Sarbanes-Oxley, Accounting Scandals, and State Accountancy Boards
Red Versus Blue State Reactions

By Karen Gantt, George Generas, and Barbara Lamberton

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  SEPTEMBER 2007 - The accounting scandals of the last several years seriously eroded confidence in the capital markets and led to unprecedented losses affecting both large and small investors. These losses led to sweeping federal legislative action; the reaction at the state level has, however, been more mixed, as shown by a review of both “red” and “blue” states affected by scandal.

The accounting scandals had a devastating effect on pensions and on trust in the capital market system. For example, in testimony in May 2002 before the U.S. Senate Commerce Subcommittee, the American Federation of State, County and Municipal Employees (AFSCME) stated that its members “lost more than $1.5 billion of their retirement assets as a result of the Enron scandal through their participation in 150 public pension systems.” The U.S. Congress determined that federal legislation was needed to stem the tide of investor apprehension and reduce the chances of future accounting irregularities. On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act (SOX), creating sweeping changes affecting the practice and regulation of accounting and auditing.

SOX requires public accounting firms to register with the newly established Public Company Accounting Oversight Board (PCAOB). More important, it also significantly narrows the scope of nonaudit services that can be provided to an audit client. Under SOX, certain consulting services, internal audit outsourcing, and other activities routinely provided to clients in the past are deemed illegal when performed by the audit firm. By imposing new restrictions on the practice of accounting, SOX sought to strengthen auditor independence in both fact and appearance. According to a white paper issued by the AICPA in October 2003, the prohibited services are “largely predicated by the SEC’s basic principles that the auditor cannot (1) audit his or her own work, (2) function in the role of management and (3) serve in an advocacy role for his or her client.”

Although SOX is a federal law, the practice of accounting is regulated on a state-by-state basis. Consequently, it is incumbent upon regulators in each state to carefully compare the provisions of SOX to their laws dealing with the practice and licensing of accounting. Under constitutional supremacy clause principles, conflicting federal and state laws are resolved in favor of the federal law. While states cannot ignore provisions of federal law, any given state may choose to enact stricter rules than those prescribed by SOX.

In order to restore public confidence, certain states have passed legislation in response to Sarbanes-Oxley. In fact, individual state accounting reform legislation provides evidence that some states have been active in quickly fine-tuning their regulation of the accounting profession. This article examines the actions of selected state accountancy boards in response to SOX to determine whether the perceived need for stricter regulation of the accounting profession varies by state.

Although SOX applies to public companies, some observers are concerned that various states could apply stricter standards to those public companies. Despite the perceived value of uniformity, there is concern that some states may react to SOX by aggressively expanding its scope to private entities.

State-by-State Analysis

The authors examined five states—Arizona, Connecticut, Texas, California, and New York—that met one or more specific criteria. First, their citizens were particularly hard hit by corporate scandals. In addition, or alternatively, the state has a reputation for favoring stricter regulation of business. Finally, the authors examined both “red” and “blue” states. The “red” states of Arizona and Texas voted Republican in the 2004 presidential election, while the “blue” states of Connecticut, California, and New York voted Democratic.

Arizona

In 1999, the Baptist Foundation of Arizona (BFA) failed. According to Alissa Blackwood of the Associated Press, Arizona state officials alleged that foundation officials used related companies to skim almost $600 million in investment funds before the foundation went bankrupt. According to the Arizona Republic, in fall 2006 two foundation officials (the former president and the former general counsel) were sentenced to prison for fraud and racketeering respectively. In February 2007, the foundation’s treasurer was also sentenced to prison.

Just like Enron, the Baptist Foundation of Arizona used Arthur Andersen LLP as its auditors. The state alleged that Andersen prepared financial statements that concealed huge losses that should have been red-flagged. In a January 2002 letter, Arizona Attorney General Janet Napolitano urged members of the U.S. Senate Committee on Commerce, Transportation, and Science to closely examine Andersen’s role in auditing Enron’s financial statements. Napolitano noted that the firm had engaged in deceptive auditing practices that have defrauded “the investing public, including the state of Arizona and the Arizona State Retirement System, out of hundreds of millions of dollars.”

