Fact Sheet: Auditing Standard on Related Parties and Amendments on Significant Unusual Transactions and a Company's Financial Relationships and Transactions with its Executive Officers

June 10, 2014

The Board adopted a new auditing standard and amendments to its auditing standards to strengthen auditor performance requirements in three critical areas that historically have represented increased risks of material misstatement in company financial statements: related party transactions, significant unusual transactions, and a company's financial relationships and transactions with its executive officers.

These areas have been contributing factors in numerous financial reporting frauds over the last several decades and have continued to be contributing factors in more recent cases. Additionally, the Board's inspection and enforcement activities indicate that there are continuing weaknesses in auditors' scrutiny in these areas.

The Board determined that its existing requirements in these critical areas do not contain sufficient required procedures and are not sufficiently risk-based, which can lead to inadequate auditor effort in the three critical areas. The auditor, serving as a gatekeeper in the financial reporting system, should be alert to the possibility that transactions in these areas pose increased risks of material misstatement, and thus require heightened scrutiny during the audit.

Subject to SEC approval, the standard and amendments will become effective 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.

The final rule will be available on the PCAOB website under Rulemaking Docket No. 038.

Relationships and Transactions with Related Parties

Auditing Standard No. 18, Related Parties, is intended to strengthen auditor performance requirements for identifying, assessing, and responding to the risks of material misstatement associated with a company's relationships and transactions with its related parties. Auditing Standard No. 18 supersedes the Board's interim auditing standard, AU sec. 334, Related Parties.

Among other things, Auditing Standard No. 18 requires the auditor to:

  • Perform specific procedures to obtain an understanding of the company's relationships and transactions with its related parties, including obtaining an understanding of the nature of the relationships and of the terms and business purposes (or the lack thereof) of transactions involving related parties. The new procedures are performed in conjunction with the auditor's risk assessment procedures in Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement.
  • Evaluate whether the company has properly identified its related parties and relationships and transactions with its related parties. In making that evaluation, the auditor performs procedures to test the accuracy and completeness of management's identification, taking into account information gathered during the audit. If the auditor identifies information that indicates that undisclosed relationships and transactions with a related party might exist, the auditor performs procedures necessary to determine whether undisclosed relationships or transactions with related parties in fact exist.
  • Perform specific procedures if the auditor determines that a related party or 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 in the financial statements or determined to be a significant risk.
  • Communicate to the audit committee the auditor's evaluation of the company's (a) identification of, (b) accounting for, and (c) disclosure of its relationships and transactions with related parties, and other related significant matters arising from the audit.

Significant Unusual Transactions

The amendments on significant unusual transactions revise AU sec. 316, Consideration of Fraud in a Financial Statement Audit, and other PCAOB auditing standards with the intent of strengthening the auditor's performance requirements for the identification and evaluation of these transactions.

Among other things, the amendments require the auditor to:

  • Perform specific procedures to identify significant unusual transactions.
  • Perform specific procedures to obtain an understanding of, and evaluate, the business purpose (or the lack thereof) of identified significant unusual transactions.
  • Consider additional factors in evaluating whether significant unusual transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.

Financial Relationships and Transactions with Executive Officers

The amendments on a company's financial relationships and transactions with its executive officers, such as executive officer compensation, recognize the key role that a company's executive officers may play in its accounting decisions or financial reporting.

The amendments are intended to heighten the auditor's attention to incentives or pressures for the company to achieve a particular financial position or operating result.

Among other things, the amendments:

  • Require the auditor, as part of the audit risk assessment process, to perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers.
  • Do not require the auditor to make any determination regarding the reasonableness of compensation arrangements or recommendations regarding compensation arrangements.

Background

  • The Board initially proposed the standard and amendments on February 28, 2012, and they were discussed at the Standing Advisory Group meeting on May 17, 2012.
  • The Board reproposed the standard and amendments on May 7, 2013, and they were discussed at the Standing Advisory Group meeting on May 15, 2013.
  • Commenters widely supported the Board's efforts to improve its auditing standards in the three critical areas. After considering the comments received on the reproposal, the Board adopted the standard and amendments substantially as reproposed.

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