The fourth title of the Sarbanes-Oxley Act is concerned with the accuracy and features of financial disclosures.
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In addition to reinforcing that all financial disclosures must meet the standard accounting rules and regulations, this title sets forth a number of rules regarding financial instruments and transactions which were used heavily in the corporate scandals of the early 2000s.
The first provision deals specifically with off-balance sheet transactions. Off-balance sheet transactions can be used to mask the amount of debt a company holds—through entities such as Special Purpose Entities a company can virtually make the debt disappear from the balance sheet. Sound too simple? Here's how it works.
Companies like Enron amassed massive amounts of debt but were able to hide it from regulators, Wall Street, and investors alike through the use of Special Purpose Entities (SPEs).
An SPE is nothing more than a newly created company owned in part or fully by the company seeking to make an off-balance sheet transaction. In Enron's case, when it was faced with large amounts of debt, it created several SPEs and transferred its debt to the companies before it filed its quarterly or annual reports.
Enron and other companies would find items usually listed as liabilities on its balance sheet and sell them as assets to the SPEs. Once this off-balance sheet transaction took place, Enron no longer reported the liabilities it had sold to its SPEs and actually reported a profit from this sale.
Enron never disclosed (and was not required to) the creation of or its ownership of these special purpose entities. Through this deceptive accounting procedure, shareholders were informed of the great amounts of debt Enron had taken on and instead believed that the company had taken in profits.
The Sarbanes-Oxley Act made it mandatory for companies to disclose any and all information on special purpose entities and their current or future effect on the financial condition of the company.
A large part of this title is also dedicated to an accounting term called pro forma. Meaning "for the sake of form" in Latin, pro forma figures represent calculations based off of the assumption that a certain transaction will take place.
A company will often calculate pro-forma numbers before a merger or acquisition to model how the company will perform if it is assumed that it will merge with or acquire another company. In the early 2000s, pro forma calculations, in conjunction with off-balance sheet transactions, were used to massively inflate earnings and create an unrealistic picture of a company's performance. Often times a pro forma calculation would omit large losses the firm had just suffered. The Sarbanes-Oxley Act prohibits such misleading calculations and essentially states that such numbers must be grounded in reality.
The last section of Title IV sets forth rules regarding transactions between executives and their companies. Personal loans to executives of a company, such as the multimillion dollar zero interest notes issued to Tyco CEO Dennis Kozlowski, are specifically prohibited.
Executives as well as other shareholders are required to report if they are an owner "of more than 10 percent of any class of any equity security." This disclosure allows for greater monitoring and oversight by regulators to prevent further instances of fraudulent behavior relating to the ownership of stock.
The Sarbanes-Oxley Series -- Learn More About Sarbox
The Sarbanes-Oxley Act: An Introduction
The Sarbanes-Oxley Act: Title I
The Sarbanes-Oxley Act: Title II
The Sarbanes-Oxley Act: Title III—Audit Committees
The Sarbanes-Oxley Act: Title III—Blackout Periods
The Sarbanes-Oxley Act: Title IV
The Sarbanes-Oxley Act: Title V
The Sarbanes-Oxley Act: Title VI
The Sarbanes-Oxley Act: Title VII—Accounting Firms
The Sarbanes-Oxley Act: Title VII— Past Violators
The Sarbanes-Oxley Act: Title VIII
The Sarbanes-Oxley Act: Title IX-XI