By reproposing today a new auditing standard on related parties and amendments regarding significant and unusual transactions and a company's financial relationships and transactions with its executive officers, we are taking an important step to further the PCAOB's mission of investor protection. The relationships and transactions addressed by the standard and amendments we are proposing today present high risks of financial misstatement and have proven in the past to be vehicles for fraud.
Given their importance, it is not surprising that last year's proposal to enhance auditing requirements in these areas was well-received. Commenters generally supported the project and the proposed enhancements to existing standards. Nevertheless, some commenters offered suggestions for improvements, and we have considered these comments carefully. Although we have made a number of changes and clarifications, our overall approach has not changed:
- The standard on related parties 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. It does so by setting forth new, specific audit procedures that require the auditor to:
- Obtain an understanding of the company's related party relationships and transactions;
- Perform procedures for transactions that require disclosure in the financial statements or that are determined to be a significant risk;
- Evaluate whether the company has properly identified its related parties and transactions; and
- Communicate with the audit committee.
- Complementing this proposed standard are proposed amendments to strengthen the auditor's identification and evaluation of significant unusual transactions, along with amendments addressing related matters, such as transactions and relationships with executive officers.
- The amendments regarding significant unusual transactions would require the auditor to perform procedures to identify such transactions; obtain an understanding of, and evaluate, the business purpose of identified transactions; and evaluate whether the transactions may have been executed to engage in fraudulent financial reporting or conceal misappropriation of assets.
- The amendments regarding transactions and relationships with executive officers require the auditor to obtain an understanding of the company's financial relationships and transactions with its executive officers (including compensation) and establish new procedures to heighten the auditor's attention to incentives or pressures for the company to achieve a particular financial position or operating result.
In response to comments, however, today's reproposal does include several important changes, some of which I would like to highlight.
First, the re-proposed standard on related parties has been more integrated with the Board's existing risk assessment standards, including by clarifying that the risk assessment procedures performed to obtain an understanding of the company's with its related parties are performed in conjunction with the risk assessment procedures performed pursuant to Auditing Standard No. 12. This should facilitate a comprehensive and thorough risk assessment leading to appropriate audit procedures in an efficient manner.
Second, the re-proposed standard on related parties allows for more auditor judgment. Under the reproposed standard, the auditor would be able to exercise discretion in (1) making inquiries of certain individuals within the company regarding the company's related party relationships and transactions and (2) determining whether to treat a related party transaction previously undisclosed to the auditor by management as a significant risk. Additionally, consistent with the proposed standard, the re-proposed standard allows for auditor judgment — and facilitates a scalable application of the standard — by establishing certain required procedures for related party transactions that would be supplemented by more in-depth procedures, as needed, based on the auditor's evaluation of the company's facts and circumstances.
Third, the Board received several comments about the proposed requirement that auditors review the company's financial relationships and transactions with its executive officers, including some expressing concern that the auditor's actions might influence the design and appropriateness of company compensation arrangements with its executive officers. In practice, auditors already need to review such agreements for other purposes, such as the proper accounting for share-based payment and bonus arrangements. In response to the concerns expressed, the Board clarified that the procedures in the reproposed standard are part of the auditor's risk assessment process — focusing on a small group of executives who are in a position to influence the company's accounting and financial statements — and do not require the auditor to make any determination regarding the reasonableness of the company's compensation arrangements with its executive officers. Rather than evaluating or judging the nature and level of executive compensation, these procedures are designed to identify any incentives and pressures for executive officers to meet financial targets, which can result in risks of material misstatement of the financial statements.
Finally, I would like to say a few words about the economic analysis related to the reproposed standards and amendments. Although the Board has always considered potential costs in the process of issuing new standards, the Board began to work on expanding its analysis in early 2012, considering whether more could be done to understand the potential economic consequences — positive and negative — of the Board's standard setting activities. Subsequently, in April of last year, Congress passed the Jumpstart Our Business Startups Act of 2012 ("JOBS Act"), which states that any rules adopted by the Board subsequent to April 5, 2012, do not apply to the audits of emerging growth companies unless the SEC "determines that the application of such additional requirements is necessary or appropriate in the public interest, after considering the protection of investors, and whether the action will promote efficiency, competition, and capital formation."
The reproposed standard and amendments, if adopted, will be the first issued by the Board, since the enactment of the JOBS Act, that require auditors to perform new audit procedures. The economic analysis and JOBS Act discussions in the release therefore are an attempt at gathering and conveying information relevant to the evaluation by the Board of the potential effects of requiring such new audit procedures. We are eager to receive input both on the substance of the economic analysis questions we have posed, as well as on our still developing economic analysis process.
The related parties standard, in particular, may present challenges in connection with the JOBS Act analysis. As noted in the release, small companies — including emerging growth companies — may engage in related party transactions more frequently and therefore be exposed to incrementally higher audit costs as a result of the new requirements. At the same time, if there is an increased incidence of such transactions at emerging growth companies, the risks of material misstatement of the financial statements also may be incrementally higher, such that the new standard may provide greater investor protection benefits in the audits of such companies. Finding the right balance of burden and benefit will be a challenge, and I look forward to receiving thoughtful input on these difficult issues, and on the reproposed standard and amendments in general.
In closing, I will join my colleagues on the Board in thanking the staff in the Office of the Chief Auditor, including Marty Bauman, Greg Scates, Nick Grillo, Brian Degano and everyone else involved, as well as members of the Office of General Counsel and the Division of Registration and Inspections, all of whom contributed to this important project.