PCAOB approves new related-party auditing requirements

New PCAOB rules approved Tuesday are designed to strengthen auditors’ scrutiny of related-party transactions and significant unusual transactions.

Auditing Standard No. 18, Related Parties, requires the auditor to perform specific procedures to evaluate a company’s identification of, accounting for, and disclosure of the transactions and relationships between a company and its related parties.

“These procedures are designed to assist the auditor in identifying and following up on red flags that indicate potential risks of material misstatement,” PCAOB Associate Chief Auditor Brian Degano said during Tuesday’s board meeting.

Degano said the standard requires the auditor to:

• Perform specific procedures to obtain an understanding of a company’s relationships and transactions with its related parties.
• Perform specific procedures for related-party transactions that require disclosure in the financial statements or are determined to be of significant risk.
• Perform procedures if the auditor determines that a related-party relationship or transaction with a related party previously undisclosed to the auditor exists.
• Evaluate if a company has properly identified its related parties, and relationships and transactions with related parties
• Communicate to the audit committee the auditor’s evaluation of, identification of, accounting for, and disclosure of its relationships and transactions with its related parties.

In addition, Degano said, the standard requires the auditor to test the accuracy and completeness of the company’s identification of its related parties, and relationships and transactions with those parties. All the information gathered during the audit should be taken into account in this evaluation, he said.

New amendments also require specific audit procedures designed to improve the auditor’s identification and evaluation of significant unusual transactions, and to enhance the auditor’s understanding of the business purposes of those transactions.

A significant unusual transaction is defined as a transaction that is outside the normal course of business for the company or that otherwise appears to be unusual due to its timing, size, or nature.

According to PCAOB Assistant Chief Auditor Nicholas Grillo, the amendments require the auditor to:

• Perform procedures to identify significant unusual transactions.
• Perform procedures to obtain an understanding of the value of and evaluate the business purpose of significant unusual transactions.
• Consider specific factors when evaluating whether a company’s significant unusual transactions have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.

Additional amendments require the auditor, during the risk assessment process, to obtain an understanding of the company’s financial relationships and transactions with its executive officers. But the auditor is not required to make a determination about whether compensation for executive officers is reasonable, or to make recommendations regarding compensation.

PCAOB Chairman James Doty said the new rules will make audit procedures more effective and efficient and align with the board’s risk assessment requirements. “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 said during the board meeting.

As with all PCAOB standards, the rules must be approved by the SEC. If the standard is approved, the SEC also will determine whether the new requirements would apply to the audits of emerging growth companies.

The Center for Audit Quality (CAQ) believes the final standard should apply to the audits of emerging growth companies. “This will avoid bifurcation of the rules applied to financial statement audits performed in accordance with PCAOB standards, which could be confusing to investors and other stakeholders,” Cindy Fornelli, the CAQ’s executive director, said in a statement.

The CAQ, which is affiliated with the AICPA, supports the PCAOB’s strengthening of related-party auditing requirements, Fornelli said.

If approved by the SEC, the new standard and amendments would take effect for audits of financial statements for fiscal years beginning on or after Dec. 15, 2014, including reviews of interim financial information within those fiscal years.

The PCAOB plans to make the standard available on its website.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA senior editor.