The Arizona State Board of Accountancy initiated proceedings to revoke the Arizona licenses of Andersen and of the manager and two accounting partners in Anderson’s Phoenix office. Pursuant to Arizona statutory authority, the board also requested $600 million as restitution for investors. The two Andersen accountants who were responsible for auditing the foundation’s books agreed to relinquish their Arizona CPA licenses. At the time of the administrative proceedings, the remaining partner’s Arizona license had expired and was never renewed. According to a December 21, 2000, New York Times article, this particular partner had been involved in the Lincoln Savings and Loan debacle of the late 1980s. Without admitting liability, Andersen settled with foundation investors for $217 million in June 2002. The settlement resolved the accountancy board action and three civil lawsuits, but not the criminal charges against BFA.

In light of how the Enron and Baptist Foundation of Arizona disasters affected Arizona investors, the authors examined Arizona’s recent accounting legislation. In 2003, the state government passed legislation updating the statutes governing the Arizona State Board of Accountancy. According to the legislative history, the purpose of the bill was to make amendments conforming state law to federal law. A review of the changes confirms that the legislation does not expand the scope beyond the federal SOX legislation.

Major provisions of the Arizona Revised Statute (section 32-701 et seq) include the following: Arizona maintained its seven-member board of accountancy, consisting of five active CPA members and two public members. However, the statute now clarifies that the two non-CPA public members must have professional or practical experience in using accounting services and financial statements. They must also be qualified to make judgments about the conduct and qualifications of the firms and individuals regulated by the board.

The definition of the practice of accounting was clarified to mean providing any accounting services, including such functions as examining, reviewing, and reporting on financial statements, rendering attestation services, as well as tax and management advisory services. Interestingly, the definition of a public accountant was also expanded to include a person on inactive status. Presumably, this would make clear that individuals (such as the Arthur Andersen auditor in the BFA case) whose licenses were not renewed would still be subject to the board’s jurisdiction.

Arizona’s revised legislation also gives the board authority to conduct investigations to determine whether reasonable cause exists to believe that a violation has occurred and, subsequently, to determine if reasonable cause exists to institute disciplinary proceedings.

Finally, the statute requires firms and individual licensees to keep records relating to civil or criminal lawsuits or state or federal administrative actions against them for three years after the legal action has been resolved. The record retention applies if the lawsuit or administrative action involved accounting or auditing standards or resulted from negligence, reckless conduct, dishonesty, fraud, or the like.

Although Arizona was directly impacted by one of the largest nonprofit bankruptcies in U.S. history, legislation passed by the state ensures conformity with SOX, rather than expanding its scope. In particular, Arizona did not go beyond SOX to include nonprofit or nonpublic entities within the purview of its revised legislation.

Connecticut

On December 22, 2000, the Connecticut Resources Recovery Authority (CRRA) signed a $220 million deal with the Enron Corporation. The deal included a provision under which the CRRA would advance Enron $220 million. In exchange, the CRRA would receive monthly payments of about $2.2 million. The payments amounted to a 7% rate of return on the monies advanced. When Enron went bankrupt in December 2001, however, the payments ended, the money was lost, and, according to the August 26, 2003, Hartford Courant, fees to municipalities had to be increased to cover the lost money. According to the Council for Citizens Against Government Waste (CCAGW), “thousands of Connecticut residents have lost billions of dollars in retirement savings and investments from Enron, MCI, Adelphia Communications and other corporate scandals.”

In response to these corporate scandals and SOX, Connecticut enacted “An Act Concerning White Collar Crime Enforcement, the Connecticut Uniform Securities Act and Corporate Fraud Accountability Act,” key provisions of which include the following:

First, the legislation increases the size of the state board of accountancy from seven to nine members. The number of CPA board members was increased from four to five, and public members were increased from three to four. In addition, the maximum civil penalties that could be imposed on individuals who violate a public accountancy law or regulation, or engage in conduct reflecting adversely on a licensee’s fitness, were increased from $1,000 to $50,000.

The bill provides whistleblower protection to publicly held corporations’ officers and employees who assist in an investigation involving violation of federal law, such as mail or wire fraud, securities fraud, or any federal or state law involving fraud against shareholders.
The legislation addresses records retention and mandates that accountants conducting audits of publicly held corporations maintain records for seven years after an audit’s conclusion.

If a CEO or CFO certifies a financial statement knowing that it does not fairly represent the corporation’s financial condition, the CEO or CFO can be fined up to $1 million, imprisoned for up to 10 years, or both. A willful certification of a corporation’s financial statements while knowing that the statements do not fairly represent the company’s financial condition can result in a $5 million fine, up to 20 years imprisonment, or both.

