WKLY.218 (BNA) (July 20, 2005). 6. An examination of twenty companies shows a stock market loss of over $300 bil- lion. About half of these companies ended up in bankruptcy. See GLASS LEWIS & Co., YELLOW CARD INTERIM ALERT: INTERNAL CONTROL DEFICIENCY DISCLOSURES, at 13, Table A2: Market Cap Declines from Date of Last Unquestioned Filing Date Priorto Disclosure Through Resolution, reprinted in Letter from Lynn E. Turner, Managing Director of Glass Lewis & Co., LLC, to Jonathan G. Katz, Secretary, Sec. & Exch. Comm'n, Apr. 12, 2005, available at www.sec.gov/news/press/4-497/ leturner041205.pdf. 7. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 (2002) (codified as amended in scattered sections of 11, 15, 28, and 29 U.S.C.). Congress enacted SOX in July 2002 by an overwhelming vote (Senate: 99-0 and House: 423-3), "during a media frenzy involving several high-profile corporate fraud and insolvency cases." Roberta Romano, The Sarbanes-OxleyAct and the Making of Quack Governance, 114 YALE L. J. 1521, 1528 (2005). 8. Securities Exchange Act of 1934, 48 Stat. 881, 15 U.S.C. § 78a-78kk (Supp. IV 2004). 9. SOX refers to "principal executive officer." Sarbanes-Oxley Act of 2002 § 302(a), 15 U.S.C. § 7241(a) (Supp. IV 2004). Usually, this position is that of a CEO. As the top person in corporate management, the CEO is responsible for overseeing the company's senior management and ensuring that the company operates in an effective and legal manner. See generally THE BUSINESS ROUNDTABLE, PRINCIPLES OF CORPORATE GOVERNANCE 7-10 (2002), available at www.brtable.orgpdf/704. pdf. 10. SOX refers to a "principal financial officer." Sarbanes-Oxley Act of 2002 § 302(a), 15 U.S.C. § 7241(a). Usually, this position is that of CFO. The CFO reports to the CEO on the company's finances. Areas of the CFO's responsibilities can in- clude strategic alliances, budgeting, financial reporting, treasury, and manage- ment of cash and fixed assets. PUB. Co. ACCOUNTING OVERSIGHT BD., ANNUAL REPORT (2005). 11. In the SEC's study of 227 enforcement actions involving financial fraud, 111 in- volved the CEO and 105 involved the CFO. See SEC. &
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