New Teeth for the Public's Watchdog: The Expanded Role of the Independent Accountant in Detecting, Preventing, and Reporting Financial Fraud
Joseph I. Goldstein and Catherine Dixon, 44(2): 439–502 (Feb. 1989)
Public expectations of the independent auditor's performance appear to exceed the scope of the duties prescribed by law and professional codes of conduct. Congress, the SEC, the media, and the legal and accounting professions are involved in an ongoing debate focused on whether legislative measures are required to narrow the gap between the public's expectations and existing guidelines for auditors' conduct. This Article discusses a variety of reforms proposed by participants in this debate.
Audit-Inquiry Responses in the Arena of Discovery: Protected by the Work- Product Doctrine
Michael J. Sharp and Abraham M. Stanger, 56(1): 183 (Nov. 2000)
Analyzing the ABA's treatment of discovery protection afforded audit- inquiry responses and examining the limited case law on the subject, this Article outlines why such responses should be immune from discovery under the work-product doctrine.
The Securities and Exchange Commission's Revised Auditor Independence Rules
William R. McLucas and Paul R. Eckert, 56(3): 877 (May 2001)
In November 2000, the Securities and Exchange Commission unanimously adopted major revisions to its auditor independence rules. These revisions focused on two principal areas of auditor independence. First, the SEC liberalized the restrictions that prohibited accountants and their family members from any investments in, or employment by, SEC audit clients. Second, the SEC identified so-called non-audit services that threaten independence when provided to SEC audit clients. This Article examines the Commission's final rule on auditor independence and compares the provisions contained in the final rule against not only the existing independence rules and the proposal first announced in June 2000, but also the existing rules of the AICPA and the work of other private standard-setting organizations such as the Independence Standards Board and the Panel on Audit Effectiveness. The Article also examines some of the events that led to the Commission's decision to engage in rulemaking in the auditor independence area and the practical consequences of certain of the compromises reflected in the final rule.
Trying to Hear the Whistle Blowing: The Widely Misunderstood "Illegal Act" Reporting Requirements of Exchange Act Section 10A
Thomas L. Riesenberg, 56(4): 1417 (Aug. 2001)
Section 10A of the Securities Exchange Act, enacted by Congress in 1995, imposes "illegal act" reporting requirements on independent auditors. The nature of those requirements has been quite uncertain. Some commentators have suggested that section 10A fundamentally changes the relationship between auditor and client. Others have concluded that the law has little impact. The Securities and Exchange Commission has taken steps towards an expansive interpretation of the law, in particular by broadly reading the term "illegal act" and by questioning why independent auditors have filed only a handful of section 10A reports with the Commission. This article examines the statutory language and its legislative history; explains how section 10A coexists with longstanding auditing procedures; and concludes that, properly understood, section 10A is a modest statute with limited significance.
Internal Investigations and the Defense of Corporations in the Sarbanes-Oxley Era
Robert S. Bennett, Alan Kriegel, Carl S. Rauh, and Charles F. Walker, 62(1): 55–88 (Nov. 2006)
Internal investigations long have been an integral part of the successful defense of corporations against charges of misconduct, as well as an important board and management tool for assessing questionable practices. With the heightened standards of conduct and increased exposure created by Sarbanes-Oxley, this essential instrument for safeguarding corporate interests has become even more crucial in identifying and managing risk in the enforcement arena. This article examines from a practitioner's standpoint when and how internal investigations should be conducted in order to protect the corporation in criminal, civil and administrative proceedings. Particular attention is paid to the issues created by a concurrent government investigation and in dealing with employees and former employees in the course of an investigation. The article also addresses the role of the Audit committee under Sarbanes-Oxley, and the important issue of reporting the findings of the investigation to appropriate corporate officials. The subject of self-reporting by the Company to enforcement authorities is considered as well. In this context, the article explores the SEC's position on crediting self-reporting and cooperation as set forth in the Seaboard report; Department of Justice policy as embodied in the Thompson Memorandum; and the impact of the Federal Sentencing Guidelines for Organizations.
Caveat Auditor: Back to First Principles
David R. Herwitz, 65(1): 95–106 (November 2009)
The Sarbanes-Oxley Act of 2002 ("SOX") substantially revised the rules governing auditors of public companies, in an effort to counter the auditing weaknesses exposed in the Enron, WorldCom, and similar fiascos. Among the most important changes were a substantial upgrade in the role and responsibility of corporate audit committees, and the creation of a new agency, the Public Company Accounting Oversight Board ("PCAOB"), to take complete charge of overseeing auditors and all aspects of the auditing process. Some commentators have expressed disappointment in the SOX efforts to reform public company auditing, and this subject is likely to receive renewed attention in view of the U.S. Supreme Court's grant of certiorari in Free Enterprise Fund v. PCAOB, a case challenging the constitutionality of the PCAOB. This Article takes the position that rather than focusing on audit committees, effective reform of auditing lies in a significant step-up in the responsibility of auditors, by returning to the original purpose of an audit: to provide as fair and meaningful a picture as possible of a company's financial performance. The Article argues that in applying this high standard to a company's proposed financial statements, the auditor should express its "present fairly" opinion without any limitation based upon GAAP; in addition, whenever there are reasonable alternatives to any of the accounting treatments utilized in the company's financial statements, the auditor's report should disclose the reason for the choice made, as well as whether the auditor would have made the same choice if deciding on its own.
