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When economic and political considerations enter into accounting standard setting, a whole new range of public interest issues arise. The SEC just announced that it is relaxing its requirement for small companies to have an auditor examine their internal control systems and issue a report on their findings. This requirement has been in place since the Enron and WorldCom scandals of the early 2000s.
Why Relax the Rules?
The reason given for relaxing the rules for companies with annual revenue below $100 million and public shares worth less than $700 million is concerning to say the least. According to SEC Commissioner Hester Pierce, with this change a company trying to develop a vaccine for the fast-spreading coronavirus “will be able to pour resources and – importantly – management’s time and attention into that effort rather than into obtaining an internal-controls audit.” This is a knee-jerk reaction to the current spread of the virus and unworthy of being a goal of standard setting.
The Commission also rationalizes its decision by saying it is consistent with the practice of scaling disclosure and other requirements for smaller issuers. The problem is small businesses have more challenges with respect to fraud than larger ones. Writing in the Journal of Accountancy, “Report Finds Big Fraud Problems for Small Businesses,” Jeff Drew reviews the 2018 Report to the Nations on Occupational Fraud and Abuse by the Association of Certified Fraud Examiners (ACFE) and concludes that the “lack of a control makes small businesses more vulnerable to fraud.”
The findings in the ACFE Report include the following.
- 25% of frauds at larger companies were due to a lack of controls compared to 42% at smaller businesses.
- Owner/executives committed 16% of frauds at larger companies compared to 29% at smaller businesses.
- Some frauds occurred more frequently at smaller companies versus larger ones including check and payment tampering (22% vs 8%) and skimming and payroll fraud (20% vs 8%).
In the past, the SEC relaxed some regulations, especially in the finance and banking world, to send a signal to Wall Street that regulatory requirements will be lessened and these firms should look to use the money saved to expand economic development and the investment in new plant and equipment. The purpose of SEC regulations should not be to stimulate the economy.
It also seems that the SEC believes more companies will be able to raise money in public markets by easing regulations. The SEC may be on to something here but standards should not be set or relaxed based on a desire to stimulate the financial markets.
Costs of Relaxing the Rules
Four accounting professors reviewed the comment letters sent to the SEC about the initial proposal to ease the rules for internal control audits. They found that at least a dozen companies that wrote letters of support to relax the rule had disclosed accounting problems of their own. Some had to restate earnings reports due to errors, while other company auditors flagged “material weaknesses” in their internal controls over financial reporting (ICFR).
The authors did a preliminary analysis of earnings restatements in 2018 of 11 companies that the Commission proposed to exempt from internal control audits and found they restated over $65 million in net income that destroyed more than $294 million in shareholder wealth. They concluded that this destruction in wealth, caused by only a handful of restatements, dwarfs the proposal’s total cost savings of $75 million across all 358 affected companies.
Furthermore, a MarketWatch analysis of SEC filing data provided by research firm Audit Analytics shows that of 100 initial public offering filings in 2019 year-to-date, companies that use a Big 4 audit firm found 20 that have voluntarily disclosed serious issues with internal controls. So, by easing the rules fewer red flags will be raised on deficiencies in internal controls making it, presumably, easier to go public. How does this protect the public interest?
PCAOB Inspections
The problem is more pronounced when we look at deficiencies cited in ICFR as a result of the annual inspection of audits by PCAOB. Writing in The CPA Journal, Thomas Calderon, Hakjoon Song and Li Wang investigated 1,025 PCAOB inspection reports for years 2002 through 2012 and found about 50 percent had audit deficiencies, 131 of which were due to ICFR-related deficiencies. This is greater than a 25 percent deficiency rate in ICFR.
Deficiencies in ICFR can indicate there are errors in the financial reports that went undetected or material misstatements of the financial statements. Now that certain small companies are exempt from auditing the controls, it is possible that fraud will go undetected. As a result, a firm may give reasonable assurance about the accuracy and reliability of financial statements when a modified opinion should have been issued. In such cases, the public interest is at stake and the reputation of the accounting profession hangs in the balance.
By allowing economic consequences to influence whether certain companies must audit ICFR, the SEC has introduced bias in the PCAOB inspection process. The rationalization given that it will help companies invest in research and human capital makes no sense. How do they know companies will use the funds saved to develop a vaccine for the coronavirus or any other health-saving activity? What prevents these companies from using the funds to buy back stock or increase executive compensation?
What is the Public Interest?
The accounting profession exists because of the 1933 SEC requirement for public company audits that can only be conducted by independent CPAs. The franchise given to the profession is designed to best serve the public interest through independent audits that provide reasonable assurance that the financial statements are free from material misstatements including fraud. Given the important role of ICFR to prevent and detect fraud, the loosening of the rules for audits of the controls can only serve the interests of those companies affected by the rule change.
The SEC should not set rules designed to be an engine for economic development. The rule change is nothing less than a crack in the ethics wall that protects the public interest. Issues such as objectivity, representational faithfulness, due care and reliability are at stake. Changes in the rules to serve a particular political or economic interest has no place in accounting standards.