Heads Up — PCAOB Adopts New Requirements for Auditing Related Parties, Significant Unusual Transactions, and Other Matters
Volume 21, Issue 16
On June 10, 2014, the PCAOB issued and approved AS 18, 1 a new auditing standard on related parties. AS 18 is part of a release 2 that also includes amendments to PCAOB auditing standards related to significant unusual transactions, executive compensation, and other matters (collectively referred to as the “new standard”). If approved by the SEC, the new standard would supersede PCAOB AU Sections 334 3 and 9334 4 (the “current standard”) and would amend certain other PCAOB auditing standards. It would be effective for audits of fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years.
The new standard is the result of modifications made by the PCAOB to a reproposed standard 5 (issued on May 7, 2013) on the basis of comment-letter feedback and a discussion at the May 15, 2013, Standing Advisory Group meeting.
Editor’s Note: The new standard is substantially the same as the reproposed standard; however, the Board clarified and refined certain sections. The most significant clarifying changes are described in Appendix 4 of the release.
In a statement about the PCAOB’s adoption of the new standard, James R. Doty, chairman of the PCAOB, noted that 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. . . . The new standard [is based on] ways to integrate the auditor’s procedures related to related party and significant unusual transactions with the overall audit approach [and aligns with the] risk assessment standards.”
Appendix 4 of the release contains detailed commentary about each aspect of the new standard, including (1) a discussion of its requirements, (2) a comparison with existing standards, (3) an overview of significant comments received and related Board responses, and (4) changes to the language in the reproposed standard.
This Heads Up gives an overview of the new standard. For a discussion of the reproposed standard and the original proposal, see Deloitte’s June 21, 2013, Heads Up and April 10, 2012, Heads Up, respectively.
The Board expects the new standard to strengthen auditor performance regarding three critical areas that historically have been associated with increased risks of material misstatement in financial statements: (1) relationships and transactions with related parties, (2) significant unusual transactions, and (3) financial relationships and transactions with executive officers. The release points out that related-party transactions “have been contributing factors in numerous financial reporting frauds over the last several decades” and notes that such frauds have sometimes involved “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” and “a company’s financial relationships and transactions with its executive officers.”
The release also explains that the PCAOB’s existing auditing requirements related to these areas needed to be updated “to address significant developments since their issuance.” Such developments include prominent corporate scandals and reports and studies supporting the need for improved requirements to better address issues related to fraudulent financial reporting. In addition, the release notes that other standard setters have undertaken projects to improve their own requirements related to these issues. For example, the International Auditing and Assurance Standards Board and the AICPA’s Auditing Standards Board updated their related-party auditing standards by issuing ISA 550 6 and AU-C Section 550 7 in 2008 and 2011, respectively.
The purpose of the new standard is to enhance audit quality by making audit procedures more effective. The release notes that the new standard establishes “basic required procedures that are supplemented by more in-depth procedures” that would be performed on the basis of the auditor’s judgment and would therefore allow the requirements to be scaled to the facts and circumstances of the audit.
The new standard carries forward much of the content from the reproposed standard. In certain circumstances, however, the Board made revisions to “clarify and refine various aspects” of the new standard. For example, the Board (1) included additional examples of others in the company to whom an auditor may direct inquiries about related parties and (2) refined the new standard to prominently emphasize that the auditor’s responsibility for the identification of related parties includes testing the accuracy and completeness of the company’s identification of its related parties and relationships and transactions with its related parties (taking into account information already gathered during the audit).
The new standard is discussed in greater detail below.
The appendix of this Heads Up lists audit procedures required under AS 18 for related parties as well as audit procedures for significant unusual transactions and company transactions with executive officers addressed by other PCAOB standards. It also identifies whether the audit procedures are new or expanded (relative to current procedures).
Editor’s Note: In addition to the items discussed below, the release includes certain conforming amendments to other PCAOB standards, including management representations, subsequent events, and interim financial information.
The new standard adds and expands requirements intended to help auditors achieve the objective of obtaining “sufficient appropriate audit evidence to determine whether related parties and relationships and transactions with related parties have been properly identified, accounted for, and disclosed in the financial statements.” Many of the requirements are carried over from the original proposal and reproposed standard, and some are consistent with those in the current standard.
Editor’s Note: Unlike the current standard, the new standard specifies the objective of the auditor’s work associated with a company’s related-party relationships and transactions.
The new standard uses a “framework neutral” approach regarding (1) the definition of related parties and (2) financial statement disclosure requirements (i.e., the release acknowledges that in preparing financial statements, issuers might use different financial reporting frameworks, such as U.S. GAAP or IFRSs). The new standard directs auditors to the SEC’s requirements for the company under audit for the accounting principles applicable to that company, including the definition of the term “related parties,” as well as the company’s financial statement disclosure requirements with respect to related parties. In this regard, the new standard does not differ from the reproposed standard. However, it differs from the current standard, which refers auditors only to U.S. GAAP.
The new standard retains certain of the current standard’s requirements related to procedures; however, it makes a number of key changes, including:
- Adding basic required procedures for auditors to respond to risks of material misstatements regarding a company’s relationships and transactions with its related parties, particularly those that require disclosure in their financial statements or have been determined to be a significant risk. The current standard includes suggested procedures for the auditor’s consideration and notes that not all procedures may be required in every audit.
