Proposed Auditing Standard on Related Parties and Proposed Amendments on Significant Unusual Transactions

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.

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