As part of its continuing effort to combat financial reporting fraud, the Public Company Accounting Oversight Board (PCAOB) recently issued Release No. 2014-002, which adopted Auditing Standard No. 18, Related Parties, and amended certain existing standards. The new standard and amendments are designed to strengthen auditor performance in three critical areas that present a heightened risk of material misstatements in a company’s financial statements: related party transactions, significant unusual transactions, and financial relationships or transactions with executives.
Related Party Transactions
To help external auditors do a better job of identifying, assessing and responding to material misstatement risks as they relate to related party transactions, the new standard requires auditors, among other things, to undertake the following steps:
- Perform specific procedures to obtain an understanding of the company’s relationships and transactions with its related parties, including the nature of these relationships and the terms and business purposes (or lack thereof) of any transactions.
- Evaluate whether the business has properly identified its related parties and related party transactions. This requires implementing procedures to test the accuracy and completeness of management’s identification, taking into account information gathered during the audit.
- Perform specific procedures if the auditor uncovers previously undisclosed related parties or related-party transactions.
- Perform specific procedures regarding each related-party transaction that is either 1) required to be disclosed in the financial statements or 2) determined to be a significant risk.
After completing these tasks, the auditor is required to communicate to the audit committee his or her evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, and other significant matters arising from the audit regarding these relationships and transactions.
Significant Unusual Transactions
The amendments require auditors to intensify their scrutiny of significant and unusual transactions, particularly when they occur near the end of a reporting period. These transactions are sometimes used to help obscure a company’s financial position or operating results. Auditors are now required to perform specific procedures to identify and evaluate significant unusual transactions. To spot potential red flags, auditors should:
- Read the underlying documentation and evaluate whether the transaction’s terms and other information are consistent with management explanations and other audit evidence regarding its business purpose,
- Determine whether the transaction has been authorized according to the company’s established policies and procedures, and
- Evaluate the other parties’ financial capabilities with respect to significant uncollected balances, guarantees and other obligations.
The amendments also expand the factors an auditor should consider in evaluating whether the business purpose (or lack thereof) indicates that a transaction may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.
Additional amendments are designed to focus the auditor’s attention on incentives or pressures for the company to achieve a particular financial position or operating result. The auditor should perform specific procedures to develop an understanding of the company’s compensation arrangements and other financial relationships or transactions with executives. The goal is to identify arrangements that may create incentives to engage in fraud to meet financial targets.
The amendments clarify that auditors aren’t expected to assess the appropriateness or reasonableness of executive compensation arrangements.
The new and amended standards take effect, subject to SEC approval, for audits of financial statements for fiscal years beginning on or after Dec. 15, 2014, including reviews of interim financial information within these fiscal years. Talk with your auditors about how these changes will affect the audit process, as additional procedures will no doubt have to be performed.