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PCAOB Issues Staff Alert on Stock Option Grants

The PCAOB last week issued its first staff audit practice alert to advise auditors of the potential implications of the timing of stock options to the audits of financial statements and internal controls over financial reporting. The PCAOB's Office of Research and Analysis will issue alerts as warranted based on the identification of issues that may affect how auditors conduct their audits. Recent reports about practices relating to stock option grants, including the back-dating of grants, may result in contingencies that require the recognition of additional expense or disclosure in the financial statements, according to the alert.

When issuers grant options with exercise prices that are less than the market price of the underlying stock on the date of the grant, this condition must be properly accounted for and disclosed to avoid a material misstatement in the financial statements. The alert notes that academic research has brought to light the possibility that some issuers have purposely granted options immediately prior to the release of information that would favorably affect the share prices. This practice could create legal or reputational risks and raise concerns about the control environment, according to the alert.

Auditors should be alert to the risk that an issuer may not have properly accounted for stock option grants. Auditors should acquire sufficient information to enable them to assess the nature and the potential magnitude of the risk. The alert outlines the accounting standards that the auditors should consider when planning or performing their audits, including those relating to the accounting for discounted options, variable plans, contingencies and tax effects.

Auditors also must consider materiality. Even quantitatively small misstatements may be material if they relate to unlawful acts that could lead to a material contingent liability, the alert warns, so in all cases the auditors should evaluate the adequacy of related issuer disclosures. In addition, auditors who become aware that an illegal act may have occurred must comply with the applicable auditing standards and 1934 Act section 10A.

When assessing the nature and potential magnitude of risks associated with the granting of stock options, auditors should consider any current or ongoing investigations relating to the timing of option grants, the responses of members of management and the board of directors to inquiries about grants and the accounting for stock options, and any public information about the issuer's timing of grants.

Auditors also should consider the terms and conditions of plans or policies under which options are granted. They should look for patterns or conditions that may suggest higher levels of inherent risk such as high levels of option grants in relation to the shares outstanding, option-based compensation that constitutes a large component of an executive's pay, highly variable grant dates or patterns of significant stock price increases following option grants.

If an auditor's consent is requested for the inclusion of his or her report in a registration statement, the alert outlines the procedures the auditor should perform before issuing the consent. The auditor should inquire of responsible officials and employees and obtain written representations about whether events have occurred since the report was issued that may have a material effect on the financial statements or that should be disclosed to prevent the financial statements from being misleading. The auditor should consider obtaining representations specifically related to the granting and recording of option grants, according to the alert.

A predecessor auditor should obtain the written representation from the successor auditor about any subsequent events that may have a material effect on the financial statements or that would require disclosure in the notes to those financial statements before consenting to the inclusion of his or her report on prior period financial statements in a registration statement. If an auditor becomes aware of information relating to the financial statements on which the auditor previously reported that would have been investigated if it had come to the auditor's attention during the audit, he or she must take the actions described in AU section 561 regarding the subsequent discovery of facts existing at the date of the auditor's report.