TCS Daily

A 'Common Sense' Dodge

By Peter J. Wallison - June 6, 2005 12:00 AM

In response to complaints from public companies about the cost of complying with the infamous Section 404 of the Sarbanes-Oxley Act, the SEC and the Public Company Accounting Oversight Board (PCAOB) have both issued statements intended to improve the efficiency of auditors and thus reduce costs. Unfortunately, this new guidance is unlikely to have any substantial positive effect. These responses were both inadequate and disingenuous. Now that Bill Donaldson will be replaced by Rep. Chris Cox, we can hope for something more substantial.

Both the SEC and the PCAOB responded to business complaints by directing accountants to use "common sense" and judgment in auditing internal controls. Internal control failures that are likely to cause substantial inaccuracies in financial reporting should get the most attention, they averred, and those that have only a remote likelihood of resulting in material losses should not occupy the auditor's time. Both agencies called for a "top-down risk based approach" to assessing the adequacy of internal controls. Although this guidance may temporarily deflect complaints away from the SEC and the PCAOB, it does not address the excessive requirements of section 404 and thus fails to address the underlying cause of the problem.

There are three fundamental reasons for unnecessary auditor attention to the details of internal controls: (i) auditors fear liability in civil suits, particularly under the securities laws; (ii) auditors fear criticism from the PCAOB and the SEC; and (iii) in current circumstances, auditors can do whatever they want to protect themselves against the first two fears without worrying about losing the client.

Civil class actions under the securities laws pose enormous dangers for auditors, since they are inevitably conducted on the basis of hindsight rather than what a reasonable person would have believed at the time. With hindsight, seemingly trivial matters can become significant at trial.

Unfortunately, accountants know that PCAOB and SEC examinations of their work will also be viewed in hindsight, and in the increasingly political enforcement environment engendered by New York's aggressive attorney general. The fact that auditors have been enjoined by their regulators to use "common sense" or judgment in deciding what to focus on and what to ignore will be little protection when a scandal has erupted and both agencies want to show that they are diligent enforcers of the highest standards.

Finally, what is the incentive of accountants to follow the precatory guidance of the PCAOB? Will they be criticized and punished for being too diligent -- for doing too much work? Very unlikely. But more important, will they have to fear that excessive attention to detail will cause them to lose the client? This is also unlikely. There are, after all, only four large accounting firms left, and large internationally active companies will find that conflicts of interest, specialization in particular industries, and restrictions on the same firm doing auditing as well as consulting work, can and will narrow their choices of auditors. In addition, explaining to analysts and the newly proliferated corporate governance rating agencies that the company fired its auditors because they were too picky will not produce a chorus of approval.

Of course, with the exception of their enforcement activities, the SEC and the PCAOB can do little about these realities. They can't affect the practicalities of civil litigation, and they can't do anything about a market for auditing services that has become so concentrated that accounting firms have real market power in setting rates and charging time. The SEC and the PCAOB are undoubtedly aware of these facts, but have chosen to throw the responsibility for the excessive costs of section 404 back onto the accounting profession, rather than provide relief by modifying the regulations. This, however, would require them to admit that the costs of the section 404 internal control regime far exceed its benefits, and thus far no one in official Washington wants to be caught saying that. Perhaps Cox, with his credibility and ties to Congress, can tell lawmakers the truth.

Peter J. Wallison is a resident fellow at the American Enterprise Institute. He was general counsel of the Treasury in the Reagan administration.



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