I support today's issuance of the reproposed auditing standard on related parties and the amendments to existing PCAOB auditing standards regarding significant unusual transactions and financial relationships and transactions with executive officers.
As described in the release, these are critical areas that can pose risks of material misstatement of companies' financial statements due to fraud and error. Related party transactions have been contributing factors in numerous financial reporting frauds over the last few decades. Financial reporting fraud also has involved significant transactions that are outside the normal course of business or that are unusual due to their timing, size, or nature (significant unusual transactions). Finally, risks to financial reporting can result from a company's financial relationships and transactions with its executive officers.
The requirements in the reproposal should aid auditors in more effectively identifying, assessing, and responding to the risks in these three critical areas, as well as provide a framework that encourages auditors to fulfill the performance requirements in an efficient manner. They should sharpen the auditor's focus on areas that experience has shown present risk of harm to investors. Existing auditing standards covering these areas provide wide latitude for auditors that can often lead to inconsistent and, in some cases, dire results. The reproposed standard and amendments are intended to raise the minimum threshold of audit performance across audit firms. Improving audit performance in these areas could improve the probability of auditors uncovering events that could impact investors, such as misstatements due to fraud or errors arising from significant unusual transactions or transactions that are not at arm's length.
The reproposal would replace the PCAOB interim standard on related parties and make amendments to other existing PCAOB standards to update and strengthen auditor performance requirements that, in some areas, have been in place for more than 30 years.
With respect to related parties, the approach reflected in the reproposal would require auditors to identify and assess the risks of material misstatement, including by obtaining an understanding of the company's relationships and transactions with its related parties, and then evaluating whether the company has properly identified and disclosed its related parties and relationships and transactions with its related parties.
The reproposal also would provide specific guidance to auditors for conducting their evaluations while permitting them to apply complementary procedures in other audit areas that are scalable to the identified risks.
As for significant unusual transactions, the reproposal would require the auditor to perform specific procedures within the Board's risk assessment framework to identify and evaluate the business purpose of the company's significant unusual transactions. This approach would also complement the auditor's ability to perform effective procedures over related parties.
In addition, the reproposal would require auditors to perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers. These requirements would also complement the auditor's work in determining the risks of fraud and error arising from related parties, significant unusual transactions, and other areas. The reproposal also would amend certain other standards to conform all of these new requirements.
Finally, the reproposal would require auditors to communicate the results of their related party procedures to the company's audit committee, enhancing communications already required under the standards. This should promote the protection of investors and the public interest through stronger oversight of financial reporting.
The release also describes how the Board's approach has been informed by observations from the PCAOB's oversight activities, discussions with the Board's Standing Advisory Group (SAG), recommendations from various studies, and international developments. In short, there is considerable evidence that auditors in too many cases have overlooked the substance of relationships and transactions, and their true effect on financial reporting, for their form.
Today's release also explains why existing auditing standards should be enhanced to promote consistent audit quality and investor protection.
Additionally, the release contains a series of questions, organized by topic throughout, designed to solicit comment from interested parties on particular aspects of the reproposal.
While all of these questions are important, I call particular attention to two matters in the reproposal. First, I encourage interested parties to comment on the revisions reflected in the reproposal that the Board made in response to comments received on the proposal originally issued on Feb. 28, 2012. Specifically, as described in the release, changes to the original proposal were made in the following areas:
- Related parties. The reproposed standard would clarify the link between related party procedures and the Board's risk assessment standards; would include a new requirement for the auditor to evaluate whether the company has identified its related parties; and would allow additional auditor judgment in executing certain requirements.
- Significant Unusual Transactions. The reproposed amendments would enhance the linkage between the requirements of the reproposed related party standard and the reproposed requirements for significant unusual transactions.
- Financial Relationships and Transactions with Executive Officers. The reproposal would clarify that procedures regarding a company's financial relationships and transactions with its executive officers would be performed as part of the auditor's risk assessment process and would not require the auditor to make any determination regarding the appropriateness or reasonableness of a company's compensation arrangements with its executive officers or recommendations regarding such compensation arrangements.
Second, I encourage interested parties to comment on economic considerations related to the reproposed requirements, including their applicability to audits of emerging growth companies. The release contains two sets of questions on these matters.
I would like to thank the staff of the Office of the Chief Auditor for their excellent work on this project, particularly Greg Scates, Brian Degano, and Nick Grillo. In addition, I would like to acknowledge the valuable contributions of the Office of the General Counsel and the Office of Research and Analysis.