Neutered Watchdog Dreams of Its Missing Parts: Jonathan Weil

Now that the Supreme Court has said the auditing profession’s main regulator can continue to exist, here’s a knottier question: Should it?

The case for preserving the Public Company Accounting Oversight Board in its current form just got much weaker. This week the court ruled that, for the board’s structure to be constitutional, the Securities and Exchange Commission must be able to fire its members at will. Previously, under the statute that created the board, the SEC could remove them only for good cause once it had appointed them to their five-year terms.

The ruling in effect transforms the board into a wholly controlled, off-balance-sheet subsidiary of the SEC. Before, the commission mainly had the authority to reject the PCAOB’s decisions. Now it has the power to tell the board what it must do, as well. As Chief Justice John Roberts wrote in the court’s opinion, “the power to remove officers at will and without cause is a powerful tool for control of an inferior.”

While the court’s decision may be sound constitutionally under the separation of powers, it probably doesn’t make for good public policy when it comes to regulating auditors. If the board in substance will be nothing more than a division of the SEC, it’s hard to justify why it shouldn’t be one in form, too.

Congress established the PCAOB when it passed the Sarbanes- Oxley Act in 2002, stripping the auditing profession of the authority to regulate itself. The board’s duties include setting auditing standards for firms that certify the books of companies with U.S.-registered securities. It inspects audit firms to see if they are complying with those standards. The board also has an enforcement division that can issue subpoenas and bring disciplinary actions against auditors for misconduct.

Government Interference

Ideally, the one PCAOB function that should be largely free from government interference is the responsibility for setting auditing standards, although it wasn’t that way in practice even before the court’s ruling.

The SEC requires that accounting standards, for instance, be set by an independent body. That’s the Financial Accounting Standards Board, whose members are picked by a private, nonprofit foundation. Auditing standards should get similar treatment. Both processes need to be insulated from political meddling as much as possible to ensure they result in fair and objective standards based on expert analysis.

Back in February 2008, shortly after Kayla Gillan, one of the PCAOB’s inaugural members, left the board after a five-year term, she gave an interview to the trade paper Compliance Week in which she blasted the SEC for pressuring the board to gut its standard for auditing companies’ internal controls. The SEC, then chaired by Christopher Cox, “pushed, pushed, pushed and really tried very hard to get something different than what” the board ended up producing, she said.

Do as You’re Told

Now the commission simply can fire board members who refuse to do as they’re told. (Gillan joined the SEC as a senior adviser last year.)

One reason the PCAOB was established as a private nonprofit corporation was so it could pay salaries to its members and staff far above the government pay scale, although practically speaking it functions like a federal agency. Bowing to pressure from the accounting profession, Congress also required that the board conduct much of its business in secret.

Its internal records aren’t subject to disclosure under the Freedom of Information Act. Disciplinary hearings are closed to the public; the proceedings become public knowledge only after an auditor has been sanctioned. And when the board releases inspection reports on individual firms, it keeps most of the contents confidential, including the names of companies where it found the firms’ audits were deficient.

Little Work

Open government, this is not. That’s reason enough to shutter the board’s enforcement division, which merely supplements the SEC’s own efforts. The board has issued just 31 disciplinary orders since its formation. Only one was against a Big Four accounting firm, Deloitte & Touche, which paid a $1 million fine in 2007 over its audit work at a small company called Ligand Pharmaceuticals Inc.

As for the board’s inspections, maybe they’ve helped improve audit quality, maybe not. Because the inspection reports are shrouded in secrecy, there’s no way for the public to tell.

Here’s my suggestion for Congress: Disband the PCAOB -- this neutered watchdog won’t be growing back what it just lost. Create a foundation independent of the accounting industry to oversee a new private-sector board that would set U.S. auditing standards. And put the PCAOB’s other units inside the SEC, along with the fees the board now collects to fund their budgets.

Multiple Failures

The quality of the firms’ inspections might suffer if the inspectors were paid less. Yet the same argument could be made for employees at other agencies who do important work, such as inspecting nuclear power plants. There’s been no rush to take them off government pay scales. Accountants are no more special than those people.

For all the PCAOB’s efforts, we still had what seemingly must have been massive audit failures at Ernst & Young, which audited Lehman Brothers; PricewaterhouseCoopers, which audited Freddie Mac; Deloitte, which audited Fannie Mae; and KPMG, which audited Citigroup. Those companies and many others blew up in 2008 sporting clean audit opinions. Yet there hasn’t been any explanation by the PCAOB or anyone else in government of whether their auditors did their jobs appropriately.

If the PCAOB can’t even do that, it’s time for a do-over.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in New York at jweil6@bloomberg.net

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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