As the Public Company Accounting Oversight Board (PCAOB) inspects audits conducted by the registered independent accounting firms it regulates, it continues to see numerous audit failures relating to the accounting for, and disclosure of, related party¹ and significant unusual transactions. To strengthen audit procedures for evaluating public companies’ identification of, accounting for and disclosure of related party transactions, the PCAOB recently proposed a new auditing standard to replace its existing auditing standard for related party transactions (New Standard).² At the same time, the PCAOB proposed amending a number of existing auditing standards to enhance procedures for the assessment of risks of material misstatements arising out of significant unusual transactions and executive compensation programs (Proposed Amendments).

Although the PCAOB has proposed the New Standard and Proposed Amendments (collectively, the Proposed Standards) to reduce the risk of material misstatements in audited financial statements, the Proposed Standards have excited concern that they will lead to auditors having greater involvement in, and, perhaps, influence over, executive compensation decisions.

Public comments on the Proposed Standards may be submitted through May 15, 2012. The PCAOB expects to adopt the Proposed Standards in the fourth quarter of 2012. Subject to Securities and Exchange Commission (SEC) approval, the PCAOB anticipates that the Proposed Standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012.

Proposed Standards

The New Standard would replace the PCAOB’s existing auditing standard AU sec. 334, Related Parties (AU 334). Although the New Standard would build on the principles in AU 334, it would, among other things, require increased auditor focus on:

• identifying related parties;
• reviewing relationships and transactions with related parties;
• evaluating whether previously undisclosed related parties, relationships or transactions might exist; and
• understanding a company’s controls relating to the identification, authorization, accounting and disclosure of related parties and related party transactions that are a part of the company’s internal control over financial reporting.

The Proposed Amendments would result in modified audit procedures relating to significant transactions outside of the normal course of business and other changes to existing auditing standards. The Proposed Standards would also place an increased emphasis on auditors understanding the business purpose of related party and significant unusual transactions.

Proposed Amendments to Auditing Standard No. 12—A Focus on Executive Compensation

Among the Proposed Amendments are changes to Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement (Auditing Standard No. 12), designed to cause auditors to obtain an understanding of a company’s financial relationships and transactions with its executive officers (as defined in Rule 3b-7 under the Securities Exchange Act of 1934, as amended). Auditors would have to perform audit procedures specifically focused on executive compensation, including perquisites, and any other arrangements between a company and its executive officers. The new procedures would include the review and understanding of employment agreements and other arrangements with executive officers and the review of proxy statements and other SEC filings that disclose a company’s financial relationships and transactions with its executive officers.

Existing procedures relating to understanding compensation arrangements with “senior management” would be modified to exclude executive officers from the scope of those procedures. Amended Auditing Standard No. 12 would also require auditors to consider interviewing the compensation committee chair and compensation consultants engaged by the compensation committee or the company in connection with the structuring of a company’s executive compensation.

PCAOB Concerns with Audit Work Relating to Related Party Transactions and Executive Compensation

The PCAOB clearly considers executive compensation programs as having the potential for being rife with fraud risks, noting in its discussion of the proposed changes to Auditing Standard No. 12 that “a company’s financial relationships and transactions with its executive officers can create risks of material misstatement that relate pervasively to the financial statements.”³ In particular, the PCAOB believes that the information obtained regarding those matters “could be used to identify account balances that are likely to be affected and could have a significant effect on the financial statements.”⁴

The PCAOB decision to issue the Proposed Standards reflects the PCAOB’s concern with the overall quality of auditors’ work relating to related party transactions and executive compensation. This concern appears justified due to the fact that approximately a quarter of the PCAOB’s settled disciplinary proceedings involve auditor failures with respect to related party or significant unusual transactions and that approximately 90 percent of the SEC's fraudulent financial reporting cases from 1997 to 2008 involved the chief executive officer or chief financial officer.⁵

