Risk Management

Will Auditors Influence How Executives Are Paid?

PCAOB proposals would have auditors reading the employment and compensation contracts of corporate leaders and, possibly, forcing changes to comp p...
Andrew LiazosMarch 12, 2012

Accounting treatment under GAAP has long been a factor in the design of executive-compensation programs. Until the release of FAS 123-R in the mid-2000s, public companies were loath to use performance goals as a vesting condition for equity-based compensation due to unfavorable accounting results. Similarly, concerns under current rules about grant-date determinations for equity-based compensation have affected how the awards are delivered to executives.

Now, CFOs should be on the lookout for an entirely new and potentially more invasive accounting-related influence on executive compensation, in the form of proposed amendments to Public Company Accounting Oversight Board (PCAOB) auditing standards. If adopted in their current form, the proposed amendments could spur corporate auditors to force changes to executive-compensation programs due to unacceptable risks of material misstatement, an increased risk of fraud, or both.

On February 28, the PCAOB issued a release proposing a new auditing standard for related-party transactions and amendments to auditing standards regarding significant unusual transactions. Tucked away in the release were “other proposed amendments to PCAOB Auditing Standards” that require auditors to more carefully consider an issuer’s executive-compensation practices during the audit process.

Executive compensation is not a new area for the PCAOB. Auditing Standard No. 12, “Identifying and Assessing Risks of Material Misstatement,” currently states that “the auditor should consider performing . . . procedures and the extent to which the procedures should be performed [to] obtain an understanding of compensation arrangements with senior management, including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses.”

What’s different now is that the proposed amendments seem to compel auditors to take additional actions regarding executive compensation as part of the standard audit process. Specifically, the proposed amendments would require auditors to “perform procedures” regarding executive compensation in order to identify risks of material misstatement. In particular, the procedures would include reading employment and compensation contracts as well as proxy statements and other relevant company filings with the Securities and Exchange Commission that relate to executive compensation.

The increased scrutiny would not be limited to just reviewing more documents. The proposed amendments also would require the auditors to consider contacting persons who are involved in executive-compensation decisions but not in financial audits — such as the compensation committee chair, the outside compensation consultant, and human-resources personnel — to better understand the company’s executive-compensation structure. Auditing procedures would also target the authorization and approval process for executive perquisites and reimbursement arrangements.

Why is the PCAOB intensifying its focus on executive compensation outside of the financial industry at this point? After all, in 2009 the SEC imposed a proxy requirement that public companies disclose “the extent that risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant.” In response, many public companies have already modified their executive-compensation programs to avoid excessive risk taking, such as imposing caps on cash-based incentive compensation, requiring stock to be held at certain levels, using fewer stock options, and instituting clawback policies (which will eventually be required for all listed public companies under Dodd-Frank).

The answer to this question appears to be that the PCAOB has been significantly influenced by academic studies on executive compensation. The release cites a May 2010 study by the Committee of Sponsoring Organizations that found that either the CEO or CFO was named in 89% of the SEC’s enforcement actions from 1997 to 2008 involving fraudulent financial reporting, and that the most commonly cited motivations for fraud included “the desire to increase management compensation based on financial results.”

While one can question how much should be drawn from these studies — recall that much of this period involved stock-option granting practices that are no longer broadly used ­— it’s not unreasonable for auditors to understand what financial performance triggers incentive-compensation payments. Such information might suggest areas susceptible to questionable accounting decisions and practices.

Unfortunately, the PCAOB is suggesting that auditors also evaluate whether the design of an executive-compensation program could itself lead to excessive risk taking. Here’s what one of the board members, Steven Harris, had to say about this matter:

“Equity-based compensation arrangements may also provide strong incentives for excessive risk-taking by executives. Studies have shown that these arrangements can position executive officers to benefit from the upside of high-risk investments, while largely insulating them from the downside risks. In addition, excessive risk taking generally is viewed as one of the contributing factors to the recent financial crisis. For example, ‘The Financial Crisis Inquiry Report’ concluded that ‘Executive and employee compensation systems at these institutions disproportionately rewarded short-term risk taking.’ The Board’s proposals would require auditors to focus on the potential opportunities and motivations for executive officers to exaggerate gains, or minimize losses, and to consider any effect compensation incentives might have on the reliability of the financial statements.” (Emphasis added)

That type of statement raises the possibility that an auditor might view the structure of an executive-compensation program to be so problematic that, when coupled with other factors, the auditor may be unable to issue an unqualified opinion. This risk (i.e., not receiving an unqualified opinion on financial statements) could give the auditor significant influence over executive-compensation decisions.

What’s particularly interesting about the timing of the PCAOB release is that its focus on executive compensation is happening when shareholders now have a “say on pay” under Dodd-Frank and there is an increasing focus on “pay for performance.” As discussed in my January column, ISS, the leading shareholder advisory service, recently revamped its guidelines for making recommendations on executive compensation by focusing on total shareholder return (TSR) as compared with peer companies, and it’s reasonable to expect that issuers will start to use TSR performance goals. One can only imagine the reaction of compensation committees if their decisions to restructure executive pay in response to shareholders were to be second-guessed by auditors, particularly in light of the current lawsuits regarding failed say-on-pay votes.

The PCAOB is moving quickly on this change. While the proposed amendments require SEC approval, the PCAOB anticipates that these changes would be effective for audits of financial statements for companies with fiscal years beginning on or after December 15, 2012.

Andrew Liazos heads the executive compensation practice at the law firm McDermott Will & Emery LLP.