Sarbanes-Oxley and the PCAOB: No Profit Motive = Bigger Bloat

Monday, October 29, 2007
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The PCAOB (Public Company Accounting Oversight Board) is a corporation created by the Sarbanes-Oxley Act of 2002. Tom Selling at the Accounting Onion presents some interesting facts regarding the PCAOB.

Tom – who has an impressive resume – says he attended a presentation by a senior PCAOB staff member who included this table in his powerpoint presentation:

table.bmp

He’s looking at the total number of US audit firms (about 750), and about 742 of them (almost 99%) rake in approximately 1% of all client revenues. Then he notes (and his facts are correct):

- The Sarbanes Oxley Act requires the Public Company Accounting Oversight Board (PCAOB) to inspect audit firms with one or more public companies as clients at least once every three years, and that firms with more than 100 clients have to be inspected every year;
- There are currently more than 700 audit firms that are subject to PCAOB inspection; and
- More than half of the PCAOB’s $130 million budget and 500 employees are dedicated to inspections?

Tom goes on to add, “The PCAOB presenter made the point that all audit firms are thoroughly inspected, so it would not be outlandish to guess that significantly more than half of the PCAOB’s inspection resources (> $65 million) are protecting the public against the equivalent of a flea bite on the hindquarters of a bull (market). And, add to the PCAOB’s waste of its own money, the significant costs imposed on small audit firms of submitting to PCAOB inspections.”

Austrian economists understand the lack of the cost-benefit motives in a government bureaucracy, and how this no-profit mode of operation subjects business to unfettered regulation. What is so remarkable about this whole point is that the science of auditing involves the understanding of a very important concept as it relates to the objective of a financial statement audit: materiality. US GAAP (Generally Accepted Accounting Principles) defines materiality as “…the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”

All accounting and auditing involves materiality judgments. In my profession, I would say that the majority of accountants do not ever learn how to properly apply the concept of materiality. That’s why they remain staff accountants instead of CPAs, firm partners, or corporate leaders. They are transaction-oriented as opposed to having the “big picture” mindset.

The PCAOB apparently thinks materiality is important because they rushed to create Auditing Standard No. 5 (AS5) this year, replacing AS2. AS2 was so ill-conceived as to force auditors to focus on immaterial issues when conducting a SOX audit. As one person said, “There is no reason to examine internal controls that, even if deficient, could have no material impact on the financial statements of the company.” That is materiality in a nutshell.

So while the PCAOB’s AS5 rushed to include a “materiality filter” for audit guidance, the PCAOB, when it comes to keeping its bureaucracy afloat, apparently ignores its own supposed principles.

The National Capital Venture Association released a wise statement regarding various materiality definitions: “These definitions are so all-inclusive that there are still only vague limits as to what an auditor can determine to be material,” the trade association wrote. “Since these determinations drive the scope of testing and the demands for documentation, AS5 would likely again drive audit work that is far in excess of any reasonable cost-benefit balance.”

Materiality does indeed drive the amount of internal control testing that is to be performed during a SOX audit. So unless materiality is properly understood, there are no limits as to what can be scrutinized under the watchful eyes of a very expensive public accounting firm. The lack of these limits creates excessive costs and/or skewed results of internal controls testing, leading to perhaps costly remediation and/or an unfavorable audit results.

As usual, one must suspect that the PCAOB, a government-created “private” not-for-profit, draws the bottom of the barrel of the accountancy profession into its ranks. Sort of like the IRS.

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