# Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules Relating to Auditing Standard No. 18, Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2014-17400 ## Record - **Collection:** Federal Register - **Document type:** Notice - **Published:** July 24, 2014 - **Citation:** 79 FR 43164 ## Text SECURITIES AND EXCHANGE COMMISSION [Release No. 34-72643; File No. PCAOB-2014-01] Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules Relating to Auditing Standard No. 18, Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards July 18, 2014. Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the “Act”), notice is hereby given that on July 10, 2014, the Public Company Accounting Oversight Board (the “Board” or the “PCAOB”) filed with the Securities and Exchange Commission (the “SEC” or the “Commission”) the proposed rules described in items I and II below, which items have been prepared by the Board. The Commission is publishing this notice to solicit comments on the proposed rules from interested persons. I. Board's Statement of the Terms of Substance of the Proposed Rules On June 10, 2014, the Board adopted Auditing Standard No. 18, Related Parties (“Auditing Standard No. 18” or the “standard”), amendments to certain PCAOB auditing standards regarding significant unusual transactions, and other amendments to PCAOB auditing standards (collectively referred to as, the “standard and amendments” or the “proposed rules”). The amendments to certain PCAOB auditing standards regarding significant unusual transactions (the “amendments regarding significant unusual transactions”) and other amendments to PCAOB auditing standards (the “other amendments”) are collectively referred to herein as the “amendments.” The text of the proposed rules is set out below. Auditing Standard No. 18 Related Parties Introduction 1. This standard establishes requirements regarding 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. 1 1 The auditor should look to the requirements of the U.S. Securities and Exchange Commission for the company under audit with respect to the accounting principles applicable to that company, including the definition of the term “related parties” and the financial statement disclosure requirements with respect to related parties. Objective 2. The objective of the auditor 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. 2 2 See, e.g., paragraphs 30-31 of Auditing Standard No. 14, Evaluating Audit Results. See also paragraph .04 of AU sec. 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Performing Risk Assessment Procedures to Obtain an Understanding of the Company's Relationships and Transactions With Its Related Parties 3. The auditor should 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 No. 12, Identifying and Assessing Risks of Material Misstatement. The procedures performed to obtain an understanding of the company's relationships and transactions with its related parties include: a. Obtaining an understanding of the company's process (paragraph 4); b. Performing inquiries (paragraphs 5-7); and c. Communicating with the audit engagement team and other auditors (paragraphs 8-9). Note: Obtaining an understanding of the company's relationships and transactions with its related parties includes obtaining an understanding of the nature of the relationships between the company and its related parties and of the terms and business purposes (or the lack thereof) of the transactions involving related parties. Note: Performing the risk assessment procedures described in paragraphs 4-9 of this standard in conjunction with the risk assessment procedures required by Auditing Standard No. 12 is intended to provide the auditor with a reasonable basis for identifying and assessing risks of material misstatement associated with related parties and relationships and transactions with related parties. Obtaining an Understanding of the Company's Process 4. In conjunction with obtaining an understanding of internal control over financial reporting, the auditor should obtain an understanding of the company's process for: 3 3 See, e.g., paragraph 18 of Auditing Standard No. 12, which requires the auditor to obtain a sufficient understanding of each component of internal control over financial reporting to (a) identify the types of potential misstatements, (b) assess the factors that affect the risks of material misstatement, and (c) design further audit procedures. See also paragraph 20 of Auditing Standard No. 12, which states that obtaining an understanding of internal control includes evaluating the design of controls that are relevant to the audit and determining whether the controls have been implemented. 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. Performing Inquiries 5. The auditor should inquire of management regarding: 4 4 See also AU sec. 333, Management Representations. Obtaining such representations from management complements the performance of procedures in paragraph 5 and is not a substitution for those inquiries. a. The names of the company's related parties during the period under audit, including changes from the prior period; b. Background information concerning the related parties (for example, physical location, industry, size, and extent of operations); c. The nature of any relationships, including ownership structure, between the company and its related parties; d. The transactions entered into, modified, or terminated, with its related parties during the period under audit and the terms and business purposes (or the lack thereof) of such transactions; e. The business purpose for entering into a transaction with a related party versus an unrelated party; f. Any related party transactions that have not been authorized and approved in accordance with the company's established policies or procedures regarding the authorization and approval of transactions with related parties; and g. Any related party transactions for which exceptions to the company's established policies or procedures were granted and the reasons for granting those exceptions. 6. The auditor should inquire of others within the company regarding their knowledge of the matters in paragraph 5 of this standard. The auditor should identify others within the company 5 to whom inquiries should be directed, and determine the extent of such inquires, by considering whether such individuals are likely to have knowledge regarding: 5 Examples of “others” within the company who may have such knowledge include: personnel in a position to initiate, process, or record transactions with related parties and those who supervise or monitor such personnel; internal auditors; in-house legal counsel; the chief compliance/ethics officer or person in equivalent position; and the human resources director or person in equivalent position. a. The company's related parties or relationships or transactions with related parties; b. The company's controls over relationships or transactions with related parties; and c. The existence of related parties or relationships or transactions with related parties previously undisclosed to the auditor. 6 6 For purposes of this standard, the phrase “related parties or relationships or transactions with related parties previously undisclosed to the auditor” includes, to the extent not disclosed to the auditor by management: (1) related parties; (2) relationships or transactions with known related parties; and (3) relationships or transactions with previously unknown related parties. 7. The auditor should inquire of the audit committee, 7 or its chair, regarding: 7 The term “audit committee” has the same meaning as the term used in Auditing Standard No. 16, Communications with Audit Committees. 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. Communicating With the Audit Engagement Team and Other Auditors 8. The auditor should communicate to engagement team members relevant information about related parties, including the names of the related parties and the nature of the company's relationships and transactions with those related parties. 8 8 This communication, which can be more effective when it occurs at an early stage of the audit, complements the discussion among engagement team members regarding risks of material misstatement in accordance with paragraph 49 of Auditing Standard No. 12. See also paragraph 5 of Auditing Standard No. 10, Supervision of the Audit Engagement, which establishes requirements regarding supervision of the engagement team members, including directing engagement team members to bring significant accounting and auditing issues arising during the audit to the attention of the engagement partner or other engagement team members performing supervisory activities. 9. If the auditor is using the work of another auditor, the auditor should communicate to the other auditor relevant information about related parties, including the names of the company's related parties and the nature of the company's relationships and transactions with those related parties. 9 The auditor also should inquire of the other auditor regarding the other auditor's knowledge of any related parties or relationships or transactions with related parties that were not included in the auditor's communications. 9 See AU sec. 543, Part of Audit Performed by Other Independent Auditors, which describes the auditor's responsibilities regarding using the work and reports of other independent auditors who audit the financial statements of one or more subsidiaries, divisions, branches, components, or investments included in the financial statements. Identifying and Assessing Risks of Material Misstatement 10. The auditor should identify and assess the risks of material misstatement at the financial statement level and the assertion level. 10 This includes identifying and assessing the risks of material misstatement associated with related parties and relationships and transactions with related parties, including whether the company has properly identified, accounted for, and disclosed its related parties and relationships and transactions with related parties. 10 See paragraph 59 of Auditing Standard No. 12. Note: In identifying and assessing the risks of material misstatement associated with related parties and relationships and transactions with related parties, the auditor should take into account the information obtained from performing the procedures in paragraphs 4-9 of this standard and from performing the risk assessment procedures required by Auditing Standard No. 12. Responding to the Risks of Material Misstatement 11. The auditor must design and implement audit responses that address the identified and assessed risks of material misstatement. 11 This includes designing and performing audit procedures in a manner that addresses the risks of material misstatement associated with related parties and relationships and transactions with related parties. 12 11 See paragraph 3 of Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement. 12 See generally, Auditing Standard No. 13 and paragraph 17 of Auditing Standard No. 15, Audit Evidence, which provides that inquiry of company personnel, by itself, does not provide sufficient audit evidence to reduce audit risk to an appropriately low level for a relevant assertion or to support a conclusion about the effectiveness of a control. Note: The auditor also should look to the requirements in paragraphs .66-.67A of AU sec. 316, Consideration of Fraud in a Financial Statement Audit, for related party transactions that are also significant unusual transactions (for example, significant related party transactions outside the normal course of business). For such related party transactions, AU sec. 316.67 requires that the auditor evaluate whether the business purpose (or the lack thereof) of the transactions indicates that the transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets. Transactions With Related Parties Required To Be Disclosed in the Financial Statements or Determined To Be a Significant Risk 12. For each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk, the auditor should: 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; 13 13 Information gathered while obtaining an understanding of the company also might assist the auditor in identifying agreements prohibiting or restricting related party transactions (for example, loans or advances to related parties). 