Academic journal article Duke Law Journal

Some Thoughts on an Agenda for the Public Company Accounting Oversight Board

Academic journal article Duke Law Journal

Some Thoughts on an Agenda for the Public Company Accounting Oversight Board

Article excerpt

INTRODUCTION

The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) (1) was enacted in response to widespread concern that there is "a serious problem in financial reporting and disclosure" and that "Enron and like cases are aberrational only in size and severity," (2) The Act includes provisions regulating corporate boards of directors, (3) corporate audit committees, (4) transactions between corporations and their executives, (5) the obligations of attorneys who represent public corporations in securities matters, (6) and the compensation and autonomy of securities analysts. (7) At the heart of the Act, though, are the provisions that authorize the creation of a new regulatory body, the Public Company Accounting Oversight Board (PCAOB or Board), require all accounting firms that audit the books of public corporations to register with the Board, and grant the Board broad authority to regulate those firms and their associated professionals. (8)

Sarbanes-Oxley directs the PCAOB to take such actions as it deems "necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, registered public accounting firms and associated persons ... in order to protect investors, or to further the public interest." (9) The Board's mission quite clearly is to develop regulations and implement regulatory procedures that will bolster--and may even restore--the public's confidence in the integrity of public accounting firms and the credibility of the financial reports they audit and certify. (10)

Public confidence in the integrity of public companies' financial reports has been shaken by numerous, highly publicized instances of financial fraud (11) at companies as prominent as Enron, (12) Rite-Aid, (13) WorldCom, (14) and HealthSouth, (15) and by the failure of auditors to detect that those companies had been "cooking their books" for many years. (16) There is no doubt that one prominent item on the PCAOB's substantive agenda will be figuring out how to encourage or require auditors to detect such frauds.

This Article, however, does not focus on the ways in which the PCAOB should deal with fraud-related issues. Rather, it is directed at two more pervasive problems that also have sapped the public's confidence in the integrity of corporations' financial reports:

* Earnings management, by which I mean the tendency of many corporate managers to make the numerous accounting judgments that generally accepted accounting principles (GAAP) (17) permit or require not in good faith, but with a view to reporting some desired level of corporate income (or some other desired figure in their company's financial statements). (18)

* The failure of public companies and their accountants to make clear to the public the extent to which critical entries in those companies' financial statements are based on highly subjective judgments, the accuracy of which cannot be measured objectively. Inevitably, with the passage of time, some of those judgments prove inaccurate. Even if those judgments were made in good faith, investors who do not appreciate the amount of subjectivity involved in preparing financial statements may suspect that the disparity between what was reported and "economic reality" is a product of earnings management, if not of outright fraud.

Professor Don Langevoort argues that the best way to address these problems is for the Securities and Exchange Commission (SEC) again to overhaul its approach to Management's Discussion and Analysis (the MD&A). (19) I disagree. The SEC has been pushing that particular string with little success for many years now, (20) which leads me to question whether any new approach the SEC is likely to adopt will be much more successful in eliciting meaningful, forward looking disclosures from corporate managers than have the SEC's past, failed efforts.

A major conceptual problem with the SEC's approach, in my view, is that the Commission has persisted in treating "historical" financial information as if it is fixed in nature, rather than inherently uncertain. …

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