The Public Company Accounting Oversight Board (PCAOB) on Tuesday adopted a new auditing standard and amendments in three areas of the audit that could pose an increased risk of material misstatement in company financial reporting.
The new guidance focuses on related-party transactions, significant unusual transactions, and a company’s financial relationships and transactions with its executive officers – key contributing factors in a number of financial reporting frauds, such as Enron Corp., Tyco International Ltd., and Adelphi Communications Corp., PCAOB officials said.
The board had determined that its existing requirements in those three areas did not contain sufficient required procedures and were not sufficiently risk-based. In addition, the PCAOB’s inspection and enforcement activities indicated that there often were weaknesses in auditors' scrutiny in those areas.
"Auditors will now scrutinize more closely company transactions with close associates, shareholders, contractors, executive officers, board members, and their families because these related-party transactions have historically been tied to financial reporting fraud and abuse," PCAOB member Steven Harris said before the meeting.
The new auditing rule, Auditing Standard No. 18, Related Parties, requires specific audit procedures for the auditor’s evaluation of a company’s identification of, accounting for, and disclosure of transactions and relationships between a company and its related parties. The new standard would supersede the board’s interim auditing standard, AU sec. 334, Related Parties.
“Auditors ought to be highly focused on risks related to related-party transactions – and many are,” Chairman James Doty said prior to the meeting. “But our inspections have found that others miss opportunities to do so by approaching existing requirements in a mechanistic way and failing to probe opaque or incomplete disclosures.
“The new auditing standard and related amendments … will update and strengthen audit procedures in these critical areas to improve the quality and reliability of disclosures to investors,” he added. “Reliable information undergirds market confidence and capital formation.”
The amendments regarding significant unusual transactions include specific audit procedures that are designed to improve the auditor's identification and evaluation of such transactions, as well as to enhance the auditor's understanding of their business purposes.
According to the PCAOB, the amendments on a company's financial relationships and transactions with its executive officers, such as compensation, recognize the key role that a firm’s executives may play in its accounting decisions or financial reporting.
As part of the audit risk assessment process, the guidance requires the auditor to perform procedures to obtain an understanding of the company’s financial relationships and transactions with its executive officers. It does not require the auditor to make any determination or recommendations regarding the reasonableness of compensation arrangements.
Harris cited a 2010 academic study sponsored by the Committee of Sponsoring Organizations, which found that the desire to increase one’s compensation served as the most commonly cited motivation to falsify financial results in all US Securities and Exchange Commission (SEC) fraud enforcement actions from 1997 to 2007.
“The amendments we are adopting today would require auditors to focus on the potential opportunities and motivations for executive officers to exaggerate gains or minimize losses, and to consider any effect compensation incentives might have on the reliability of the financial statements,” Harris said before the meeting. “Without getting into the issue of the reasonableness of the compensation arrangements, auditors now will be required to obtain an understanding of the company's financial relationships and transactions with its executive officers. The amount and type of compensation paid to executive officers are matters best left to the compensation committees or boards of directors.”
The PCAOB initially proposed the standard and amendments on February 28, 2012, and reproposed them on May 7, 2013.
The new guidance will be effective, subject to SEC approval, for audits of financial statements for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years. The SEC will also determine if the new requirements would apply to audits of emerging growth companies.