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; 14 and 14 Examples of information that might be relevant to the auditor's evaluation of a related party's financial capability include, among other things, the audited financial statements of the related party, reports issued by regulatory agencies, financial publications, and income tax returns of the related party, to the extent available. e. Perform other procedures as necessary to address the identified and assessed risks of material misstatement. Note: The applicable financial reporting framework may allow the aggregation of similar related party transactions for disclosure purposes. If the company has aggregated related party transactions for disclosure purposes in accordance with the applicable financial reporting framework, the auditor may perform the procedures in paragraph 12 for only a selection of transactions from each aggregation of related party transactions (versus all transactions in the aggregation), commensurate with the risks of material misstatement. Intercompany Accounts 13. The auditor should perform procedures on intercompany account balances as of concurrent dates, even if fiscal years of the respective companies differ. Note: The procedures performed should address the risks of material misstatement associated with the company's intercompany accounts. Evaluating Whether the Company Has Properly Identified Its Related Parties and Relationships and Transactions With Related Parties 14. The auditor should evaluate whether the company has properly identified its related parties and relationships and transactions with related parties. Evaluating whether a company has properly identified its related parties and relationships and transactions with related parties involves more than assessing the process used by the company. This evaluation requires the auditor to perform procedures to test the accuracy and completeness of the related parties and relationships and transactions with related parties identified by the company, taking into account the information gathered during the audit. 15 As part of this evaluation, the auditor should read minutes of the meetings of stockholders, directors, and committees of directors, or summaries of actions of recent meetings for which minutes have not yet been prepared. 15 Information obtained from identifying and evaluating a company's significant unusual transactions and obtaining an understanding of a company's financial relationships and transactions with its executive officers could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. Note: Appendix A contains examples of information and sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. 15. If the auditor identifies information that indicates that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist, the auditor should perform the procedures necessary to determine whether previously undisclosed relationships or transactions with related parties, in fact, exist. 16 These procedures should extend beyond inquiry of management. 16 See paragraph 29 of Auditing Standard No. 15, which states that if audit evidence obtained from one source is inconsistent with that obtained from another, or if the auditor has doubts about the reliability of information to be used as audit evidence, the auditor should perform the audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects of the audit. 16. If the auditor determines that a related party or relationship or transaction with a related party previously undisclosed to the auditor exists, the auditor should: a. Inquire of management regarding the existence of the related party or relationship or transaction with a related party previously undisclosed to the auditor and the possible existence of other transactions with the related party previously undisclosed to the auditor; b. Evaluate why the related party or relationship or transaction with a related party was previously undisclosed to the auditor; 17 17 See AU sec. 333.04, which states that if a representation made by management is contradicted by other audit evidence, the auditor should investigate the circumstances and consider the reliability of the representation made. Based on the circumstances, the auditor should consider whether his or her reliance on management's representations relating to other aspects of the financial statements is appropriate and justified. c. Promptly communicate to appropriate members of the engagement team and other auditors participating in the audit engagement relevant information about the related party or relationship or transaction with the related party; d. Assess the need to perform additional procedures to identify other relationships or transactions with the related party previously undisclosed to the auditor; e. Perform the procedures required by paragraph 12 of this standard for each related party transaction previously undisclosed to the auditor that is required to be disclosed in the financial statements or determined to be a significant risk; and f. Perform the following procedures, taking into account the information gathered from performing the procedures in a. through e. above: i. Evaluate the implications on the auditor's assessment of internal control over financial reporting, if applicable; ii. Reassess the risk of material misstatement and perform additional procedures as necessary if such reassessment results in a higher risk; 18 and 18 See paragraph 74 of Auditing Standard No. 12, which states that when the auditor obtains audit evidence during the course of the audit that contradicts the audit evidence on which the auditor originally based his or her risk assessment, the auditor should revise the risk assessment and modify planned audit procedures or perform additional procedures in response to the revised risk assessments. iii. Evaluate the implications for the audit if management's nondisclosure to the auditor of a related party or relationship or transaction with a related party indicates that fraud or an illegal act may have occurred. If the auditor becomes aware of information indicating that fraud or another illegal act has occurred or might have occurred, the auditor must determine his or her responsibilities under AU secs. 316.79-.82, AU sec. 317, Illegal Acts by Clients, and Section 10A of the Securities Exchange Act of 1934, 15 U.S.C. 78j-1. Evaluating Financial Statement Accounting and Disclosures 17. The auditor must evaluate whether related party transactions have been properly accounted for and disclosed in the financial statements. This includes evaluating whether the financial statements contain the information regarding relationships and transactions with related parties essential for a fair presentation in conformity with the applicable financial reporting framework. 19 19 See paragraphs 30-31 of Auditing Standard No. 14. Assertions That Transactions With Related Parties Were Conducted on Terms Equivalent to Those Prevailing in Arm's-Length Transactions 18. If the financial statements include a statement by management that transactions with related parties were conducted on terms equivalent to those prevailing in an arm's-length transaction, the auditor should determine whether the evidence obtained supports or contradicts management's assertion. If the auditor is unable to obtain sufficient appropriate audit evidence to substantiate management's assertion, and if management does not agree to modify the disclosure, the auditor should express a qualified or adverse opinion. 20 20 See paragraph .06.l. of AU sec. 333, which requires the auditor to obtain written representations from management if the financial statements include such an assertion. Representations from management alone are not sufficient appropriate audit evidence. See also paragraphs .35-.36 of AU sec. 508, Reports on Audited Financial Statements. Note: Transactions with related parties might not be conducted on terms equivalent to those prevailing in arm's-length transactions (e.g., a company may receive services from a related party without cost). Except for routine transactions, it may not be possible for management to determine whether a particular transaction would have taken place, or what the terms and manner of settlement would have been, if the parties had not been related. Accordingly, it may be difficult for the auditor to obtain sufficient appropriate audit evidence to substantiate management's assertion that a transaction was consummated on terms equivalent to those that prevail in arm's-length transactions. A preface to a statement such as “management believes that” or “it is the company's belief that” does not change the auditor's responsibilities. Communications With the Audit Committee 19. The auditor should 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. 21 The auditor also should communicate other significant matters arising from the audit regarding the company's relationships and transactions with related parties including, but not limited to: 21 See Auditing Standard No. 16 regarding the timing of the communications to the audit committee. a. The identification of related parties or relationships or transactions with related parties that were previously undisclosed to the auditor; b. The identification of significant related party transactions that have not been authorized or approved in accordance with the company's established policies or procedures; c. The identification of significant related party transactions for which exceptions to the company's established policies or procedures were granted; d. The inclusion of a statement in the financial statements that a transaction with a related party was conducted on terms equivalent to those prevailing in an arm's-length transaction and the evidence obtained by the auditor to support or contradict such an assertion; and e. The identification of significant related party transactions that appear to the auditor to lack a business purpose. APPENDIX A—Examples of Information and Sources of Information That May Be Gathered During the Audit That Could Indicate That Related Parties or Relationships or Transactions With Related Parties Previously Undisclosed to the Auditor Might Exist A1. This Appendix contains examples of information and sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. Specifically, paragraph A2. of this Appendix contains examples of information that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. Similarly, paragraph A3. contains examples of sources that could contain such information. The examples contained in this Appendix are not intended to represent a comprehensive listing. A2. The following are examples of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist: • Buying or selling goods or services at prices that differ significantly from prevailing market prices; • Sales transactions with unusual terms, including unusual rights of return or extended payment terms generally not offered; • “Bill and hold” type transactions; • Borrowing or lending on an interest-free basis or with no fixed repayment terms; • Occupying premises or receiving other assets or rendering or receiving management services when no consideration is exchanged; • Engaging in a nonmonetary transaction that lacks commercial substance; • Sales without economic substance (e.g., funding the other party to the transaction to facilitate collection of the sales price, or entering into a transaction shortly prior to period end and unwinding that transaction shortly after period end); • Loans to parties that, at the time of the loan transaction, do not have the ability to repay and possess insufficient or no collateral; • Loans made without prior consideration of the ability of the party to repay; • A subsequent repurchase of goods that indicates that at the time of sale an implicit obligation to repurchase may have existed that would have precluded revenue recognition or sales treatment; • Advancing company funds that are used directly or indirectly to pay what would otherwise be an uncollectible loan or receivable; • Sales at below market rates to an intermediary whose involvement serves no apparent business purpose and who, in turn, sells to the ultimate customer at a higher price, with the intermediary (and ultimately its principals) retaining the difference; • Guarantees and guarantor relationships outside the normal course of business; or • Transactions between two or more entities in which each party provides and receives the same or similar amounts of consideration (e.g., round-trip transactions). A3. The following are examples of sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist: • Periodic and current reports, proxy statements, and other relevant company filings with the SEC and other regulatory agencies; • Disclosures contained on the company's Web site; • Confirmation responses and responses to inquiries of the company's lawyers; • Tax filings and related correspondence; • Invoices and correspondence received from the company's professional advisors, for example, attorneys and consulting firms; • Relevant internal auditors' reports; • Conflicts-of-interest statements from management and others; • Shareholder registers that identify the company's principal shareholders; • Life insurance policies purchased by the company; • Records of the company's investments, pension plans, and other trusts established for the benefit of employees, including the names of the officers and trustees of such investments, pension plans, and other trusts; • Contracts or other agreements (including, for example, partnership agreements and side agreements or other arrangements) with management; • Contracts and other agreements representing significant unusual transactions; • Significant contracts renegotiated by the company during the period under audit; • Records from a management, audit committee, or board of directors' whistleblower program; • Expense reimbursement documentation for executive officers; or • The company's organizational charts. Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions A. Identifying Significant Unusual Transactions Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated With An Audit of Financial Statements Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, as amended, is amended as follows: In paragraph 14: • The first bullet point is replaced with: Controls over 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 (“significant unusual transactions”), particularly those that result in late or unusual journal entries; 10A/ and • Footnote 10A is added at the end of the first bullet: 10A/ See paragraphs .66-.67A of AU sec. 316, Consideration of Fraud in a Financial Statement Audit. Auditing Standard No. 9, Audit Planning Auditing Standard No. 9, Audit Planning, as amended, is amended as follows: In paragraph 12, subparagraph a. is replaced with: The nature and amount of assets, liabilities, and transactions executed at the location or business unit, including, e.g., 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 (“significant unusual transactions”) executed at the location or business unit. 14/ Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, is Amended as follows: a. In paragraph 13: • The fifth bullet point is replaced with: The methods the company uses to account for 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 (“significant unusual transactions”); 7A/ and • Footnote 7A is added at the end of the fifth bullet: 7A/ See AU secs. 316.66-.67A. b. In paragraph 56.a.: • In item (6), delete the word “and” at the end of the item. • In item (7), change the period (.) at the end of the phrase to a semicolon (;) and add the word “and” after the semicolon. • Add Item (8): (8) Whether the company has entered into any significant unusual transactions and, if so, the nature, terms, and business purpose (or the lack thereof) of those transactions and whether such transactions involved related parties. 31A • Add footnote 31A at the end of item (8): 31A See AU secs. 316.66-.67A. c. In paragraph 56.b.: • In item (3), delete the word “and” at the end of the item. • In item (4), change the period (.) at the end of the phrase to a semicolon (;) and add the word “and” after the semicolon. • Add item (5): (5) Whether the company has entered into any significant unusual transactions. d. In paragraph 56.c.: • In item (3), delete the word “and” at the end of the item. • In item (4), change the period (.) at the end of the phrase to a semicolon (;) and add the word “and” after the semicolon. • Add item (5): (5) Whether the company has entered into any significant unusual transactions. e. In paragraph 57, the third bullet point is replaced with: Employees involved in initiating, recording, or processing complex or unusual transactions, e.g., a sales transaction with multiple elements, a significant unusual transaction, or a significant related party transaction; and f. Paragraph 71.g., is replaced with: Whether the risk involves significant unusual transactions. g. Paragraph 73A is added after paragraph 73: 73A. The auditor should obtain an understanding of the controls that management has established to identify, authorize and approve, and account for and disclose significant unusual transactions in the financial statements, if the auditor has not already done so when obtaining an understanding of internal control, as described in paragraphs 18-40 and 72-73 of this standard. Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement, as amended, is amended as follows: a. The second sentence of footnote 3 to paragraph 5.d. is replaced with: See also paragraphs .66-.67A of AU sec. 316, Consideration of Fraud in a Financial Statement Audit, and paragraphs .04 and .06 of AU sec. 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles . b. Paragraph 15.c. is replaced with: Evaluating whether the business purpose for 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 (“significant unusual transactions”) indicates that the transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets (AU secs. 316.66-.67A). AU sec. 316, “Consideration of Fraud in a Financial Statement Audit” SAS No. 99, “Consideration of Fraud in a Financial Statement Audit” (AU sec. 316, “Consideration of Fraud in a Financial Statement Audit”), as amended, is amended as follows: a. The first item in paragraph .85A.2, section a., under “Opportunities” is replaced with the following two items: • Related party transactions that are also significant unusual transactions (e.g., a significant related party transaction outside the normal course of business) • Significant transactions with related parties whose financial statements are not audited or are audited by another firm b. The fourth item in paragraph .85A.2, section a., under “Opportunities” is replaced with: • Significant or highly complex transactions or significant unusual transactions, especially those close to period end, that pose difficult “substance-over-form” questions c. The following item is added as the last item to paragraph .85A.2, section a., under “Opportunities”: • Contractual arrangements lacking a business purpose AU sec. 722, “Interim Financial Information” SAS No. 100, “Interim Financial Information” (AU sec. 722, “Interim Financial Information”), as amended, is amended as follows: a. In paragraph .55, Appendix B, paragraph B1., the tenth bullet is replaced with the following two bullets: • The occurrence of infrequent transactions • The occurrence of significant unusual transactions B. Evaluating Significant Unusual Transactions Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement, as amended, is amended as follows: a. Paragraph 11A is added after paragraph 11: 11A. Responding to Risks Associated with Significant Unusual Transactions. Paragraph 71.g. of Auditing Standard No. 12 indicates that one of the factors to be evaluated in determining significant risks is whether the risk involves significant unusual transactions. Also, AU secs. 316.66-.67A establish requirements for performing procedures to respond to fraud risks regarding significant unusual transactions. Because significant unusual transactions can affect the risks of material misstatement due to error or fraud, the auditor should take into account the types of potential misstatements that could result from significant unusual transactions in designing and performing further audit procedures, including procedures performed pursuant to AU secs. 316.66-.67A. Auditing Standard No. 16, Communications with Audit Committees Auditing Standard No. 16, Communications with Audit Committees, is amended as follows: a. In paragraph 13.d., the phrase “rationale for” is replaced with the phrase “purpose (or the lack thereof) of.” AU sec. 316, “Consideration of Fraud in a Financial Statement Audit” SAS No. 99, “Consideration of Fraud in a Financial Statement Audit” (AU sec. 316, “Consideration of Fraud in a Financial Statement Audit”), as amended, is amended as follows: a. Paragraph .66 is replaced with: .66 Evaluating whether the business purpose for significant unusual transactions indicates that the transactions may have been entered into to engage in fraud. 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 (“significant unusual transactions”) may be used to engage in fraudulent financial reporting or conceal misappropriation of assets. Note: The auditor's identification of significant unusual transactions should take into account information obtained from: (a) The risk assessment procedures required by Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement (e.g., inquiring of management and others, obtaining an understanding of the methods used to account for significant unusual transactions, and obtaining an understanding of internal control over financial reporting) and (b) other procedures performed during the audit (e.g., reading minutes of the board of directors meetings and performing journal entry testing). Note: The auditor should take into account information that indicates that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist when identifying significant unusual transactions. See paragraphs 14-16 of Auditing Standard No. 18, Related Parties. Appendix A of Auditing Standard No. 18, Related Parties, includes examples of such information and examples of sources of such information. b. Paragraph .66A is added after paragraph .66: .66A The auditor should design and perform procedures to obtain an understanding of the business purpose (or the lack thereof) of each significant unusual transaction that the auditor has identified. The procedures should include: a. Reading the underlying documentation and evaluating 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. Determining whether the transaction has been authorized and approved in accordance with the company's established policies and procedures; c. Evaluating the financial capability of the other parties with respect to significant uncollected balances, loan commitments, supply arrangements, guarantees, and other obligations, if any; fn 24A and d. Performing other procedures as necessary depending on the identified and assessed risks of material misstatement. Note: Paragraph 11A of Auditing Standard No. 13 requires the auditor to take into account the types of potential misstatements that could result from significant unusual transactions in designing and performing further audit procedures. c. Footnote 24A is added after subparagraph c. of paragraph .66A fn 24A Examples of information that might be relevant to the auditor's evaluation of the other party's financial capability include, among other things, the audited financial statements of the other party, reports issued by regulatory agencies, financial publications, and income tax returns of the other party, to the extent available. d. Paragraph .67 is replaced with: .67 The auditor should evaluate whether the business purpose (or the lack thereof) indicates that the significant unusual transaction may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets. In making that evaluation, the auditor should evaluate whether: • The form of the transaction is overly complex (e.g., the transaction involves multiple entities within a consolidated group or unrelated third parties); • The transaction involves unconsolidated related parties, including variable interest entities; • The transaction involves related parties or relationships or transactions with related parties previously undisclosed to the auditor; fn 25A • The transaction involves other parties that do not appear to have the financial capability to support the transaction without assistance from the company, or any related party of the company; • The transaction lacks commercial or economic substance, or is part of a larger series of connected, linked, or otherwise interdependent arrangements that lack commercial or economic substance individually or in the aggregate (e.g., the transaction is entered into shortly prior to period end and is unwound shortly after period end); • The transaction occurs with a party that falls outside the definition of a related party (as defined by the accounting principles applicable to that company), with either party able to negotiate terms that may not be available for other, more clearly independent, parties on an arm's-length basis; • The transaction enables the