New PCAOB Auditing Standards

The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.

The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.

Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.

Transactions with Related Parties

The proposed auditing standard, Related Parties, would supersede the PCAOB’s interim standard AU sec. 334, Related Parties, and is intended to strengthen existing audit procedures for identifying, assessing and responding to the risks of material misstatement associated with a company’s related party transactions. [1] The most significant changes from existing standards would:

• Require the auditor to perform specific procedures to identify the company’s related parties, obtain an understanding of the nature of the relationships between the company and its related parties, and understand the terms and business purposes of the types of transactions involving related parties, including:
  • Obtaining an understanding of controls established by management to identify, authorize, account for and disclose related party transactions;
  • Making specified inquiries of management (and other individuals of the company likely to have additional information, such as personnel in a position to initiate, process or record transactions with related parties and those who supervise or monitor such personnel, internal auditors, in-house legal counsel, the chief compliance officer and human resources director) regarding related parties and transactions, as well as significant related party transactions that have not been authorized in accordance with the company’s policies and procedures or for which an exception was granted;
  • Making inquiries of the audit committee or its chair regarding the committee’s understanding of relationships and transactions with related parties that are significant to the company and any concerns regarding relationships or transactions with related parties;
  • Communicating with the engagement team and any other auditors regarding relevant information about related parties; and
  • Evaluating whether information that comes to the auditor’s attention during the audit indicates that related parties or transactions previously undisclosed to the auditor may exist.
• Require the auditor to perform specific procedures for each related party transaction (or type of related party transaction) that is either required to be disclosed in the financial statements or determined to be a significant risk, including:
  • Reading underlying documentation to determine whether the terms and business purpose of the transaction are consistent with explanations from inquiries and other audit evidence;
  • Determining whether the transaction has been authorized in accordance with the company’s established policies and procedures and whether any exceptions were granted; and
  • Evaluating the financial capability of the related parties with respect to any significant uncollected balances, guarantees and other obligations.
• Require the auditor to perform specific procedures if the auditor determines that related parties or transactions previously undisclosed to the auditor exist.
• Require that the auditor communicate to the audit committee, in a timely manner and prior to the issuance of the auditor’s report, the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, as well as other significant matters arising from the audit regarding the company’s relationships and transactions with related parties, including:
  • Identification of related parties or relationships or transactions that were previously undisclosed to the auditor;
  • Identification of significant related party transactions that have not been authorized in accordance with the company’s established policies and procedures or for which exceptions were granted;
  • Inclusion of a statement in the financial statements that a related party transaction was conducted on arm’s-length terms and the evidence obtained by the auditor to support such assertions; and
  • Identification of significant related party transactions that appear to the auditor to lack a business purpose.

The PCAOB intends for the proposed standard and the proposed amendments described below to work with and build on the foundational requirements of the PCAOB’s existing risk assessment standards, including the consideration of fraud in a financial statement audit.

Significant Unusual Transactions

The PCAOB is proposing to amend existing standards to strengthen the auditor’s evaluation of significant transactions that are outside the normal course of business for the company or that otherwise appear to be unusual due to their timing, size or nature (such transactions, “significant unusual transactions”). Among other things, the proposed amendments would:

• Require the auditor to perform additional specific procedures to identify significant unusual transactions, including:
  • Making specified inquiries of management, the audit committee or its chair, and internal audit personnel regarding significant unusual transactions; and
  • Obtaining an understanding of controls established by management to identify, authorize, account for and disclose significant unusual transactions.
• Require the auditor to design and perform procedures to obtain an understanding of the business purpose of each significant unusual transaction, including:
  • Reading underlying documentation to determine whether the terms and business purpose of the transaction are consistent with explanations from inquiries and other audit evidence;
  • Determining whether the transaction has been authorized in accordance with the company’s established policies and procedures; and
  • Evaluating the financial capability of the other parties with respect to any significant uncollected balances, guarantees and other obligations.
• Require the auditor to evaluate certain additional matters when determining whether the business purpose of a significant unusual transaction suggests that the transaction may have been entered into to engage in fraudulent reporting or conceal misappropriation of assets, including whether:
  • The form of the transaction is overly complex;
  • The transaction involves unconsolidated related parties, including variable interest entities;
  • The transaction (or series of related transactions) lacks commercial or economic substance;
  • The transaction is on arm’s-length terms;
  • The company’s accounting for the transaction enables the company to achieve certain financial targets; and
  • Management is placing more emphasis on the need for a particular accounting treatment than on the underlying economic substance of the transaction.

The PCAOB notes that if the proposed amendments regarding significant unusual transactions are adopted, the amendments would include any corresponding changes to the recently reproposed standard, Communications with Audit Committees, [2] that may be appropriate to match the communication requirements with the underlying procedures.

Executive Compensation and Other Financial Relationships with Executive Officers

Under existing Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatements, auditors are already required to obtain “an understanding of compensation arrangements with senior management, including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses” in order to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement. The proposed amendments to this Auditing Standard would expand the list of procedures that the auditor should undertake in order to gain this understanding. These additional procedures would include reading employment and compensation contracts, as well as proxy statements and other relevant company filings made with the SEC and other regulatory agencies that relate to the company’s financial relationships and transactions with its executive officers. [3] The proposed amendments would also require the auditor to consider making inquiries to the chair of the compensation committee (or its equivalent) and any compensation consultants engaged by either the compensation committee or the company regarding the structuring of the company’s compensation for executive officers. The auditor would also be required to consider obtaining an understanding of controls over the authorization and approval of executive officer expense reimbursements and their effect on the risk of material misstatement of the financial statements.

The PCAOB intends these proposed additional procedures to assist the auditor in identifying and assessing risks associated with a company’s financial relationships and transactions with its executive officers, including unrecognized compensation, illegal acts or other matters, such as self-dealing or other conflicts of interest.

Endnotes

[1] The term “related party” would continue to be defined by reference to applicable SEC accounting rules. For U.S. GAAP audits, Regulation S-X defines the term by reference to the FASB ASC Master Glossary, which essentially includes directors and executive officers and members of their immediate families, 10% equity holders and members of their immediate families, other control persons and affiliates of the issuer.
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[2] For additional information about the PCAOB’s reproposed standard, please refer to our March 1, 2012 memorandum to clients, “Audit Committees: PCAOB Reproposes Auditing Standard Related to Communications Between Auditors and Audit Committees”.
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[3] For purposes of the proposed amendments, “executive officer” would be defined based on the definition of executive officer in Rule 3b-7 under the Securities Exchange Act of 1934.
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