Non-arm's length transactions with company insiders, or with entities controlled by insiders, have a long and notorious history in the annals of fraudulent financial reporting. Similarly, for nearly a century, every accounting student has learned about the possibilities and perils of period-end window-dressing and other kinds of form-over-substance maneuvers intended to produce an accounting effect rather than to promote a business purpose. And, as the idea of pay-for-performance has become business orthodoxy during the last several decades, the risk that accounting measures may be manipulated to meet compensation-triggering targets has become painfully obvious.
Competent auditors are of course already well-aware of these risks, and competently performed audits already address them. The hunt for transactions and relationships with friendly parties, and for unusual transactions with material financial reporting consequences, is — or at least should be — a key part of any audit. Nevertheless, the Board's inspection findings, the SEC and PCAOB enforcement dockets, and the newspaper headlines all make clear that there is considerable room for improvement.
However, I do not think it is the case that undetected related party dealings, or financial statements that are misleading because they elevate form-over-substance, are principally the result of weak auditing standards. The root causes often lie in lack of professional skepticism, lack of proper training and technical competence, and lack of adequate time and audit effort. I do agree, however, that strengthening the standards in these areas is a necessary step on the road to reducing the incidence of misleading financial reporting and better protecting investors and increasing their confidence.
The proposals the Board is considering seek to move auditing down that road in several ways. For example —
- Auditors would be required to perform specific procedures to determine whether there are related parties that management has failed to identify. The proposal would explicitly recognize the risk that management may fail to disclose all related party transactions and would tell the auditor how to respond when that occurs. The underlying theme of the proposed standard is the need for heightened skepticism where related parties are involved.
- Similarly, auditors would be required to perform specific procedures to identify significant unusual transactions and to obtain an understanding of the business purpose — or lack thereof — once such transactions are identified. The proposal would also require the auditor to evaluate whether significant unusual transactions have been appropriately accounted for and adequately disclosed.
- Further, while Auditing Standard No. 12 already requires the auditor to consider the risks of material misstatement associated with a company's financial relationships with senior management, the proposal would be more focused. It would expressly require the auditor to obtain an understanding of relationships, including compensation, with "executive officers" and, in particular, to read executive officers' employment and compensation contracts.
The proposals would also sharpen the requirements around what the auditor must tell the audit committee about related party and significant unusual transactions and when the committee must be told. For example, the proposed standard would require that the auditor provide the audit committee with the auditor's assessment of the company's accounting and disclosure regarding transactions with related parties, prior to the issuance of the auditor's report. The proposal would also require the auditor to inform the audit committee if significant related party transactions that have not been appropriately authorized, or that appear to lack a business purpose, come to the auditor's attention.
In my view, these communications requirements are critical components of what the Board is seeking to accomplish. In many cases, the sorts of abuses these proposals address are evidence of both a financial reporting break-down and a corporate governance break-down. The board of directors needs to be promptly armed with information so that it can take appropriate action.
I support issuing these proposals for comment. Of course, to make sure that final standard setting in this area accomplishes its investor protection goals, it is important that commenters tell the Board what the practical effect would be on the way audits are conducted. Also, if commenters have other ideas about ways to strengthen auditing in these areas, I would encourage them to give the Board their suggestions.
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I want to thank the staff members who have worked on this proposal. I particularly want to acknowledge the efforts of Deputy Chief Auditor Greg Scates, Associate Chief Auditor Brian Degano, and Assistant Chief Auditor Nick Grillo. They have been ably supported with advice and input from OCA's Counsel, Karen Burgess, and by Associate General Counsel Bob Burns and Assistant General Counsel Nina Mojiri-Azad. Thanks to all of you for your hard work and commitment to this important project.