company to achieve certain financial targets; • Management is placing more emphasis on the need for a particular accounting treatment than on the underlying economic substance of the transaction (e.g., accounting-motivated structured transaction); and • Management has discussed the nature of and accounting for the transaction with the audit committee or another committee of the board of directors or the entire board. Note: Paragraphs 20-23 of Auditing Standard No. 14, Evaluating Audit Results, provide requirements regarding the auditor's evaluation of whether identified misstatements might be indicative of fraud. e. Footnote 25 is deleted and footnote 25A is added at the end of the third bullet in paragraph .67: fn 25A Related parties or relationships or transactions with related parties previously undisclosed to the auditor includes, to the extent not disclosed to the auditor by management: (1) Related parties; (2) relationships or transactions with known related parties; and (3) relationships or transactions with previously unknown related parties. Auditing Standard No. 18, Related Parties, requires the auditor to perform certain procedures in circumstances in which the auditor determines that related parties or relationships or transactions with related parties previously undisclosed to the auditor exist. f. Paragraph .67A is added after paragraph 67: .67A The auditor must evaluate whether significant unusual transactions that the auditor has identified have been properly accounted for and disclosed in the financial statements. This includes evaluating whether the financial statements contain the information regarding significant unusual transactions essential for a fair presentation of the financial statements in conformity with the applicable financial reporting framework. fn 25B Note: The auditor considers management's disclosure regarding significant unusual transactions in other parts of the company's Securities and Exchange Commission filing containing the audited financial statements in accordance with AU sec. 550, Other Information in Documents Containing Audited Financial Statements . g. Footnote 25B is added at the end of paragraph.67A: fn 25B See paragraphs 30-31 of Auditing Standard No. 14. Other Amendments to PCAOB Auditing Standards Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, is amended as follows: a. The following sentence is added to the end of footnote 3 of paragraph 4: Also, Auditing Standard No. 18, Related Parties, 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. b. In paragraph 10, the note following the final bullet is deleted. c. Paragraph 10A is added after paragraph 10: 10A. To assist in obtaining information for identifying and assessing risks of material misstatement of the financial statements associated with a company's financial relationships and transactions with its executive officers (e.g., executive compensation, including perquisites, and any other arrangements), the auditor should perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers. The procedures should be designed to identify risks of material misstatement and should include, but not be limited to (1) reading the employment and compensation contracts between the company and its executive officers and (2) reading the proxy statements and other relevant company filings with the Securities and Exchange Commission and other regulatory agencies that relate to the company's financial relationships and transactions with its executive officers. d. In paragraph 11: • The third bullet is replaced with: Obtaining an understanding of compensation arrangements with senior management other than executive officers referred to in paragraph 10A, including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses; • In the fourth bullet, delete the period (.) and add a semicolon (;) at the end of the bullet. • Add a fifth bullet: Inquiring 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 • Add a sixth bullet: Obtaining an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements. e. In Appendix A, paragraph A3A is added after paragraph A3: A3A. Executive officer—For issuers, the 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.) Auditing Standard No. 16, Communications with Audit Committees Auditing Standard No. 16, Communications with Audit Committees, is amended as follows: a. The phrase “AU sec. 334, Related Parties ” in footnote 25 is replaced with the phrase “Auditing Standard No. 18, Related Parties .” b. The following bullet is inserted after the third bullet in Appendix B: • Auditing Standard No. 18, Related Parties, paragraphs 7 and 19. AU sec. 315, “Communications Between Predecessor and Successor Auditors” SAS No. 84, “Communications Between Predecessor and Successor Auditors” (AU sec. 315, “Communications Between Predecessor and Successor Auditors”), as amended, is amended as follows: a. The following bullet is added to the end of paragraph .09: • The predecessor auditor's understanding of the nature of the company's relationships and transactions with related parties and significant unusual transactions. fn 5A b. Add the following footnote to the end of paragraph .09: fn 5A Paragraph .66 of AU sec. 316, Consideration of Fraud in a Financial Statement Audit, describes significant unusual transactions. c. In paragraph .11, replace the fifth sentence with: The predecessor auditor should ordinarily permit the successor auditor to review working papers, including documentation of planning, internal control, audit results, and other matters of continuing accounting and auditing significance, such as the working papers containing an analysis of balance sheet accounts, those relating to contingencies, related parties, and significant unusual transactions. AU sec. 316, “Consideration of Fraud in a Financial Statement Audit” SAS No. 99, “Consideration of Fraud in a Financial Statement Audit” (AU sec. 316, “Consideration of Fraud in a Financial Statement Audit”), as amended, is amended as follows: a. The heading before paragraph .79 is replaced with: Communication about Possible Fraud to Management, the Audit Committee, the Securities and Exchange Commission, and Others fn 37 b. Paragraph .81A is added after paragraph .81: .81A The auditor has a responsibility, under certain conditions, to disclose possible fraud to the Securities and Exchange Commission to comply with certain legal and regulatory requirements. These requirements include reports in connection with the termination of the engagement, such as when the entity reports an auditor change and the fraud or related risk factors constitute a reportable event or are the source of a disagreement, as these terms are defined in Item 304 of Regulation S-K and Item 16F of Form 20-F. These requirements also include reports that may be required pursuant to Section 10A(b) of the Securities Exchange Act of 1934 relating to an illegal act that the auditor concludes has a material effect on the financial statements. c. For paragraph .82: • Footnotes 39 and 41 are deleted. • The paragraph is replaced with: .82 The auditor also may have a duty to disclose the existence of possible fraud to parties outside the entity in the following circumstances: a. To a successor auditor when the successor makes inquiries in accordance with AU sec. 315, Communications Between Predecessor and Successor Auditors . fn 40 b. In response to a subpoena. c. To a funding agency or other specified agency in accordance with requirements for the audits of companies that receive governmental financial assistance. d. The following item is added to paragraph .85A.2, section b., under “Opportunities”: • The exertion of dominant influence by or over a related party AU sec. 330, “The Confirmation Process” SAS No. 67, “The Confirmation Process” (AU sec. 330, “The Confirmation Process”), as amended, is amended as follows: a. Footnote 2 to paragraph .27 is replaced with: Auditing Standard No. 18, Related Parties, establishes requirements regarding the auditor's evaluation of relationships and transactions between the company and its related parties. AU sec. 333, “Management Representations” SAS No. 85, “Management Representations” (AU sec. 333, “Management Representations”), as amended, is amended as follows: a. The third sentence of paragraph .03 is replaced with: For example, after the auditor performs the procedures described in Auditing Standard No. 18, Related Parties, the auditor should obtain a written representation that management has no knowledge of any relationships or transactions with related parties that have not been properly accounted for and adequately disclosed. The auditor should obtain this written representation even if the results of those procedures indicate that relationships and transactions with related parties have been properly accounted for and adequately disclosed. b. In paragraph .06: • Subparagraph c. is replaced with: Availability of all financial records and related data, including the names of all related parties and all relationships and transactions with related parties. • Subparagraph f. is replaced with: Absence of (1) unrecorded transactions and (2) side agreements or other arrangements (either written or oral) undisclosed to the auditor. • Subparagraph l. is replaced with: Information concerning related party transactions and amounts receivable from or payable to related parties, including support for any assertion that a transaction with a related party was conducted on terms equivalent to those prevailing in an arm's-length transaction. fn 9 c. Footnote 9 to paragraph .06 is replaced with: See paragraph 18 of Auditing Standard No. 18, Related Parties. d. The second sentence in paragraph 4 of Appendix A is replaced with: Examples are fraud, in section 316, Consideration of Fraud in a Financial Statement Audit, and related parties, in Auditing Standard No. 18, Related Parties. e. In paragraph 6 of Appendix A: • Item 2.a. is replaced with: Financial records and related data, including the names of all related parties and all relationships and transactions with related parties. • Item 11.d. is added: Side agreements or other arrangements (either written or oral) that have not been disclosed to you. AU sec. 334, “Related Parties” SAS No. 45, Omnibus Statement on Auditing Standards —1983 (AU sec. 334, “Related Parties”), as amended, is superseded. AU sec. 9334, “Related Parties: Auditing Interpretations of Section 334” AU sec. 9334, “Related Parties: Auditing Interpretations of Section 334,” as amended, is superseded. AU sec. 336, “Using the Work of a Specialist” SAS No. 73, “Using the Work of a Specialist” (AU sec. 336, “Using the Work of a Specialist”), as amended, is amended as follows: a. Footnote 6 of paragraph .10 is replaced with: The term relationship includes, but is not limited to, those situations meeting the definition of “related parties” contained in the financial reporting framework applicable to the company under audit. AU sec. 560, “Subsequent Events” SAS No. 1, “Codification of Auditing Standards and Procedures,” section 560, “Subsequent Events” (AU sec. 560, “Subsequent Events”), as amended, is amended as follows: a. In paragraph .12b.: • Item (v) is added: Whether there have been any changes in the company's related parties. • Item (vi) is added: Whether there have been any significant new related party transactions. • Item (vii) is added: Whether the company has entered into any significant unusual transactions. AU sec. 722, “Interim Financial Information” SAS No. 100, “Interim Financial Information” (AU sec. 722, “Interim Financial Information”), as amended, is amended as follows: a. In paragraph .24: • Subparagraph g. is replaced with: Availability of all financial records and related data, including the names of all related parties and all relationships and transactions with related parties. • Subparagraph j. is replaced with: Absence of (1) unrecorded transactions and (2) side agreements or other arrangements (either written or oral) undisclosed to the auditor. • Subparagraph m. is replaced with: Information concerning related party transactions and amounts receivable from or payable to related parties, including support for any assertion that a transaction with a related party was conducted on terms equivalent to those prevailing in an arm's-length transaction. b. The second sentence of paragraph C5 of paragraph .56 is replaced with: Examples are fraud, in section 316, Consideration of Fraud in a Financial Statement Audit, and related parties, in Auditing Standard No. 18, Related Parties. c. Within paragraph C6 of paragraph .56, within the first illustrative representation letter (1.) for a review of interim financial information (statements): • Item 2.a. is replaced with: All financial records and related data, including the names of all related parties and all relationships and transactions with related parties. d. Within paragraph C6 of paragraph .56, within the second illustrative representation letter (2.) for a review of interim financial information (statements): • Item 2.a. is replaced with: All financial records and related data, including the names of all related parties and all relationships and transactions with related parties. • Item 12.d. is added: Side agreements or other arrangements (either written or oral) that have not been disclosed to you. II. