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Clawback compensation refers to the reclaimed payment from an employee or an executive. The clawback provisions find their place In the Sarbanes Oxley Act 2002 and the Dodd-Frank Act 2010.

As per Section 304 of the Sarbanes Oxley Act (SOX), the Securities and Exchange Commission (SEC) has the power to sue the CEO and CFO to recover the compensation based on incentives in the event of misstated financial reports.

Section 954 of the Dodd-Frank Act inserted Section 10D to the Exchange Act, which requires the SEC to adopt rules instructing the National Stock Exchanges to accept listing standards that require every listed company to adopt, enforce, and disclose a written clawback policy or be subject to delisting. The clawback provisions apply on a ‘no fault’ basis; hence, there is no need to establish an intention to cause error when there is an accounting restatement owing to material noncompliance.

While the Act intends to hold leaders and executives responsible for misstatements, several reports have suggested that financial statements are being revised and not restated post-implementation of these provisions.

Many audit firms have followed suit and introduced voluntary firm-initiated clawback provisions. The US member of one of the Big Four accounting firms has gone a step ahead and introduced the clawback provisions to include not only the auditors involved in an audit that is found faulty but also the firm’s leadership.

The intent of the audit firm is to demonstrate that audit quality will not be an afterthought; rather, it will be the nucleus of an audit engagement with accountability flowing from top to bottom. The strong message is that leadership will be held accountable for faulty audits. The audit firm has also subjected itself to public leadership certifications for its system of quality controls, maintaining transparency and accountability as its core values. While the larger audit firms have previously impacted engagement partner compensation through clawbacks as they are actively involved in the audits, including leadership is a step ahead.

Audit quality is a commitment of the profession to the public at large. The profession is responsible for holding the investors’ trust, the markets’ decisions, and the information that builds the markets. Accountability is a significant pathway to ensure adherence.

KNAV’s Viewpoint

The step taken by the US member of the Big Four audit firm is indeed commendable. It is a message to the stakeholders that errors or failures, whether innocent or not, will have consequences. It seems fair that if leadership is reaping the benefits of good audits, they must take the brunt of faulty audits.

However, many fine points will need to be addressed, like what constitutes faulty audits, whether all kinds of errors come under the purview of the clawback, what will be compensation that will be recouped, and so on.

The clawback provisions on executive compensation applicable to the listed companies have seen an effect, some good and some not. Clawback is a penalty in case of a default. Given the nature of penalties, there is always an attempt to find a workaround. Ensuring audit quality must be a commitment of every professional involved in an audit and adherence to quality must be a proactive approach rather than imposed.