Statement on the Effect of the FASB Codification on Audit Response Letters
committee on Audit Responses, ABA Business Law Section, 65(2): 491–492 (February 2010)
Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency
Henry T. C. Hu; 70(2): 347-406 (Spring 2015)
Financial innovation has fundamental implications for the key substantive and information-based mechanisms of corporate governance. “Decoupling” undermines classic understandings of the allocation of voting rights among shareholders (via, e.g., “empty voting”), the control rights of debtholders (via, e.g., “empty crediting” and “hidden interests”/ “hidden non-interests”), and of takeover practices (via, e.g., “morphable ownership” to avoid section 13(d) disclosure and to avoid triggering certain poison pills). Stock-based compensation, the monitoring of managerial performance, the market for corporate control, and other governance mechanisms dependent on a robust informational predicate and market efficiency are undermined by the transparency challenges posed by financial innovation. The basic approach to information that the SEC has always used—the “descriptive mode,” which relies on “intermediary depictions” of objective reality—is manifestly insufficient to capture highly complex objective realities, such as the realities of major banks heavily involved with derivatives. Ironically, the primary governmental response to such transparency challenges—a new system for public disclosure that became effective in 2013, the first since the establishment of the SEC—also creates difficulties. This new parallel public disclosure system, developed by bank regulators and applicable to major financial institutions, is not directed primarily at the familiar transparency ends of investor protection and market efficiency.
As starting points, this Article offers brief overviews of: (1) the analytical framework developed in 2006−2008 for “decoupling” and its calls for reform; and (2) the analytical framework developed in 2012−2014 reconceptualizing “information” in terms of three “modes” and addressing the two parallel disclosure universes.
As to decoupling, the Article proceeds to analyze some key post- 2008 developments (including the status of efforts at reform) and the road ahead. A detailed analysis is offered as to the landmark December 2012 TELUS opinion in the Supreme Court of British Columbia, involving perhaps the most complicated public example of decoupling to date. The Article discusses recent actions on the part of the Delaware judiciary and legislature, the European Union, and bankruptcy courts—and the pressing need for more action by the SEC. At the time the debt decoupling research was introduced, available evidence as to the phenomenon’s significance was limited. This Article helps address that gap.
As to information, the Article begins by outlining the calls for reform associated with the 2012−2014 analytical framework. With revolutionary advances in computer- and web-related technologies, regulators need no longer rely almost exclusively on the descriptive mode rooted in intermediary depictions. Regulators must also begin to systematically deploy the “transfer mode” rooted in “pure information” and the “hybrid mode” rooted in “moderately pure information.” The Article then shows some of the key ways that the new analytical framework can contribute to the SEC’s comprehensive and long-needed new initiative to address “disclosure effectiveness,” including in “depiction-difficult” contexts completely unrelated to financial innovation (e.g., pension disclosures and high technology companies). The Article concludes with a concise version of the analytical framework’s thesis that the new morphology of public information—consisting of two parallel regulatory universes with divergent ends and means—is unsustainable in the long run and involve certain matters that need statutory resolution. However, certain steps involving coordination among the SEC, the Federal Reserve, and others can be taken in the interim.
Simple Insolvency Detection for Publicly Traded Firms
J.B. Heaton, 74(3) 723-734 (Summer 2019)
This article addresses current limitations of financial-market-based solvency tests by proposing a simple balance-sheet solvency test for publicly traded firms. This test is derived from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation. The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The solvency test is a generated upper bound on the total amount of debt the firm can have and still be solvent or, alternatively, the minimum amount of stock-market capitalization the firm must have if it is solvent at current debt prices. The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. The method proposed here can identify insolvent firms that should be retaining assets and not paying them out to shareholders as dividends or repurchases, identify stocks that brokers and investment advisers should treat as out-of-the-money call options that may be unsuitable investments, and can help auditors identify publicly traded firms that are candidates for going-concern qualifications and other disclosures.
The ABA Statement on Audit Responses: A Framework that Has Stood the Test of Time
Alan J. Wilson, Stanley Keller, Randall D. McClanahan, Noël J. Para, James J. Rosenhauer, and Thomas W. White, Audit Responses Committee, ABA Business Law Section, 75(3): 2085-2102 (Summer 2020)
This article summarizes key developments in the preparation of audit response letters concerning loss contingencies since the American Bar Association Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests for Information was published in 1976. These developments illustrate both the utility of the framework set forth in the ABA Statement and the responsiveness of the American Bar Association through the Business Law Section Audit Responses Committee (and predecessor committees) to issues arising under the ABA Statement and changes in accounting and auditing standards and practice.