Mr. Chairman, the proposals before us enhance investor protection
and I support them. They address three audit areas that involve a
higher than normal risk of material misstatement and an increased
risk of fraud — namely, related party transactions, significant
unusual transactions, and executive officer compensation.
Today's proposals build on existing rules, but they go further.
They would compel the auditor to give greater thought to the
financial reporting risks inherent in conducting business with
subsidiaries, key shareholders or family members who may be tied to
the company. Similarly, they would require auditors to examine more
closely activities that appear to be outside the normal course of
the business of the issuer under audit, that appear overly complex
or that have a questionable nature, size or timing. As the Board's
release notes, the need to bolster auditor attention in these areas
is confirmed by the continued exposure of financial reporting frauds
involving transactions of this nature as well as by our own findings
of auditor shortcomings in both our inspections and our enforcement
programs.
You only have to look at some of our settled enforcement
activities to understand the basis for this rule. Fully one-quarter
of our settled disciplinary orders cite auditor failures with
respect to related party or significant unusual transactions.[1]
For example, in a recent Board order, the Board found that the
auditor failed to adequately examine an unusual transaction that
comprised 98 percent of the total assets of the issuer.[2] In another settled order, the Board
found that the auditor issued clean opinions on the financial
statements of an issuer for three consecutive years despite failing
to determine whether past-due receivables from related parties —
representing over 50 percent of the issuer's total assets — would
ever be collected.[3]
With respect to executive officer compensation, the proposal
would amend existing standards to require auditors to perform
procedures to obtain an understanding of the company's financial
relationships with its executive officers. As the release explains,
this would include an auditor's reading employment and compensation
contracts to obtain an understanding of compensation arrangements
including incentive compensation plans, changes or adjustments to
those plans, special bonuses, perquisites and other
compensation-related arrangements.
While it is clear that the vast majority of executive officers
operate with sound intentions and the highest integrity, some
studies suggest that executive officers with equity-based
compensation packages have, in the past, influenced earnings to
inflate the value of their compensation. These studies have examined
a variety of industries and explored situations involving the
alteration of revenues, accruals and reserves.[4]
In addition, a May 2010 academic study sponsored by the Committee
of Sponsoring Organizations (COSO) noted "that either the chief
executive officer or the chief financial officer were involved in 89
percent" of the SEC's fraudulent financial reporting cases from 1997
to 2008. [5] According to that study, among the
most commonly cited motivations for financial reporting fraud was
the desire to increase management compensation based on financial
results.[6]
Given that almost 90 percent of fraudulent financial reporting
cases appear to have involved top executives, 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. 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.[7] 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:
"[some] large investment banks, bank holding companies, and
insurance companies … experienced massive losses related to the
subprime mortgage market because of significant failures of
corporate governance, including risk management. Executive and
employee compensation systems at these institutions
disproportionately rewarded short-term risk taking."[8]
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. As the release accompanying the amendments we
are considering this morning suggests, these sorts of misplaced
incentives produced abuses that were at the core of many of the
problems that led to the enactment of the Sarbanes-Oxley Act.
As with all of our standards, these proposed auditing standards
are the result of the hard work of the PCAOB staff. In particular, I
would like to thank Greg Scates, Brian Degano, Nick Grillo and Karen
Burgess from Marty Bauman's Office of the Chief Auditor and Bob
Burns and Nina Mojiri-Azad from the General Counsel's Office.