Intermediate Financial Management (with Thomson One)

If all of these safeguards were functioning as designed, investors and shareholders
could be reasonably sure (1) that the financial information companies
report accurately reflects the firms’ past performance and (2) that all market participants
have access to the same information. This would make the financial
markets a “level playing field” and raise investor confidence, which would lower
the cost of capital, increase corporate investment, and make the economy more
efficient.
The financial scandals of the late 1990s and early 2000s showed clearly that
these safeguards were not functioning as intended. Numerous companies engaged
in deceptive, if not fraudulent, practices. Retirees lost their life savings. And many
other investors saw their portfolios drop sharply as evidence of executive malfeasance
emerged. Governmental officials recognized that the resulting crisis of confidence
could cause capital to dry up, which would slow corporate investment and
lead to a serious recession. Accordingly, in 2002 Congress stepped in with new regulations
to shore up investor protections.
The Sarbanes-Oxley Act of 2002
The accounting scandals and fraud perpetrated by the managers at Enron, World-
Com, Tyco, Global Crossing, and other companies and uncovered in the early
2000s clearly showed that management does not always act in shareholders’ best
interests. In addition to stealing corporate assets and engaging in fraudulent transactions
to enrich themselves at shareholders’ expense, these managers systematically
misled shareholders and the financial markets by releasing financial statements that
did not reflect their companies’ true financial condition. Some of these companies’
auditing firms were also complicit in this deception, overlooking questionable
accounting practices in return for lucrative consulting deals. Investors who bought
shares on the basis of this inaccurate information lost billions when the stocks
plunged.
Stock analysts also misled the public about companies’ prospects. Although
supposedly impartial, some analysts issued buy recommendations on stocks they
really thought were dogs because of pressure from their investment bank employers.
Investment banks get more business from the companies if their analysts give
positive recommendations. Investors were the ultimate losers when the market
learned what the analysts already knew—that the shares were overvalued.
These scandals showed that the then-existing rules weren’t sufficient to rein in
selfish behavior. Some managers put their personal interests ahead of those of the
stockholders they were supposed to be serving. The public accounting firms that
were supposed to provide independent audits abrogated this responsibility in
return for consulting contracts. And stock analysts were falsifying their recommendations
to win salary increases and bonuses. These actions violated thencurrent
ethical standards, but penalties for the violations weren’t strong enough to
prevent the abuses. So, in 2002 Congress stepped in to address this widespread
fraud with the passage of the Sarbanes-Oxley Act, known in the industry now as
SOX. SOX consists of eleven chapters, or titles, which establish wide-ranging new
regulations for auditors, CEOs and CFOs, boards of directors, investment analysts,
and investment banks. These regulations are designed to ensure that (a) companies
that perform audits are sufficiently independent of the companies that they
audit, (b) a key executive in each company personally certifies that the financial
statements are complete and accurate, (c) the board of directors’ audit committee
is relatively independent of management, (d) financial analysts are relatively independent
of the companies they analyze, and (e) companies publicly and promptly
Chapter 1 An Overview of Financial Management • 17