Washington Moves on Legislation to Reform Corporate Accounting and Restore Trust

By Simon Eskow

NEW YORK—Congress in July swiftly responded to waves of accounting scandals with legislation that changes the relationship between auditors and their clients, in an effort to shore up the much discussed erosion of public trust in capital markets.

A bill originating from Senate Banking Committee Chairman Paul Sarbanes (D-Md.) passed in the Senate 97-0, underwent modifications in a conference with the House of Representatives, passed in the House 423-3, and went back to the Senate, where it passed 99-0—all within 10 days time.

The Sarbanes-Oxley Act of 2002 (also named for the senator and Rep. Michael G. Oxley (R-Ohio), who sponsored a more limited corporate-governance proposal) was signed into law by President George W. Bush on July 30. It establishes an independent board to oversee the accounting industry, limits consulting services that auditors can sell to their clients, and creates tougher criminal penalties for corporate financial fraud.

An increasing number of high-profile accounting fiascoes this summer put the onus on Washington to take resolute action. Bush importuned Wall Street to adopt a culture of ethical responsibility, while announcing a special task force under the Securities and Exchange Commission to bring corporate rogues to justice. Congress announced a compromise on the accountability act on July 24, the same day the task force arrested five former executives of the moribund Adelphia Communications on charges of alleged securities and bank fraud. Both events appeared to restore some investor trust as Wall Street saw its best single-day rally in years, but how they play out in the accounting profession remains to be seen.

“The public was clamoring for something to be done,” said New York State Society of CPAs President Jo Ann Golden. “The question is, ‘Is this the right approach?’ and the answer is, ‘Only time will tell.’ Is this more a cultural issue that has emerged over a number of years, and is legislation going to resolve this? Have we had a change in attitudes that really needs to be dealt with?”

Golden said the act could have a far-reaching impact on the profession as a whole because, though it mandates reform for auditors of publicly traded companies, such regulation traditionally has informed profession-wide standards, such as Financial Accounting Standards Board statements.

“The act will affect both public practitioners and the practitioners in industry because it affects the whole audit process,” Golden said. “This is geared to SEC clients but the major problem here is there’s going to be a trickle-down effect.”

The act, for example, requires auditors to disclose reports to a corporation’s audit committee—not to management—something that Goldens says “could drain the resources” of smaller businesses.

Accountability

The act could have a far-reaching impact on the profession and on the corporations CPAs audit (for a summary of the act, see the sidebar below). The act that emerged from Congress keeps much of Sarbanes’ language, adds penalties for corporate defrauders, grants more staff and funding to the SEC and gives a new Public Accounting Board some teeth. The act sets out to prevent the kind of actions that allegedly occurred at Adelphia Communications, which contributed to its downfall and the arrest of founding-family members.

A complaint unsealed in Manhattan federal court on July 24 accuses former CEO John Rigas, former CFO Timothy Rigas and former Executive Vice President Michael Rigas of pilfering company money for private use—such as the construction of a multi-million-dollar golf course and the purchase of a New York City cooperative building. James Brown, a former vice president, and Michael Mulcahey, a company adviser, also were named in the complaint. The personal loans amounted to more than $2 billion that the company allegedly hid from investors, resulting in a $1 billion loss in capitalization, according to a separate civil suit filed the same day by the SEC.

The new legislation prohibits corporations from making personal loans to management.
Other prohibitions are meant to keep auditors honest by disallowing designated consulting services while a CPA firm is engaged in an audit, though the new accounting oversight board could grant amnesty on a case-by-case basis. The consulting services include the following:

• Bookkeeping or other services related to the accounting records or financial statements of the audit client
• Financial information systems design and implementation
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
• Actuarial services
• Internal audit outsourcing services
• Management functions or human resources Broker or dealer, investment adviser, or investment banking services
• Legal services and expert services unrelated to the audit
• Any other service that the board determines, by regulation, is impermissible.

The State of Things to Come

Accounting reform legislation remained motionless in the New York state legislature as the summer recess rolled around, and according to sources in Albany, it was unclear at the time of this writing when the legislature would reconvene, or what would happen to bills waiting on the back burner. The far-reaching federal legislation does not address the licensure of CPAs, which remains in the hands of the states and which Golden hopes will be addressed in the fall.

“The SEC can control the ability of an SEC auditor,” Golden said. “The SEC cannot pull someone’s license. That’s where the states have to step up to the plate.”

Two bills sponsored by state Sen. Kenneth P. LaValle were in a holding pattern when the Senate went into recess on June 21. LaValle’s Accountability Act of 2002 (S.6269-A) would prohibit CPAs from providing nonaudit services to their audit clients, would prohibit the client hiring an auditor within two years after an engagement, and would require entities to rotate auditors every seven years. Another LaValle bill, S.5628-A, would strengthen the New York State Board for Public Accountancy, and require mandatory peer review of auditors every three years, mandatory continued education, registration of CPAs with the state, fines for misconduct and the establishment of a Public Accountancy Oversight Account.

In the other house, Assemblyman Richard Brodsky’s bill was referred to the Codes Committee. The pending bill (A.11371-A) would prohibit auditors from providing nonaudit services to their clients. At first this applied to auditors of SEC registrants, but expanded to include all companies that issue securities, raising a red flag for many state practitioners whose clients rely on CPAs for many nonaudit services they can’t afford to perform themselves.

A second pending Brodsky bill (A.9831-A) sets out criminal penalties for misconduct in relation to audited financial statements, while a bill (S.6248-A) in the Senate by Sen. John DeFrancisco would make it a crime for corporate officers to knowingly deceive anyone with a financial stake in a corporation. The DeFrancisco bill also was referred to the Senate Rules Committee.