The Public Company Accounting Oversight Board (PCAOB) has finalized changes to its auditing standards that will require auditors to consider the need to review the compensation programs of executive officers to identify and assess the extent to which they create risks that company financials would be misstated. Subject to Securities and Exchange Commission (SEC) approval, the new auditing standard and amendments to certain others will take effect for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years.
According to the PCAOB, the final rules “do not require the auditor to make any determinations regarding the appropriateness or reasonableness of the company's compensation arrangements with its executive officers.” Notwithstanding this statement, questions remain as to how audit firms will implement this change and what procedures they will adopt for assessing whether pay programs give rise to a risk of material misstatement. We also have questions about what the next steps might be when an auditor makes such a determination.
It’s worth noting that the increased focus on executive compensation programs is part of a broader package of rule changes that call for auditors to focus on increased risks of material misstatement in company financial statements. The final rules have been modified from those originally proposed. (For more on the original proposal, see “PCAOB Proposal Could Bring Added Auditor Involvement in Executive Compensation Decisions,” Executive Pay Matters, March 2012.)
For example, the final rules soften the requirements from the original proposal in new Paragraph 10A of Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement:
“To assist in obtaining information for identifying and assessing risks of material misstatement of the financial statements associated with a company's financial relationships and transactions with its executive officers (e.g., executive compensation, including perquisites, and any other arrangements), the auditor should perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers. [Emphasis added]
The procedures should be designed to identify risks of material misstatement and should include, but not be limited to:
- reading the employment and compensation contracts between the company and its executive officers and
- reading the proxy statements and other relevant company filings with the Securities and Exchange Commission and other regulatory agencies that relate to the company's financial relationships and transactions with its executive officers.”
Further, the manner in which audit firms must accomplish this assessment may lead to increased auditor interaction with the company’s compensation committee and its compensation consultant. A new bullet in paragraph 11 of Auditing Standard No. 12 provides that, as part of obtaining an understanding of the company, the auditor should consider:
- “Inquiring of the chair of the compensation committee, or the compensation committee's equivalent, and any compensation consultants engaged by either the compensation committee or the company regarding the structuring of the company's compensation for executive officers.”
Simply because an auditor inquires about pay programs does not suggest a particular program creates the potential for a greater risk of misstatement, although it’s too soon to speculate whether or how often auditors will do so. We await the SEC’s approval of these amended audit standards to see how these issues play out.
Steve Seelig and Bill Kalten are senior regulatory advisors for executive compensation in Towers Watson’s Research and Innovation Center in Arlington, Virginia and White Plains, New York. Email firstname.lastname@example.org, email@example.com or firstname.lastname@example.org