Two days after the Securities and Exchange Commission issued executive-pay-disclosure rules mandating that corporations report on the backdating of stock-option grants, the Public Company Accounting Oversight Board issued guidance to auditors on the same subject.
In putting out Friday’s guidance, the PCAOB sounded the alarm for independent auditors to be on the lookout for backdating and other finagling related to the reporting of options-related costs in their clients’ financial statements. “Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock option grants and, as a result, may have materially misstated its financial statements or may have deficiencies in its [internal controls over financial reporting],” the PCAOB said in the nine-page guidance, the first in a series of audit-practice alerts.
Unlike the SEC’s executive-pay rules approved by the commission on Wednesday, which refrained from using the term backdating, the PCAOB alert trots out the term in the first sentence. In some cases, the board notes, actual backdating practices may be inconsistent with how they were first reported and disclosed.
Earlier this month, the SEC and the PCAOB discussed delivering a one-two regulatory punch aimed at curbing backdating violations. “A few weeks ago, the SEC made us aware that their upcoming executive-pay-package rules would include information regarding options, and asked that we delay our release in order to assure that our respective documents were not at odds in what they communicated,” says Michael Shokouhi, the PCAOB’s deputy director of public affairs.
The SEC’s director of public affairs, John Nester, says it was normal for the SEC and the PCAOB to check in with each other, especially since they were working on the same subject matter at the same time. The commission’s final rule and the accounting board’s alert “were nearing completion around the same time, and it made sense to release them at the same time,” he says.
In its alert, the PCAOB warns independent auditors that backdating has already resulted in restatements and could spawn illegalities that might require companies to recognize added expense in their financials. Auditors should assess backdating-related risks in their audits of both financials and internal-controls reports, the board says.
The PCAOB observed that company failures to account for options in which the exercise price is lower than the price of the underlying stock on the date of the option grant — so called in-the-money options — can produce errors in recording compensation costs. Those errors can, in turn, cause material misstatements on corporate financial statements.
Concerning in-the-money options, the board suggests that auditors keep a close watch on option-plan provisions that let companies choose exercise prices based on market prices on dates earlier than the grant date. They should also scrutinize option awards that allow option holders to get an exercise price that’s equal to or lower than the stock’s market price at the grant date or the price during a specified period of time after the grant date.
Executives can also improperly report backdating when they prepare or change option documentation to show a lower exercise price than the market price on the date the option was actually granted, according to the alert. Another potential problem area: treating a date as the grant date when all of the conditions necessary to issue a grant haven’t yet occurred.
The PCAOB also cautions auditors to be aware of the tax effects of in-the-money options on financial reporting. “The grant of discounted stock options may affect the issuer’s ability to deduct expenses related to these options for income tax purposes, thereby affecting the issuer’s cash flows and the accuracy of the related accounting for the tax effects of options,” according to the alert.
In taking stock of whether a backdating-related, expense-reporting error is material, auditors should be aware that quantity isn’t everything, according to the board. “Quantitatively small misstatements may be material when they relate to unlawful acts or to actions by an issuer that could lead to a material contingent liability,” the board opined.