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PCAOB's Standing Advisory Group Looks at Back-Dating of Stock Options

The PCAOB's Standing Advisory Group met on June 12-13 to consider possible amendments to Auditing Standard No. 2, including the role of company-level controls in audits of internal control over financial reporting and the auditor's involvement in management's assessment of internal control. Members also considered the emerging issue of the back-dating of stock options and whether the PCAOB should issue guidance to auditors on identifying the practice. The SAG members also heard from a panel of analysts involved in the Research Synthesis Program which is reviewing existing research to determine issues that may be relevant to PCAOB standard-setting, and from a panel of academicians on the implications of internal controls over financial reporting for auditing.

Two SAG members asked to discuss the back-dating of stock option grants during the emerging issues segment of their meeting to consider whether the PCAOB should respond to the practice with guidance. PCAOB Chief Auditor Thomas Ray noted that the back-dating of stock option grants presents both accounting and legal issues and raises questions about the auditor's responsibility. Sarbanes-Oxley Act section 403 changed the SEC reporting deadline for stock option grants from 45 days to two days. Ray questioned whether the earlier filing deadline resolved the problem.

Randy Fletchall, with Ernst & Young LLP, noted that the revelations about back-dating are in the very early stages so a lot of facts are not available. He said his firm is committed to finding out what went wrong and how to get to the bottom of it. The accounting issues with respect to stock option grants are pretty cut-and-dried, he said. Vincent Colman, with PricewaterhouseCoopers, agreed that the rules are not terribly difficult to follow. He believes the change in the Form 4 filing dates has had an effect and that many of the abuses that have been reported go back to the 1990s.

Damon Silvers with the AFL-CIO said that no one knows the full range of the abuses yet, but it seems to be growing. It is corrupting practice, he said, because it guts the performance-based qualities that the grants were supposed to provide. Silvers questioned where the gatekeepers were when the abuses were taking place, especially when the financial statements were affected by the abuse.

Lynn Turner, with Glass Lewis & Co., pointed to the number of late filings of Forms 4, which he believes is totally unacceptable. Auditors should take a look at that, he said. Turner added that management has complained about auditors getting too much into the "nitty-gritty," but this is an area in which they may not have wanted auditors to venture.

John Fogarty, with the Auditing Standards Board, pondered what kind of controls could be designed to address the whole range of people who engaged in the back-dating of stock option grants. Company-level controls would not come close to touching it, he said.

Craig Omtvedt with Fortune Brands said the issue is not "nitty-gritty." It is a pretty significant item, in his view, and one of the areas in which the auditors should be looking.

Rebecca McEnally with the CFA Institute said the news of the abuses was very discouraging. She is concerned that the cases that have been reported are not isolated and that other forms of abuse may also be lurking. Arnold Hanish with Eli Lilly said there must be accountability by boards of directors and their counsel. Going forward, he said the focus from an auditing standpoint should be on cases in which there was an impact on the financial statements. Hanish said it is important to look for a pattern in the history of stock option grants. He cautioned the PCAOB and the SEC, in looking at this issue, not to let it get out of control.

Turner agreed that there was some potential for a feeding frenzy and reported that some funds are going through their portfolios looking for abuses. He suggested that the SEC consider asking companies to self-report abuses to avoid the "Chinese torture, drip-drip-drip" as these cases come to light. He also believes it is time for the SEC to start cracking down on deficient late filings. The fact that companies continue to file late Forms 4, post-Enron, is outrageous, he said.

FASB's Ed Trott said that when he was an auditor he would not have considered option grant dates to be a high-risk area. The abuse was discovered when someone saw a pattern with a number of companies, he said. Now a previously low risk area has more risk than anticipated. Ray said the PCAOB would welcome views on what the auditors should look for in identifying abuses.

Turner reported that he has also seen abuses associated with FAS 123R in accounting for stock options. These abuses suggest that it is not a low risk area, he said. The SEC should be concerned about the quality of the implementation of 123R, he said. Turner said he has been troubled by what he has seen.