The Public Company Accounting Oversight Board, or PCAOB, has reproposed a new auditing standard, Related Parties, and certain other amendments to its standards.  Overall, the reproposal is directed at detecting material misstatements and fraud.  But the proposed standards also include audit procedures related to executive compensation, given the possible incentive compensation can have on to manipulate financial results or engage in fraud.

Required audit procedures include reading employment and compensation contracts with executive officers and reading proxy statements.  For some reason, I thought auditors already did this.  The term “executive officers” is defined the same as Rule 3b-7 under the Exchange Act. The proposal does not change the existing standard to obtain an understanding of compensation arrangements with “senior management,” a broader term than “executive officers.”

Some procedures the auditors “should consider” include (see pages A3-1 to A3-2):

• Inquiries of the compensation committee chair and any compensation consultant regarding the structure of executive officer compensation; and
• Obtaining an understanding of policies and procedures regarding the expense reimbursements of executive officers.

Influence on Executive Compensation.  The reproposal and comments on the original proposal are explained on pages A4-75 to A4-87.  Some commenters objected to the initial proposal on the grounds that auditors might influence the design of compensation programs or require the auditor to substantively judge the executive compensation programs. The PCAOB thinks it solved these problems by emphasizing that the purpose of the procedures is to further the auditor’s risk assessment of material misstatement rather than to determine the appropriateness of executive compensation.

Inquiries of Compensation Committee Chair and Consultants.  The PCAOB received mixed comments on suggesting the auditors make inquiries of the compensation committee chair and compensation consultants.  Not surprisingly, some said this would be intrusive.  The PCAOB responded by stating it is not required, the auditors only need consider it.  Once this suggestion appears on an audit checklist, we wonder how many auditors will be able to resist, given the threat of a PCAOB inspection.

Litigation.  Another commenter pointed out that auditor documentation could complicate any litigation or claims related to executive compensation disclosures.  The PCAOB seems to give this the short shrift by stating litigation is not a concern when preparing audit workpapers.  We can now see these workpapers on a standard discovery list by the strike-suit types, and can only hope that they are prepared with the same sensitivity as say loss contingency and tax accrual workpapers.

Determination of Executive Officers.  Some commenters recommended that the amendments clarify the role of the auditor  in determining who is an executive officer. The PCAOBs response is the amendments do not require the auditor to evaluate management’s identification of “executive officers” for SEC filing purposes and that the SEC definition is “objective.”  Objective perhaps, but fact intensive and specific, and who knows what happens if the auditors draw a different conclusion, including possible significant Section 16 issues.

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