The Auditors and Options Backdating

Amidst the continuing calls for relaxation of the Sarbanes Oxley rules by the business community, come more instances of corporate executives, corporate counsels and now compensation consultants being investigated regarding improper backdating of stock option grants.

On both of these topics, the audit firms have been mostly silent. That’s because they are between a rock and a hard place.

First, the Sarbanes-Oxley rules relaxation requests place them in conflict with their clients (who don’t care for them much anymore anyway…), their desire to make more and more money from these clients (or at least to continue at the level they were before) and their new regulators, the PCAOB. Their relationship with the PCAOB is a double-edged sword because the audit firms play two roles – the watcher and the watched.

As the watcher, the role of the audit firms is to protect the shareholders and other stakeholders by providing a service to a paying client that is the same entity they are supposed to objectively scrutinize. It’s no wonder the relationship has become even more adversarial than it ever was. At least when the audit firms could provide consulting services to their audit clients, they could balance higher fees for their higher risk clients against the ability to solve the issues they identified and provide end-to-end, overall service to the client. That is, if something was wrong with a policy, procedure, system or strategy, the audit firm could step in and fix it and win the client’s money and gratitude either way. They used an expression at KPMG Consulting when it was still a part of KPMG, “share of the wallet.” The stated goal was to get the largest share of the client’s spend on professional services as was possible.

Sarbanes-Oxley has provided a giant revenue stream and large profits to the audit firms. Their generally risk averse nature, combined with the lack of competition for audits of public firms means that their interpretation of what was required to comply with Sarbanes-Oxley and protect all involved was in no position to be debated. Clients had very little choice and the lack of initial clarity in the rules for 404 provided an easy way for firms to put their own stamp on each case. They required more and more tests, more and more evidence and the strictest possible interpretation, except when it was not in their interest to do so.

When was it not in their best interest to do so? When the scrutiny could impact opinions of the quality of their prior audits. There have been some academic studies done in the attempt to determine if former Arthur Andersen clients had higher rates of material weaknesses and significant deficiencies than other firms. There have also been discussions regarding auditor changes and “opinion shopping.” Were changes really made, post Sarbanes, for competitive cost or an improved service rationale? Many of these studies were done in the early days after passage of Sarbanes-Oxley. It would be interesting to see a more recent set of data.

So while the relaxation of Sarbanes-Oxley rules would not be in their best interest from a revenue perspective, it would be in their best interest as a regulated industry and as the “watched.” More rules and stricter rules mean that the firms must spend a lot of money on the training and monitoring of quality (and the systems that monitor rules like independence and ethics) and the PCAOB must remain vigilant in reviewing the quality of the audits and the profession.

Inspections have increased in number, including spreading to international affiliates and the depth of scrutiny has also increased each year. The Big 4 firms have gone through at least two rounds of PCAOB inspections through report and response. They have all had a chance to see a report, prepare for another and respond to at least the first. The quality of the responses, the level of improvement seen by PCAOB in areas seen as weaknesses (which continue to be a very large number in all four of the firms) and the level of continuing compliance of the firms in areas such as independence and ethics will determine if the inspection process broadens further. Given that the PCAOB only recruits their inspectors from the ranks of former Big 4 partners and Big 4 trained technical professionals, this is either a good thing or another case of the insularity of the profession and the difficulty of having a sufficient regulatory framework as long as the audit business is a private enterprise.

In the case of the stock options backdating scandal, we have seen the probes widen and that the transgressions continued after the passage of Sarbanes-Oxley. Initially, the passage of the law was seen as a barrier to future illegal activity. However, to get around the new SOx requirements to file reports of option grants on a timelier basis with the SEC, companies just filed late. The rule had changed but there was no monitoring or enforcement of compliance with the rules, so the illegal activity continued.

Update: Professor Erik Lie, who was the academic who first studied the anomaly that uncovered the backdating issue has some great info on his webpage at the University of Iowa. It gives a good background on the issue to those who want more detailed information.

Where were the auditors when these activities occurred? They were either aware and looking the other way or unaware, if their review and testing did not include questioning decisions and processes around executive compensation. Recent articles mention the involvement of compensation consultants in these activities. It would not surprise me to find that audit firms’ compensation consulting arms or tax consulting arms were also involved but they have yet to be targeted. (I also expect to see Mercer, the preeminent compensation consultant to the Big 4, mentioned eventually, too.) It is also interesting to note that while the audit firms, both before and especially after Sarbanes Oxley was passed, neither highlighted nor called out these types of activities based on their audits, they are now making big money on the backdating issue anyway. Every Big 4 firm is actively involved as the hired gun of the law firms that are investigating these activities, albeit only for the companies they do not audit nor have any other independence conflict.