Although Connecticut was greatly impacted by the accounting scandals, the Connecticut statute adopts, but does not exceed, the seven-year record retention and 10-year mail and wire fraud provisions contained in SOX.

Texas

At the time of its collapse, Enron was headquartered in Houston. The company’s failure triggered legislative and regulatory activity.

In 2003, Texas Senate Bill 536 proposed prohibiting CPAs from providing “other services” to a publicly held corporation or any other business if the audit firm provides more than $250,000 in audit services to the client. It would also apply if the CPA has provided audit services to the publicly held corporation within the past five years. Moreover, the bill would have provided that the CPA cannot be employed by a former client within two years of performing audit services that exceed $250,000 in fees. Under the proposal, maximum administrative penalties would increase from $1,000 to $1 million.

The bill did not pass. On September 1, 2003, the Texas legislature amended the Public Accountancy Act, section 29a of the Texas Occupations Code. The amendments to the Public Accountancy Act continued the board of public accountancy for the next 12 years. The Act also directed the board to review the provisions of SOX and report to the governor and the speaker of the Texas House of Representatives concerning any restrictions on public-interest entities (including nonprofit entities such as school districts) and any legislation or other action needed to conform state law to the requirements of SOX.

The 2003 Public Accountancy Act gave the board new enforcement powers and the authority to adopt rules intended to comply with SOX and the federal Government Accountability Office (GAO; formerly General Accounting Office) study of audit firm rotation. Other provisions of the Public Accountancy Act include the following:

The board was given subpoena powers and emergency license-suspension power. The maximum administrative fine was increased to $100,000; fines for practicing without a license were increased to $25,000; and criminal penalties were imposed for intentional fraud, which is a felony offense.

The Texas State Board of Accountancy also implemented rules to comply with the provisions of the 2003 Public Accountancy Act and SOX. On November 11, 2004, the board issued a report to the governor, lieutenant governor, and speaker of the House of Representatives concerning the implementation of SOX in Texas.

According to the report, the Texas state board recommended that Texas not adopt an additional layer of regulations concerning nonprofits and other public entities. Instead, it was the board’s position that any standards should be developed nationally and that the cost of such legislation should be reviewed in light of the benefits. The board did not believe that SOX-like legislation should be imposed across the board on the private business community. The board also recommended against audit-firm rotation. The Texas state board does, however, believe that SOX-like legislation is needed to make it illegal for an officer or director of a company to fraudulently influence, coerce, manipulate, or mislead an independent public accounting firm performing an audit for a public-interest entity. The state board recommended that Texas implement legislation to prosecute and impose penalties on such non-CPA company officers or directors.

In 2003, HB 2039 was also signed into law. This legislation gives authority to the corporate integrity unit of the attorney general’s office and mandates ethics and disclosure requirements for those who provide financial services to the state government. It does not, however, address corporate or auditor requirements for publicly held corporations.

California

The state of California was particularly hard hit by the actions of Enron. In testimony before the U.S. Senate Commerce, Science, and Transportation Committee on April 11, 2002, California State Senator Joseph Dunn noted that Californians were harmed not only because of the accounting scandals, but because of Enron’s role in the energy crisis that occurred after California partially deregulated its electricity market in 2000 and 2001.

In light of the impact Enron had on the state, it is not surprising that the California legislature tightened regulation of the accounting profession a full year prior to the federal government’s enactment of SOX. On February 16, 2001, California Assembly Member Lou Correa and State Senator Liz Figueroa coauthored Assembly Bill 270, “An Act to Amend Sections of the Business and Professions Code, Relating to Accountancy,” which was signed into law on August 23, 2002.

The first significant change in the California Business and Professions Code as a result of the 2002 Act involved the composition of the state board of accountancy. The Act increased the size of the board from 11 to 15 members. The number of public members increased from five to eight, and the number of licensed members increased from six to seven. The second notable change limited an accountant’s ability to perform services for a commission. In those limited situations in which an accountant is allowed to accept such payments, adequate disclosure must be made to the client.

The Act also tightened and clarified a number of events that must be reported to the board on a timely basis. For example, the board must be notified within 30 days if another jurisdiction has refused to renew a licensee’s certificate to practice accounting or if the licensee’s certificate has been cancelled, revoked, or suspended. Other reportable events include the conviction of a felony; any crime relating to the qualifications, functions, or duties of a public accountant; or any crime involving theft, embezzlement, misappropriation, breach of fiduciary responsibility, or the preparation, publication, or dissemination of false, fraudulent, or materially misleading financial statements, reports, or information. Similarly, any client restatement and related disclosure audited by the licensee is considered a reportable event.

