Maire Loughran - Financial Accounting For Dummies

SOX does not apply to privately held companies; the Auditing Standards Board (ASB) regulates privately held companies.

SOX is organized into 11 titles or sections. You can read all about them at www.sec.gov/about/laws/soa2002.pdf , but here is just a quick rundown:

Public Company Accounting Oversight Board (PCAOB): SOX formed PCAOB, which I discuss in the next section of this chapter. PCAOB is the watchdog of the accounting and auditing professions.

Auditor independence: The legislation establishes standards for external auditor independence in order to limit conflicts of interest.

Corporate responsibility: SOX lays out the responsibility senior executives take for the accuracy and completeness of corporate financial reports.

Enhanced financial disclosures: This part of the legislation requires enhanced reporting for financial transactions so users can make better-informed decisions.

Analyst conflicts of interest: This section addresses the code of conduct for security analysts and requires the analysts to disclose any conflicts of interest.

Commission resources and authority: SOX defines the SEC’s authority to censure or bar security professionals from practice.

Studies and reports: The SEC is required to perform studies on topics such as security violations and enforcement actions and report its findings.

Corporate and criminal fraud accountability: This section addresses criminal penalties for “cooking the books” and any other manipulation of financial records.

White-collar crime penalty enhancements: This section beefs up criminal penalties that can be assessed for white-collar crimes, including management’s failure to certify corporate financial reports.

Corporate tax returns: This title states that the Chief Executive Officer should sign the company’s tax returns.

Corporate fraud and accountability: SOX identifies corporate fraud and altering financial records as criminal offenses.

SOX created the watchdog of the public company accounting and auditing profession: the PCAOB. The PCAOB is private, nonprofit corporation charged with bringing a halt to the financial shenanigans on the part of corporate chief financial officers (CFOs) and chief executive officers (CEOs) for publicly traded companies. Public accountants — those doing work for companies other than their own employer — support this goal through the preparation of informative, fair, and independent financial statement (audit) reports.

The PCAOB consists of five members, including a chairman appointed by the SEC and two members who must be — or previously have been — certified public accountants (CPAs). The chairman must be one of the two CPA members, but she cannot be an active CPA; in fact, she cannot have been a practicing CPA for at least five years prior to being appointed to the position. Being a member is a full-time, five-year commitment.

The PCAOB sanctions CPA firms for not following its standards. Its authority includes the death knell of revoking the CPA firm’s license and barring its partners from working in public accounting. This is pretty serious stuff because it effectively closes the CPA firm’s doors and keeps the individual CPAs from plying their trade.

Resulting from some congressional criticism of the standard-setting work being done by the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Foundation (FAF) was established in the state of Delaware as a nonprofit corporation by accountant Teresa S. Polley in June 1972.

The FAF in turn established the Financial Accounting Standards Board (FASB), which is currently the private-sector body establishing generally accepted accounting principles (GAAP) for all nongovernmental entities. (Governmental entities follow procedures set up by the Governmental Accounting Standards Board or GASB; see Chapter 6for more information.)

The FASB has seven full-time members, who are selected by FAF. All are required to have knowledge of accounting, finance, and business. For more info about the FASB, accounting standards, and FAF, check out the FASB website at www.fasb.org .

The recognition of the FASB as an authority is contained in the Securities and Exchange Commission (SEC) Financial Reporting Release No. 1, Section 101 and reaffirmed in its April 2003 Policy Statement and the American Institute of Certified Public Accountants (AICPA) Rule 203, Rules of Professional Conduct.

Most years, SEC and PCAOB representatives get together for a chit-chat about various financial accounting issues. The 2019 conference held in January 2020 addressed various SEC, accounting, and auditing matters. One topic of particular interest to financial accounting students is qualified audit reports (see Chapter 16). Spoiler alert! An unqualified audit report is the best you can get; qualified, not so much. As of this writing, the next conference is scheduled to start December 7, 2020. Two topics on the agenda are the future of the economy and emerging technologies — a topic I discuss in Chapter 17.

I know your spoon is probably full at this point, but before I explain what GAAP are and why they matter so much, I need you to swallow just one more acronym. The FASB formed the Emerging Issues Task Force (EITF) in 1984 to help identify emerging accounting issues in need of standardization. The EITF is composed of accounting professionals who meet six times a year with nonvoting members of the SEC and FASB to mull over current economic, business, and industrial developments.

GAAP define for financial accountants the acceptable practices in the preparation of financial statements in the United States. The preponderance of the information I provide in Parts 3, 4, and 5of this book directly ties back to GAAP. Specifically, GAAP tell financial accountants exactly how financial data has to show up on the income statement, balance sheet, and statement of cash flows.

For example, GAAP state that assets, liabilities, and equity go on the balance sheet and not on the income statement. GAAP are also pretty darn picky as to how these accounts are arranged on the balance sheet (see Part 3). In addition, GAAP give specific rules for separating operating revenue (which is related to the business purpose) from non-operating revenue (non-business-related revenue, such as profit from selling a company asset), which I explain in Chapter 7.

Like most things in life, there are exceptions to the rule that all businesses must follow GAAP. Some businesses can deviate from GAAP, a topic that will be briefly covered in your financial accounting course. However, your financial accounting class likely won’t concern itself much with these exceptions to the GAAP rule.

Are GAAP the same for public and nonpublic companies? For now, yes. FASB sets accounting and reporting standards for both, which also include not-for-profit organizations. The SEC has the statutory authority to set accounting standards for publicly held companies, but historically it has relied on private sector bodies to set those standards.