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Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

6. Internal Controls and Reporting Cash

Sarbanes-Oxley Act

The Sarbanes-Oxley (SOX) Act of 2002 was a response by the US Government to instances of large scale fraud in the early 2000s. Professors love to talk about SOX because it had major implications for accountants, especially auditors of public companies.


Sarbanes-Oxley Act of 2002

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So in the early 2000's there were some huge accounting scandals that become big hot topics in your accounting classes. Okay. And from these accounting scandals, there was legislation that passed called the Sarbanes Oxley Act to try and stop these scandals from happening again in the future. Let's learn a little more about the Sarbanes Oxley Act. Okay. So in the early two thousand's, those famous accounting scandals that they love to mention in your accounting textbooks is Enron, There was a company called Enron and another one called Worldcom. Okay. And both these companies, they basically falsified information. They said they were making all sorts of money that they weren't making and it ended up being a problem, Right? And this is an accounting problem, right? Because it comes down to the financial information that they released those balance sheets, income statements that they were giving to their investors, they were false. They didn't show true information. Alright. And the problem there is that these, these financial statements, they were audited by an auditor who came in and he's supposed to be completely separate from the company and say, hey, this is all Okay. So in the end, it ended up being even worse because it was the auditors themselves that were also under fire. Okay, So in response to this to these scandals, we saw the Sarbanes Oxley act. Okay. And it's called socks for short. Alright. So let's learn just on a high level, some of the things that the Sarbanes Oxley Act did and see how that would make financial statements more reliable and help the investors feel safe with the financial information that they're getting again. Okay. So let's see what were some of the key features here. One of the most important things was the creation of the P. C. A. O. B. The public company accounting oversight board. So what the P. C. A. Or B. Basically does is set standards for the auditors as well. Okay. So they're basically they make sure that the auditors are doing what they're supposed to be doing there. The auditors of the auditors. Okay. So isn't that sound really productive right now? We're auditing the people who are supposed to be auditing. Either way. It helps us feel safer with what the auditors are doing, right? There's more strict guidelines on the auditing process. Okay. Next is executive accountability. So after the Sarbanes Oxley act required that the Ceo and CFO of public companies. Companies that are traded on stock exchanges, well, they're now required to sign off on the statements. They have to literally sign the statement and say, hey, I'm okay with this. Right? They're certifying that. This is all good information and there's big penalties if they sign these statements and then they end up being false, they could definitely go to prison. Okay. Next is non audit services. So what this this uh made it illegal for auditors to perform non audit services. Okay, so now auditors, the only thing they can do for the company is audit the company right before it was able for them to do things like consulting services as well. Right? And this ended up making it like a conflict of interest, right? Maybe the auditor wanted to keep this client and make more money off of them. So they wanted to get these other engagements like consult engagements and make these friendly terms. But there shouldn't be friendly terms between the company and the auditor. The auditor needs to be very objective and make sure that everything is done correctly. Okay? So those non audit services like consulting, they're no longer allowed. The audit firm can only audit next work paper retention. So auditors are required to hold on to important documents for seven years. That's a pretty long time. Right? So they can always go back and make sure that those audits were done correctly. Especially when the P. C. A. O. B. Comes in and audits those auditors and check those work papers. Cool. Next is auditor rotation. So the lead auditor on an engagement. So whoever is like the partner of the engagement. Well that's gonna have to change every five years. This is so that there's not friendliness that starts to happen between the partner and the executives of the company. They want to keep that rotating. Okay. And it also makes it so that the new auditor can come in and have a fresh look at the statements and maybe find new problems that the other one didn't notice. Next is conflicts of interest. So this one seems pretty obvious, right? The audit firms cannot audit companies where the executives used to work for the auditors right? This is a situation where maybe someone who worked for the company is now the ceo of the company or auditing. Well that wouldn't really make sense. Right? You can see a conflict of interest there. They're probably on friendly terms with their auditors, which is never good. Okay. The audit committee, so now P. C. A. Uh the Sarbanes Oxley act forces an audit committee to be formed and the audit committee is what hires uh the audit committee hires the auditors. Okay. So it's no longer the management of the company can hire the auditor and they can pick and choose who they want. No. The audit committee which is the board of directors uh from the board of directors, they're the ones who choose the auditors and last but not least the topic of internal controls. So there has to be internal controls in place and management must assess their effectiveness. So management must make a statement in the financial statements or a written statement saying hey our controls are effective and they should make our our information more reliable. On top of that statement, the auditors are gonna test internal controls to make sure that they are working properly. Okay? So you can see that. And just by the way if if this is your first time hearing about internal controls. These are like safeguards, checks within the company procedures, policies that are in place that make sure that assets are safeguarded, are that financial information is reliable? Right. This can be just as simple as locking the door to the warehouse. That's an internal control, locking the warehouse at night. That's a control to make sure that nobody can steal the inventory. Right? Obviously there's all sorts of more complicated controls, but that's an example there. Okay. So you can see that the Sarbanes Oxley Act has forced accounting information to hopefully be more reliable, right? Because they've put all these extra restrictions and extra regulations to make sure that the auditors are doing their job as well as management. Cool. Alright, let's go ahead and move on to the next video.