On the surface, the new wording seems to represent a beachhead for the "principals-based" auditing that would represent a relief for audit clients over the old "rules-based" regime. After all, wouldn't the "reasonably possible" definition ask auditors to exert a lot more judgment — and a lot less scurrying after minutiae — than "more than remote likelihood" would?
But the capital markets committee had another suggestion. The materiality standard for internal controls, it says, should be consistent with the one used in financial reporting. In line with that, the committee wants the SEC to revise its financial-reporting guidelines "so that scoping materiality is generally defined, as it was traditionally, in terms of a five percent pre-tax income threshold."
"Traditionally," however, seems to mean "before 1999." In a staff bulletin the SEC issued that year, the commission sharply curbed the use of "rules of thumb" — like 5 percent of net income or earnings per share — as gauges of how big a misstatement must be before a company must report it. While such measures could be used as a jumping-off points in figuring out what to report, executives and auditors must "consider all the relevant circumstances" in evaluating what's material, according to the bulletin.
In that context, the committee seems to be proposing a shift back to bright-line rules — to a specificity that's generally considered the root of many of the problems associated with 404. Of course, the SEC and the PCAOB aren't obliged to proceed in lockstep with the Paulson Group's proposals. But the committee is bound to have an influence.
Similarly, the currently strong movement to limit auditor liability could lose steam. To be sure, both the capital markets committee's report and an earlier "vision statement" by the chief executives of the five biggest auditors have called for reforms that would curb the effect of lawsuits against the firms.
The groups contend that another big prosecutor-driven auditor failure like Arthur Andersen's would destroy existing competition in the market for audit services. They also argue that the threat of lawsuits has made auditors overly cautious — causing them to pile on 404 tests, for example.
In a striking statement that reveals the current level of support for auditor tort reform, Conrad Hewitt, the SEC's chief accountant reportedly expressed worry on January 25 about potential auditor liability because there are only four major accounting firms left. "It's a concern to us if something should happen to any of the four firms," Hewitt said. "Something can be done, and should be done, for the accounting profession" to limit exposure to lawsuits, he added.
Others, however, think that placing a cap on the legal damages independent auditors can suffer removes an important deterrent to fraud. Douglas Carmichael, who was the PCAOB's first chief accountant, feels that Hewitt's comments were inappropriate in light of a January 22 report by the board that found abundant blunders in auditors' fraud detection. The way to boost deterrence is for the PCAOB to follow up with the firms, says Carmichael, now the Wollman Distinguished Professor of Accountancy at Baruch College in New York City. "It's certainly not to give auditors freedom from legal liability."
In the current Democratically controlled Congress, such views are likely to get a sympathetic hearing. Indeed, advocates of liability caps could encounter tough sledding, considering the financial support Democrats get from the plaintiffs' bar. As is the case with other apparent regulatory and legal rollbacks, the jury on tort reform is still out.
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