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Heads Up — PCAOB reproposes new auditing requirements on related parties, significant unusual transactions, and other matters

Published on: Jun 21, 2013

Download PDFJune 21, 2013
Volume 20, Issue 18

by Carol Gottschall, Deloitte & Touche LLP; Brent A. Simer, Deloitte LLP; and Megan Zietsman, Deloitte & Touche LLP

On May 7, 2013, the PCAOB issued a reproposed auditing standard on related parties as part of a release1 that includes reproposed amendments to PCAOB standards related to significant unusual transactions, executive compensation, and other matters (collectively referred to as the “reproposed standard”). The reproposed standard would supersede PCAOB AU Sections 3342 and 93343 (the “current standard”) and would amend certain other PCAOB auditing standards. The reproposed standard would be effective for audits of fiscal years beginning on or after December 15, 2013, depending on PCAOB and SEC approval.

Editor’s Note: The actual effective date may change, depending on the time it takes for the PCAOB and SEC to complete their approval process.

The reproposed standard is the result of modifications the PCAOB made to a proposed standard4 (issued on February 28, 2012) on the basis of comment-letter feedback and a discussion at the May 17, 2012, Standing Advisory Group meeting. In a news release announcing the reproposed standard, Martin F. Baumann, chief auditor and director of professional standards at the PCAOB, noted that “[t]he Board’s goal with the initial proposal and this reproposal has been to develop an approach that promotes audit quality and investor protection, while at the same time taking into account economic considerations, including avoiding unnecessary costs and implementation issues.” Appendix 4 of the release contains detailed commentary about each aspect of the reproposed standard, including a discussion of its requirements, a comparison with existing standards, and an overview of significant comments received and related Board responses.

This Heads Up gives an overview of the reproposed standard. For a discussion of the original proposal, see Deloitte’s April 10, 2012, Heads Up.

Reproposed Standard: Themes and Considerations

The reproposed standard is expected to strengthen auditor performance in three critical areas: (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 prominent financial reporting frauds over the last few decades,” noting that such frauds have sometimes involved (1) “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 (2) “a company’s financial relationships and transactions with its executive officers.”

The PCAOB further observes that existing auditing requirements on these topics need to be updated and that other standard setters have undertaken projects to do so. 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 5505 and AU-C Section 5506 in 2008 and 2011, respectively.

The reproposed standard carries forward much of the content from the proposed standard. In certain circumstances, however, the Board made revisions to focus on the auditor’s 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. For example, the Board revised the proposed standard to highlight that an auditor’s risk assessment procedures, performed in accordance with Auditing Standard 12,7 include obtaining an understanding of a company’s relationships and transactions with its related parties. The reproposed standard would also establish requirements for the auditor’s evaluation of the company’s identification of related parties and its relationships and transactions with those parties.

The release indicates that the purpose of the reproposed standard is to enhance audit quality by making audit procedures more effective, noting that the reproposal establishes “basic required procedures that would be supplemented by more in-depth procedures” on the basis of the auditor’s judgment and would therefore allow the requirements to be scaled to the facts and circumstances of the engagement.

Economic Analysis: Considerations Related to Audits of Emerging Growth Companies and Audits of Brokers and Dealers

Economic analysis is now an important element of the Board’s rulemaking activities. The JOBS8 Act requires the SEC to perform a specific economic analysis when considering whether PCAOB rules, including auditing standards, should apply to audits of emerging growth companies (EGCs).9 (For more information, see Deloitte’s April 2, 2012 (updated May 8, 2012), Heads Up.) Accordingly, the release includes questions10 that request feedback on the economic considerations outlined therein.

The release states that the Board “is particularly interested in obtaining empirical data regarding both benefits and costs and other effects that may be related to the reproposed standard and amendments,” especially comments and data on whether:

  • Applying the reproposed standard to EGC audits would encourage efficiency, competition, and capital formation.
  • The reproposed standard would have unforeseen consequences.
  • Incremental costs would result from the reproposed standard.

Because the SEC may update its rules to make PCAOB standards applicable to audits of brokers and dealers, the Board is also seeking comments on issues related to such audits.

The reproposed standard and amendments are discussed in greater detail below.

Audit Procedures Associated With Related Parties and Related-Party Transactions

The reproposed standard establishes requirements for the auditor’s evaluation of a company’s identification of, accounting for, and disclosure of relationships and transactions between the company and its related parties. Many of these requirements are carried over from the original proposal, and some are consistent with those in the current standard. The reproposed standard includes new and more detailed requirements to help auditors achieve their objective in addressing related parties and relationships and transactions with related parties. The release states that this objective is to “obtain 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.”

