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 Proposed Auditing Standard on Related Parties and Proposed Amendments on Significant Unusual Transactions

DATE: Feb. 28, 2012
SPEAKER: Lewis H. Ferguson, Board Member
EVENT: PCAOB Open Board Meeting
LOCATION: Washington, DC

I support the release of the proposed standard dealing with related parties that would supersede AU 334, as well as the proposed amendments to AU 316, Consideration of Fraud in a Financial Statement Audit, to strengthen the auditor's evaluation of significant unusual transactions, and the amendments to PCAOB standards that would address the auditor's consideration of a company's financial relationships and transactions with its executive officers. Taken together, these new standards further elucidate and strengthen the Board's risk assessment standards set forth in Auditing Standards 8 through 15.

Related party transactions, significant and unusual transactions, and transactions between a company and its executive officers may or may not overlap, but together they encompass types of relationships and transactions that may be especially vulnerable to fraud or material misstatement of financial statements. Indeed, an examination of the major financial frauds and financial statement restatements in recent years, both in the U.S. and abroad, reveals that one or more of the relationships or types of transactions addressed by these proposals have been present in many of these cases. The PCAOB's own inspection results have shown that some auditors have not given adequate consideration to the risks of material misstatement from related party transactions. Our inspection results have also revealed deficiencies in some auditors' consideration and understanding of off-balance sheet structures which can also be a source of material misstatement.

These facts suggest two things to me: 1) that the types of relationships and transactions addressed by the Board's proposals deserve special scrutiny by auditors and 2) that audit committees should be informed in detail of the work performed by auditors in these areas so that they can fully understand their meaning and implications. These new standards should both clarify for auditors those areas that the Board believes require special attention and should insure that audit committees are better informed about them.

With respect to related parties, auditors should ascertain from management information about the identity, background, nature of the relationship, types of transactions and business reasons for the transactions as well as whether they were authorized in accordance with company policy. These rules are designed to give the auditor an understanding of the economic substance and business rationale for the transaction, an understanding that should make abuses easier to spot.

The amendments to AU 316 will require auditors to perform specific procedures to identify significant unusual transactions, to understand and evaluate the business purpose of such transactions and to evaluate whether they have been appropriately accounted for and adequately disclosed. Additionally, other amendments will require auditors to perform procedures to obtain an understanding of the company's financial relationships and transactions with its executives, to obtain representations from management that there are no other arrangements, whether oral or written, concerning such relationships and transactions that have not been disclosed. The amendments will also emphasize the auditor's existing responsibilities to communicate possible fraud to management, the audit committee and under certain circumstances the U.S. Securities and Exchange Commission.

Together, the proposed changes should provide clearer guidance about the types of investigative and analytic steps that auditors need to undertake in connection with types of relationships and transactions that experience has shown are particularly subject to abuse. If they operate as intended they may improve the analytical rigor with which auditors approach such matters and the understanding of audit committees of such transactions. If, as hoped, this is the case, investors will be the beneficiaries.

I want to acknowledge and express my appreciation for the dedicated of the Office of the Chief Auditor and the General Counsel on the proposals and specifically Greg Scates, Brian Degano, Nick Grillo, Bob Burns and Nina Mojiri-Azad. We look forward to receiving comments on these proposals.