Additionally, the board must be informed if there has been any civil action settlement or arbitration award against the licensee relating to the practice of public accountancy where the amount or value of the settlement or arbitration award is $30,000 or greater and where the licensee is not insured for the full amount of the award.

Any notice of the opening or initiation of a formal investigation of the licensee by the SEC or its designee, and any notice from the SEC to a licensee requesting a Wells submission, must be reported to the board within 30 days. (A Wells submission is the submission by a prospective defendant explaining why the individual believes the investigators reached a wrong conclusion.) The board must also be informed of any notice of the opening or initiation of an investigation by the PCAOB or its designee.

The Act also mandates peer review for all license renewals after July 1, 2006. In addition, the enforcement powers of the board were strengthened. In particular, the board now has the power to investigate any alleged violation of any state or federal law, regulation, or rule relevant to the practice of accountancy, and to issue subpoenas for the production of documents and testimony pertinent to any inquiry.

Despite the tone of the 2002 Act with regard to tightening regulation, it made no additions or revisions to the monetary penalties for violations of the California Business and Professions Code, an omission rectified in subsequent legislation. Specifically, on September 29, 2004, Senate Bill 1543, authored by Senator Figueroa, became effective. The 2004 Act appropriated an additional $2 million for enforcement and litigation activities of the board. It also added a section to the code stating that a licensee could disclose confidential information concerning a client only upon the written consent of the client or for specified legal or professional requirements. At the time of this writing, California does not require mandatory peer review, and the effective date for the requirement has been extended to 2010.

One notable provision of the 2004 Act relates to administrative penalties. Specifically, any licensee who violates any provision of the administrative penalties chapter of the code may be assessed a penalty of up to $5,000 for the first violation and up to $10,000 for each subsequent violation. The forgoing fines refer to violations of general provisions of the code. A firm violating certain specific sections of the code may be assessed up to $1 million for the first violation and up to $5 million for any subsequent violation. The corresponding penalties for individuals are $50,000 and $100,000 respectively. The Act listed specific violations that would trigger greater penalties, such as conviction of any crime substantially related to the qualifications, functions, and duties of a CPA or a public accountant.

In 2004 Assembly Bill 2150, introduced by Assemblyman Lloyd Levine, amended the code to permit the board to request reimbursement for the cost of all investigation and prosecution for violations under the code. Cost recovery does not, however, apply to administrative hearings.

New York

The collapse of Enron, in addition to a host of other corporate scandals, had a large impact on New York for a number of reasons, including New York’s standing as the financial capital of the world. In addition, according to Marc Humbert’s January 30, 2002, AP report, New York State’s public pension fund lost about $58 million from the collapse of Enron. The following year, the state lost about $63 million from investments in Global Crossing, a telecommunications company that filed for bankruptcy.

As was seen in other states, Enron had been a major contributor to political candidates in New York, both Democrat and Republican. After the company collapsed, great pressure was placed on politicians to divest those contributions, and some donated Enron contributions to funds established to help former Enron employees. According to AP reports, the political donors included the state Republican Party, Governor George Pataki, and U.S. senators Charles Schumer and Hillary Rodham Clinton.

In its January 2005 testimony before the New York Senate Higher Education Committee, the New York State Education Department (NYSED) noted that, even prior to the Enron scandal, the NYSED was looking to expand its authority over public accounting, specifically as it related to nonattest services. The NYSED does not have statutory authority over public accountants with regard to nonaudit services. In
New York, the State Board for Public Accountancy functions in an advisory role to the Board of Regents, a regulatory body charged with licensing and regulating public accounting through the provisions of the state’s education law. To date, however, the proposed changes to the scope of statutory authority have not been enacted.

After the collapse of Enron, interest in accounting reform intensified and the Higher Education Committee conducted a number of hearings on public accountancy. In testimony before the committee, the ED and the state board proposed several changes to regulation of accountancy. Their recommendations included implementing a “stronger concept of mandatory peer review,” restriction of nonaudit services, and clarification of the record retention rules. The NYSSCPA testified before the state senate during the February 2002 “Hearings on CPAs in Post-Enron Era.” Its recommendations included giving the state board “more power, independence, stature, and resources,” improving disciplinary proceedings and peer review, and tightening the regulation and registration of CPAs. The NYSSCPA also suggested incorporating ethics training into high school and college coursework.