Concern Over Greater Auditor Involvement with Executive Compensation

Commentators' concerns. The Release’s publication has prompted expressions of concern from various commentators regarding the implications of the proposed amendments to Auditing Standard No. 12. One commentator has written that the amendments, “in some cases, may enhance auditors’ influence on executive pay decision-making.”⁶ That commentator goes on to suggest that the proposed amendments raise “the possibility that compensation committees for companies outside the financial services industry could have their business judgment second-guessed by their corporate auditors.”⁷ Another commentator has suggested that “CFOs should be on the lookout for an entirely new and potentially more invasive accounting-related influence on executive compensation … .”⁸ This commentator further notes that “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.”⁹

Looking solely at the Proposed Amendments, a disinterested observer could conclude that the commentators’ concerns are overblown and that the Proposed Standards should serve only to make auditors more exacting in the discharge of their audit responsibilities.

PCAOB statements raise concern over auditor’s role. Statements by PCAOB board members regarding the Proposed Standards appear to have fueled some of the concerns that auditors would exert new influence on executive compensation decisions. Regarding the proposed amendments to Auditing Standard No. 12, one PCAOB board member stated that “it makes sense that auditors should consider the possible incentive to questionable accounting treatments created by compensation arrangements. Equity-based compensation arrangements may also provide strong incentives for excessive risk-taking by executives. … 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.”¹⁰ Another PCAOB board member cited the “possibilities and perils of period-end window-dressing and other kinds of form-over-substance maneuvers intended to produce an accounting effect rather than to promote a business purpose“ prior to observing that as pay-for-performance has become the “business orthodoxy,” the risk exists that accounting manipulation may occur to meet “compensation-triggering targets.”¹¹

The PCAOB is not likely suggesting, even obliquely, that auditors become involved in or influence executive compensation decisions, especially when any actual involvement in such decisions could result in independence concerns for auditors. As the Release notes, the proposed amendments to the audit procedures in Auditing Standard No. 12 “are not intended to call into question the policies and procedures of the company, but rather to assist the auditor in identifying and assessing risks associated with a company’s financial relationships and transactions with its executive officers.“¹² The greater concern with the statements of the PCAOB board members, such as the one noting that equity-based compensation could result in excessive risk-taking by executives, is that the PCAOB could be seen as suggesting that auditors should be assessing whether executive compensation programs incentivize risky decisions by executive officers made in an attempt to increase their payouts under performance-based compensation plans and somehow considering that as a part of their audit.

The concern that performance-based compensation programs lead to executive officers making decisions and taking excessive risks calculated to increase an executive’s compensation is not a new one, and well designed performance-based compensation programs create safeguards against such behavior. However, the structure and effects of executive compensation programs are the responsibility of a company’s board of directors. It is not for auditors to judge whether a company’s incentive structure is ill-considered, but rather to look at the risks of material misstatement created by the incentive structure to obtain assurance that the financial statements do not contain any material misstatements.

Executive compensation program risk. The source of the risks of material misstatement concerning the PCAOB is clear. Public companies now operate in an environment in which shareholder activists insist that at least a substantial part of executive pay be linked directly to the performance of the company, and, under certain circumstances, proxy advisors recommend votes against the re-election of board members that have approved executive compensation programs without pay-for-performance features acceptable to the proxy advisors. When the amount of compensation that an executive actually receives, whether cash or equity, depends on a company’s achievement of financial targets as reflected in its financial statements, the risk that unscrupulous executives will “cook the books” to increase their pay will exist.

While it is certainly not unheard of for executives to make fraudulent accounting entries to improve their company’s operating results, at least as those results are reflected in the financial statements, the methods for achieving their goals can be less crude, with varying degrees of subtlety. For example, bogus transactions entered into at the end of a period and unwound after the beginning of a period, most often between the company and related parties or other cooperative persons and generally with no true business purpose, have often been fraudsters’ method of choice. In fact, the auditing standards currently in effect should be sufficient to guide careful and properly skeptical auditors in identifying misstatements in financial statements created by such methods.

