US watchdog--auditors should review exec pay deals

Tue Feb 28, 2012 3:02pm EST

* Execs involved in 89 pct of reporting fraud

* Proposal would increase auditors' scrutiny of pay

* Related-party dealings might get closer look

By Dena Aubin

Feb 28 (Reuters) - Auditors of U.S. companies would have to look harder at executive pay and at accounting maneuvers used to dress up financial results under a revised standard proposed on Tuesday by the watchdog for the audit industry.

The proposal from the Public Company Accounting Oversight Board would require auditors to read compensation contracts and look for any incentives that might encourage executives to inflate earnings.

Many executives are paid in stock options that rise in value with a company's shares, a type of compensation that critics say encourages earnings management.

Senior executives were involved in 89 percent of financial reporting fraud cases brought by the U.S. Securities and Exchange Commission between 1997 and 2008, according to an academic study cited by PCAOB board member Steven Harris.

"Among the most commonly cited motivations for financial reporting fraud was the desire to increase management compensation based on financial results," Harris said at the group's meeting on Tuesday.

The proposal also calls for auditors to delve deeper into "significant unusual transactions" and companies' dealings with related parties such as key shareholders or family members.

The PCAOB is accepting public comments on the proposals until May 15.

The PCAOB has been warning auditors to pay more attention to unusual transactions since Lehman Brothers Holdings Inc was accused of using complex deals to move as much as $50 billion off its balance sheet at quarter ends. The maneuvers hid leverage at the investment bank before its 2008 bankruptcy.

In related-party abuses, executives in a company structure transactions to benefit themselves or relatives at the expense of shareholders. Buying materials or services from a company partly owned by an executive or his family is one type of such abuse.

Financial frauds at Enron, Tyco and Refco all involved related-party transactions.

Auditors should already be looking for related-party dealings, but the PCAOB's inspections and enforcement actions have shown there is considerable room for improvement, board member Dan Goelzer said.

The proposals would amend existing standards to strengthen auditors' duties in checking related-party and unusual transactions.

Under the proposed rules, auditors would also have to tell board audit committees when they find related-party dealings that were not properly disclosed or authorized.

"In many cases, the sorts of abuses these proposals address are evidence of both a financial reporting break-down and a corporate governance break-down," Goelzer said. "The board of directors needs to be promptly armed with information so that it can take appropriate action."

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