Peeling away financial reporting issues one layer at a time

The PCAOB is Auditing the Wrong Auditors

Did you know that:

  • 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?

If you knew all that, you’re a nerd like me.  But, here is something I didn’t know until I attended a presentation by a senior PCAOB staff member recently, who included this table among his Powerpoint slides:

The first three columns aren’t a big surprise, but the fourth one is a whopper: of the 750 audit firms out there, 99% of them audit an aggregate 1% of the reported revenues of public companies!  The 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.

I am certainly not against regulations to incentivize high-quality audits by all firms, but what we have here is an Economics 101 case study on the pitfalls of centralized planning happening right here in the good ‘ole US of A. 

No Incentives to Right the Wrong

If you passed my trivia test, you would also know that the demand for qualified accountants and auditors has increased since SOX–and so have their salaries.  I have heard SEC staffers claim that they have trouble hiring qualified accountants for their own inspection work due to the competition provided by the PCAOB. 

What I find most irritating is that PCAOB members, each paid over $500,000, are not screaming loudly at Congress that the static burdens imposed by statute on their august organization render one of its two most important functions (the other is promulgating auditing standards) half as efficient as it could be.   Well, here’s the freakonomics of it:

  • The PCAOB has no incentive to control costs by reducing the number of unnecessary inspections.  The more inspections that are mandated by SOX, the larger the budget that can be justified for approval by the SEC. 
  • The Board members personally benefit (albeit indirectly) from bloat. The larger the scale of PCAOB’s operations, the easier it is to justify their salaries.

The Board’s greatest fear should be that their inspection of the audit of a Fortune 100 company concludes without discovering a problem — and that the audit turns out to be as big a bust as the Arthur Andersen audit of Enron.  Evidently, it doesn’t register with the Board that the big bucks they get are to make sure that one thing doesn’t happen. They should be doing everything in their power to make the inspection process more efficient–including lobbying Congress to craft a more sensible mandate for the PCAOB’s inspections — and by the way, puts an end to the persecution small audit firms.   

1 Comment

  1. Reply Krupo November 28, 2007

    Good entry, I’ll be linking back to it. BTW, Krupo <>= Neil. 🙂

Leave a Comment