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Penalty to Auditors in Violation of Security Laws

In: Business and Management

Submitted By manuta
Words 1584
Pages 7
Overview of Security Exchange Commission
U.S. Security and Exchange Commission (SEC) is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the security market in the United States. SEC was established in 1934 as an independent, quasi-judicial regulatory agency after the massive market crash in 1929. “The mission of U.S. Security and Exchange Commission is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation” (SEC. The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation. From http://www.sec.gov/about/whatwedo.shtml#create).
Currently, SEC is responsible for administering Securities Act of 1933 and 1934, The Trust Indenture Act of 1939, The Investment Company Act of 1940, The Investment Advisors Act of 1940, The Sarbanes-Oxley Act of 2002 and Credit Rating Agency Reform Act of 2006. Congress has allowed SEC to bring civil enforcement actions against individual or companies in violation of securities law. It is the primary body to regulate public companies and their activities in United States.
SEC has enacted various rules, regulations and releases to pursue its objective of investor protection mission. Out of numerous provisions, section 10(A) –Audit Requirement is fundamental one. “In 1995, with little fanfare, the SEC added a powerful new weapon to its enforcement arsenal, specifically directed at independent auditors ... Section 10A of the Securities Exchange Act of 1934, as amended. Although, to date, the SEC has only made limited use of Section 10A, the recent spate of false financial disclosures ensures more extensive use of this powerful new weapon” (Hecht, Charles. The SEC’s New Weapon: Section 10A. Retrieved July 2002 from http://accounting.smartpros.com/x34666.xml). Section 10(A) has three components that are audit procedures, let the audit committee know and let the SEC know.
Section 10(A)-Audit Requirement
Independent registered public accounting firm has to audit the financial statements of issuers (registered public companies) in accordance with generally accepted auditing standards. Auditor is directly responsible to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts, identify related party transactions that are material or otherwise require disclosure on the audited financial statement and evaluate the ability of issuer to continue as a going concern during the ensuring fiscal year.
If auditor detects or becomes aware of any illegal acts, he/she has to determine whether such illegal act has occurred. Then, possible effect of that illegal act on the financial statement should be determined by the auditor. If the act is material enough, auditor must inform his conclusion to the appropriate level of management and audit committee of the issuer. In response to failure to take remedial actions by the management and audit committee, auditor must report the conclusion to the board of directors. The board of directors will have one day to report that matter to SEC. Auditor will get one additional day to report the issue directly to the SEC incase board of director fails comply with law. SEC may impose civil penalty to the auditor if the auditor fails to communicate the illegal act with board of director and SEC (only if board of director fails to notify SEC). However, auditor will not be charged in a private litigation if the litigation relates to auditor’s report that was given to management, board of director or SEC.
Notwithstanding the law's unassuming origin, the SEC has taken steps towards a far-reaching application. The SEC first stated a broad approach in Staff Accounting Bulletin 99 (SAB 99), where the Commission stated that "illegal acts" covered by section 10A include non-fraudulent and quantitatively immaterial books and records/internal control violations of the Foreign Corrupt Practices Act. The Commission even suggested that "personal misconduct" of a corporation's officers and directors--that is, misconduct unrelated to business activities--is included within the definition. Next, the Commission brought two enforcement cases in late 2000. “These two section 10A enforcement cases likewise suggest a possible transformation of the law from a relatively innocuous amendment, intended to streamline and improve the auditor resignation reporting process, to a significant enforcement device, for use against accountants in financial fraud cases, either by itself or as a supplement to other, better-established enforcement tools” (Riesenberg, Thomas L. Trying to Hear the Whistle Blowing: The Widely Misunderstood "Illegal Act" Reporting Requirements of Exchange Act Section 10A: Retrieved August 1, 2001 from http://business.highbeam.com/127/article-1G1-78967692/trying-hear-whistle-blowing-widely-misunderstood-illegal).