Editor’s Note: The “Introduction” and “Objective” sections of the reproposed standard do not differ substantively from those in the proposed standard. In contrast, the current standard does not specify the objective of the auditor’s work associated with a company’s related-party relationships and transactions.

The introduction of the reproposed standard is “financial reporting framework neutral” with respect to (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 reproposed standard directs auditors to consult the SEC’s requirements for the company under audit to determine the accounting principles applicable to that company. In this respect, the reproposal does not differ from the proposed standard but does change the current standard, which refers only to U.S. GAAP.

Performing Risk Assessment Procedures to Obtain an Understanding of the Company’s Relationships and Transactions With Its Related Parties

The reproposed 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 [Auditing Standard 12].” The reproposal states that such procedures should include:

a. Obtaining an understanding of the company’s process;

b. Performing inquiries; and

c. Communicating with the audit engagement team and other auditors. [Paragraph references omitted]

 

Editor’s Note: The Board substantially revised this requirement from the proposed standard to clarify the auditor’s responsibility for understanding a company’s relationships and transactions with related parties. Instead of carrying forward the proposed standard’s requirement for the auditor to “perform procedures to identify the company’s related parties,” the reproposed standard focuses on the auditor’s responsibility for understanding the relationships and transactions with related parties the company has identified as a basis for the auditor’s identification and assessment of risks of material misstatement, thereby clarifying the interrelationship between the reproposed standard and the Board’s risk assessment standards. The reproposal requires the auditor to obtain its understanding “in conjunction with” procedures performed in accordance with Auditing Standard 12 and specifies various procedures to be performed. In contrast, the proposed standard only stipulated that the auditor should “take into account information obtained from the performance of risk assessment procedures.”

Obtaining an Understanding of the Company’s Process

Paragraph 4 of the reproposed standard contains the following requirement:

In conjunction with obtaining an understanding of internal control over financial reporting, the auditor should obtain an understanding of the company’s process for:

a. Identifying related parties and relationships and transactions with related parties;

b. Authorizing and approving transactions with related parties; and

c. Accounting for and disclosing relationships and transactions with related parties in the financial statements. [Footnote omitted]

 

Editor’s Note: This provision of the reproposed standard does not differ substantively from that in the proposed standard, although a footnote referencing relevant sections in Auditing Standard 12 has been added to emphasize that the auditor should comply with such requirements in conjunction with its risk assessment process.

Performing Inquiries

The reproposed standard carries forward provisions from the original proposal that would require the auditor to make inquiries of management about related parties and about the company’s relationships and transactions with them, including the business purpose (or lack thereof) of such transactions. The reproposed standard would also require the auditor to identify others in the company to whom similar inquiries should be directed.

Finally, the auditor would be required to make inquiries of the audit committee or its chairman about:

a. The audit committee’s understanding of the company’s relationships and transactions with related parties that are significant to the company; and

b. 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: These provisions of the reproposed standard do not differ substantively from those in the proposed standard. However, the reproposal includes a new footnote referring to the guidance in AU Section 33311 on management representations. The footnote states that “[o]btaining such representations from management complements the performance of procedures in paragraph 5 [‘Performing Inquiries’] and is not a substitution for those inquiries.” These new provisions build on the requirements in the current standard and include more details about (1) the nature of the required inquiries and (2) to whom to address the inquiries.

Identifying and Assessing Risks of Material Misstatement Associated With Related Parties and Related-Party Transactions

Like the original proposal and in a manner consistent with the PCAOB’s risk assessment standards, the reproposal 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 whether the company has properly identified, accounted for, and disclosed its related parties and its relationships and transactions with them. The release indicates that this provision “would highlight, among other things, that
the auditor’s assessment of risk includes a focus on risks related to the company’s less than complete identification of its related parties or relationships or transactions with related parties.”

Responding to the Risks of Material Misstatement Associated With Related Parties and Related-Party Transactions

Relationships and transactions with related parties can pose increased risks of material misstatement in company financial statements. Like the original proposal, the reproposed standard prescribes specific auditing procedures for related-party transactions that either (1) must be disclosed in the financial statements or (2) are determined to be a significant risk. These procedures include the following:

a. Read the underlying documentation and evaluate whether the terms and other information about the transaction are consistent with explanations from inquiries and other audit evidence about the business purpose (or the lack thereof) of the transaction;

b. Determine whether the transaction has been authorized and approved in accordance with the company’s established policies and procedures regarding the authorization and approval of transactions with related parties;

c. Determine whether any exceptions to the company’s established policies or procedures were granted;

d. Evaluate the financial capability of the related parties with respect to significant uncollected balances, loan commitments, supply arrangements, guarantees, and other obligations, if any; and

e. Perform other procedures as necessary to address the identified and assessed risks of material misstatement.

