The standards we are proposing today "raise the bar" for what auditors are required to do in auditing related party transactions and other transactions deemed to be significant and unusual. Investors have been harmed in the past by frauds perpetuated in connection with related parties as well as surprised by the significance of related party transactions and significant unusual transactions not disclosed to them. These proposed standards are intended to address both problems.
Many years ago, as a young audit senior, I was responsible for detecting a fraud at a client. As it turned out, the fraud went to the highest level of the organization. The business was struggling to meet its cash needs and found "creative" ways to obtain more money from its asset based lender. The creative ways ultimately crossed the line. In reviewing the audit results, it became clear that too many things failed to add up. Several related parties had been identified and disclosed in the past, and as I dug deeper into these related parties, I encountered more questions than answers. The simple question, "where is this related party located?" was met with evasive answers. The answer to the question of how many employees the related party had — zero — was troubling and created serious doubt about whether the related party was actually providing any services. As I began to understand the flow of transactions, or, rather, the flow of funds, it became clear how the lender was being defrauded. Unfortunately, the business did not have an audit committee, and the CEO was deeply involved in the fraud. Ultimately, the CEO pled guilty to charges against him and died in prison.
This is but one example of many similar scenarios, some of which are not discovered until great harm has been done to investors. In some cases, related party transactions involve difficult measurement and recognition issues that pose a risk of material misstatement in the financial statements; in other cases, related party transactions have been used — as in the situation I encountered — to engage in fraud.
The auditing standard addressing related parties dates back almost 30 years to 1983, and the standard we are proposing today is the result of a fresh look at this important topic. It is intended to strengthen the existing audit procedures for identifying, assessing and responding to the risks of material misstatement associated with a company's related party transactions. Complementing this proposed standard are proposed amendments to strengthen the auditor's identification and evaluation of significant unusual transactions, along with a series of amendments to standards addressing related matters, such as transactions and relationships with executive officers.
The changes we are proposing today attempt to apply a comprehensive and common sense approach to the auditor's work to identify and understand related party transactions, significant and unusual transactions, and their respective implications.
The proposed related party standard requires auditors:
Similar to the proposed standard on related parties, the proposed amendments to AU sec. 316 are intended to focus auditors on the identification and evaluation of significant unusual transactions. Identifying such transactions — broadly defined in the proposed amendments as significant transactions outside the normal course of business or that otherwise appear to be unusual due to their timing, size or nature — may be difficult. However, it is a procedure that is vital to protecting the interests of investors. The proposed amendments would require auditors to inquire about such transactions with a variety of parties, to understand and consider the implications of the company's internal controls related to such transactions, and to review other information that comes to light during the performance of the audit that may evidence significant unusual transactions. The amendments also would require auditors to design and perform specific audit procedures intended to address the risks of material misstatement uniquely presented by significant unusual transactions and to facilitate a clearer understanding by auditors of the business purpose of such transactions.
As I noted earlier, the proposed standard, Related Parties, and the proposed amendments regarding significant unusual transactions also are intended to complement each other. For example, while Appendix A to the new related parties standard provides guidance to auditors on examples of information that could indicate the existence of transactions with related parties, it may also help auditors to identify significant unusual transactions. At the same time, the new procedures required in connection with the auditor's evaluation of significant unusual transactions may also help the auditor identify related parties or transactions with related parties that were previously undisclosed to the auditor.
I believe that the proposed standard and proposed amendments — through the increased focus on related party and significant unusual transactions, and the increase in audit procedures required in these areas — will increase investor confidence in the financial statements and serve the public interest. However, I am, as always, interested in the costs associated with the proposals, and whether there are any unintended consequences that we should consider before adopting final standards. In crafting the proposed standard and other amendments, we considered what burdens would be imposed on auditors and their clients. For example, in connection with the proposed requirements relating to the auditor's work to understand the company's financial relationships and transactions with its executive officers, we thought carefully about what procedures to require in order to obtain the maximum benefit without imposing unreasonable burdens, and I believe we have struck an appropriate balance.
Cost-benefit analysis has been a much discussed topic recently in the context of financial regulation. Many believe, and I agree, that it is difficult to monetize or otherwise quantify the benefits of such regulations. Nevertheless, we can explain the benefits and consider the costs of implementing our proposals. In that vein, I encourage commenters to provide us with your views on the benefits to investors of the amendments that we have proposed, as well as to let us know whether management or auditors anticipate significant cost increases as a result of the additional procedures. Are some firms already performing the proposed procedures, even if not currently required? If not, consider whether you can try to apply the proposed standard and provide us with feedback on your experiences. Are there other procedures that firms or audit committees have found effective in these areas? Do investors or audit committees believe that we have missed any steps that should be required? Do audit committee members believe that more should be done, or that additional items should be discussed by the auditor and the audit committee?
I look forward to receiving thoughtful comments on these questions and many others posed in the release. In the meantime, I would like to join my fellow Board members in thanking members of the Office of the Chief Auditor and of the Office of General Counsel for their hard work, particularly Greg Scates, Brian Degano, Nick Grillo, Karen Burgess, Bob Burns, and Nina Mojiri-Azad. As usual, their work is exemplary. I would also like to thank the staff of the SEC who took time to provide their views; we always benefit from their expertise and perspective.