The Public Company Accounting Oversight Board (“PCAOB”) yesterday adopted new and amended auditing standards that expand audit procedures required to be performed with respect to three important areas: (1) related party transactions; (2) significant unusual transactions; and (3) a company’s financial relationships and transactions with its executive officers. The standards also expand the required communications that an auditor must make to the audit committee related to these three areas. They also amend the standard governing representations that the auditor is required to periodically obtain from management.
- Related party transactions. The new standard for related parties, Auditing Standard No. 18, supersedes AU sec. 334, Related Parties, which had not been substantively updated since it was issued in 1983. While AU sec. 334 included limited direction for obtaining an understanding of the company’s relationships and transactions with its related parties, the new standard requires the auditor to perform specific procedures to obtain an understanding of the nature of the relationships and of the terms and business purposes (or the lack thereof) of related party transactions identified by management. For example, the auditor should inquire of management and other company personnel regarding: (1) background information on the related parties; (2) the business purpose for entering into a transaction with a related party; and (3) if a transaction was not approved in accordance with the company’s established policies or procedures, the reasons for granting the exception. The auditor also must undertake additional procedures to evaluate whether the company has properly identified all of its related parties and transactions with such parties, and in cases where an undisclosed transaction is identified further steps are required. While the prior standard focused on the adequacy of disclosure of identified related party transactions, the PCAOB says the goal of the new standard is to focus the auditor not only on the disclosure aspects of related party transactions, but also the appropriate accounting for such transactions. In view of this expansion of procedures, companies should focus on ensuring that appropriate authorizations and approvals are in place and documented for related party transactions.
- Significant unusual transactions. The PCAOB amended AU sec. 316, Consideration of Fraud in a Financial Statement Audit, to require the auditor to perform specific procedures to identify and evaluate significant unusual transactions. It indicated that, particularly when such transactions are entered into on or around period ends, their purpose in some instances is to engage in fraudulent financial reporting rather than legitimate business purposes. The amended standard states that, for each significant unusual transaction the auditor has identified, the auditor should read the underlying documentation and evaluate whether the terms are consistent with the explanations of the transaction, and the auditor should determine whether the transaction has been authorized in accordance with the company’s established policies and procedures. The PCAOB stated that the goal of the new standard in this area is to focus the auditor on improving its performance in identifying and evaluating a company’s significant unusual transactions and enhancing the auditor’s understanding of the business purpose (or lack thereof) of such transactions.
- Financial relationships and transactions with executive officers. The PCAOB amended Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, to improve the audit procedures regarding the company’s financial relationships and transactions with its executive officers. Although existing Auditing Standard No. 12 already states that an auditor “should consider” performing procedures to “[o]btain[] an understanding of compensation arrangements with senior management,” the amended standard goes further and requires the auditor to perform procedures to obtain an understanding of the company’s financial relationships and transactions with its executive officers, including executive compensation. The new procedures are intended “to heighten the auditor’s attention to incentives or pressures for the company to achieve a particular financial position or operating result, recognizing the key role that a company’s executive officers may play in the company’s accounting decisions or in a company’s financial reporting.” To evaluate the potential financial statement risks associated with compensation arrangements, the amended standard requires the auditor to review, among other things, the employment and compensation arrangements with executive officers and the proxy statement and other relevant filings with the SEC and other regulatory agencies that relate to financial relationships with executive officers. The PCAOB made clear in the adopting release that the auditor is not expected to make any assessment as to whether the compensation arrangements are reasonable or to make recommendations regarding these arrangements.
Communications with Audit Committees. The new and amended standards also expand the litany of an auditor’s required communications with the company’s audit committee. For example, new Auditing Standard No. 18 states that “[t]he auditor should 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.” Among the amendments to the standards for significant unusual transactions is a requirement that the auditor communicate to the audit committee “the auditor’s understanding of the business purpose (or lack thereof) of significant unusual transactions.” In addition, we can expect that auditors will communicate with audit committees about the review of compensation arrangements. Companies will want to consider whether the compensation committee (or chair) also should be part of those discussions or how this information will be conveyed to compensation committees.
Management Representations. The standards also expand the list of required representations that must appear in management representation letters to include the following items: (1) management has made available to the auditor the names of all related parties and relationships and transactions with related parties; (2) there are no side agreements or other arrangements (either written or oral) undisclosed to the auditor; and (3) support for any assertion in the financial statements that transactions with related parties were conducted on terms equivalent to those prevailing in an arm’s-length transaction. Although management representation letters to the auditors sometimes include these or similar representations, it will now be more difficult for companies to press back against inclusion of such language in these letters.
Effective Date of the Standard. The new and amended standards, which were initially proposed on February 28, 2012 and were re-proposed with modifications on May 7, 2013, are available here and must be submitted to the SEC for approval. Subject to such approval, the standards will become effective for audits of financial statements for fiscal years beginning on or after December 15, 2014. Also, pursuant to Section 104 of the JOBS Act, if the SEC approves the standards, the SEC also will make a determination whether the standards will apply to audits of emerging growth companies. The PCAOB is recommending that the standards apply to such audits.