I am pleased to support the standard and amendments before the Board today. The standard and amendments more clearly establish the auditor's obligations to understand and evaluate transactions with related parties and significant unusual transactions. The amendments also include requirements addressing a company's financial relationships and transactions with its executive officers.
Fraud and material misstatement of financial statements are often perpetrated through transactions involving related parties, including between executive officers and companies that employ them. Fraud and material misstatement of financial statements are also too often found in significant unusual transactions, such as those close to period end without clear economic substance. In arriving at an opinion on the financial statements overall, the auditor must evaluate the appropriateness of the accounting and disclosures for these transactions, as well as other transactions reflected in the financial statements. Where related parties are involved, the auditor must seek to understand who the related parties are, and why the issuer has entered into transactions with them.
Our inspections have revealed that, where related party or significant unusual transactions are involved, auditors need to adopt a particularly inquisitive and professionally skeptical mindset. The standard and amendments we are approving today help ensure that these expectations are understood, not just by the auditor but also by management and audit committees.
The standard appropriately provides that management — not the auditor — should be the initial source of the auditor's information identifying related parties, transactions entered into with them, and the business purpose for transacting with a related party rather than an unrelated party. This appropriately reflects management's responsibility for the financial statements and disclosures. Through the comment process, we heard that the proposed standard was not sufficiently clear that management should be the starting point for this information. We have corrected that in the final standard.
The standard does not stop with these inquiries, however. Appropriately, it makes clear that the auditor must critically evaluate the risk of material misstatement and respond to such risks. In these respects, I would like to highlight two areas in which the standard complements other PCAOB standards.
First, in issuing Auditing Standard No. 16, Communications with Audit Committees, the Board set out requirements that should improve this important category of the auditor's responsibility to communicate. The related party standard before us today complements AS 16 by requiring the auditor to communicate with the audit committee on various aspects of its audit of related party transactions. Among other things, this includes the identification of related parties; transactions with the related parties not authorized in accordance with the company's established policies, or which required an exception to those policies; and identification of significant related party transactions that appear to the auditor to lack a business purpose. Importantly, the standard requires that the auditor involve the audit committee if the auditor learns of a related party relationship or transaction that management did not disclose to the auditor. The standard aims to ensure common understanding between the auditor and the audit committee about the existence of related party relationships and transactions and any significant unusual transactions. Better information in these important areas will aid the audit committee as it evaluates the appropriateness of the issuer financial statements it oversees.
Second, the standard builds upon, and refers to, Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement. The standard, for example, requires the auditor, in conjunction with risk assessment procedures performed under AS 12, to understand the company's relationships and transactions with related parties that might affect the risk of material misstatement of the financial statements.
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The complexities of detecting and preventing fraud are well established. Better gatekeeper functions by the auditors with respect to significant unusual transactions and transactions with related parties, including executive officers, will not eliminate the risk of fraud, but today's standard and amendments are an important step toward improving the quality of scrutiny that auditors provide in this area.
For these reasons, I support the adoption of the standard and amendments. I would like to thank the PCAOB staff in our Office of the Chief Auditor — in particular, Greg Scates, Brian Degano, Nick Grillo, John Powers and Karen Burgess — as well as staff in the Office of the General Counsel and the Office of Research and Analysis for their assistance to OCA and the Board over the course of this project. We have also benefitted from the helpful comments and insights from the SEC's Office of the Chief Accountant.