Related Parties to Face Enhanced Auditor Scrutiny
Issues with related parties played a prominent role in the scandals that surfaced more than a decade ago at Enron, Tyco International and Refco. Public outrage about these scandals led Congress to pass the Sarbanes-Oxley Act of 2002 and establish the Public Company Accounting Oversight Board (PCAOB). Similar problems have arisen in more recent financial reporting fraud cases, prompting the PCAOB to unanimously approve a tougher audit standard on related-party transactions and financial relationships.
Standard focuses on 3 critical areas
On June 10, the PCAOB released its final version of Auditing Standard No. 18 (AS 18), Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards. The guidance will require auditors to beef up their efforts in financial statement matters that pose increased risk of fraud, including these three critical areas:
- Related-party transactions, such as those involving directors, executives and their family members,
- Significant unusual transactions that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size or nature, and
- Other financial relationships with the company’s executive officers and directors.
Subjecting these transactions and financial relationships to enhanced auditor scrutiny may help avert corporate failures. The PCAOB also hopes that enhanced auditor scrutiny will lead to improvements in accounting transparency and disclosures, which will help investors to gauge financial performance and fraud risks more clearly. According to PCAOB Chairman James R. Doty, “The goal of this project is to improve the quality and consistency of the auditor’s work to protect investors from the risk of being misled by poorly explained, or undisclosed, related-party transactions and significant unusual transactions outside the normal course of business.”
Better understanding from start to finish
Ultimately, companies are responsible for the preparation of their financial statements, including the identification of related parties. However, auditors will be on the lookout for undisclosed related parties and unusual transactions under the new standard. Examples of information that may be gathered during the audit that could reveal undisclosed related parties include:
- Proxy statements,
- Disclosures contained on the company’s website,
- Confirmation responses, correspondence and invoices from the company’s attorneys,
- Tax filings,
- Life insurance policies purchased by the company,
- Contracts or other agreements, and
- Corporate organization charts.
Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold — also might signal that a company is engaged in unusual or undisclosed related-party transactions. AS 18 requires auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including its nature, terms and business purpose (or lack thereof). Tougher related-party audit procedures will be performed in conjunction with the auditor’s risk assessment procedures, which occur in the planning phase of an audit. In addition, the new standard expects auditors to communicate with the audit committee throughout the audit process regarding the auditor’s evaluation of the company’s identification of, accounting for and disclosure of its related-party relationships and transactions — not just at the end of the engagement.
Wide support could broaden scope
Audit firms, public companies and investors generally support the new related-party standard. In the interest of preserving the consistency of public company auditing standards, the board said the new standard should also be applied to emerging growth companies, a category of public companies with less than $1 billion in annual gross revenues that are exempt from many accounting and auditing standards until they’ve been publicly traded for at least five years. The tougher public company auditing standard might also have spillover effects for private company audits. PCAOB research shows that smaller companies and startups also tend to engage in numerous related-party transactions, such as rental and compensation arrangements. These arrangements increase the risks of fraud and legal violations, warranting increased attention for companies of all sizes.
Example highlights scope (and limits) of the enhanced standard
Executive compensation arrangements are an example of related-party transactions that will be subject to increased scrutiny under Auditing Standard No. 18 (AS 18). Executives can potentially influence financial reporting and may feel incentives or pressures to meet financial targets, leading to increased fraud risks. During the planning phase of audits, the enhanced guidance requires auditors to ask management about executive compensation arrangements, including performance-based bonuses and stock options. During fieldwork, auditors must test the accuracy and completeness of management’s reporting for and disclosures of these transactions. But AS 18 does not require auditors to make any recommendations or determinations regarding the reasonableness of compensation arrangements.
Before a PCAOB standard goes into effect, the SEC must approve it, which it’s expected to do. AS 18 is scheduled to be effective for public companies for fiscal years that start Dec. 15, 2014, or later, including quarterly financial statements reviews. Stay tuned for more information on whether the enhanced standard will apply to audits of emerging growth or private companies.