The bankruptcies of Enron in late 2001 and of WoldCom in mid 2002 shocked investors and forced US government to impose more regulations to corporations in order to rebuild investors’ confidence and prevent future fraud. However, strict regulations may not be the most effective solution to the problem since information asymmetry, which sometimes result adverse selection and moral hazard, can never be prevented in market. Yet four years after Sarbanes-Oxley Act (SOX), rising trends of restatements make people wonder the necessity and efficacy of all the new rules.
How do we know financial statements are trustworthy? As a report card of management, financial statements function to provide reliable and relevant information to all users and faithfully reveal the financial position of the corporation, if possible. Nonetheless, it is a self-graded report card prepared by the management. The application of accounting rules, the regulations from agencies such as SEC and CICA, the inspection of auditors, and all kinds of methods are created to protect investors and creditors – frauds happen. And despite the intensive restatement issues, sarcastically, executives decide to blame “complex accounting rules” and “hypersensitive auditors” for their mystic and inaccurate financial statements.
To a CEO, the struggle to protect self-interest or to fight for corporation’s interest always exists, especially at the day account closed. The management does have the fiduciary duty to shareholders but considering the short term benefit and the long term damage to the corporation, the decision is usually a tough one. Grabbing some treats from candy jar to smoothen income and urging in-house accountants to recognize revenue in a slightly different way may seem to be normal practices since the option of restatement is always there. The fact is that restatements provide irrelevant delay information and make investors to question the reliability of future financial statements. Such suspicion will force market to raise risk assessment toward the company and thus reduce stock price. Further, if restatement becomes a common event for all companies, investors may decide to retreat from the market and invest other financial instruments – consequences may be catastrophic.
In September 2005, SEC for the third time postponed the deadline for smaller companies to comply with Section 404 of SOX, which requires them to hire independent auditors to report their evaluation of company’s internal control to investors. The raising concern of accurate financial information due to massive restatements pushes SEC to do a complete health check of small businesses; however, cost efficiency becomes a major issue in this wave of examinations since many small companies have no designated CFO or rely on part-time CFO. Thus, whether easing internal-control rules, which designed to avoid accounting mistakes or fraud, is really a good idea in a time when it would likely be most needed becomes doubtful. Taub tries to justify the moderation of rules with the fact that 55% of restatements are due to “basic mistakes” such as recording problem or misapplication of basic accounting rules. While the errors may not be deliberate or fraud, continuous accumulation of immaterial errors may eventually become material. After all, using “basic mistakes” as the argument to lax the rules is apparently illogical.
To provide a secure, reliable, and stable investing environment is the objective of various regulations. Undoubtedly, new rules may reduce the chance of fraud and regain investor confidence to a certain degree. Nonetheless, they will also increase expenses of firms and discourage new firms to enter the market. More regulations always indicate less freedom and more trouble to businesses. In the long run, competition may reduce, trading in private market may increase, and businesses may move to other countries. Finding an equilibrium point to minimize fraud and maximize the benefit of economy as a whole will be a necessary but challenging task. By providing incentives such as tax reduction, implementing more reasonable management bonus policy, making accounting rules more flexible, and legislating more severe punishment for dishonest companies and managements should be helpful than enforcing regulations alone.
How do we know financial statements are trustworthy? As a report card of management, financial statements function to provide reliable and relevant information to all users and faithfully reveal the financial position of the corporation, if possible. Nonetheless, it is a self-graded report card prepared by the management. The application of accounting rules, the regulations from agencies such as SEC and CICA, the inspection of auditors, and all kinds of methods are created to protect investors and creditors – frauds happen. And despite the intensive restatement issues, sarcastically, executives decide to blame “complex accounting rules” and “hypersensitive auditors” for their mystic and inaccurate financial statements.
To a CEO, the struggle to protect self-interest or to fight for corporation’s interest always exists, especially at the day account closed. The management does have the fiduciary duty to shareholders but considering the short term benefit and the long term damage to the corporation, the decision is usually a tough one. Grabbing some treats from candy jar to smoothen income and urging in-house accountants to recognize revenue in a slightly different way may seem to be normal practices since the option of restatement is always there. The fact is that restatements provide irrelevant delay information and make investors to question the reliability of future financial statements. Such suspicion will force market to raise risk assessment toward the company and thus reduce stock price. Further, if restatement becomes a common event for all companies, investors may decide to retreat from the market and invest other financial instruments – consequences may be catastrophic.
In September 2005, SEC for the third time postponed the deadline for smaller companies to comply with Section 404 of SOX, which requires them to hire independent auditors to report their evaluation of company’s internal control to investors. The raising concern of accurate financial information due to massive restatements pushes SEC to do a complete health check of small businesses; however, cost efficiency becomes a major issue in this wave of examinations since many small companies have no designated CFO or rely on part-time CFO. Thus, whether easing internal-control rules, which designed to avoid accounting mistakes or fraud, is really a good idea in a time when it would likely be most needed becomes doubtful. Taub tries to justify the moderation of rules with the fact that 55% of restatements are due to “basic mistakes” such as recording problem or misapplication of basic accounting rules. While the errors may not be deliberate or fraud, continuous accumulation of immaterial errors may eventually become material. After all, using “basic mistakes” as the argument to lax the rules is apparently illogical.
To provide a secure, reliable, and stable investing environment is the objective of various regulations. Undoubtedly, new rules may reduce the chance of fraud and regain investor confidence to a certain degree. Nonetheless, they will also increase expenses of firms and discourage new firms to enter the market. More regulations always indicate less freedom and more trouble to businesses. In the long run, competition may reduce, trading in private market may increase, and businesses may move to other countries. Finding an equilibrium point to minimize fraud and maximize the benefit of economy as a whole will be a necessary but challenging task. By providing incentives such as tax reduction, implementing more reasonable management bonus policy, making accounting rules more flexible, and legislating more severe punishment for dishonest companies and managements should be helpful than enforcing regulations alone.
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