Regulating Public Accounting Firms

This article was written by Phin Upham

The Enron scandal was a failure of auditing as much as it was one of the biggest restructurings in banking history. Through loopholes and faulty accounting, the company intentionally misled its board of directors and an independent audit committee. It was able to mask billions in losses, and was one of many cases that led to the formation of the Sarbanes-Oxley Act.

The act created a new form of oversight that was aimed at preventing fraudulent practices. Enron was one of the more famous cases, but taxpayers and shareholders had shouldered billions in poor debts from companies looking to hide their losses.

The Public Company Accounting Oversight Board, or “peekaboo,” is a private-sector nonprofit corporation with several important regulatory powers. It can register accounting firms, set rules on quality control for audits and conduct inspections of any firms that it registers.

It also made two important precedents. The first was the power to regulate non-audit services, which covered things like tax consultation or various tax services. The reasoning was that these independent accountants had become compromised. Huge earnings from large corporate clients were incentivizing these firms to advise risky and often illegal activity.

The second important part of legislation forced the executives of these firms to sign off on financial documentation, which is meant to keep firms honest by holding the executives accountable for their failure. PCAOB can even disbar an executive if that person is found to not comply with requests for testimony.

Through regulation of corporate accounting methods, it is hoped that companies will keep their books honest. Time will tell if the Sarbanes-Oxley Act will truly help.

About the Author: Phin Upham is an investor at a family office/hedge fund, where he focuses on special situation illiquid investing. Before this position, Phin Upham was working at Morgan Stanley in the Media & Technology group. You may contact Phin on his Phin Upham website