Sarbanes-Oxley and ‘Segregation of Services’

By Philip K. Kleckner and Craig Jackson

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Editor’s Note: Part 2 of a series

Auditors are retained by publicly held companies to “skeptically” review operational results. Most service industries would crumble if they didn’t support their customers, but not so with accounting. Due in large part to the relationship between Enron and Arthur Andersen, the Sarbanes-Oxley Act has imposed measures to ensure that a company’s auditors remain skeptical of their client’s financial reporting.

Title II of the Sarbanes-Oxley Act (“Auditor Independence”) lists services that auditors can no longer provide to audit clients. The justification for this prohibition is that maintaining independence is critical during the process of auditing financial statements. Our society would not have the confidence to invest billions of dollars in the stock market without the clean opinions of independent auditors.

Other provisions of the act aid in maintaining independence as well as preventing conflicts of interest. The rules of the act, issued on January 28, 2003, address the following areas:

Nonaudit services. Sarbanes-Oxley creates explicit categories of nonaudit services that, if provided to an audit client, are now deemed to impair the auditor’s independence:

  • Bookkeeping or other services relating to the accounting records or financial statements of the audit client
  • Financial information systems design and implementation
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
  • Actuarial services
  • Internal audit outsourcing services
  • Management functions
  • Human resource services
  • Broker/dealer, investment adviser, or investment banking services
  • Legal services
  • Expert services unrelated to the audit
  • Any other service that the Public Company Accounting Oversight Board (PCAOB) determines by regulation to be impermissible.

Preapproval requirements. Audit committees must preapprove all services provided by their auditors.

Partner rotation. Audit partners are prohibited from providing service to the same audit client for five to seven consecutive years, depending on the partner’s role in the engagement.

Auditor reports to audit committees. Auditors now must communicate certain matters to audit committees, including accounting policies of the company.

Conflicts of interest. An accounting firm is prohibited from auditing the financial statements of a client if key members of management were on the audit engagement team within a one-year period.

Enhanced financial disclosure. The act requires more comprehensive disclosure in the financial statements, including off–balance-sheet transactions.

Partner compensation. Sarbanes-Oxley indicates that independence shall become impaired if the audit partner’s compensation is based on selling nonaudit engagements to the audit client.

Commission authority. It is now unlawful for any registered public accounting firm to prepare or issue any audit report with respect to any issuer, if the firm engages in any activity prohibited by any of the subsections (g) through (l) of section 10A of the Securities Exchange Act of 1934.

The provision that will have the greatest impact on the accounting profession will be the loss of selling additional services to current clients. During the 1990s and the early 2000s, advanced technology and improved education enabled accounting firms to provide many nonaudit services to their current clients. A company’s external auditors seemed to be the best candidates to perform these additional services because they know the business. But this raised an issue: How many services can a firm provide before losing its independence? Arthur Andersen was providing so many services to Enron that it was in effect auditing its own work.

Small companies may lack the resources to comply with many Sarbanes-Oxley requirements, particularly those under section 404, which requires public companies to attach an internal control report to their annual filings indicating the following:

  • An acknowledgment that it is the responsibility of management to establish and maintain adequate internal controls.
  • An assessment of the effectiveness of the internal control structure and procedures for financial reporting.
  • An attestation by an external auditor on the assertions made by management in its assessment of internal controls.

Companies with more than $75 million in market capitalization have to comply in 2004 if their fiscal year ends on or after November 15, 2004. The PCAOB extended the deadline for small companies to fiscal years ending on or after July 15, 2005.

Reinstilling Confidence

The consulting engagements that companies employ accountants to provide go a long way with respect to discovering errors and improving internal controls. Many observers fear that outsiders will be unable to perform these services as well as current auditors. This fear may be alleviated by the skills that forensic accountants bring to the table.

Although segregation of duties has always been a critical component of internal controls, the recent accounting failures have necessitated that all aspects of financial reporting, including oversight, be segregated. Not only will such segregation be good for the public, it will ultimately be good for accountants, by reinstilling confidence in a profession that has been tarnished by several well-publicized audit failures.

Philip K. Kleckner, CFE, CPA/ABV, is the director in charge of the Business Crimes Group, and Craig Jackson is an associate, both at RosenfarbWinters, LLC, in Roseland, N.J.




















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