Catch-43

PCAOB in trouble?

Kenneth Starr is taking on the constitutionality of the Public Company Accounting Oversight Board ("PCAOB"), which is a snarling pit bull of an agency created by the Sarbanes-Oxley Act of 2002 ("SOX"). It has the authority to set auditing standards for publicly traded companies (related to SOX testing only), to inspect and test any SOX audits for proper compliance, and to devise and enforce penalties against both companies which violate SOX and auditing firms which perform unsatisfactory SOX testing.

Under SOX, public companies are required to maintain, document, and test a rigorous system of internal controls designed to decrease the risks of fraud and/or material misstatement of the financial statements. Accounting firms are required to test the compliance of their clients with these requirements, as well as do their own controls testing and issue their own audit opinion on internal controls.

In the post-Enron environment, both companies and their auditors were highly interested in taking a conservative approach to audit risk. They wanted to know exactly how to comply with this new law. The PCAOB wasted no time telling them, issuing a series of pronouncements which could be interpreted as:
a) draconian, or
b) vague, and thus the only safe interpretation of them was draconian

Either way, chaos and anarchy ruled the day, and there were a lot of 100-hour workweeks.

Next, the PCAOB got to work auditing the work of the auditors - you can see the results here.

Now, they have turned around and said that, in addition to doing terrible work, auditors are milking this whole SOX thing too much. They are running inefficient audits and charging higher audit fees to their clients, as if SOX was the Permanent Employment For Accountants Act. They are currently threatening to punish audit firms that run inefficient audits. If you're keeping score at home, they first chastised auditors for doing too little work and now they are chastising them for doing too much.

However, there is hope on the horizon.

Kenneth Starr's aforementioned lawsuit says two explosive things:

1) The PCAOB violates the Appointments Clause of the U.S. Consitution, which says that officers of the United States are to be appointed by the President with the advice and consent from the Senate. PCAOB members are not appointed by the President, but are instead appointed by the SEC (whose members are appointed in compliance with the Appointments Clause). Given the immense power wielded by the PCAOB, this is a strong argument

2) The PCAOB violates the separation of powers principle because it has "executive, legislative and quasi-judicial functions." In other words, it is judge, jury, and executioner, which equals tyranny. Now, one could make a strong argument that many federal agencies (i.e. the unofficial fourth branch of government) violate this principle as well, but that is for another post!

Further, if the PCAOB is ruled unconstitutional the entire Sarbanes-Oxley Act will be struck down (according to Kenneth Starr).

I am very pleased.

posted by JM @ 5:54 AM