June 9, 2005
Sarbanes-Oxley Section 404: the Regulatory Problem
I have read the full transcript of the April 13th SEC roundtable on Section 404, attended by all the SEC Commissions, the chair of the PCAOB and various auditors and industry representatives. At the conclusion Commissioner Goldschmid noted that there was little criticism of Section 404 itself or of the SEC rules on Section 404 or of Audit Statement 2 from the PCAOB on 404 (with the exception of small business problems) that the problems were in the "implementation" of the Section. Accountants were too "conservative" in applying the Section and rules. The SEC/PCAOB repeated this theme in its interpretative release of May 16th, 2005. The accountants were too "mechanical", using a "one-size-fits-all" mentality.
The position fundamentally disregards the incentive structure set up by the Section. Accountants know that if they audit a company that has defrauded its investors that accountants will be in a heap of trouble. Moreover the accountants know that they are subject to periodic inspections by the PCAOB. So audits pursue a strategy to minimize after the fact prosecution risk -- they standardize (based on industry group principles), they are literal (dot every i and cross every t) and they interpret ambiguity in the rules in favor of checks and tests (I guess this is how the Commissioner uses the term "conservative"). The auditor's engage in "defensive auditing." Moreover, this labor intensive approach has the not unappreciated tendency to increase auditor's bills (by 60% this year). The SEC does not want to write detailed rules; it wants to rest on principles and standards. So the audits take the general rules and push them in favor of coverage and tests.
The SEC's repines is to criticize the auditors' conservatism when the auditors can be expected to do nothing else. The SEC is now calling for the auditor's to exercise more "judgment" on what is "reasonable" when auditors want to do nothing of the sort. A reasonable judgment made now does not look so reasonable in court when the firm is bankrupt as the result of financial fraud. The SEC needs to have a better handle on the inherent incentives of those regulated when it promulgates these rules. The "surprise" in implementation is due to SEC negligence (or ignorance), not the misbehavior of industry participants.
June 9, 2005 | Permalink
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