Because the New York State education law gives rulemaking authority to the Board of Regents, some elements of accounting reform were handled through this power. For example, effective September 1, 2001, the board mandated “four hours of continuing education focused on ethics” for registered accountants. Effective January 3, 2003, the rules of the board were amended to require “uniform standards for work papers documentation,” mandating that work papers and other documentation be “maintained for a minimum of seven years.” In addition, effective July 13, 2006, the board expanded the concept of “unprofessional conduct” to include federal disciplinary actions, and mandated timely notification to the board of such events. The implication of this rule change is that an individual CPA or a CPA’s firm, or both, could be subject to disciplinary actions by the State of New York “ranging from censure and reprimand to the revocation of their professional license,” based upon disciplinary measures imposed by the PCAOB or SEC pursuant to SOX.

In response to the corporate scandals, several bills were introduced in the New York State Legislature dealing with accounting reform issues. As shown in Exhibit 1, during the 2005–2006 session, and the 2007 session (see Exhibit 2) as well, several new pieces of legislation were introduced in both the State Assembly and State Senate. In many instances, these bills represented reintroductions of legislation from prior sessions. On a positive note, however, for the first time in several years the Senate and Assembly bills (S4642-A and A10432 respectively) cover the same issues. A key provision of both bills is making CPAs accountable for nonaudit services, a change that, according to the state board, has long been one of its goals. In the 2007 session, a similar bill (S5240) has passed the Senate but has not been voted on in the Assembly.

Difficulties in the States

Title I of SOX empowers the PCAOB to establish rules “to oversee the audit of public companies that are subject to the securities laws … in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.”

While SOX was written and enacted to apply to the audit of publicly traded companies, there has been some expectation that the states would enact legislation going beyond Sarbanes-Oxley. The reasoning was that states hard hit by the accounting scandals and states with a reputation for aggressive prosecution of corporate malfeasance would be most likely to tighten control over the accounting profession. The above examination of the legislative activity of five states suggests that, with the exception of California, none of these states implemented regulations more stringent than Sarbanes-Oxley.

Review of the legislative activity also seems to indicate that all five states examined have gone beyond a “wait-and-see” stance, and implemented specific changes in the regulation of accounting. As summarized in Exhibit 3, Arizona, Connecticut, and California increased the number of members of their accountancy boards and also began requiring more public (non-CPA) members. Texas, while concluding that regulations beyond SOX were not needed, made amendments to its public accountancy act that continued the state accountancy board for another 12 years. In addition, Arizona, Texas, and California broadened the authority given to the state accountancy board. Penalties were increased substantially in the states of Connecticut, Texas, and California. California mandated peer review for all license renewals after July 1, 2008. Other changes implemented include whistleblower protection in Connecticut, additional ethics and disclosure requirements in Texas, and limiting accountants’ ability to receive commissions in the state of California. In New York State, the Board of Regents amended the rules used to regulate accounting to include mandatory ethics training, seven-year record retention, and timely notification of federal disciplinary actions. In addition, the Board of Regents expanded the concept of “unprofessional conduct” to include actions taken by regulatory bodies outside of the state. In addition to New York, Arizona and Connecticut implemented new record retention regulations.

On balance, despite the perceived value of uniformity in the regulation of accounting, the evidence from these five states suggests a great deal of variance continues to exist. The fact that Texas and California, the two states arguably most affected by Enron, took very different approaches, suggests future challenges for providing uniformity in the regulation of public accountancy.

In addition, one of the major challenges facing states may be resources. In testimony before the New York State Senate in January 2005, the Office of Professions of the State Education Department warned that a “massive infusion of resources” is needed to adequately investigate and regulate the conduct of professional accountants. The evidence from both California and Arizona shows that high levels of resources (financial and otherwise) are needed to deal with audit failures. What is not clear are the future implications if SOX-like legislation is not consistently applied at the state level and if the resources are not available for state boards to discipline unprofessional conduct.


Karen Gantt, JD, LLM, and George Generas, JD, CPA, are assistant professors of law, and Barbara Lamberton, PhD, is an associate professor of accounting in the department of accounting, all at the University of Hartford, West Hartford, Conn.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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