Tuesday, July 29, 2008

Auditing the Auditors

Last year we took a look at the progress the Public Company Accounting Oversight Board (PCAOB) was making in checking up on the audit industry. That is after all their job - auditing the auditors - to see if the public accounting firms are doing a good job of watching over the books of public companies. Back then we found them to be not just months, but years behind in providing the report cards on auditors that was mandated by the Sarbanes-Oxley Act that was passed by Congress in 2002.

Our concern was that users of audited financials - investors like you and me - were getting short changed. A high price was being paid in the form of legal and consulting fees to comply with Sarbanes-Oxley requirements - an inordinate percentage of sales in the case of small cap companies.

Yet we were learning little more about the public accounting firms performing them to know if the audits they were providing was quality work. In five years the PCAOB only fined one firm. In December 2007, Deloitte Touche was fined $1 million for mishandling the 2003 audit of Ligand Pharmaceuticals. The rest of the PCAOB actions - if they can be called actions - were little more than conversations and polite requests for improvements. It looks like peer review at its best - or worst depending upon your perspective.

It appears we are not the only ones who are disappointed in the PCAOB. An accounting firm, Beckstead & Watts based in Las Vegas, filed suit against the PCAOB, charging that the board’s structure violates the Constitutional separation of powers. A Washington-based anti-government group, the Free Enterprise Fund, has joined in.

The constitutionality question is an entirely separate issue than whether they actually do a good job. Or is it? Peel back a layer or two of the onion you find that Beckstead & Watts filed their suit against the PCAOB soon after the board found that Beckstead was deficient in at least eight audits. In other words, the board got themselves into trouble by actually doing their job, demonstrating how sensitive the public auditing profession is to scrutiny.

You have to give the Beckstead group credit for creativity, because their lawsuit has put something in motion that is not likely undone. One solution that is being bandied about is to make the oversight board as part of the SEC. Now these are the same folks who were recently caught napping while investment banks and commercial banks ran amok with securitizing shaky mortgage loans.

A lower court threw out Beckstead’s case, but fortified with help from the Free Enterprise Group, Beckstead & Watts has appealed. A U.S. federal appeals court is expected to make a decision on the constitutionality question later this year.

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