- Adding specific procedures to help auditors understand the company’s process; specifically, to help them understand the terms and business purposes (or the lack thereof) of related-party transactions and make inquiries of others in the company in addition to management. The current standard provides limited guidance on this.
- Adding specific procedures for auditors to test the accuracy and completeness of the related parties and relationships and transactions with related parties identified by the company. The current standard does not include this.
- Aligning related-party procedures with the PCAOB’s risk assessment standards (issued in 2010) so that the new standard’s required procedures are performed in conjunction with the auditor’s overall risk assessment.
- Improving the auditor’s focus on accounting by evaluating the adequacy of the accounting and disclosures of related-party transactions. The current standard primarily focuses on the adequacy of the disclosures.
- Adding audit committee communications to obtain an understanding of related-party transactions as well as to communicate the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of related parties. The current standard does not describe communications to audit committees.
- Emphasizing a complementary audit approach in which auditors use information gathered throughout the audit when evaluating a company’s identification of related-party transactions.
Performing Risk Assessment Procedures to Obtain an Understanding of the Company’s Relationships and Transactions With Its Related Parties
The new standard requires the auditor to “perform procedures to obtain an understanding of the company’s relationships and transactions with its related parties that might reasonably be expected to affect the risks of material misstatement of the financial statements in conjunction with performing risk assessment procedures in accordance with [AS 12 8].” Such procedures should include:
- “Obtaining an understanding of the company’s process.”
- “Performing inquiries.”
- “Communicating with the audit engagement team and other auditors.”
Obtaining an Understanding of the Company’s Process
AS 18 requires the auditor, in conjunction with obtaining an understanding of internal control over financial reporting, to obtain an understanding of the controls that management has established to:
- “[I]dentify related parties and relationships and transactions with related parties.”
- “[A]uthorize and approve transactions with related parties.”
- “[A]ccount for and disclose relationships and transactions with related parties in the financial statements.”
Editor’s Note: These provisions differ from those in the current standard, which state that the auditor should obtain an understanding of management’s responsibilities when determining the work to be performed for possible related-party transactions. Further, the current standard requires the auditor to consider controls over management activities, whereas the new standard requires the auditor to understand the controls in place specifically for the items noted above, which means that auditors will need to perform procedures to evaluate the design of such controls and determine that they have been implemented. If auditors are performing integrated audits, they will also be required to test the operating effectiveness of such controls.
This provision is unchanged from the reproposed standard.
The new standard requires the auditor to make inquiries of management about related parties and about the company’s relationships and transactions with them, including the business purposes (or lack thereof) of such transactions and authorization in accordance with established policies and procedures. The new standard also requires the auditor to identify others in the company to whom similar inquiries should be directed.
Finally, the auditor is required to make inquiries of the audit committee or its chair about:
- “The audit committee’s understanding of the company’s relationships and transactions with related parties that are significant to the company.”
- “Whether any member of the audit committee has concerns regarding relationships or transactions with related parties, and, if so, the substance of those concerns.”
Editor’s Note: The new standard adds procedures the auditor is required to perform regarding inquiries of management and others. The current standard only describes audit procedures that the auditor should consider in determining the existence of related parties, including requesting from management the names of related parties and whether there were any transactions with these parties during the period under audit. In addition, the current standard does not specify any required communication with the audit committee.
In developing the new standard, the PCAOB modified the reproposed standard to clarify that auditor inquiries of management and others should address transactions with an entity’s related parties that were changed during the period, whereas the reproposed standard only addressed transactions that were initiated or terminated. The new standard also includes examples of other individuals in the company to whom it is appropriate for the auditor to direct such inquiries (e.g., internal auditors, in-house legal counsel, human resources director).
Communicating With the Audit Engagement Team and Other Auditors
The new standard states that auditors “should communicate to engagement team members relevant information about related parties, including the names of the related parties and the nature of the company’s relationships and transactions with those related parties.” In addition, for audits in which other auditors participate, such as group audits, the auditor ”should inquire of the other auditor regarding the other auditor’s knowledge of any related parties or relationships or transactions with related parties that were not included in the auditor’s communications.”
Editor’s Note: The new standard prescribes the procedures to be performed by the auditor, whereas the current standard describes various procedures that the auditor would consider performing when communicating with engagement team members and other auditors. The new standard’s required procedures are similar to the suggested procedures under the current standard.
In the new standard, the PCAOB modified the reproposed standard’s language to state that the required communication to engagement team members and other auditors “can be more effective when it occurs at an early stage of the audit.”
Identifying and Assessing Risks of Material Misstatement Associated With Related Parties and Related-Party Transactions
In a manner consistent with the PCAOB’s risk assessment standards, the new standard requires the auditor to identify and assess the risks of material misstatement associated with related parties and related-party transactions as the basis for planning and performing audit procedures to respond to such risks. The requirement directs the auditor to focus on . . .
For the full version of the Heads Up, see the attached PDF.
1 Auditing Standard No. 18, Related Parties.
2 PCAOB Release No. 2014-002, Auditing Standard No. 18 — Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards.
3 PCAOB AU Section 334, Related Parties.
4 PCAOB AU Section 9334, Related Parties: Auditing Interpretations of Section 334.
5 PCAOB Release No. 2013-004, Proposed Auditing Standard — Related Parties, Proposed Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Proposed Amendments to PCAOB Auditing Standards.
6 ISA 550, Related Parties.
7 AICPA AU-C Section 550, Related Parties.
8 Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement.