Financial Debacles and State Regulation
Boards of Public Accountancy and the ‘Cascade Effect’ of Sarbanes-Oxley

By Daniel J. Tschopp, Steve C. Wells, and Douglas K. Barney

The AICPA, the U.S. Congress, and state regulatory agencies have taken the need for reform in the accounting profession seriously as a result of recent financial debacles. The AICPA announced a renewed effort in promoting exacting compliance to a strict code of professional conduct. Congress passed the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board (PCAOB) to set and enforce standards for auditors of public companies. Sarbanes-Oxley does not cover nonregistered public accounting firms; section 209 states that “the standards applied by the Board under this act should not be presumed to be applicable for purposes of this section for small and medium-sized non-registered public accounting firms.” While the Sarbanes-Oxley Act was intended to apply only to publicly traded companies, state legislatures or state boards of accountancy could implement laws or regulations for nonpublic companies that follow the federal act, a “cascade effect.”

Position of the AICPA

In response to concerns about cascading regulation, the AICPA created a Special Committee on State Regulation to provide recommendations to state regulatory agencies on actions that should be taken at the state level. The initial findings of this committee were issued in January 2003 in the first of a series of white papers and briefs referred to as A Reasoned Approach to Reform. In the first report, which details concerns of adding additional regulations to the audits of nonpublic companies, the committee says the regulations will result in increased audit fees and reduced quality of audits. According to the committee, “some audit firms are projecting that the expenses involved in complying with provisions of the Act could necessitate an increase in fees for public company audits (in the range of 20–30 percent).”

In expressing that the uniformity of state regulations is important to the accounting profession and cautioning individual states trying to enact legislation, the committee warns that “proactive and premature legislation or regulation by well-meaning state legislators and regulators will do little to protect the public good if they embrace efforts to ‘outdo’ every other state.”

In the report, the committee addressed the possibility of increased regulation at the state level and developed several conclusions. The committee wants states to be patient in their decision-making processes and wait until the impact of Sarbanes-Oxley on public companies can be evaluated. It believes that the costs and logistics of implementing mandatory concurring partner reviews and audit firm rotation are costly and damaging to smaller firms, and the quality of audits will be reduced: that “audit failures are three times more likely in the first two years of a client/auditor relationship, and that there is a positive relationship between firm tenure and auditor competence.”

Recent research suggests that private companies are voluntarily implementing stricter governance and accounting practices to meet public companies’ requirements. A survey conducted by Robert Half Management Resources found that 58% of CFOs of private companies with more than 20 employees adjusted their accounting standards voluntarily in the direction now required of public companies. These CFOs changed their companies’ accounting and internal audit practices and reduced or eliminated the hiring of their auditors for consulting work.

The result of the costs and time commitments caused by new regulations may be that nonpublic companies decide to forgo having audits performed—the opposite of the intended purpose, which is to address the increasing public concern over reporting practices. The AICPA is working with state legislators and regulators to help them understand that Sarbanes-Oxley was intended for public companies and their audit firms, and that any regulation beyond that scope could be counterproductive.

Position of the State Boards of Accountancy

The June 2003 regional meetings of the National Association of State Boards of Accountancy (NASBA) addressed the significance of the Sarbanes-Oxley Act for state regulation of the accounting profession. NASBA’s goal is uniform standards across all 54 U.S. jurisdictions. At these meetings the state boards agreed that there was no immediate crisis involving the audits of nonpublic companies. The consensus was that users which rely on the financial statements of nonpublic companies were usually more experienced in analyzing financial statements and the additional regulations under Sarbanes-Oxley were unnecessary. The state boards agreed that audit quality is improved and the public benefits by allowing auditors to provide consulting and other nonaudit services to nonpublic companies.

NASBA has the same concerns as the AICPA. At the 2003 NASBA regional meetings, the organization presented a paper titled “Assessing the Impact: The Significance of the Sarbanes-Oxley Act of 2002 for State Regulation of the Accounting Profession,” which was prepared as a resource guide for the participants. NASBA’s argument is supported by a quote from Senator Sarbanes:

This bill applies only to public companies that are required to report to the SEC. It says plainly that State regulatory authorities should make independent determinations of the proper standards and should not presume that the bill’s standards apply to small and medium-sized accounting firms that do not audit public companies.

The participants at the NASBA regional meeting agreed on the following principles:

  • Mandatory auditor rotation rules are not necessary for nonpublic entities.
  • Concurring partner reviews could substitute for partner rotation in nonpublic company audits.
  • CPE should include an ethics requirement.

At its annual meeting in October 2003, NASBA addressed the concerns—higher audit fees, legal fees, insurance costs, and increased compliance and information technology requirements—of implementing Sarbanes-Oxley measures at the state level. NASBA introduced a discussion memorandum titled “Answering the SOX Challenge: Guidelines for State Boards of Accountancy.” This document gave the state boards recommendations or suggested guidelines in an effort to create a unified approach to new regulations (see Exhibit 1).

State Board Actions

Most state boards reacted to the new federal regulations less quickly than state governments did. To assess the responses of the 54 boards, the authors asked each of them two questions:

  • What changes has your state board of accountancy made in regards to regulating small and medium-sized nonregistered public accounting firms?
  • What proposed actions are being considered by your state board in regard to regulating small and medium-sized nonregistered public accounting firms?

The responses are summarized in Exhibit 2. The findings indicate that significant actions taken by the state boards with regard to section 209 of the Sarbanes-Oxley Act have been slow or nonexistent. From the responses received and from discussions with several directors of state boards, the authors believe most state boards are taking a “wait and see” approach, postponing action until the federal legislation can be evaluated.

State Legislative Actions

Since the Sarbanes-Oxley Act was enacted, 13 states have passed some type of accounting reform legislation. Most of the legislation stays within the boundaries of the federal act, including items such as increased penalties, the composition of the state board, and increased oversight of the accounting profession. States that have taken some of the aforementioned actions include: California, Colorado, Connecticut, Illinois, Kentucky, Maryland, Massachusetts, Montana, New Mexico, Texas, and Washington.

Two pieces of legislation that go beyond the scope of the Sarbanes-Oxley Act came from New Jersey and New York. New Jersey passed legislation prohibiting CPAs from providing any nonaudit services to nonpublic companies. New York introduced legislation that prohibits consulting services and requires auditor rotation in firms that audit nonpublic companies with fewer than 20 employees and gross revenues of less than $2 million per year.

The impact of the Sarbanes-Oxley Act and reactions from state regulatory agencies should continue to be monitored. Concerns of a “cascade effect” are legitimate. Any rush toward increasing the regulations of nonpublic companies would be premature.

Daniel J. Tschopp, CPA, is an assistant professor of business administration at Daemen College, Amherst, N.Y. Steve C. Wells, PhD, is a professor of accountancy at Alcorn State University, Natchez, Miss. Douglas K. Barney, PhD, is a professor of accountancy at Indiana University Southeast, New Albany, Ind.