Others have blogged on this previously, but I want to be sure no one misses it. Last month, the SEC approved Auditing Standard No. 18, adopted by the PCAOB in June 2014. (I blogged on the proposed standard in May 2013: “PCAOB Re-Proposes New Auditing Standard Affecting Executive Compensation and Risk Assessments.”) The standards become effective for audits of financial statements for fiscal years beginning on or after December 15, 2014, e.g., January 1, 2015, for companies with calendar year fiscal years. (Therefore the full impact of this may not be felt until the beginning of 2016.)

Auditing Standard No. 18 focuses on three areas:

  • Related party transactions;
  • Significant unusual transactions and financial relationships; and
  • Transactions with executive officers (such as executive compensation and perks).

The new auditing standard requires the auditor to perform additional procedures to obtain an understanding of the company's relationships and transactions with related parties, including executives, to assist the auditor in identifying red flags that indicate potential risks of material misstatement. In the executive compensation area, for example, the auditors likely will want to review and analyze the company’s incentive compensation plans for executives to determine whether those plans create excessive pressure to achieve certain objectives that might unduly incentivize executive to “fudge” results.

Specifically, the new auditing standard requires the auditor to consider:

  • Obtaining 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;
  • 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; and
  • Obtaining an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements.

A company should alert its compensation committee chair that he or she should expect a call from the auditors under the new auditing standard.

Helpfully, the new auditing standard explicitly states that “these amendments do not require the auditor to make any determination regarding the reasonableness of compensation arrangements or recommendations regarding compensation arrangements.” As noted above, the new auditing standard is not likely to have an impact until near the end of 2015. However, at that time, auditors will have no choice but to review and become familiar with their clients’ executive compensation programs.