Lecture Slides

1. Aalto University - MikkeliWeek 3 (Day 3): 9-00am – 10-00pmRegulation and Corporate Governance Failures Lecture Slides

2. Enron Corp

3. Who is to Blame for Enron? • Lax accounting by Arthur Anderson (AA) Co? • “Rogue” AA auditor David Duncan (fired 1/15/02)? • Enron’s senior management for hiding losses in dubious off-balance-sheet partnerships? • CFO Andrew Fastow for setting up these partnerships (6 year prison sentence 9/26/2004)? • Timothy Belden (trading schemes, 2yrs probation 2007) • CEO Jeff Skilling (24 year prison sentence 10/23/06)? • CEO Kenneth Lay (died 7/23/06 with charges pending)? • Media exaggeration and frenzy? • Stock analysts who kept pushing Enron stock?

4. Bad Accounting Practices? Generally Accepted Accounting Practices (Prior to 2002): •Auditing companies often consult for the companies they audit (conflict of interest). •Audit company partners often later accept jobs from their client companies. •Companies often retain the same auditing company for long periods of time. •Auditing companies have been allowed to police themselves.

5. Bad Accounting Practices? Generally Accepted Accounting Practices (Prior to 2002)… Continued • Appointment of auditor company is in theory by shareholders but in practice by senior management • Audit Committee members often are not independent of senior management – insiders are the ones with the most accurate understanding. • Audit Committee members have typically been required to own company stock to align their incentives with those of company.

6. Other Dubious Practices? • Board of Directors have traditionally been paid largely in stock to align their interests with shareholders. • Directors can sell out early based on insider information. • When senior executives are charged with failure to abide by SEC rulings, the company typically pays the fine.

7. The regulatory solution?

8. The Sarbanes-Oxley Act • Enacted in 2002 as a result of a series of large corporate financial scandals • Improves confidence in financial reporting by • Promoting effective execution of controls • Increasing corporate governance • Reducing fraudulent practices and accounting inconsistencies Michael Oxley Paul Sarbanes

9. Sarbanes-Oxley Act of 2002 • The Sarbanes-Oxley Act of 2002 (often referred to simply as Sarbanes-Oxley) applies only to companies whose stock is traded on public exchanges. Its purpose is to restore public confidence and trust in the financial statements of companies.

10. What Is It? • Act passed by Congress in response to the recent and continuing corporatescandals. • Signed into law July 30, 2002. • Established sweeping changes dealing with financial reporting, conflicts of interest, corporate ethics, and oversight of the accounting profession. • Applies to public companies.

11. Key Provisions

12. Sections 101, 102 and 104 – Public Company Accounting Oversight Board • The act requires the establishment of a Public company Accounting Oversight Board: • All accounting firms that audit public companies must register with the board. • Board will establish rules governing substance and content of audits. • Inspections of auditing firms will be conducted by the Board.

13. Section 204 - Communications • Auditor Communications with Audit Committees: • Increases communications between auditor and audit committee on critical accounting policies and practices, alternative accounting treatments, and other material written communications with management.

14. Section 301- Audit Committee Standards • Makes audit committee directly responsible for the appointment, compensation, and oversight of auditors • Limits audit committee membership to independent directors. • Requires procedures for complaints from whistleblowers and others. • Requires company to provide audit committee with funding for auditors and other advisors as audit committee deems necessary.

15. Section 302 Certifications • Certifications must include: • CEO and CFO have reviewed the periodic filing and to their knowledge, information provided presents fairly the financial results of the company. • CEO and CFO have established and maintain disclosure controls and procedures that ensure that all material information is made known to them. • CEO and CFO have evaluated the effectiveness of the disclosure controls and procedures as of 90 days prior to the date of the periodic report and presented their conclusions in the report. • CEO and CFO have disclosed all internal control deficiencies and any fraud, whether or not significant, that involves management or other employees who have a significant role in the companies internal controls. • Statement of whether the company has established a Code of Ethics for senior financial officers. • Other miscellaneous items.

16. Section 304 – Forfeiture of Certain Bonuses and Profits • Requires CEO and CFO to forfeit certain bonuses received and profits realized on the sale of securities following a financial report that is later restated due to material non-compliance with securities laws, as a result of misconduct.

17. Section 402 – Executive Loans • Prohibits personal loans to officers and directors.

18. Section 403 – Accelerated Reporting • Requires accelerated reporting of trades by insiders. • Transactions must be reported via EDGAR by the end of the second business day following execution of a transaction.

19. Section 404 Evaluating Internal Controls • Requires a public company to document and evaluate the effectiveness of internal controls and procedures for financial reporting. • Elements of internal control. • Internal control environment • Risk assessment • Control activities • Information and communication • Monitoring • Effective internal controls provide reasonable assurance that risk is manageable. • Effective internal controls provide clear definition of responsibilities and accountabilities.

20. (Cont’d) • Requires external auditor to attest to management’s assertions in the annual report. • Annual report to include management’s assessment of the effectiveness of internal control over financial reporting. • Effective for fiscal years ending after June 30, 2004.

21. Section 409 – Real Time Issuer Disclosures • “Rapid and current” disclosure of material changes in financial condition or operations.

22. Section 906 Certifications • Requires that each periodic report filed with the SEC (Securities and Exchange Commission) be accompanied by the certification of the CEO and CFO that: • The report fully complies with applicable Security Exchange Act rules. • The information contained in the report fairly presents, in all material respects, the financial condition and results of operations of the company. • Fraudulent certifications carry penalties! • $1 million fine • Up to 10 years in prison • Willful falsification carries a steeper penalty • $5 million fine • Up to 20 years in prison

23. Sections 1102 & 802 - Penalties • Record tampering or otherwise impeding an official proceeding and Criminal penalties for altering documents: • Criminal penalties for corruptly altering or destroying documents or otherwise impeding an official proceeding. • Expands criminal penalties for whoever alters documents, including audit reports, to obstruct an investigation.