PCAOB Addresses Related Party Transactions and Unusual Transactions

The Public Company Accounting Oversight Board (PCAOB) has adopted Auditing Standard No. 18, Related Parties (AS 18), addressing related party transactions, as well as related amendments addressing significant unusual transactions and transactions with executive officers.  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.

The changes are designed to strengthen auditor performance requirements in areas posing an increased risk of material misstatements in financial statements and contributing to prominent financial frauds.  In his statements in connection with the adoption, PCAOB member Lewis H. Ferguson noted that “our inspections have revealed that, where related party or significant unusual transactions are involved, auditors need to adopt a particularly inquisitive and professionally skeptical mindset.  [These] standards and amendments ... help ensure that these expectations are understood, not just by the auditor, but also by management and audit committees.”

Where existing standards provide only guidance and suggested procedures for evaluating related parties and related party transactions, AS 18 prescribes specific procedures that auditors will be required to perform.  AS 18 will require auditors to:

• Obtain an understanding of the company’s relationships and transactions with related parties, including understanding the nature of the relationships and the terms and business purposes (or lack thereof) of transactions;

• Evaluate whether the company has properly identified its related parties and relationships and transactions with related parties; 

• Perform specific procedures if the auditor determines that a relationship or transaction with a related party previously undisclosed to the auditor exists;

• Perform specific procedures regarding each related party transaction that is either required to be disclosed or determined to be a significant risk; and

• Communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties and other significant matters arising from the audit regarding the company’s relationships and transactions with related parties.

Additionally, during its risk assessment process, the auditor must inquire of the audit committee or its chair about the audit committee’s understanding of the company’s significant relationships and transactions with related parties, as well as whether any member of the audit committee has any concerns about relationships or transactions with related parties.  

Significant unusual transactions are generally those outside the normal course of business or otherwise unusual given the auditor’s understanding of the company and its environment.  Amendments adopted concurrently with AS 18 prescribe specific audit procedures intended to improve the auditor’s identification and evaluation of significant unusual transactions, and add factors for the auditor to consider in evaluating whether they may have been transacted to engage in fraudulent financial reporting or misappropriation of assets.  The PCAOB also adopted amendments prescribing procedures the auditor must perform to obtain an understanding of the company’s financial relationships and transactions with executive officers.  Though auditors will not be called upon to assess the appropriateness or reasonableness of executive compensation, it is notable that the auditorwill be required to conduct inquiries of the compensation committee chair and any compensation consultants regarding the structuring of executive officer compensation arrangements.

Though the new standard and amendments are applicable to auditors, not the companies they audit, and the PCAOB has indicated that the largest auditing firms already perform many of the newly required procedures, companies are still likely to find the enhanced and expanded requirements to have a noticeable impact on the conduct of their audits.  In particular, as a result of the increased focus on the auditor’s understanding of the business purpose underlying transactions, auditors may request more, and spend more time reviewing, underlying transaction documents.  They may also spend more time discussing these topics with management and board members.  Company management teams and audit engagement leaders should discuss the impact of these changes during the audit planning phase, as they will have to make arrangements to address the auditor’s expanded inquiry and communication requirements with respect to the compensation committee, compensation consultants and audit committee.  The increased attention to related party and significant transactions also identifies the importance of involving auditors early when entering these transactions.

This development also underscores the importance of maintaining appropriate related party transaction policies and complying with them.  Companies should consider revisiting their policies to determine if revisions are merited and to confirm they are following appropriate recordkeeping and other procedures. 

Auditor’s Reporting Model

The PCAOB has proposed two new auditing standards that would expand the content of audit reports.  Key among the changes would be a requirement to include a discussion of critical audit matters, as well as expand the auditor’s responsibility regarding information outside the financial statements.  In connection with the auditor reporting model proposal, the Center for Audit Quality (CAQ) has released a report of its key findings from a collaborative effort by members of the public company auditing profession to field test certain aspects of the auditor’s reporting model proposals.  The CAQ’s report identified certain implementation challenges and recommended that the PCAOB consider suggestions to mitigate them, such as including materiality as a factor to be considered in determining what constitutes a critical audit matter, and clarifying how an auditor would effectively communicate those factors that were most important to the determination that a matter was a critical audit matter.

The PCAOB’s Standard-Setting Agenda indicates that it is analyzing the comments received on the proposal and, during the second half of 2014, drafting a reproposal for the board’s consideration.  Given that the PCAOB intends to issue a reproposal, which will be subject to another round of public comment, it appears that the changes from the original proposal may be substantial.