Lita Epstein - Reading Financial Reports For Dummies

Boards of directors: Most companies must restructure their board of directors and audit committees to meet the Sarbanes-Oxley Act's requirements, ensuring that independent board members control key audit decisions. The structure and operation of nominating and compensation committees must eliminate even the appearance of conflicts of interest. Companies must make provisions to give shareholders direct input in corporate governance decisions. Businesses also must provide additional education to board members to be sure they understand their responsibilities to shareholders.

In addition to the new requirements for CEOs and CFOs, Sarbanes-Oxley changed other aspects of corporate reporting:

Established the Public Company Accounting Oversight Board (PCAOB; https://pcaobus.org ). This is an independent regulator of auditors of public companies and brokers. The PCAOB has the authority to inspect the operations of these entities in addition to enforcement and standard-setting authority.BEARING THE BURDEN AND EXPENSE OF SARBANES-OXLEYMany major corporations already had the internal controls in place and produced the documentation that the Sarbanes-Oxley Act required. Smaller companies were hit harder with these new requirements. The SEC's only concession for smaller companies was when they must be in compliance with the new rules on internal controls: All small businesses had to be in compliance by November 2004.The rules imposed by Sarbanes-Oxley were such a significant burden on small companies that some of them decided to buy out shareholders and make the companies private again, or merge with larger companies, or even liquidate.When a private company thinks about going public, it must consider whether the process is worth the costs. With the new Sarbanes-Oxley rules in place, a small company pays close to $3 million in legal, accounting, and other costs of being public. Before Sarbanes-Oxley, these costs totaled closer to $2 million. Nowadays, large corporations budget more than $7 million to cover the costs of being a public company.

Strengthened audit committees and corporate governance. Corporate audit committees must now be independent of management for all public companies. The audit committee also has sole authority for the appointment, compensation, and oversight of the external auditor. Every audit committee is required to have at least one financial expert on the committee and the expert’s identity must be disclosed.

Mandated that auditors must now attest to management’s effectiveness of internal controls over financial reporting.

Established the “Fair Funds” program at the SEC, which provides a source of funds to compensate victims of securities fraud.

For more than 100 years, public accounting firms were self-regulated. Sarbanes-Oxley changed that, and now the PCAOB regulates these firms by:

Requiring that public auditing companies register with the PCAOB

Establishing auditing and ethics standards

Conducting audit quality inspections to assess firms’ compliance with standards and SEC and PCAOB rules, and to identify audit quality issues

Investigating allegations of wrongdoing

Disciplining auditors of public companies and broker-dealers

The SEC has full oversight of the activities of the PCAOB. The SEC appoints members of the PCAOB in consultation with the Secretary of the Treasury and the Chair of the Federal Reserve. Two seats are occupied by individuals certified as public accountants. In addition, the SEC has the opportunity to review rules and standards set by the board It can approve or disapprove of the standards set, but cannot amend them. The SEC also approves the budget of the board. The SEC also has the authority to review and modify final disciplinary sanctions imposed by the board.

Another major piece of legislation passed by Congress after the 2008 financial crisis is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This act sought to restore stability and oversight in the financial industry with the hopes of preventing a repeat of that crisis.

The law was written by two of its namesakes, former Senator Chris Dodd and former Representative Barney Frank. Its key provisions protect U.S. consumers and investors by

Forming the Financial Stability Oversight Council (FSOC), whose primary responsibility is to keep banks and other financial firms from becoming “too big to fail.”

Mandating stress tests run by the Federal Reserve to more carefully monitor the largest banks and financial institutions and giant insurance companies. The annual tests make sure very large institutions are prepared for future financial crises. If a bank doesn’t pass the test, the Federal Reserve can suspend share buybacks or put a cap on dividends to ensure that the bank remains strong enough so it can lend to struggling businesses and survive hard times.

Creating the Consumer Financial Protection Bureau (CFPB), which is intended to protect consumers from risky or abusive financial products. This bureau can regulate companies that sell financial products to consumers and enforce laws against discrimination in consumer finance.

Creating the Volcker Rule to prevent banks from engaging in speculative trading activities. This rule was named after Federal Reserve Chairman Paul Volcker. Prior to this rule, and leading up to the financial crisis of 2008, banks were creating and then trading highly risky derivatives, most of which became huge liabilities that bankrupted entire financial institutions. American International Group (AIG) was one of the most notorious (see the nearby sidebar “What Led to Dodd-Frank?”). Under this rule, banks can only trade when it’s necessary to run their business, such as currency trading or working to support an agent, broker, or custodian for their customers’ funds.

Providing for the regulation of derivative trading by the SEC. These are contracts between two parties to exchange financial assets, which can include bonds, commodities, currencies, interest rates, market indexes, or stocks. Regulators have the power to identify risks in the trades and take action before they trigger a financial crisis.

Requiring hedge funds to register with the SEC. In addition, hedge funds must provide critical information about their trades and portfolios to the SEC, so it can then assess their overall risk.

Creating the SEC Office of Credit Ratings (OCR), which oversees credit ratings agencies, such as Standard & Poor’s and Moody’s. These credit ratings agencies rank the safety of bonds and impact bond purchase decisions by brokers and individuals.

Many people point to the near failure of American International Group (AIG) in 2008 as a critical event that led to the financial crisis of 2008. AIG, which was a global financial company with about $1 trillion in assets prior to the crisis, lost $99.2 billion in 2008.

Many are still trying to understand what caused the massive failure. Two key factors have been identified as the culprits that led to the major collapse. The company’s credit default swaps played a major role in the collapse. AIG lost $30 billion. Securities lending resulted in a $21 billion lost, which also shares a large part of the blame for the failure. Mortgage-back securities also played a major role in AIG’s collapse. The Federal Reserve rescued AIG with an $85 billion loan so it would not fail.

All of these factors were part of the reason for enacting the Dodd-Frank legislation, which identifies entities “too big to fail” and designates them a “systematically important financial institution (SIFI)” that must go through stricter Federal oversight. Interestingly, the Financial Statbility Oversight Committee decided in 2017 AIG no longer was too big to fail and removed the SIFI designation for AIG.