Compliance in Accounting: What Does it Mean and Why is it Important?
Money is a prime area in which wrongdoing and misconduct can occur. Because of this, there are pages of regulations that companies must follow — or otherwise face penalties.
Most of these rules come down to the accurate reporting of financial information. To ensure your financial reporting is accurate, you need to have clear processes and procedures for recording and verifying revenues, expenses, assets, and liabilities.
In accounting, keeping in line with these rules is called compliance. Although there are many sources of accounts and finance regulations and laws, we’ll discuss two of the primary ones in this article.
Sarbanes-Oxley Act of 2002 (SOX)
Several accounting scandals shook the world and severely damaged investor confidence in the early 2000s. You may have heard of them — the most notorious were the Enron, Tyco, and Worldcom scandals.
Lawmakers enacted the Sarbanes-Oxley Act of 2002 (SOX) as a reaction to these financial wrongdoings. The goal of SOX was to restore investor confidence by increasing the oversight responsibilities of corporations and corporate boards, making auditors more independent of their public company clients, minimizing the effects of conflicts of interest, and harshening the penalties for financial misconduct.
SOX consists of 11 broad “titles”, each with various sections.
- Title I: Public Company Accounting Oversight Board (PCAOB) — Title I created the PCAOB and tasked them with the regulations, inspection, and oversight of accounting firms that audit public companies. In other words, they, in a way, audit the auditors.
- Title II: Auditor Independence — Before SOX, auditing firms could perform other paid work for their clients. These firms were self-regulated. However, conflicts of interest formed. Audit firms performing other services for their clients (such as bookkeeping) could be biased in favor of their clients when they audited them. Title II restricts other services audit firms can perform for clients and establishes several other requirements to increase auditor independence.
- Title III: Corporate Responsibility — Title III makes the CEO and CFO responsible for the accuracy and completeness of all financial reports. If revisions must be made due to misconduct, both officers forfeit bonuses and other executive compensation. This title also mandates that companies establish independent audit committees consisting of members lacking any financial ties to the company. These committees ensure external auditors maintain their independence.
- Title IV: Enhanced Financial Disclosure — Title IV mandates that corporations report various transactions public, such as stock trading performed by corporate officers or transactions taking place off the balance sheet. Additionally, companies must now include a report on internal controls with each annual company report.
- Title V: Analyst Conflicts of Interest — Securities analysts may have conflicts of interests that cause them to issue a biased favorable recommendation of a company. Title V, issued to improve investor confidence, requires that analysts disclose these conflicts of interest so that the public can consider any potential bias. In doing so, the analyst is also incentivized to be unbiased in their recommendations.
- Title VI: Commission Resources and Authority — The sections in Title VI were developed to improve investor confidence further. Additionally, they outline the SEC’s authority to bar securities professionals from their industry due to misconduct and the conditions under which an analyst can be barred from the profession.
- Title VII: Studies and Reports — This title required the Comptroller General and the SEC to conduct several studies regarding the accounting scandals of the early 2000s, the consolidation of accounting firms, and more.
- Title VIII: Corporate and Criminal Fraud Accountability — Interfering with federal investigations by manipulating or destroying pertinent information is a felony under Title VIII. This title also offers various protections to corporate whistleblowers.
- Title IX: White Collar Crime Penalty Enhancement — Title IX increases the punishment for financial crimes/conspiracies to commit crimes. On top of harsher sentencing and penalties, Title IX makes failure to certify financial reports a crime.
- Title X: Corporate Tax Returns — Under Title X, the CEO must sign the corporate income tax return. This title further promotes transparency and responsibility.
- Title XI: Corporate Fraud Accountability — Title XI adds and strengthens sentencing/penalty guidelines for corporate fraud and tampering with records. Additionally, it gives the SEC various powers to aid in its investigations of fraud.
Generally Accepted Accounting Principles (GAAP)
GAAP has three primary sets of rules with which you must comply.
Basic Accounting Principles
There are 10 basic accounting principles.
- Economic Entity Assumption: Companies are separate and distinct from individuals and owners
- Monetary Unit Assumption: all financial information is expressed in US dollars or other local denominations
- Time Period Assumption: Financial statements must be presented in a timely manner
- Cost Principle: Items purchased for the company, especially those which are capitalized, must be recorded in the amount for which they were purchased, not at market value.
- Full Disclosure Principle: Companies must disclose any information that a financial statement user might find important. For example, if a company is engaged in a lawsuit, you must disclose that in financial statement footnotes.
- Going Concern Principle: Companies must assume they will be in business for the foreseeable future unless it intends to liquidate your business or cease operations.
- Matching Principle: Companies must record expenses in the same period that their respective revenues are earned. For example, if a company earn sales revenue this month, it must record any sales commissions expenses associated with that revenue in the same related month.
- Revenue Recognition Principle: Companies must recognize revenues when earned, regardless of whether the money is received.
- Materiality: A company cannot omit or misstate information that can influence the decisions of financial statement users. Materiality is up to professional judgment. For example, if a controller finds that the company failed to record the purchase of a single stapler last accounting, it’s probably not necessary to adjust and reissue revised financial statements.
- Conservatism: Companies must choose the alternative that results in lower net income or asset amount when “breaking a tie”.
Financial Accounting Standards Board (FASB) Rules and Standards
The FASB is an independent organization in charge of setting financial accounting standards. They issue an annual, regularly-updated set of standards called the FASB Accounting Standards Codification.
Generally Accepted Industry Practices
No two industries are the same. Each has unique financial reporting requirements due to differences in how each industry operates. Businesses follow the accounting best practices of their industry. An airline would follow different industry standards than a construction company.
Keeping track of so many regulations is daunting — yet the penalties for violating them can be steep. But with a team of professionals like CFO Hub at your back, you’re in good hands. We can help you stay compliant with broad regulations and standards, as well as those of your industry — all without the cost and headache of hiring full-time employees to ensure compliance.