Risks of material misstatement and fraud may also arise out of the judgments and estimates that management makes in preparing a company’s financial statements. Management can make judgments, including as to the application of accounting principles, and estimates with an eye to their effect on executive compensation. Where certain levels of financial performance must be achieved for any payout to be made under a performance-based stock award or cash bonus plan or to achieve the maximum payout, a judgment or estimate could be made in a manner calculated to ensure that a payout or the maximum payout occurs. The shading of judgments and estimates to increase executive compensation presents a more subtle risk and can result in a material misstatement that is much more difficult for an auditor to identify than are fraudulent accounting entries or bogus transactions.

The existence of performance-based executive compensation programs will present opportunities for unscrupulous executive officers and other members of management to take advantage of their control of the accounting records and the preparation of a company’s financial statements and to engage in some self-help in order to increase the amount of their compensation. Faced with such risks, the conscientious auditor must scrutinize a company’s accounting, the application of accounting principles, and accounting judgments and estimates to determine if a material misstatement exists, not just the risk of such a misstatement.

Auditor involvement in executive compensation decisions. The proposed amendments to Auditing Standard No. 12 would not, in and of themselves, give auditors carte blanche to meddle in executive compensation programs or decisions. Nevertheless, it is legitimate to question whether these proposed amendments would cause auditors to interfere with, to attempt to influence or to second guess executive compensation decisions. Merely discussing the terms of executive compensation programs with the chair of a compensation committee or a compensation consultant, reviewing the terms of employment agreements, compensation plans and awards, reviewing proxy statement disclosure, performing other audit procedures regarding accounts that may affect executive compensation and discussing such matters with the audit or compensation committees should not result in an auditor’s involvement in compensation decisions.

It would be naïve to conclude, however, that auditors cannot and will not take positions or have discussions with board committees, directors or management that could influence decisions regarding the terms of a performance-based executive compensation program. For example, an auditor could assert such influence, perhaps unwittingly, by suggesting that particular performance measures for performance-based compensation awards that are sensitive to management’s judgments and estimates could be changed or eliminated to lessen or avoid the risk of material misstatements. Suggestions that a qualified audit opinion is possible have been known to cause companies to act, sometimes rashly or needlessly, on matters at least as important as executive compensation. The likelihood of a public company changing its executive compensation program in reaction to such suggestions may seem very slight, but the possibility is real.

Moreover, if the PCAOB proceeds to expand the scope of the audit report to add additional disclosures by the auditor, including disclosures relating to identified audit risks, as the PCAOB has suggested it may do,¹³ the ability of the auditor to affect executive compensation decisions, even indirectly, may very well increase.

Implications of the Proposed Standards for Public Companies

Even if various commentators may have overreacted regarding the potential impact of the proposed amendments to Auditing Standard No. 12, the Proposed Standards are not without implications for public companies.

Increased costs. Each additional audit procedure conducted by the auditor may have multiple costs for a company, including increased audit fees, the cost of greater management and accounting staff time being devoted to the audit, the cost of even greater board involvement in the audit, and additional fees of compensation consultants relating to their interviews with the auditors.

Internal control reassessments. In light of the Proposed Standards, public companies may need to reassess their internal control over financial reporting to determine whether changes are necessary. As a practical matter, significant reassessments of particular aspects of internal control over financial reporting occasioned by new information or standards could result in the identification of a significant deficiency or a material weakness. If a material weakness existing at fiscal year end is identified, a company would have to report that material weakness in its annual report on Form 10-K.

Disagreements with auditors. More exacting auditing standards could increase the risk of disagreements between a company and its auditors over the company’s accounting with respect to related party transactions and executive compensation matters, which disagreements might have to be publicly disclosed in certain circumstances. The PCAOB expects auditors to exhibit professional skepticism when performing an audit, and the Release suggests that the PCAOB’s expectations for auditors may also include that an auditor harbor an active distrust of management where self-dealing, conflicts of interest and similar conditions are present that “may call into question the integrity of the management representations or represent violations of the company’s established policies and procedures.”¹⁴ It should not be overlooked that a conflict of interest will exist in any instance in which management has involvement in the preparation of financial statements that will influence the amount of management’s compensation. It remains to be seen if the adoption of the Proposed Standards would cause companies and their auditors to work in an atmosphere of new or heightened mutual distrust and the number of disagreements and, of greater concern, unresolved disagreements to rise.

