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From Securities Regulation Daily, June 10, 2014

PCAOB adopts new standard on related party transactions

By Jacquelyn Lumb

The PCAOB today adopted a new standard and related amendments to strengthen auditors’ procedures with respect to related party transactions, significant unusual transactions, and financial relationships and transactions with executive officers. PCAOB Chair James Doty noted that related party transactions led to the fall of Enron, and significant unusual transactions nearly destroyed Dynegy. These types of transactions have been a contributing factor in numerous financial reporting frauds over the past decades, according to Doty. The Board believes the new auditing standard and related amendments will enhance audit procedures in these critical areas and improve the quality and reliability of disclosures to investors.

In opening remarks at today’s open meeting, Doty noted that auditors should be highly focused on risks associated with related party transactions, but the Board’s inspections have identified instances where auditors have approached the existing requirements in a mechanistic way or have failed to further investigate inadequate disclosures.

Auditing Standard No. 18. Auditing Standard No. 18, which supersedes AU sec. 334, Related Parties, will require auditors to perform specific procedures to gain an understanding of a company’s relationships and transactions with its related parties, including the business purpose of the relationships and transactions. The procedures will be performed in conjunction with the auditor’s risk assessment procedures in Auditing Standard No. 12.

Auditors will be required to evaluate whether companies have properly identified their related party transactions by testing the accuracy and completeness of management’s representations against the information gathered during the audit. Further procedures must be performed if the auditor discovers a related party transaction that was not disclosed. Specific procedures also must be performed for related party transactions that are required to be disclosed in the financial statements or that are deemed to be a significant risk.

Amendments. The amendments revise AU sec. 316, Consideration of Fraud in a Financial Statement Audit, and other auditing standards, to require auditors to perform specific procedures to identify significant unusual transactions, to obtain an understanding of the business purpose of these transactions, and to consider additional factors in evaluating whether the transactions may involve fraudulent financial reporting or the intent to conceal a misappropriation of assets.

The amendments also will heighten auditors’ attention to incentives or pressures for companies to achieve a particular financial goal or operating result. Auditors will be required to perform procedures that enable them to understand financial relationships and transactions with executive officers, but will not be required to make a determination with respect to any compensation arrangements.

Effective date. The standard and amendments require SEC approval. If approved, they will become effective for audits of financial statements for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information.

The Board members were unanimous in their support of the new standard and amendments. Board member Steven Harris noted that not only has the inspection division continued to find audit quality problems in these areas, but these issues have also arisen in the Board’s disciplinary orders. The SEC has brought similar enforcement actions against audit firms.

Differences from IAASB/ASB standards. Harris highlighted a number of differences between the Board’s rules and the analogous standards of the International Auditing and Assurance Standard Board and the Auditing Standards Board. Unlike the IAASB’s and ASB’s standards, he noted that the Board will require auditors to focus on the business purpose of related party transactions and relationships. The Board also will require auditors to make inquiries of the audit committee or its chair about the committee’s understandings and concerns about these transactions. In addition, unlike the IAASB and the ASB, the Board will require auditors to gain an understanding of the compensation package of executive officers.

Board member Lewis Ferguson, in his written statement, noted that during the comment process, the Board heard that its proposed standard was not clear enough in stating that management is the initial source of the auditor’s information about these transactions. The final standard addresses that concern.

Impact on smaller firms. Board member Jay Hanson said it is his understanding that the largest audit firms already perform most of the procedures required in the new standard, so the benefits and associated costs likely will accrue largely to the audit clients and investors of small and medium-sized firms that do not consistently perform the optional procedures in the existing standard. This is an important improvement, he said, but not one that will have a significant impact on the audits of the largest companies.

The Board will seek the SEC’s approval to apply the new standard and amendments to emerging growth companies. Chief Auditor Martin Baumann noted that smaller companies and newer companies tend to have more related party transactions and therefore more risks, so it is appropriate to apply the standard to these companies. He added that commenters also supported the requirement to apply the standard to emerging growth companies.

Monitoring implementation. Board member Jeanette Franzel asked about plans for evaluating the implementation of the new standard and amendments. Baumann advised that the inspection division always focuses on new auditing standards to provide the Board with real-time experience. If the inspectors see problems with the implementation, the staff can issue a practice alert to provide further guidance. The Center for Economic Analysis also plans to do further assessments once the standard goes into effect.

MainStory: TopStory PCAOBNews AccountingAuditing

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