The reproposed standard also requires the auditor to “perform procedures on intercompany account balances as of concurrent dates, even if fiscal years of the respective companies differ.”

Editor’s Note: These provisions strengthen the requirements in existing standards and do not differ substantively from those in the original proposal.

Evaluating Whether the Company Has Properly Identified Its Related Parties and Relationships and Transactions With Related Parties

The reproposed standard requires the auditor to “evaluate whether the company has properly identified its related parties and relationships and transactions with related parties.” In doing so, “the auditor should take into account the information gathered during the audit.”

In addition, the reproposed standard indicates that the auditor’s evaluation “involves more than assessing the process used by the company” and that the auditor is also required “to perform procedures to test the accuracy and completeness of the related parties and relationships and transactions with related parties identified by the company.”

The reproposed standard carries forward the original proposal’s requirements for the procedures to be performed when the auditor determines the existence of a related party (or a relationship or transaction with a related party) that was not previously disclosed to the auditor.

Editor’s Note: These provisions of the reproposed standard substantially revise the original proposal to form a new section focusing on the auditor’s evaluation of the company’s identification of its related parties and on the relationships and transactions the company has with them. The PCAOB release emphasizes that the auditor may not merely rely on management’s representations about the accuracy and completeness of the related-party information the company provided to the auditor.

Appendix A of both the proposed standard and the reproposed standard gives examples of information and sources of information that could indicate the existence of related parties, or relationships or transactions with related parties, not previously disclosed to the auditor. The release indicates that the auditor would not be expected to perform procedures for each source of information referenced in Appendix A. However, the release further notes that the auditor would be expected to perform procedures to test the accuracy and completeness of the company’s identification of related parties and its relationships and transactions with them, adding that other auditing standards may require the auditor to perform procedures for particular sources listed in the reproposed standard.

Evaluating Financial Statement Accounting and Disclosures

Under the reproposed standard, the auditor would be required to evaluate the company’s accounting for and disclosure of relationships and transactions with related parties, including whether the financial statements contain the information necessary to achieve fair presentation in accordance with the applicable accounting framework. The auditor is specifically directed to determine whether the evidence contradicts any management assertion that transactions with related parties were conducted as arm’s-length transactions and to adjust the auditor’s report if sufficient appropriate evidence is not obtained or the evidence is contradictory.

Editor’s Note: The proposed standard and the reproposed standard broaden the scope of the auditor’s responsibility in the current standard to focus on evaluating the accounting for, and the disclosures about, relationships and transactions with related parties. This provision of the reproposed standard does not differ substantively from that in the proposed standard.

Communications With the Audit Committee

The reproposed standard would require the auditor to “communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties.” It further states that “[t]he auditor also should communicate other significant matters arising from the audit regarding the company’s relationships and transactions with related parties.”

Editor’s Note: Unlike the reproposed standard, the current standard does not include any specific requirement for the auditor to communicate matters concerning related parties and related-party transactions to the audit committee. However, the PCAOB indicates in its release that requiring the auditor to engage in meaningful dialogue with the audit committee will (1) benefit both the auditor and the audit committee by providing “information regarding significant risks of material misstatement in the financial statements and other matters that may affect the integrity of the company’s financial reports, including matters arising from a company’s relationships and transactions with related parties,” and in turn (2) strengthen financial reporting. This provision of the reproposed standard is substantially similar to that in the proposed standard; however, it adds a reference to Auditing Standard 1612 regarding the timing of the required communications.

Audit Procedures Related to Significant Unusual Transactions

The release notes that “[f]inancial reporting frauds have demonstrated that companies may use significant unusual transactions . . . to materially misstate their financial statements. Significant unusual transactions can also result in material misstatement of financial statements due to error. Improving the auditor’s identification of significant unusual transactions can promote audit quality.” The reproposed standard defines significant unusual transactions as “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.” The reproposed standard contains amendments that would conform the use of this term and definition throughout the Board’s standards.

In addition, the reproposed standard would strengthen existing PCAOB requirements related to the auditor’s identification and evaluation of significant unusual transactions by:

• Requir[ing] the auditor to perform procedures to identify significant unusual transactions;

• Requir[ing] the auditor to perform procedures to obtain an understanding of, and evaluate, the business purpose (or the lack thereof) of identified significant unusual transactions; and

• Add[ing] factors for the auditor to consider in evaluating whether significant unusual transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.