Section 10(A) also includes several lists of services that should not be provided by audit firm to the audit client such as bookkeeping or other accounting records, design and implementation of information system, appraisal or valuation service, actuarial service, internal audit, management or human resource functions, broker-dealer, investment advisor or investment banking service, legal and expert service that are unrelated to audit and other services prohibited by PCAOB. However, other non audit service such as tax service is permitted in early approval of audit committee. Allowed non audit services performed by audit firm should be disclosed to investors in periodic report. In addition to non audit service, approval of audit committee for an audit service within the scope of the engagement is also required.
Furthermore, audit firm has to communicate with audit committee with the matters of critical accounting policies and practices to be used, alternative treatment of financial information within the scope of GAAP and material written communication between audit firm and management. Section 10(A) also requires rotation of audit firm at least in 5 years of audit service. Audit firm is barred to be in a position of influence to the audit client.
Moreover, section 10(A) requires independent audit committee where each member should not accept any consulting, advisory or other compensatory fee from the company and be an affiliated person beyond his capacity as a member of the committee.
District Court on Section 10(A)
In SEC v. Solucorp Ind., Limited, 197 F. Supp. 2d 4 (S.D.N.Y. 2002), Federal District Court set a low threshold for triggering section 10(A)’s reporting requirement. In the case, the management backdated a licensing agreement and improperly applied the licensing fees from the agreement to the previous quarter. The auditor was aware of the backdating who advice chief financial officer about the finding but failed to act properly and expressed unqualified opinion. The Court concluded that under the plain and unambiguous terms of the statue, an auditor becomes subject to section 10(A) requirement. The Court emphasized that there is no scienter requirement in section 10(A). It only requires knowledge of facts indicating that an illegal act may have occurred and that the SEC does not even have to allege reckless or fraudulent behavior by the auditor.
Company’s Compliance with Section 10(A)
Corporate manager and directors should be aware of new developments and provisions in SEC enforcement and broad scope of section 10(A). Company has to ensure the open lines of communication between audit firm and management and audit committee members to mitigate the illegal acts, discuss beforehand any new or unique audit procedures that audit firm may utilize during the audit, set out meaning of undefined terms of section 10(A) with the audit firm prior to audit and communicate clearly with audit firm about related party transactions.
Open Legal Issues in Relation to the Section 10(A)
Because of the limited litigation to date and the terminology of section 10(A), there are number of legal issues appeared.
 Will the court limit the definition of illegal acts?
 What is the true meaning of the word “likely” in the “let the audit committee know” element of the statute?
 How does the outside auditor determine whether an illegal act is likely to have occurred?
 What is the meaning of "timely and appropriate remedial measures?
 Does Section 10(A) apply to illegal acts discovered outside of the audit?
 What new obligations, if any, does Section 10(A) impose on management and audit committees?
 What effect does Section 10A have on the SEC's authority to promulgate auditing standards that vary from GAAS?

Conclusion
Section 10(A) is a potentially powerful new weapon in the SEC enforcement arsenal to be launched whenever the SEC believes the outside auditor fails to bring an illegal act or related party transaction impacting on the company's financial statements to the attention of the company's management, audit committee, board of directors (if required) and SEC itself (if required). Because of its newness and uniqueness, this statute should prove to be a fruitful ground for litigation in the future. At the very least, the financial professionals must be aware of this statute, what it requires, the time limits imposed and ramifications if the company does not promptly take appropriate remedial action.

References http://www.sec.gov/about/whatwedo.shtml#create http://www.accountingresearchmanager.com.proxy2.ulib.iupui.edu/WK/RM.NSF/arm.html?Open http://accounting.smartpros.com/x34666.xml http://retheauditors.com/2012/02/22/are-auditors-reporting-fraud-and-illegal-acts-the-sec-knows-but-isnt-telling/ http://corporate.findlaw.com/human-resources/greater-use-of-sec-enforcement-tool-against-accounting-firms-has.html Whittington, Ray and Kurt Pany. Principles of Auditing and Other Assurance Services. New York: Mc Graw-Hill; Print, 120-121
http://business.highbeam.com/127/article-1G1-78967692/trying-hear-whistle-blowing-widely-misunderstood-illegal…...

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