Extended audit periods. For some companies, the additional audit procedures included in the Proposed Standards may serve to extend the period over which the audit is performed or require additional staffing by the auditor to avoid extending the time required to perform the audit. In an era in which the deadlines for filing annual reports on Form 10-K have been shortened for large accelerated filers and accelerated filers, the addition of audit procedures would mean that audit work must start earlier or the auditor’s staff may have to be larger or have specialized members. Moreover, in an environment in which the PCAOB’s inspections are resulting in serious and very public criticisms of the performance of auditors, including members of the Big Four, the modified standards may lead auditors to conclude that they must bring additional expertise to audits of companies with complex, performance-based executive compensation programs, and hire or train specialists in assessing the risks of material misstatement arising from compensation programs for executive officers, all of which would be paid for by the audit clients.

Concluding Observations

The Proposed Standards need not cause auditors to deviate from their traditional role or create significant additional audit costs. However, as auditors look at the Proposed Standards and consider the publicity that they have received as the PCAOB announces the results of its inspections of the auditors’ work and the numerous audit failures identified, auditors may now feel the need to probe more deeply into executive compensation programs and look even more carefully at those accounts and financial statement items that influence payouts under performance-based compensation programs and awards. Auditors may scrutinize, with even greater skepticism and a new sense of distrust, those judgments, estimates and applications of accounting principles made by management that affect executive compensation. Auditors wary of being cited with an audit failure after a PCAOB inspection may subconsciously raise their own bar for achieving the reasonable assurance they want that the audited financial statements contain no material misstatements of line items that affect executive compensation.

Despite the best intentions of the PCAOB, the Proposed Standards may result in a public company finding itself with an auditor whose heightened sense of concern with the company’s executive compensation program results in the company considering how to structure an executive compensation program that avoids issues with the auditor and pleases shareholder activists and proxy advisors, but still permits the company to attract, retain and properly reward talented executive officers.

1. In the context of financial statements, the term “related party” has the meaning given the term in the Master Glossary that is a part of the Accounting Standards Codification (ASC) of the Financial Accounting Standards Board. The term is defined in the ASC Master Glossary differently and more broadly than the term “related person” is defined in Item 404(a) of Regulation S-K, although the persons who are “related persons” are generally included in the term “related party.” Rule 1-02(u) of Regulation S-X defines the term “related party” by adopting the definition of the term contained in the ASC Master Glossary.

2. See Proposed Auditing Standard - Related Parties, Proposed Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions and Other Proposed Amendments to PCAOB Auditing Standards, PCAOB Release No. 2012-001 (Feb. 28, 2012) (Release).

3. Release at p. A4-43.

4. Id.

5. Steven B. Harris, PCAOB Board Member, Statement at PCAOB Open Board Meeting (Feb. 28, 2012), available at http://pcaobus.org/News/Speech/Pages/02282012_HarrisStandard.aspx (Harris Statement).

6. Steve Seelig, PCAOB Proposal Could Bring Added Auditor Involvement in Executive Compensation Decisions [Blog Post from Executive Pay Matters Blog] (Mar. 1, 2012), at http://www.towerswatson.com/blog/executive-pay-matters/6523.

7. Id.

8. Andrew Liazos, Will Auditors Influence How Executives are Paid?, CFO.com (Mar. 12, 2012), at             
http://www3.cfo.com/article/2012/3/compensation_liazos-executive-compensation-audit-pcaob-fas123r.

9. Id.

10. See Harris Statement.

11. Daniel L. Goelzer, PCAOB Board Member, Statement at PCAOB Open Board Meeting (Feb. 28, 2012), available at           
http://pcaobus.org/News/Speech/Pages/02282012_GoelzerStandard.aspx.

12. Release at p. A4-44.

13. See Dudley Murrey and Quentin Faust, PCAOB Considers Changes to Standards for Auditors’ Reports on Audited Financial Statements, published by A.S. Pratt in the November/December 2011 issue of the Financial Fraud Law Report; Copyright © 2011 THOMPSON MEDIA GROUP LLC.

14. Release at p. A4-44.