Wednesday, December 3, 2014

PCAOB Expands Purview of Accounting Profession to Review Compensation Arrangements

Unless you are in a field related to accounting or review of public companies, you may never have heard of the PCAOB, or more formally, the Public Company Accounting Oversight Board. It is actually a private-sector, non-profit company that was created by the Sarbanes-Oxley Act (SarbOx or SOx) in 2002. According to SOx, the PCAOB is to, among other things, oversee the audits of public companies. In part, to do so, the PCAOB creates a set of auditing standards that must be approved by the Securities and Exchange Commission (SEC).

Got that?

So, why am I writing about this? Earlier this year, the PCAOB issued Auditing Standard 18. In late October, the SEC approved it. And, so it is.

Auditing Standard 18 (AS18) is a lovely document. It's 223 pages of, and I can't think of a better word for it, stuff carrying the clearly far too brief title, "Related Parties and Amendments on Significant Unusual Transactions and a Company's Financial Relationships and Transactions with its Executive Officers."

Got that as well?

Among other things, AS18 asks that auditors, among other things:

  1. Read the employment and compensation contracts between the company and its executive officers
  2. Read the proxy statements and other relevant company filings with the SEC and other relevant regulatory agencies that relate to the company's financial relationships and transactions with its executive officers
  3. Obtain an understanding of compensation arrangements with senior management other than executive officers including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses
  4. Inquire of the Chair of the Compensation Committee as well as outside compensation consultants
  5. Obtain an understanding of expense reimbursement policies with respect to executive officers
All of this is to be done to identify risks of material misstatement.

I understand why all of this is being done. Early in this century, there were a number of corporate scandals resulting from apparently fraudulent misstatement of financials. Many of you remember Enron, WorldCom, and Tyco. This is intended to be one more step to lessen the likelihood of such abuses and to restore faith that corporate America, as a whole, are being good citizens.

We place lots of faith in auditors in this regard. Now, I have friends and acquaintances who are auditors. Some of them are very good and knowledgable. And, this is not intended to say that the rest (the complement of some of them) are not good, but in any profession, some practitioners will always be better than others.

Here, however, the PCAOB and the SEC are either assuming that auditors have sufficient expertise in compensation arrangements to handle this undertaking or that the firms of which they are a part have this expertise internally to which the auditors may refer. At the Big 4, this is probably the case. They have massive staffs and are able to engage specialists to handle such complex questions. How about the next tier of auditing firms? Do they have this expertise? I don't know, but I suspect the answer is sometimes. Let's take it down one more tier. Do those firms have that expertise? Again, I'm guessing, but I suspect that the answer is not very often. And, if we move to the smallest of the auditing firms, I would be inclined to move the needle to rarely, if at all.

Most auditors that I know are nice people. Most auditors that I know are pretty smart. Most auditors that I know are pretty honest. That said, most auditors that I know are being asked here to weigh in on matters in which they have no training and are frankly not likely to have it anytime soon.

What is the answer? I'm not sure. I'm not a fan of more regulation or more government control generally, but perhaps people who engage in review of compensation arrangements of public companies need some sort of licensure. Actuaries need it for many functions that we perform and we are also, as a group, pretty nice, smart, and honest.

I think that the PCAOB and SEC have used their unencumbered power to stretch too far. Perhaps, it's time to rein them in?

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