February 16, 2006
CORPORATE ACCOUNTING SCANDALS
By: Kristin Sullivan, Associate Analyst
You asked about the major corporate accounting scandals. You wanted to know when they occurred and what laws Congress and the General Assembly passed, if any, in response to them.
There was a wave of corporate accounting scandals between 2000 and 2005, with the lion's share occurring in 2002. The most well-known were arguably those involving Enron and WorldCom, but several less-publicized scandals implicated companies like Duke Energy, Homestore.com, and Peregrine Systems. Almost all the scandals involved accusations of so-called “creative accounting,” or complex methods of misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of corporate assets, or underreporting liabilities. Several involved accusations of securities fraud.
Since 2000, federal government oversight agencies, including the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ), have launched investigations into the accounting practices of over 20 major corporations. Many ended with the indictment of top executives and million or billion dollar settlements or fines. In addition, most of the large public accounting firms, including Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG, and
PricewaterhouseCoopers, either admitted to or faced charges of negligence in the execution of their duty as auditors for failing to identify and prevent the publication of falsified financial reports by their corporate clients.
In reaction to the scandals, Congress passed The Sarbanes-Oxley Act of 2002 (P.L. 107-204) and the Connecticut General Assembly passed An Act Concerning White Collar Crime Enforcement, the Connecticut Uniform Securities Act and Corporate Fraud Accountability and Volunteer Firefighters and Members of Volunteer Ambulance Services or Companies (P.A. 03-259). Both acts included provisions expanding oversight of public accounting firms, offering whistleblower protections for employees who provide information or assist with investigations involving conduct they believe violates certain federal or state laws, and imposing civil and criminal penalties for falsifying financial statements, among other things.
TIMING OF CORPORATE ACCOUNTING SCANDALS
We searched several sources including Forbes.com, MSNBC.com, The New York Times, and The Wall Street Journal to comprise a list of the major corporate accounting scandals occurring between 2000 and 2005. Table 1 shows that list by year.
TABLE 1: CORPORATE ACCOUNTING SCANDALS
AOL Time Warner
Merck & Co.
Qwest Communications Int'l.
El Paso Corporation
Table 1: Continued
Congress passed the Sarbanes-Oxley Act of 2002 (P.L. 107-204) in reaction primarily to the Enron scandal. The act called for the creation of the Public Company Accounting Oversight Board, a private-sector, non-profit corporation to oversee auditors of publicly traded companies “in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.” It vests the board with four main responsibilities: (1) registering accounting firms that audit public companies trading in U.S. securities markets; (2) inspecting registered accounting firms; (3) establishing standards for auditing, quality control, ethics, and independence for registered accounting firms; and (4) investigating and disciplining registered accounting firms, and people associated with them, for violations of law or professional standards.
The act places requirements and prohibitions on accounting firms. It makes it unlawful for firms not registered with the board to audit public companies and, among other things, it:
1. requires auditors to report all critical accounting policies and practices to the firm's audit committee (§ 204);
2. requires lead audit and reviewing partners to rotate off an audit every five years and subjects them to a five-year time-out period after the rotation (§ 203);
3. prohibits public accounting firms from providing certain non-audit services such as bookkeeping or appraisal without pre-approval from the board (§ 201);
4. requires public accounting firms to establish an audit committee (§ 301);
5. requires chief executive officers (CEOs) and chief financial officers (CFOs) to certify that financial statements accurately and fairly represent the financial condition and operations of the company and subjects them to criminal penalties for intentional false certification (§ 302);
6. prohibits firms from making loans to any of their directors or executives (§ 402);
7. requires public companies to establish an internal control system for tracking and auditing financial processes and further requires an external auditor's report on management's assertions about that system (§ 404);
8. requires rapid disclosure of material changes in the financial conditions of a public firm (§ 409);
9. provides comprehensive whistleblower protections (§ 806); and
10. makes it a crime for any person to destroy, alter, or conceal any document to prevent its use in official legal proceedings (§ 1102).
The public company audit committee, established pursuant to section 301, must be independent and competent. Only directors who are unaffiliated with a company or its subsidiaries may serve as members and they may not accept any consulting, advisory, or other compensatory fees, other than director and committee fees. The committee must appoint and oversee the work of a publicly traded company's auditor and establish procedures for (1) the receipt, retention, and treatment of complaints received by the company regarding accounting matters and (2) the confidential, anonymous submission of concerns by employees regarding questionable accounting matters. The committee may also hire independent counsel and other advisors as needed.
The civil and criminal liability provisions in Sarbanes-Oxley cover a broad range of retaliatory measures taken against employees regardless of whether their reporting is directed internally within the corporation or toward relevant government authorities. Section 806 of the act protects employees of publicly traded companies who lawfully provide evidence or otherwise assist in the investigation of conduct they reasonably believe constitutes violations of the federal mail, wire, bank, or securities fraud statutes, any SEC rule or regulation, or any federal law relating to shareholder fraud. Under the act, the employee is protected if he provides information or assistance to (1) a federal regulatory or law enforcement agency; (2) any member or committee of Congress; or (3) anyone with supervisory authority over the employee.
According to David Guay, executive director of the Connecticut State Board of Accountancy, the General Assembly passed Public Act 03-259 during the 2003 legislative session in response to the then-recent corporate accounting scandals. The act makes several changes to banking and criminal laws regarding white-collar crime enforcement and increases penalties for bribery, hindering prosecution, and related crimes. Generally its provisions:
1. increase the fines for certain accounting and banking law violations and the offense levels for specific white-collar crimes;
2. condition financial institutions' ability to effect certain transactions in part on whether they have adequate anti-money laundering programs, policies, and procedures and a record of compliance with anti-money laundering laws and regulations;
3. establish whistleblower protections for employees who assist in investigations or proceedings regarding certain state and federal white-collar crime laws;
4. prohibit accountants from altering, destroying, or concealing documents from the end of the fiscal year in which they concluded the audit until seven years after the audit's conclusion; and
5. increase the maximum civil penalty the State Board of Accountancy may impose for violations of public accountancy law and expand the grounds for which the board can take disciplinary action.
Section 34 of the act prohibits a publicly held corporation from discharging, demoting, or threatening an employee because he provides information or assists in an investigation involving conduct the employee believes violates federal bank or securities fraud laws, any SEC rule or regulation, or any federal or state law regarding fraud against shareholders. An employee alleging discharge or other discrimination in violation of the whistleblower protection may bring an action for damages and injunctive relief against the violator in Superior Court for up to one year after knowledge of the specific incident giving rise to the claim.
Under the act, an accountant conducting an audit of a public company cannot alter, destroy, or conceal any documents created in connection with the audit and containing information related to the audit from the end of the fiscal year in which he concluded the audit until seven years after the audit's conclusion. The same requirement applies to accounting licensees who prepare work papers in the course of auditing a publicly held corporation. Further, if a registered public accounting firm performs certain federally-restricted activities while conducting an audit, it is subject to State Board of Accountancy penalties for conduct reflecting adversely on a licensee's fitness as a public accountant, such as revocation, suspension, or refusal to renew a certificate, license, or permit, or imposition of a civil penalty. The maximum civil penalty the board may impose is $50,000 (§§ 35, 37, and 43).
Certification of Financial Statements
Like Sarbanes-Oxley, the act subjects a CEO or CFO who certifies a financial statement knowing that it does not fairly represent his corporation's financial condition to a fine of up to $1 million, up to 10 years imprisonment, or both. A CEO or CFO who willfully certifies a financial statement knowing that it does not fairly represent his corporation's financial condition may be fined up to $5 million, imprisoned up to 20 years, or subject to both (§ 36).