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules In its filing with the Commission, the Board included statements concerning the purpose of, and basis for, the proposed rules and discussed any comments it received on the proposed rules. The text of these statements may be examined at the places specified in Item IV below. The Board has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. In addition, the Board is requesting that the Commission approve the proposed rules, pursuant to Section 103(a)(3)(C) of the Sarbanes-Oxley Act, for application to audits of emerging growth companies (“EGCs”), as that term is defined in Section 3(a)(80) of the Securities Exchange Act of 1934 (the “Exchange Act”). The Board's request is set forth in Section D below. A. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules (a) Purpose Introduction The Board is adopting a new auditing standard and amendments to its auditing standards to strengthen auditor performance requirements in three critical areas that historically have represented increased risks of material misstatement in company financial statements. Related party transactions; 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 (“significant unusual transactions”); and a company's financial relationships and transactions with its executive officers, 22 have been contributing factors in numerous financial reporting frauds over the last several decades. 23 Prominent corporate scandals involving these critical areas served to undermine investor confidence and resulted in significant losses for investors, as well as the loss of many jobs. 24 These critical areas have continued to be contributing factors in more recent cases. 25 As discussed below, the Board's oversight activities indicate that there are continuing weaknesses in auditors' scrutiny of these areas. 22 A company's related party transactions, significant unusual transactions, and financial relationships and transactions with its executive officers, are collectively referred to herein as “the critical areas” or “these critical areas.” 23 Such prominent corporate scandals include Enron Corporation, Tyco International, Ltd., Refco, Inc., and WorldCom, Inc. For a more detailed discussion of such financial reporting frauds, see: (i) Proposed Auditing Standard—Related Parties, Proposed Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions and Other Proposed Amendments to PCAOB Auditing Standards (the “proposing release” or the “proposal”), PCAOB Release No. 2012-001 (February 28, 2012) at 9-11, http://pcaobus.org/Rules/Rulemaking/Docket038/Release_2012-001_Related_Parties.pdf and (ii) Proposed Auditing Standard—Related Parties, Proposed Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions and Other Proposed Amendments to PCAOB Auditing Standards (the “reproposing release” or the “reproposal”), PCAOB Release No. 2013-004 (May 7, 2013) at 2, http://pcaobus.org/Rules/Rulemaking/Docket038/Release%202013-004_Related%20Parties.pdf . 24 In one such example, Enron Corporation was the nation's largest natural gas and electric marketer, with reported annual revenue of more than $150 billion. When it filed for bankruptcy on December 2, 2001, its stock price had dropped, in less than a year, from more than $80 per share to less than $1. See SEC Settles Civil Fraud Charges Filed Against Richard A. Causey, Former Enron Chief Accounting Officer; Causey Barred From Acting as an Officer or Director of a Public Company (U.S. Securities and Exchange Commission (“SEC” or “Commission”) Litigation Release No. 19996, February 9, 2007). 25 See, e.g., SEC Accounting and Auditing Enforcement Release (“AAER”) No. 3447, SEC v. Keyuan Petrochemicals, Inc. and Aichun Li (February 28, 2013), and SEC AAER No. 3385, SEC v. China Natural Gas, Inc. and Qinan Ji (May 14, 2012). The Board developed the standard and amendments because, as described more fully below, the Board believes its existing requirements need to be strengthened to heighten the auditor's attention to areas that have been associated with risks of fraudulent financial reporting and that also may pose increased risks of error. The Board has concluded that its existing requirements in these critical areas do not contain sufficient required procedures and are not sufficiently risk-based, which can lead to inadequate auditor effort in the critical areas. The auditor, serving in the role as a gatekeeper 26 in the financial reporting system, should be alert to the possibility that transactions in these critical areas pose increased risks and, thus, require heightened scrutiny during the audit. 27 Increased auditor attention to these critical areas should, in the Board's view, increase the likelihood of the auditor identifying material misstatements. 26 According to the SEC, “The federal securities laws, to a significant extent, make independent auditors “gatekeepers” to the public securities markets. These laws require, or permit us to require, financial information filed with us to be certified (or audited) by independent public accountants. Without an opinion from an independent auditor, the company cannot satisfy the statutory and regulatory requirements for audited financial statements and cannot sell its securities to the public. 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.” See SEC Securities Act Release No. 33-7870, Proposed Rule: Revision of the Commission's Auditor Independence Requirements (June 30, 2000) at Section II.A. See also, SEC Securities Act Release No. 33-7919, Final Rule: Revision of the Commission's Auditor Independence Requirements (November 21, 2000) at Section III.A. 27 See, e.g., SEC AAER No. 3427, In the Matter of the Application of Wendy McNeeley, CPA, at 10-12 (December 13, 2012), http://www.sec.gov/litigation/opinions/2012/34-68431.pdf . That opinion states, in part, that the SEC and courts have repeatedly held that related party transactions require heightened scrutiny by auditors. See also McCurdy v. SEC , 396 F3d 1258, 1261 (D.C. Cir. 2005) (citing Howard v. SEC, 376 F3d 1136, 1149 (D.C. Cir. 2004) noting that related-party transactions “are viewed with extreme skepticism in all areas of finance,” aff'g James Thomas McCurdy, CPA, 57 SE.C. 277 (2004)). The standard and amendments being adopted by the Board include: the standard; amendments regarding significant unusual transactions; and other amendments. As described below, the standard and amendments address: • Relationships and Transactions with Related Parties; • Significant Unusual Transactions; and • Financial Relationships and Transactions with Executive Officers. Relationships and Transactions with Related Parties: The standard addresses the auditing of relationships and transactions between a company and its related parties. A company's related party transactions could pose increased risks of material misstatement, as their substance might differ materially from their form. 28 Related party transactions also may involve difficult measurement and recognition issues that can lead to errors in financial statements. Such transactions 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. Moreover, in some instances, related party transactions 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. 29 The importance to investors of auditing related party transactions is reflected in Section 10A of the Securities Exchange Act of 1934 (the “Exchange Act”), which requires each audit of financial statements of an issuer to include “procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein.” 30 The standard is designed to strengthen auditor performance requirements by setting forth specific procedures 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. The standard supersedes the Board's existing standard, AU sec. 334, Related Parties, (the “existing standard”), which has not been substantively updated since it was issued in 1983. 31 28 See also Section D for additional discussion of such risks. 29 See paragraph .06 of AU sec. 316, Consideration of Fraud in a Financial Statement Audit. 30 See Section 10A(a)(2) of the Exchange Act, 15 U.S.C. 78j-1(a)(2), which was added to the Exchange Act by the Private Securities Litigation Reform Act, enacted by Congress in 1995. 31 AU sec. 334 is one of the Board's interim auditing standards. Shortly after the Board's inception, the Board adopted the existing standards of the American Institute of Certified Public Accountants (“AICPA”), as in existence on April 16, 2003, on an initial, transitional basis. See Establishment of Interim Professional Auditing Standards, PCAOB Release No. 2003-006 (April 18, 2003). Significant Unusual Transactions: The amendments regarding significant unusual transactions recognize that a company's significant unusual transactions can create complex accounting and financial statement disclosure issues that could pose increased risks of material misstatement. In some instances, significant unusual transactions have been used to engage in fraudulent financial reporting. For example, significant unusual transactions, especially those close to period end that pose difficult “substance-over-form” questions, may be entered into to obscure a company's financial position or operating results. 32 In such cases, management may place more emphasis on the need for a particular accounting treatment than on the underlying economic substance of the transaction. Existing audit requirements regarding significant unusual transactions are principally contained in AU sec. 316. The amendments regarding significant unusual transactions include specific procedures that are designed to improve the auditor's identification and evaluation of a company's significant unusual transactions and, in particular, to enhance the auditor's understanding of the business purpose (or the lack thereof) of such transactions. 32 See, e.g., SEC AAER No. 1631, In the Matter of Dynegy Inc., Respondent (September 24, 2002), http://www.sec.gov/litigation/admin/33-8134.htm ; and SEC AAER No. 2775, In the Matter of Michael Lowther, CPA, Respondent (January 28, 2008), http://www.sec.gov/litigation/admin/2008/34-57210.pdf . Financial Relationships and Transactions with Executive Officers: The other amendments include, among other things, improved audit procedures addressing a company's financial relationships and transactions with its executive officers. A company's executive officers are in a unique position to influence a company's accounting and disclosures. A company's financial relationships and transactions with its executive officers (as one example, executive officer compensation) can create incentives and pressures for executive officers to meet financial targets, which can result in risks of material misstatement to a company's financial statements. The other amendments modify Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, to require the auditor to perform specific procedures, as part of the auditor's risk assessment process, 33 to obtain an understanding of the company's financial relationships and transactions with its executive officers. However, these amendments do not require the auditor to make any determination regarding the reasonableness of compensation arrangements or recommendations regarding compensation arrangements. 