June 2014

With its new audit standards and amendments aimed at specific transaction types, the Public Company Accounting Oversight Board (“PCAOB”) has targeted three critical areas in its ongoing efforts to combat financial reporting fraud. The new rules are intended to increase heighten auditor scrutiny regarding (i) related-party deals, (ii) significant unusual transactions, and (iii) financial relationships with executives.

The PCAOB notes that related party deals represent increased risks of material misstatement involving substance over form in that they may:

  • potentially provide more of an opportunity for management to act in its own interests, rather than in the interests of the company and its investors
  • involve difficult measurement and recognition issues that can lead to errors in financial statements
  • have been used to engage in fraudulent financial reporting and to conceal misappropriation of assets — types of misstatements that are relevant to the auditor’s consideration of fraud” and
  • include “counterparties that are willing to structure transactions to achieve desired accounting results….
    [with] more emphasis on the need for a particular accounting treatment than on the underlying economic substance of the transaction.

The new Auditing Standard No. 18, Related Parties, supersedes the original 1983 standard AU sec. 334, Related Parties. It requires that auditors obtain “an understanding of the terms and business purposes (or the lack thereof) of related-party transactions”. Among other things, the standard requires the auditor to:

  • Perform specific procedures to obtain an understanding of the company’s transactions with its related parties
  • Evaluate whether the company has properly identified its related parties and transactions with its related parties
  • Perform specific procedures if the auditor determines that a previously undisclosed related party transaction exists
  • Perform specific procedures regarding each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk
  • Communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its transactions with related parties, and other significant matters arising from the audit regarding the company’s related party transactions

With regard to significant unusual transactions, the PCAOB’s changes require identification and evaluation of (i) the business purpose and (ii) whether such transactions may serve an ulterior motive to conceal a company’s actual financial position, operating results or misappropriation of assets. The PCAOB especially cautions about such transactions which occur near a reporting period end. Auditors will specifically be required to perform the following basic procedures to identify red flags for material misstatement:

  • read the underlying documentation relating to significant unusual transactions 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;
  • determine whether the transaction has been authorized in accordance with the company’s established policies and procedures; and
  • evaluate the financial capability of the other parties to the transaction with respect to significant uncollected balances, guarantees, and other obligations.

The amendments concerning transactions with an entity’s executive officers focus on (i) the auditors’ understanding of such arrangements and (ii) how such dealings may create incentives to engage in fraudulent behaviors to meet financial targets. However, there is no obligation to address the overall reasonableness of executive compensation.

The new rules will need to be approved by the SEC, but are expected to become effective for audits of interim financials and financial statements involving fiscal years beginning on or after December 15, 2014. As previously described by the SEC, the auditor is “the only professional that a company must engage before making a public offering of securities and the only professional charged with the duty to act and report independently from management”. This increased scrutiny should improve the critical gatekeeping function played by auditors.

Fulcrum Inquiry performs forens