September 24, 2012

Study: Peer Group Benchmarking Falsely Used Because Talent Isn’t Transferable

A new study – entitled “Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution” – examines flawed peer group methodology, finding that CEO pay has become untethered from both broader organizational wage structure and from economic fundamentals due to the use of peer benchmarking. Funded by the IRRC Institute, Professors Charles Elson and Craig Ferrere of the University of Delaware wrote the study. Here’s a NY Times article about the study from yesterday – and here’s IRRC’s press release.

This new study makes it clear that peer grouping with minimal board discretion is a seriously flawed methodology even when the peer groups are fairly constructed. The authors note their study is the first to document that peer group benchmarking has accidentally become the de facto standard even though it never was designed to determine CEO compensation.

The fact that most CEOs aren’t transferable is something that we have been saying for a long time (eg. this blog). And we also have been warning compensation committees that if they rely heavily on peer groups – and don’t use alternative benchmarking techniques like internal pay equity instead – they can be in trouble in court since so many have warned that pay has skyrocketed over the past two decades due to peer group benchmarking. In other words, it arguably isn’t reasonable to rely on peer group surveys any more (here’s my latest rant on this topic). Will boards and their advisors finally wake up on this issue? They should before the lawsuits come – because then it will be too late…

COSO Issues Draft Update of Internal Controls Framework

Last week, the Committee of Sponsoring Organizations of the Treadway Commission (known as “COSO”) released an exposure draft of its Internal Control over External Financial Reporting (ICEFR): Compendium of Approaches and Examples for comment. This is a big deal as it’s a new look at 20 years worth of internal control guidelines. The final product is expected in early 2013…

Concerns Over PCAOB’s New Auditing Standard 16, Communications with Audit Committees

Good stuff from this blog by Davis Polk’s Richard Sandler and Elizabeth Weinstein:

As we discussed here, the PCAOB recently approved Auditing Standard No. 16, Communications with Audit Committees. While the bulk of the new standard concerns communications that the auditors are required to provide to the audit committee, one notable provision relates to inquiries required to be made of the audit committee by the independent auditor. Under the new standard, auditors are required to inquire whether the audit committee “is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations.” This expands the inquiries of the audit committee required by previous auditing standards, which required the auditor to inquire of the audit committee regarding the matters important to the identification and assessment of risks of material misstatement and fraud risks.

As at least one comment letter on the proposed standard noted, the new standard could jeopardize attorney-client and work product privileges. In its adopting release, the PCAOB acknowledged the criticisms of the comment letter regarding the risk of loss of privileges, but declined to exclude the language. The PCAOB stated that it did not remove the language because “limiting the scope of information that the audit committee might provide to the auditor could severely affect the auditor’s ability to conduct an effective audit…Due to the audit committee’s oversight responsibilities, it is appropriate for the auditor to ask the audit committee for information relevant to the audit, including matters related to violations or possible violations of laws or regulations.” The final standard did exclude language from an interim proposal which would have required the auditor to inquire of the audit committee about matters that “might be” relevant to the audit, somewhat narrowing the scope of inquiry. However, the risk of loss of privileges remains an issue. The PCAOB did not provide guidance to companies regarding mitigating such risk.

If approved by the SEC, Auditing Standard No. 16 will be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012.

– Broc Romanek