33 In 2010, the Board adopted eight standards on assessing and responding to risk in an audit (the “risk assessment standards”), which cover the entire audit process, from initial planning activities to evaluating audit evidence to forming the opinion to be expressed in the auditor's report. See Auditing Standards Related to the Auditor's Assessment of and Response to Risk and Related Amendments to PCAOB Standards, PCAOB Release 2010-004 (August 5, 2010). The auditor's efforts regarding these critical areas are, in many ways, complementary. For example, the auditor's efforts to identify and evaluate a company's significant unusual transactions could identify information that indicates that a related party or relationship or transaction with a related party previously undisclosed to the auditor might exist. Likewise, obtaining an understanding of a company's financial relationships and transactions with its executive officers also could identify such information. The standard and amendments direct the auditor to consider the linkage between a company's relationships and transactions with its related parties, its significant unusual transactions, and its financial relationships and transactions with its executive officers. This complementary audit approach should help the auditor “connect the dots” between different aspects of the audit. Both the auditor and the investor benefit from a comprehensive and consistent examination of the critical areas, not only because of the risk of material misstatement due to fraud, but also because these transactions, due to their nature, could pose a risk of material misstatement due to error. In addition, the standard imposes new requirements relating to the auditor's communications with the company's audit committee. These changes recognize that the new auditor performance requirements contained in the standard relate to areas of the audit that warrant discussion with the audit committee. The new communication requirements in the standard work in concert with the communication requirements in Auditing Standard No. 16, Communications with Audit Committees , 34 and require the auditor to include, as one of the auditor's required communications with the audit committee, the auditor's evaluation of the company's identification of, accounting for, and disclosure of its relationships with related parties. Additionally, the amendments regarding significant unusual transactions are intended to enhance the discussion between the auditor and the audit committee regarding the business purpose (or the lack thereof) of a company's significant unusual transactions required by Auditing Standard No. 16. 35 Similarly, requiring the auditor to perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers is intended to improve the auditor's identification of fraud risks or other significant risks, which are also already required to be discussed with the audit committee pursuant to Auditing Standard No. 16. 36 34 See Communications with Audit Committees; Related Amendments to PCAOB Standards; and Transitional Amendments to AU Sec. 380, PCAOB Release No. 2012-004 (August 15, 2012). 35 See paragraph 13.d. of Auditing Standard No. 16, as revised by certain amendments regarding significant unusual transactions. As revised, the auditor is required to communicate to the audit committee the auditor's understanding of the business purpose (or the lack thereof) of significant unusual transactions. 36 See paragraph 9 of Auditing Standard No. 16, which requires the auditor to discuss with the audit committee the significant risks identified during the auditor's risk assessment procedures. As discussed below, recommendations to improve the requirements in the critical areas have been longstanding. The standard and amendments reflect public input, including discussions with the Board's Standing Advisory Group (“SAG”) 37 and comments received on a proposal in 2012 38 and a reproposal in 2013. 39 A wide range of commenters, including audit firms serving companies of all sizes, were supportive overall of the need to improve existing standards in these critical areas. During the standard-setting process, the Board considered various alternatives, including some proposed by commenters, in order to develop new requirements that would promote investor protection, but that also would provide opportunities for efficient implementation. After considering the comments received on the reproposal, the Board is adopting the standard and amendments substantially as reproposed. 37 The SAG discussed the topic of related parties at a number of its meetings prior to the issuance of the Board's proposal, including at meetings occurring on: September 8-9, 2004; June 21, 2007; and October 14-15, 2009. The SAG also discussed the proposal and reproposal on May 17, 2012 and May 15, 2013, respectively. See the SAG Meeting Archive at http://pcaobus.org/Standards/SAG/Pages/SAGMeetingArchive.aspx . 38 See the proposing release, which included: (i) an auditing standard, Related Parties (“proposed standard”); (ii) amendments to certain PCAOB auditing standards regarding significant unusual transactions; and (iii) other amendments to PCAOB auditing standards (collectively, these are referred to as the “proposed standard and amendments”). 39 See the reproposing release, which included: (i) an auditing standard, Related Parties (“reproposed standard”); (ii) amendments to certain PCAOB auditing standards regarding significant unusual transactions; and (iii) other proposed amendments to PCAOB auditing standards (collectively, these are referred to as the “reproposed standard and amendments”). In general, the Board's new performance requirements for auditors are designed to promote heightened scrutiny in the critical areas, with the goal of promoting the auditor's ability to identify, evaluate, and respond to risks of material misstatement. The new requirements represent a targeted approach, focusing on areas that have historically reflected increased risks of fraudulent financial reporting and that also may pose increased risks of error. The Board believes that the standard and amendments, which are aligned with the risk assessment standards, represent a cohesive audit approach that will contribute to audit effectiveness and provide opportunities for an efficient implementation. In the Board's view, the new requirements further the Board's overall mission of improving audit quality, protecting the interests of investors, and furthering the public interest in the preparation of informative, accurate, and independent audit reports. 40 40 See Section 101 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley” or the “Act”), Public Law 107-204, 116 Stat. 745. Under Section 101 of the Act, the mission of the PCAOB is “to oversee the audit of companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports . . . .” Background and Need for Improvement As described more fully in the Board's proposing and reproposing releases, the Board developed the standard and amendments against the backdrop of several decades of financial reporting frauds involving companies' relationships and transactions with related parties, significant unusual transactions, and financial relationships and transactions with executive officers. 41 41 See also Section D, which further elaborates on the Board's consideration of the need, the alternatives considered, and the Board's existing requirements and current audit practices, in connection with the Board's consideration of the economic impacts of the standard and amendments. In considering the need for improvement, the Board noted that some of its existing requirements in these critical areas had not been updated to address significant developments since their issuance. For example, the existing standard addressing the auditing of related parties, AU sec. 334, had remained largely unchanged for many years, despite prominent corporate scandals. 42 The Board observed that the existing standard provided guidance and examples of procedures the auditor could perform, in lieu of specific required procedures. This could result in inadequate audit effort in an area that could pose increased risks of material misstatement. Additionally, the nature and extent of audit procedures addressing a company's related party transactions could vary widely. AU sec. 334 also does not reflect the risk-based approach taken in the Board's risk assessment standards, adopted in 2010, which provide an overall framework for the audit, based on the auditor's assessment of, and response to, risks of material misstatement. 43 42 Audit procedures regarding a company's related parties have remained largely unchanged since the issuance of AU sec. 335, Related Party Transactions, in July 1975. In 1983, AU sec. 335 was replaced with AU sec. 334, but the nature and extent of the auditor's responsibilities and procedures pertaining to related parties in AU sec. 335 were carried over into AU sec. 334. AU sec. 334 removed guidance relating to accounting considerations and disclosure standards for related parties (in response to the issuance of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 57, Related Party Disclosures, which is now contained in FASB Accounting Standards Codification Topic 850, Related Party Disclosures ), along with other related technical changes. 43 See PCAOB Release 2010-004 (August 5, 2010). The Board's view was also informed by a number of prominent reports and studies that supported the need to improve its existing requirements in the critical areas to better address issues pertinent to fraudulent financial reporting. These included studies by the audit profession that predated the establishment of the Board, and that suggested improvements to certain auditing standards adopted by the Board on an interim basis in 2003. For example, the Report of the Quality Control Inquiry Committee (the “QCIC Report”) of the AICPA's SEC Practice Section recommended, after studying more than 200 cases involving audit failures, that “required audit procedures be broadened to help ensure the auditor gains a more complete understanding of related-party transactions, including the business aspects of the transactions.” 44 44 See AICPA SEC Practice Section, Memo To Managing Partners of SECPS Member Firms, “Recommendations for the Profession Based on Lessons Learned from Litigation” (October 2002), which includes the QCIC Report as an attachment. The Board also considered the results of its oversight activities. For example, the Board has observed that the facts underlying a significant percentage of the Board's settled disciplinary actions to date have involved auditors' failures to perform sufficient procedures regarding related party transactions. 45 Many of these cases involve smaller audit firms. Likewise, the Board's inspection program has identified a range of deficiencies in auditing related party transactions, particularly with respect to audits of smaller public companies that were conducted by smaller domestic audit firms. 46 The audit deficiencies cited included failures to test for undisclosed related parties and failures to address risks posed by known related party transactions, including failures to obtain an understanding of the business purpose of such transactions. The types of audit deficiencies observed by the Board indicate that audit practice is inconsistent under the existing framework, which suggests that this is a challenging area warranting additional auditor effort and focus. 45 See, e.g., Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions: In the Matter of P. Parikh & Associates, Ashok B. Rajagiri, CA, Sandeep P. Parikh, CA, and Sundeep P S G Nair, CA, Respondents, PCAOB Release No. 105-2013-002 (April 24, 2013); Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions: In the Matter of Jaspers + Hall, PC, Thomas M. Jaspers, CPA, and Patrick A. Hall, CPA, Respondents, PCAOB Release No. 105-2008-002 (October 21, 2008); Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions: In the Matter of Williams & Webster, P.S., Kevin J. Williams, CPA, and John G. Webster, CPA, Respondents, PCAOB Release No. 105-2007-1 (June 12, 2007); and Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions: In the Matter of Kenny H. Lee CPA Group, Inc., and Kwang Ho Lee, CPA, Respondents, PCAOB Release No. 105-2005-022 (November 22, 2005). 46 See Report on 2007-2010 Inspections of Domestic Firms that Audit 100 or Fewer Public Companies, PCAOB Release No. 2013-001 (February 25, 2013) at 29, http://pcaobus.org/Inspections/Documents/02252013_Release_2013_001.pdf, which states, in part, “Inspections staff have observed deficiencies related to firms' failures to test for undisclosed related parties or transactions with undisclosed related parties. Some of those firms failed to identify and address the lack of disclosure of related party transactions in the financial statements. Inspections staff have also identified deficiencies relating to the firms' failure to obtain an understanding of the nature and business purpose of transactions with related parties and to evaluate whether the accounting for those transactions reflects their economic substance.” See also Report on the PCAOB's 2004, 2005, and 2006 Inspections of Domestic Triennially Inspected Firms, PCAOB Release No. 2007-010, at 7 (October 22, 2007), http://pcaobus.org/Inspections/Documents/2007_10-22_4010_Report.pdf. Significantly, the need for heightened scrutiny of related party transactions has been highlighted by SEC enforcement actions. For example, in a 2012 opinion issued by the SEC involving a company's transactions with its executive officers, the SEC stated “although in an ordinary arms-length transaction, one may assume that parties will act in their own economic interest, this assumption breaks down when the parties are related.” 