Public Company Accounting Oversight Board

By Edward H. Trompke

In response to the discovery of massive financial fraud perpetrated by a number of large companies, Congress adopted new laws in August that will change accounting standards forever.

In order to protect investors, the new law creates a Public Company Accounting Oversight Board (PCAOB) to regulate audit practices of companies that are subject to securities laws. The most important function of PCAOB will be to establish accounting rules for all financial audits of publicly traded companies. In addition, accounting firms that prepare audits for publicly traded companies must register with PCAOB, which will supervise them and their activities. Finally, the new law creates a few new standards for companies to follow. These substantive rules (1) require officers to sign financial statements for veracity, (2) prohibit insiders from trading in stock during certain time periods, and (3) increase disclosure of transactions that involve conflicts of interest. All appear to be reasonable, but sometimes will be costly to administer, making them appropriate for publicly traded companies, but not for private companies.

The new accounting standards must be adopted by PCAOB before the end of February 2003. The new accounting standards will very likely be similar to the current generally accepted accounting principals (GAAP), but will also include many new provisions to stop "off balance sheet financing" and other creative financing schemes that tend to mislead shareholders about the financial risks and condition of a company.

For publicly traded companies, compliance with PCAOB accounting rules will be mandatory. In addition, the accounting rules will be mandatory for about 2,500 private companies that are required under the Securities and Exchange Act of 1934 to file reports with the SEC due to their larger size. And this is where a problem arises for private companies. All these larger "reporting" companies will be required to use the PBAOB-approved audited financial statements when reporting to the Securities and Exchange Commission, their bondholders, their shareholders, and probably their banks.

Because these banks do not lend to just large publicly traded companies, but also to medium-sized and smaller private companies, they will want to use one set of accounting standards in order to have consistency in the financial statements they review. This means the PBAOB rules are likely to become the standard for all companies, public and private.

The rules may not be at all appropriate for privately held companies. The audit committee of the board of directors must have a "financial expert," but the SEC has not yet defined the term. In addition, senior financial officers must obey a code of ethics to be developed by the SEC. If small businesses are required by their lenders to comply with the public company standards, these provisions are likely to be costly.

However, it is hard to predict which will be worse: having to deal with two sets of financial rules, or using the more stringent public company rules. To make matters even more complex, neither sets of these financial accounting rules will be the same as tax accounting rules, so there will be yet another set of rules.

Only time will tell how these rules will sort out.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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