by Cydney Posner
The PCAOB has adopted a new auditing standard and related amendments addressing related-party transactions, significant unusual transactions and transactions with executive officers. (See the standard and related fact sheet.) These transactions are considered to pose an increased risk of material misstatement in financial statements, having been a contributing factor in numerous prominent financial reporting frauds over many years. (Remember why SOX was enacted?) The new standard and amendments will be effective, subject to SEC approval, for audits of financial statements for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years.
In his statement at the meeting to consider adoption of these changes, PCAOB Chair Jim Doty noted that the new standard is articulated “in terms that align it with [the PCAOB’s] overarching risk assessment standards. Some auditors already approach their procedures to audit related party and significant unusual transactions with a focus on risk. For others, the new standard should help them identify the right procedures to perform in order to examine transactions with a view toward what could go wrong, or even be improper. Risk isn’t just about doing more procedures in areas that matter, and less in areas that matter less. A risk-based approach mandates not wasting the audit or nullifying the usefulness of its procedures by performing them in a mechanistic, unthinking way….What the new standard and amendments do, through their focus on risk, is to more clearly articulate the importance of approaching such transactions with skepticism.”
PCAOB member Lewis Ferguson commented that the PCAOB’s “inspections have revealed that, where related party or significant unusual transactions are involved, auditors need to adopt a particularly inquisitive and professionally skeptical mindset. The standard and amendments [the PCAOB is] approving today help ensure that these expectations are understood, not just by the auditor but also by management and audit committees.” Member Steven Harris cited studies suggesting that “executive officers with equity-based compensation packages have, in the past, influenced earnings to inflate the value of their compensation. These studies examined a variety of industries and explored situations involving the alteration of revenues, accruals and reserves. In addition, as noted in a May 2010 academic study sponsored by the Committee of Sponsoring Organizations, the desire to increase one’s compensation served as the most commonly cited motivation to falsify financial results in all SEC fraud enforcement actions from 1997 to 2007.”
Auditing Standard No. 18, Related Parties, prescribes specific audit procedures for the auditor’s evaluation of a company’s identification of, accounting for and disclosure of transactions and relationships between a company and its related parties, including obtaining an understanding of the nature of the relationships and of the terms and business purposes (or lack thereof) of transactions involving related parties. Under the new standard, management will be expected to be the initial source of the auditor’s information identifying related parties and transactions, as well as the business purpose for engaging in transactions with related, rather than unrelated, parties. Specific procedures are also required if the auditor identifies a previously undisclosed related-party relationship or transaction. Consistent with AS 16, Communications with Audit Committees, the results of the auditor’s evaluation will be communicated to the audit committee, including transactions with the related parties that were not authorized in accordance with, or that were required to be excepted from, company policies and transactions that appear to the auditor to lack a business purpose. If the auditor learns of a related-party relationship or transaction that management did not disclose to the auditor, the auditor must advise the audit committee. Apparently, the Big Four already perform many of these procedures.
The amendments regarding significant unusual transactions revise AU sec. 316, Consideration of Fraud in a Financial Statement Audit, and other PCAOB auditing standards. These amendments also require auditors to perform specific audit procedures that are designed to improve the auditor’s identification and evaluation of these unusual transactions (such as those close to period end without clear economic substance) and to enhance the auditor’s understanding of their business purposes (or lack thereof). This information is intended to help the auditor identify “substance-over-form” issues, particularly where transactions may have been entered into to obscure financial results. In evaluating whether significant unusual transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets, the auditor will need to take specified factors into account.
The amendments regarding transactions with executive officers are “intended to heighten the auditor’s attention to incentives or pressures for the company to achieve a particular financial position or operating result.” The amendments require the auditor to perform specific audit procedures during the risk assessment process to enhance the auditor’s understanding of a company’s financial relationships and transactions with its executive officers. However, auditors will not be required to assess the reasonableness of compensation arrangements or recommendations regarding compensation arrangements.