BILL ANALYSIS AB 2970 Page A Date of Hearing: May 7, 2002 ASSEMBLY COMMITTEE ON BUSINESS AND PROFESSIONS Lou Correa, Chair AB 2970 (Wayne) - As Amended: April 29, 2002 SUBJECT : Accounting. SUMMARY : Prohibits an accountant from accepting employment from an audit client or its affiliate within 24 months of issuance of a financial statement when the employment permits the accountant to exercise authority over accounting or financial reporting. Specifically, this bill : Prohibits licensees (accountants) from accepting employment from a publicly traded corporation or its affiliate within 24 months of issuance of a financial statement if the following conditions are met: 1) The licensee had significant participation in the corporation's audit engagement process from the levels of the person in charge of field work up through positions of being a partner on the engagement; and 2) The employment would permit the licensee to exercise significant authority over accounting or financial reporting, including authority over the controls related to those functions. EXISTING LAW establishes the California Board of Accountancy, in the Department of Consumer Affairs (DCA), for the purposes of licensing and regulating public accountants. In addition to other requirements, a licensee is required to issue a report conforming to professional standards upon completion of a compilation, review, or audit of financial statements. FISCAL EFFECT : Unknown COMMENTS : Purpose of the bill . According to the author, it is in the best interest of consumers for an auditor's independence to be protected by prohibiting employment by an audit client for a period of 24-months when the auditor has significantly participated in an audit engagement. Under this bill, auditors AB 2970 Page B would be prohibited from becoming employees of the client for a "cooling off" period of 24-months following the issuance of the financial statement report. Employment restrictions would apply only to those auditors who are required to exercise significant judgment in the audit process, and would include positions, however titled, where the auditor was the person in charge of the fieldwork up through partner on the audit engagement. Employment restrictions would apply only when the auditor moves to a position with the client that permits the auditor/employee to exercise significant authority over accounting or financial reporting, including authority over the controls related to those functions. Such financial positions are often referred to as controller or CFO, but would include any position exercising significant authority over financial controls. California Board of Accountancy . This bill mirrors the findings and recommendation of the California Board of Accountancy (Board). In developing its recommendations, the Board reviewed existing professional standards and Securities and Exchange Commission (SEC) rules. After careful consideration, the Board concluded that additional restrictions would be appropriate. The Board identified positions in the accounting firm and positions with the audit client where the restrictions would increase public protection without unduly restricting employment opportunities for auditors. Also, the 24-month restriction is consistent with pending federal legislation (H.R. 3818). Conflict of interest . An independent auditor's job is to determine whether or not a company's financial performance is reported accurately. The word "independent" is important because an auditor's duty is not to the audited company, but to the shareholders and the public at large. In the words of the United States Supreme Court, "by certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to AB 2970 Page C the public trust ."<1> It is common practice for large publicly traded corporations to hire members of the team that has audited it into senior-level financial or accounting positions-these audit team members have experience with and knowledge of the corporation and its inner workings. However, such employment can frequently come at the expense of the independence of the auditor and at the expense of the audit, the public trust function delegated by Congress to CPAs in 1933, in several ways: 1)An audit team member can barely be expected to maintain independence, objectivity, and professional skepticism toward the audit client while currying favor in order to obtain subsequent employment with the audit client. 2)A company executive who is a former member of the audit team that continues to audit the company knows exactly how the audit works, its processes and procedures, and its personnel. This inside information about one's auditors may enable or promote fraud or aggressive accounting practices that the company knows will not be detected in the ordinary course. 3)The ability of an audit firm's personnel to be independent and objective in auditing the work of someone who was previously one of their peers is questionable. For example, even in the case of the "whistleblower" at Enron, although the executive did go to management and warn of fraudulent accounting practices within the company, she kept in-house the damaging information against her former employer, Arthur Andersen, as she silently divested her own holdings of Enron stocks. She did not go public with the information until after the bankruptcy filing and subsequent national scandal. "It is clearly a conflict of interest for an auditor to go to work for the client," according to Michael Greenberger, a professor at the Maryland School of Law and former director of trading at the Commodity Futures Trading Commission. "It completely undercuts the independence of the audit. It's a serious problem and it's widespread." "The suspicion is that the future employee might be currying favor while on the audit team," said Stephen Lubet, professor of --------------------------- <1> United States v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984) AB 2970 Page D legal ethics at Northwestern University School of Law. "It is the well-known and often-discussed problem of the revolving door." The SEC has no prohibition against an auditor leaving his job to work for a client, but it does require the auditor to sever any financial ties to the auditing firm. Federal preemption . A legal analysis issued by the Office of the Attorney General on May 1, 2002, concluded that federal law would not preempt California from enacting legislation to restrict accountants from obtaining employment with a company while performing, or for a certain amount of time after performing, an independent audit of the company. Federal legislation . There are several bills pending in Congress addressing Enron-related reforms, ranging from auditor conflicts of interest to a complete elimination of the private sector's involvement in auditing publicly traded companies (e.g., the government would make the decisions to assign accountants to conduct specific audits). Because of the Big Five's opposition to most, if not all, of these reforms, it is unlikely Congress will provide the public with a remedy in an expeditious manner. According a recent article in the Wall Street Journal, "Don't look for a major overhaul of the accounting industry soon?It remains uncertain if anything will pass this year." And on April 12, 2002, the Washington Post reported, "The accounting industry?has a long history of successfully fighting off efforts to regulate it in the aftermath of financial disasters, such as the savings and loan crisis?. It is far from clear that significant change will result." As recently as the April 29, 2002, issue of Business Week Magazine, an article, "Accounting: Congress Only Looks Like It's Getting Tough" summarized the viability of any meaningful accounting reform occurring, "But don't expect a White House ceremony any time soon. House Republicans and Senate Democratic leaders are poles apart on how best to curb auditing abuses." In the same Business Week article, referring to the House GOP leadership's stand on accounting reform, "They want to rattle the legislative sword, but they don't want to take it out of the scabbard," says John Endear, president of the American Business Conference, which represents small and midsize companies. AB 2970 Page E The SEC, the enforcement body for the accounting standards already in place, requested additional funds for 2003 in an attempt to increase its staff to accommodate the growing demands placed on the agency since the Enron/Andersen debacle and the plethora of corporate financial restatements impacting the stock market. The White House rejected the SEC's request. REGISTERED SUPPORT / OPPOSITION : Support California Public Interest Research Group (CALPIRG) Center for Public Interest Law (CPIL) Congress of California Seniors Consumer Attorneys of California Consumer Federation of California Consumers Union Opposition None on file. Analysis Prepared by : David Pacheco / B. & P. / (916) 319-3301