47 Additionally, a study performed by the SEC of five years of enforcement actions that was required by Section 704 of the Act examined 227 enforcement matters and found that 23 of those cases included the failure to disclose related party transactions. 48 47 See SEC, In the Matter of the Application of Wendy McNeeley, CPA, AAER No. 3427, at 15 (December 13, 2012), http://www.sec.gov/litigation/opinions/2012/34-68431.pdf. As previously noted, that opinion states, in part, that the SEC and courts have repeatedly held that related party transactions require heightened scrutiny by auditors and notes the importance of the auditor understanding the business purpose of material related party transactions. 48 Section 704 of the Act directed the SEC to study enforcement actions over the five years preceding its enactment “to identify areas of issuer financial reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management.” See Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002 (January 24, 2003) at 6. SEC enforcement cases also have highlighted the role played by executive officers in fraudulent financial reporting by public companies. For example, a study examining SEC AAERs from 1998 to 2007 noted that the most commonly cited motivations for fraud included the need to: (i) Meet external earnings expectations of analysts and others; (ii) meet internally set financial targets or make the company look better; (iii) conceal the company's deteriorating financial condition; (iv) increase the stock price; (v) bolster financial position for pending equity or debt financing; (vi) increase management compensation through achievement of bonus targets and through enhanced stock appreciation; and (vii) cover up assets misappropriated for personal gain. 49 That study indicated that the chief executive officer and/or chief financial officer were named in 89 percent of the cases involving fraudulent financial reporting brought by the SEC during that period. 49 See Mark S. Beasley, Joseph V. Carcello, Dana R. Hermanson, and Terry L. Neal, Fraudulent Financial Reporting 1998-2007: An Analysis of U.S. Public Companies, Committee of Sponsoring Organizations of the Treadway Commission (May 2010) at 3, http://www.coso.org/documents/COSOFRAUDSTUDY2010_001.pdf . The Board further considered that other standard-setters already have taken action to update their standards in related areas. For example, in July 2008, the International Auditing and Assurance Standards Board (“IAASB”) took action to update and revise its auditing standard on related parties with the issuance of International Standard on Auditing No. 550, Related Parties. The IAASB emphasized that its new standard was warranted given the public focus on the accounting and auditing of related party relationships and transactions after recent major corporate scandals. 50 The Auditing Standards Board (“ASB”) of the AICPA also revised its auditing standard on related parties with the issuance of AU-C Section 550, Related Parties, contained in Statement on Auditing Standards No. 122, Statement on Auditing Standards: Clarification and Recodification, in October 2011. 50 See IAASB Exposure Draft, Related Parties (December 2005). In addition, the IAASB staff issued guidance in August 2010 addressing the auditing of significant unusual or highly complex transactions. See IAASB Staff Questions and Answers, Auditor Considerations Regarding Significant Unusual or Highly Complex Transactions (August 2010). These considerations, particularly the magnitude and number of financial fraud cases over the last several decades involving companies' relationships and transactions with related parties, significant unusual transactions, and financial relationships and transactions with executive officers, strongly indicate the need to strengthen existing auditing standards addressing these critical areas to promote audit quality and investor protection. The Board's Proposals and Development of the Board's Approach The following discussion highlights a number of key decisions made by the Board as it developed the standard and amendments, beginning with its proposal in 2012. 51 51 Prior to proposing the standard and amendments, the Board considered a number of alternatives. Section D contains a more detailed discussion of alternatives considered by the Board, including alternatives considered before the Board determined to issue the proposed standard and amendments in 2012. The Board's Proposals: The Board issued its proposal on February 28, 2012. 52 The Board received 37 comment letters on the proposed standard and amendments and discussed the proposed standard and amendments with the SAG on May 17, 2012. 53 52 See the proposing release. 53 The comment period was extended from May 15, 2012 until May 31, 2012 to accommodate the discussion and comments received in connection with the SAG meeting. The transcript of the SAG's discussion of the proposed standard and amendments is available at http://pcaobus.org/Rules/Rulemaking/Docket038/2012-05-17_Transcript-Related_Parties.pdf. In general, commenters were supportive of the Board's standard-setting efforts to enhance the auditor's efforts in the critical areas addressed by the proposal. However, commenters suggested several areas in which the proposed standard and amendments could be clarified or improved, including with respect to the other proposed amendments regarding a company's financial relationships and transactions with its executive officers. In response to comments received, the Board made a number of revisions to its proposal and issued a reproposal for comment on May 7, 2013. 54 The Board's reproposing release discussed the Board's consideration of comments received and the reasons for making the changes in the reproposed standard and amendments. Additionally, the Board sought comment, and empirical data, on the potential economic implications of the reproposed standard and amendments, as well as on issues pertinent to the application of the reproposed standard and amendments to audits of brokers and dealers. Further, as a result of the enactment of the Jumpstart Our Business Startups Act (the “JOBS Act”), the Board also sought comment in its reproposal on issues pertinent to the applicability of the reproposed standard and amendments to audits of emerging growth companies (“EGCs”). 55 54 See the reproposing release. 55 Public Law 112-106 (April 5, 2012). See Section 103(a)(3)(C) of the Act (15 U.S.C. 7213(a)(3)(C)), as added by Section 104 of the JOBS Act. The Board received 24 comment letters on the reproposed standard and amendments and discussed the reproposed standard and amendments with the SAG on May 15, 2013. 56 In general, commenters were supportive overall of the Board's efforts to improve existing standards in these critical areas. Notably, virtually all of those who commented on the reproposed amendments regarding a company's financial relationships and transactions with its executive officers indicated that the reproposed amendments sufficiently clarified an issue raised during the initial proposal, i.e., that the requirement for the auditor to obtain an understanding of the company's financial relationships and transactions with its executive officers does not require the auditor to assess the appropriateness of the compensation of the company's executive officers. Those who commented on the applicability of the standard were generally supportive of applying the standard and amendments to companies of all sizes, as well as to audits of brokers and dealers and audits of EGCs. 56 The transcript of the SAG's discussion of the reproposed standard and amendments is available at http://pcaobus.org/Rules/Rulemaking/Docket038/2013-05-15_SAG%20Transcript-Related_Parties.pdf. In response to the Board's request for input and empirical data regarding economic considerations, commenters provided their views regarding whether the standard and amendments would improve audit quality, as well as their views regarding potential costs and implementation issues. However, commenters did not provide empirical data. 57 57 Section D discusses the Board's consideration of the economic impacts regarding the standard and amendments in greater detail. As noted above, after consideration of the comments received, the Board is adopting the standard and amendments substantially as reproposed, with some clarifications and revisions in response to certain comments received. Section C contains a detailed discussion of comments received by the Board during the reproposal process, including the Board's response to significant comments received on the reproposed standard and amendments. Additionally, to assist the auditor in implementing the standard and amendments, Section C includes discussion and examples from the Board's proposing and reproposing releases modified to address the standard and amendments being adopted by the Board. The Board's Overall Approach: The following discussion describes the Board's overall approach to developing the standard and amendments, and highlights some of the alternatives and policy choices made as the Board moved from its proposal to its reproposal and then to the adoption of the standard and amendments. In general, in developing the standard and amendments, the Board determined to develop an approach that would promote the auditor's heightened scrutiny of the critical areas but that would, at the same time, also provide opportunity for efficient implementation. Key considerations included: • Aligning with the Risk Assessment Standards: The Board initially proposed to align the auditor's efforts with the risk assessment standards, which require the auditor to consider the risks of material misstatement, whether due to error or fraud, throughout the audit. In the Board's view, this overall risk assessment approach promotes a cohesive audit, with opportunities to integrate audit effort where appropriate, and, at the same time, positions the auditor to identify areas in which there may be increased risks of material misstatement in company financial statements. In response to comments on its proposal, the Board took steps in its reproposal to more closely align the reproposed standard and amendments with its risk assessment standards. Commenters who addressed this aspect of the reproposal generally agreed that the revisions improved the alignment with the risk assessment standards. This approach is retained in the standard and amendments being adopted by the Board. • Addressing Complementary Audit Areas: The proposed standard and amendments were intended to highlight: (i) linkages between the standard and amendments and (ii) the opportunity for complementary audit work, which could improve audit effectiveness and offer opportunities for efficient implementation. For example, the auditor's work in identifying and evaluating significant unusual transactions could assist the auditor in identifying related parties or relationships or transactions with related parties previously undisclosed to the auditor by management. In its reproposal, the Board made revisions to improve the linkage between the reproposed standard and amendments. This approach is retained in the standard and amendments being adopted by the Board. • Using Existing Concepts and Procedures: The Board included some existing auditing concepts and procedures in its proposed standard and amendments. This was intended to permit audit firms to build on existing methodologies and training. This approach could minimize the costs of implementing the standard and amendments. In its reproposal, the Board sought comment on such issues. Several auditing firms who commented indicated that they would be able to update their methodologies and train staff to apply the standard and amendments in a short period, suggesting that the implementation of the standard would not be unduly burdensome. This approach is retained in the standard and amendments being adopted by the Board. • Providing Opportunity for a Scaled Approach: The proposed standard was intended to provide for a scaled approach, establishing basic required procedures intended to assist the auditor in identifying red flags that indicate potential risks of material misstatement. The basic procedures were supplemented by more in-depth procedures that are commensurate with the facts and circumstances of the company under audit. Such facts and circumstances may include the size or complexity of the transaction, the nature of the company's relationships or transactions with its related parties, and the related risk of material misstatements in the financial statements. In response to a request for comments arising out of the Board's reproposal, many commenters agreed that the reproposed standard and amendments provide for a scaled approach. This approach is retained in the standard and amendments being adopted by the Board. Additionally, commenters raised a variety of issues for consideration by the Board during the standard-setting process. A number of such comments resulted in revisions and clarifications to the standard and amendments. 