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 Statement on Adoption of Auditing Standard on Related Parties and Amendments on Significant Unusual Transactions

DATE: June 10, 2014
SPEAKER: James R. Doty, Chairman
EVENT: PCAOB Open Board Meeting
LOCATION: Washington, DC

Thank you for that summary of the standard and amendments before us today. And thank you for your work to consider the comments we received as we developed the standard and sought public views.

The goal of this project is to improve the quality and consistency of the auditor's work to protect investors from the risk of being misled by poorly explained, or undisclosed, related party transactions and significant unusual transactions outside the normal course of business.

Related party transactions brought down Enron, and significant unusual transactions entered into just to dress up the books nearly destroyed Dynegy.

Related party transactions, and significant transactions that are outside the normal course of business, have been a contributing factor in numerous prominent financial reporting frauds over the decades.

Given this background, auditors ought to be highly focused on risks related to related party transactions, and many are. But our inspections have found that others miss opportunities to do so, by approaching existing requirements in a mechanistic way and failing to probe opaque or incomplete disclosures.

The new auditing standard and related amendments before the Board today will update and strengthen audit procedures in these critical areas to improve the quality and reliability of disclosures to investors. Reliable information undergirds market confidence and capital formation.

The new standard and amendments are based on our evaluation of ways to integrate the auditor's procedures related to related party and significant unusual transactions with the overall audit approach, thus making the auditor's procedures both more effective and more efficient.

The standard has benefitted from two exposures for public comments and suggestions about alternative approaches we could have taken to improve the quality and consistency of auditor performance.

The alternative we have chosen articulates the new standard in terms that align it with our overarching risk assessment standards. Some auditors already approach their procedures to audit related party and significant unusual transactions with a focus on risk. For others, the new standard should help them identify the right procedures to perform in order to examine transactions with a view toward what could go wrong, or even be improper.

Risk isn't just about doing more procedures in areas that matter, and less in areas that matter less. A risk-based approach mandates not wasting the audit or nullifying the usefulness of its procedures by performing them in a mechanistic, unthinking way.

This is important. Identifying and reacting appropriately to related party and significant unusual transactions does not involve sophisticated new software or complex new procedures. In most cases, related party and significant unusual transactions are evident from even the most basic audit procedures and even if management doesn't flag them.

What the new standard and amendments do, through their focus on risk, is to more clearly articulate the importance of approaching such transactions with skepticism.

The new standard also benefits from our staff guidance on using economic analysis in standard setting. That guidance directs the staff to describe the need for a new rule, develop a baseline for measuring the effects of the rule, consider reasonable alternatives to the rule, and analyze the economic impacts of the rule (and alternatives to the rule), including the benefits and costs.

The guidance was released publicly last month, but at my direction staff have been using the concepts and performing the analysis it describes for some time now.

To help the staff do so in this project, in May 2013, the PCAOB solicited public comment on the potential economic implications of the standard and amendments, including for audits of emerging growth companies.

The guidance on economic analysis reflects the PCAOB's commitment to the use of economic analysis in its rulemaking. Moreover, last year, the PCAOB formed a new Center for Economic Analysis to promote economic research relating to the role of the audit in capital formation and investor protection.

Both of these initiatives will help us explore and examine how markets use audits and how the auditor's work can help strengthen our markets. Initiatives such as the one before us today are an important step along this road.