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Did the Financial Accounting Standards Board (FASB) meet all the criteria of The Sarbanes-Oxley Act (SOX) when it was approved by the U.S. Securities and Exchange Commission (SEC) in 2003?

Passed by Congress in 2002, SOX was enacted with the purpose of protecting investors from fraudulent accounting activities by corporations. The bill was created in response to major corporate accounting scandals that shook the U.S. at the time, including those of Enron and Worldcom. SOX, which is comprised of eleven sections requiring added criminal penalties for certain misconduct, requires the SEC to ensure corporations comply with the law. But when the SEC approved the FASB, it may not have had adequate proof of its standing.

In a recent paper published in the Richmond Journal of Law & the Public Interest titled “The SEC’s Ultra Vires Recognition of the FASB as a Standard-Setting Body” Dr. Wm. Dennis Huber (“Dennis”), professor of Forensic Accounting and Business Law at Capella University, argues that the FASB did not meet the standards set by SOX and that the SEC exceeded its statutory authority in recognizing the FASB as a standard-setting body. Huber took some time to share the details of his paper in the interview below.

Q&A with Dennis Huber

What conditions must private accounting standard-setting bodies meet to be officially recognized by the SEC under SOX?

DH: As part of the Sarbanes-Oxley Act of 2002 Congress gave authority to the SEC to officially recognize private accounting standard-setting bodies provided that the private standard-setting body met five conditions. For a private accounting standard-setting body to be recognized it must: (1) be organized as a private entity; (2) its trustees must serve in the public interest; (3) it must be funded according to 15 U.S.C. § 7219; (4) it must have adopted procedures for prompt amendment of accounting principles; and (5) it must consider “in adopting accounting principles, the need to keep standards current in order to reflect changes in the business environment, the extent to which international convergence on high quality accounting standards is necessary or appropriate in the public interest and for the protection of investors.”

After the FAF and FASB sent a letter to the SEC affirming that FASB met the standards of SOX, was any evidence uncovered to suggest the contrary?

DH: Yes, an investigation of the FAF and FASB’s internal documents uncovered evidence that the FASB does not, in fact, fulfill the criteria set out in the Sarbanes-Oxley Act. I recently detailed that evidence in my article “The SEC’s Ultra Vires Recognition of the FASB as a Standard-Setting Body” published in the Richmond Journal of Law & the Public Interest.

In what ways does the FASB fail to meet SOX standards?

DH: The FAF created the FASB to which it “delegated all authority, functions, and powers of the Corporation and the Board of Trustees in respect of standards of financial accounting and reporting…which authority, functions, and powers shall be exercised by the FASB in conformity with the By-Laws.” According to the FAF’s Bylaws members of the FASB must have “knowledge of accounting, finance, and business.” In addition, they must also have “a concern for the public interest in matters of financial accounting and reporting.” Unfortunately, “concern for the public interest” is not measureable and certainly not enforceable. Nor is it equivalent to protecting either investors’ interest or the public interest.

Does the FAF, as the parent organization of FASB meet any of SOX standards?

DH: The FAF’s 2014 Annual Report states it is an independent, private-sector, not-for-profit, non-stock corporation with responsibility for establishing financial accounting and reporting standards and educating stakeholders about those standards. The FAF is responsible for the oversight, administration, finances, and selection of the members of the FASB. The FASB’s 2014 Annual Report states that the FASB “was organized in 1973 as an independent standard-setting body created by the FAF” and that “the FASB is the designated body in the private sector responsible for establishing standards of financial accounting and reporting in the United States for non-governmental entities. Those standards govern the preparation of financial reports and are provided for the guidance and education of the public, including issuers, auditors and users of financial information.” As with the Articles of Incorporation and Bylaws, nothing in either annual report suggests that the purpose of either the FAF or FASB is to protect investors or to protect or be concerned with the public interest.

Both the original 1972 Articles of Incorporation of the FAF and the amended Articles of Incorporation of 2002 and 2012 state that the purposes of the FAF are: “To advance and to contribute to the education of the public, investors, creditors, preparers, and suppliers of financial information, reporting entities, and certified public accountants in regard to standards of financial accounting and reporting; to establish and improve the standards of financial accounting and reporting by defining, issuing, and promoting such standards; to conduct and commission research, statistical compilations, and other studies and surveys; and to sponsor meetings, conferences, hearings, and seminars, in respect of financial accounting and reporting.” There is nothing in the Articles of Incorporation that refers either to protecting investors, or considering or protecting the public interest.

What constitutes a body “serving in the public interest” and why do you think the FAF and FASB do not adequately fit this criteria?

DH: The Sarbanes-Oxley Act requires that trustees of a private standard setting “serve in the public interest.” Trustees serving in the public interest is not equivalent to the standard-setting body itself protecting either investors’ interest or the public interest. In fact, to “serve in the public interest” means only that “the majority of [Trustees] are not, concurrent with their service on such board, and have not been during the 2-year period preceding such service, associated persons of any registered public accounting firm.”

Since the FASB does not meet the criteria set forth by the Sarbanes-Oxley Act, the SEC’s recognition of the FASB was not authorized by Congress and therefore its accounting standards cannot be recognized. Thus, unless either the statute is amended, or the FAF’s Articles of Incorporation are amended, the FASB’s accounting standards may not be enforceable. Consequently, violations of the FASB’s standards may be difficult to prosecute.