Making new connections: compensation committees present a unique set of risks for internal auditors to consider

Internal Auditor, Feb, 2004 by James Roth, Donald Espersen

THE U.S. SARBANES-OXLEY ACT of 2002 is filled with onerous requirements, emerging interpretations, and perilous risks. The new regulations are forcing organizations to take a closer look at board and audit committee governance roles and responsibilities. As part of that scrutiny, compensation committees are undergoing change, as they play a vital role and have daunting responsibilities in the governance process.

Until now, many internal audit groups have lacked a good reason to connect with their compensation committees. Sarbanes-Oxley requirements and increasing governance risks have created an opportunity for internal auditors to offer their services to these groups.

ROLES AND RESPONSIBILITIES

Most publicly traded companies have a compensation committee, and the board of directors often delegates many of its human resources responsibilities to this group. Common activities of the compensation committee include developing and communicating the organization's compensation philosophy, approving compensation plans, reviewing the objectives and evaluating the performance of the chief executive officer, reviewing and approving incentive compensation actions, and preparing reports in proxy statements. Like all board members, these directors have a fiduciary responsibility to the company's shareholders.

Similar to the audit committee's reliance on internal auditing, the compensation committee relies heavily on the human resources function to assist them in carrying out their key governance responsibilities. Compensation and audit committees also share many of the same soft controls, including active members, member expertise and ongoing education, annual agendas and calendars, open discussions, and the quality of the internal liaison.

By asking compensation committee members the following questions, internal auditors can gauge their personal understanding of committee activities as well as the organization's level of "control risk."

* How aware are committee members of their fiduciary responsibilities, and can they demonstrate that they are "walking the talk?" Although the answer to the first part of the question is probably "acutely aware," committee members may not be able to produce the evidence needed to demonstrate that they are carrying out their responsibilities.

* How well are the compensation and audit committees coordinating activities ? These activities may include compensation philosophy, financial reporting risks, and employee opinion survey results regarding integrity and ethics.

* How comfortable is the overall committee with its ability to effectively carry out the responsibilities in its charter? The charter covers many complex activities, and the committee may need additional expertise or resources to carry out its role.

* How effective are the compensation committee's soft controls, such as open discussions, good questions, and productive member attitudes?

These questions deal with several sensitive areas and issues. When connecting with this--and any--client the discussions should be tactful and constructive.

RISKS FACING THE COMMITTEE

Compensation committees may be navigating through the "perfect storm." They play a very visible role in Sarbanes-Oxley, and many organizations are cutting back on pension/benefits programs. Thus, committees are juggling governance requirements, economic constraints, and employee morale and productivity issues that can require tough decisions. Internal auditors need to consider how they can help the committee navigate the storm.

The compensation committees' governance risks can be broken down into four categories:

* Strategic risks. The number one issue that many committees are dealing with is ensuring that their compensation philosophy and strategies are consistent with the organization's mission and goals. They are doing this under the vigilant eyes of external stakeholders and other interested parties. A conservative compensation philosophy could reduce Sarbanes-Oxley governance risks and increase other strategic risks (e.g., retention of key employees). The consequences of a business-as-usual compensation philosophy have been highlighted recently in several high-profile executive dismissals.

* Compliance risks. In addition to the Sarbanes-Oxley disclosure and proxy statement issues, the compensation committee needs to be aware of the organization's bylaws, codes of conduct, and compensation benefit plan agreements. Additionally, some whistleblowing or hotline calls may address compensation issues, and the committee may need to be part of the solution.

* Reporting risks. Much of the committee's success depends on the quality of the information it receives or the quality of the information that the human resources department uses to produce the analyses that it provides to the committee (e.g., incentive compensation information and salary surveys). Many human resources groups are not strong in financial analysis. This weakness can threaten the quality of the committee's decision-making information and ability to achieve its strategic and compliance objectives. To compensate for this weakness, many human resources groups have partnered with their organization's accounting or finance groups.