Moreover, the reproposed standard would require the auditor to evaluate the company’s accounting for, and disclosure of, significant unusual transactions in the financial statements, including whether the financial statements contain the information necessary to achieve fair presentation in accordance with the applicable financial reporting framework. This requirement is related to paragraph 31 of Auditing Standard 14,13 the existing requirement that addresses how the auditor should evaluate the presentation of the financial statements.

Editor’s Note: This provision of the reproposed standard does not differ substantively from that in the proposed standard, although certain notes and footnotes have been added to link the requirements to the reproposed amendments to Auditing Standard 12 and AU Section 316.14

Audit Procedures Related to Company Transactions With Executive Officers

The releases states that “[a] company’s financial relationships and transactions with its executive officers might create incentives and pressures that could create risks of material misstatement of the financial statements.” The PCAOB notes that executive officers are “a group that, because of their position in the company, can exert influence over the company’s accounting and financial statement presentation.” The reproposed amendments to Auditing Standard 12 would strengthen existing risk assessment procedures by requiring the auditor “to perform procedures to obtain an understanding of the company’s financial relationships and transactions with its executive officers (for example, executive compensation, including perquisites, and any other arrangements).” Such procedures would include:

• Reading the employment and compensation contracts between the company and its executive officers; and

• Reading proxy statements and other relevant company filings with the SEC and other regulatory agencies that relate to the company’s financial relationships and transactions with its executive officers.

In addition, the auditor would be required to consider:

• Inquir[ing] of the chair of the compensation committee, or the compensation committee’s 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; and

• Obtain[ing] an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements.

“Executive officers” are defined in the reproposed standard as follows:

[T]he president; any vice president of a company in charge of a principal business unit, division, or function (such as sales, administration or finance); any other officer who performs a policy-making function; or any other person who performs similar policy-making functions for a company. Executive officers of subsidiaries may be deemed executive officers of a company if they perform such policy-making functions for the company. (See Rule 3b-7 under the Exchange Act.) For brokers and dealers, the term “executive officer” includes a broker’s or dealer’s chief executive officer, chief financial officer, chief operations officer, chief legal officer, chief compliance officer, director, and individuals with similar status or functions. (See Schedule A of Form BD.15)

 

Editor’s Note: These provisions of the reproposed standard do not differ substantively from those in the proposed standard. The provisions’ purpose, as the Board explains in the release, is to “clarify that procedures regarding a company’s financial relationships and transactions with its executive officers would be performed as part of the auditor’s risk assessment process and would not require the auditor to make any determination regarding the appropriateness or reasonableness of a company’s compensation arrangements with its executive officers or recommendations regarding such compensation arrangements.”

The additional time an auditor may need to read and understand the employment and compensation contracts could prove significant, especially when there are many executive officers and the arrangements are complex. Further, the auditor may need assistance from individuals with the specialized skills and knowledge to understand the contracts and evaluate their impact on the auditor’s identification and assessment of risks of material misstatement, including fraud risks.

Opportunity for Public Comment

We encourage stakeholders to study the reproposal and submit comments to the PCAOB. Comments should be sent to the Office of the Secretary, PCAOB, 1666 K Street, N.W., Washington, D.C. 20006-2803. Comments also may be submitted by e-mail to comments@pcaobus.org or through the Board’s Web site at www.pcaobus.org. All comments should refer to PCAOB Rulemaking Docket Matter No. 038 in the subject or reference line and should be received by the Board no later than 5:00 p.m. (EDT) on July 8, 2013.

 

1 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.

2 PCAOB AU Section 334, Related Parties.

3 PCAOB AU Section 9334, Related Parties: Auditing Interpretations of Section 334.

4 PCAOB Release No. 2012-001, Proposed Auditing Standard — Related Parties, Proposed Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Proposed Amendments to PCAOB Auditing Standards.

5 ISA 550, Related Parties.

6 AICPA AU-C Section 550, Related Parties.

7 PCAOB Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement.

8 Jumpstart Our Business Startups.

9 As defined in Section 3(a)(80) of the Securities Exchange Act of 1934.

10 See pages A4-109–110 and A4-116–117 of the release.

11 PCAOB AU Section 333, Management Representations.

12 PCAOB Auditing Standard No. 16, Communications With Audit Committees.

13 PCAOB Auditing Standard No. 14, Evaluating Audit Results.

14 PCAOB AU Section 316, Consideration of Fraud in a Financial Statement Audit.

15 Form BD is the SEC’s “Uniform Application for Broker-Dealer Registration.” Schedule A of that Form is the source of this definition, in the context of a broker-dealer.

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