58 Some of the more significant of these include: 58 Section C contains a more detailed discussion of comments received by the Board during the reproposal process, including the Board's response to significant comments received on the reproposed standard and amendments. • Expanding Auditor Judgment: In response to comments, the Board made changes to the proposed standard to allow for more auditor judgment, in appropriate circumstances. For example, in its proposal, all related party relationships or transactions that were not previously disclosed to the auditor, as well as those that would require disclosure in the company's financial statements, would have been considered to be a significant risk, requiring additional audit attention in all cases. In response to comments, the Board removed from the reproposal the requirement that the auditor always treat each related party relationship or transaction previously undisclosed by management as a significant risk. In making this change, the Board observed that not all undisclosed related party relationships or transactions might represent a significant risk. Instead, the additional procedures would only be required in circumstances where previously undisclosed transactions were determined by the auditor to require disclosure in the financial statements or consideration as a significant risk. This change, which is retained in the standard being adopted by the Board, could eliminate potentially unnecessary audit work. • Clarifying the Auditor's Responsibilities To Identify a Company's Related Parties: In response to comments received, the Board made clarifications to the proposed standard to emphasize that the auditor's efforts to identify a company's related parties and relationships and transactions with its related parties begins with management's work. The approach taken in the Board's reproposal in this area recognizes that the company is responsible for the preparation of its financial statements, including the identification of the company's related parties, and that the auditor begins the audit with information obtained from the company. This approach is retained in the standard being adopted by the Board. Additionally, in response to comments received on the reproposed standard, several clarifying changes have been made. Those changes emphasize more prominently the auditor's responsibility to perform procedures to test the accuracy and completeness of the company's identification of its related parties, taking into account the information gathered during the audit. Those changes also clarify that Appendix A of the standard contains examples of information and sources of information that may be gathered by the auditor during the audit. • Clarifying the Focus Regarding Executive Officers: As proposed, the other amendments provided direction to the auditor to consider the potential risks of material misstatement relating to a company's executive compensation arrangements as part of the auditor's risk assessment procedures. While some commenters were fully supportive of this approach, other commenters on the proposal raised concerns regarding whether the Board intended that the auditor make an assessment of the reasonableness of executive compensation arrangements. As reproposed, the other amendments relating to this area were clarified to explicitly provide that the procedures required for the auditor to obtain an understanding of a company's financial relationships and transactions with its executive officers do not require the auditor to make any determinations regarding the appropriateness or reasonableness of the company's compensation arrangements with its executive officers. This approach is retained in the amendments being adopted by the Board. Overview of the Standard and Amendments and Key Improvements From Existing Standards The following discussion provides a summary of the standard and amendments being adopted by the Board, key improvements from existing standards, and changes being made to the reproposed standard and amendments. Auditing Standard No. 18, Related Parties Overview of the Standard: The standard is intended to strengthen auditor performance requirements for identifying, assessing, and responding to the risks of material misstatement associated with a company's relationships and transactions with its related parties. Among other things, the standard requires the auditor to: • Perform specific procedures to obtain an understanding of the company's relationships and transactions with its related parties, including obtaining an understanding of the nature of the relationships between the company and its related parties and of the terms and business purposes (or the lack thereof) of transactions involving related parties. The new procedures are performed in conjunction with the auditor's risk assessment procedures pursuant to Auditing Standard No. 12. • Evaluate whether the company has properly identified its related parties and relationships and transactions with its related parties. 59 In making that evaluation, the auditor performs procedures to test the accuracy and completeness of management's identification, taking into account information gathered during the audit. If the auditor identifies information that indicates that undisclosed relationships and transactions with a related party might exist, the auditor performs procedures necessary to determine whether undisclosed relationships or transactions with related parties in fact exist. 59 To further assist the auditor's efforts in this area, the other amendments include a complementary provision that expands existing management representations contained in AU sec. 333, Management Representations. However, the auditor may not rely solely on management's representations since they are not a substitute for the application of those audit procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit. • Perform specific procedures if the auditor determines that a related party or relationship or transaction with a related party previously undisclosed to the auditor 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 relationships and transactions with related parties, and other significant matters arising from the audit regarding the company's relationships and transactions with related parties. The Existing Standard: The existing requirements for auditing relationships and transactions with related parties are contained primarily in AU sec. 334. AU sec. 334 recognizes that the auditor performs procedures to identify and evaluate a company's relationships and transactions with its related parties as part of performing an audit of financial statements. In doing so, AU sec. 334 provides guidance and examples of procedures for the auditor's consideration in identifying and evaluating related party transactions. Examples of procedures in AU sec. 334 include procedures to obtain information from management (such as obtaining the names of all related parties and inquiring whether there were any transactions with these parties during the period) as well as procedures intended to assist the auditor in identifying related parties that have not been disclosed to the auditor by management (such as reviewing filings with the SEC, reviewing company accounting records and certain invoices, and making inquiries of other auditors). Notably, AU sec. 334 states that not all of the procedures may be required in every audit. It further states that, in the absence of evidence to the contrary, related party transactions should not be assumed to be outside the ordinary course of business. 60 Finally, AU sec. 334 states that the auditor should place primary emphasis on the adequacy of disclosure of related party transactions. 60 Thus, AU sec. 334 could be misunderstood to create a “presumption of validity” for the business purpose of related party transactions in situations where experience suggests a need for heightened scrutiny. Key Improvements from the Existing Standard: The standard includes some auditing concepts and procedures from AU sec. 334 that relate to identifying and evaluating related parties and related party transactions. However, the standard differs from AU sec. 334 in a number of key respects. These include: • Adding Basic Requirements: AU sec. 334 suggests procedures for the auditor's consideration, noting that not all of them may be required in every audit. The standard requires basic procedures for the auditor's response to the risks of material misstatement associated with a company's relationships and transactions with its related parties that focus on those related party transactions that require disclosure in the financial statements or that are determined to be a significant risk. These procedures are designed to assist the auditor in identifying red flags that indicate potential risks of material misstatement. Additionally, the standard requires more in-depth procedures that are designed to be scalable and commensurate with the company's facts and circumstances. • Enhancing Procedures To Obtain an Understanding of the Company's Relationships and Transactions With Its Related Parties: Unlike AU sec. 334, which includes limited direction for obtaining an understanding of the company's relationships and transactions with its related parties, the standard requires the performance of specific procedures in this area, including obtaining an understanding of the terms and business purposes (or the lack thereof) of related party transactions. • Aligning With the Risk Assessment Standards: Since the adoption of AU sec. 334, the Board adopted and amended a number of auditing standards, including its risk assessment standards. The standard is designed to align with and build upon the risk assessment standards that were adopted in 2010. The new procedures are intended to be performed in conjunction with the procedures performed during the auditor's risk assessment. • Improving the Auditor's Focus on Accounting: As noted above, AU sec. 334 states that the auditor should place primary emphasis on the adequacy of disclosure of related party transactions. The standard requires that the auditor evaluate both the accounting for, and disclosure of, related party transactions. • Adding Audit Committee Communications: AU sec. 334 does not mention communications with audit committees regarding related party transactions. The standard requires the auditor to communicate with the audit committee (or its chair) to obtain information during the auditor's risk assessment, as well as to communicate to the audit committee regarding the auditor's evaluation of the company's identification of, accounting for, and disclosure of its relationships and transactions with related parties. • Emphasizing a Complementary Audit Approach: The standard requires the auditor to take into account information gathered during the audit when evaluating a company's identification of its related parties, for example, information with respect to significant unusual transactions. Changes From the Reproposed Standard: The Board is adopting the standard substantially as reproposed, except for certain clarifications and changes that are being made largely in response to comments. One change more prominently emphasizes that the auditor's evaluation of whether a company has properly identified its related parties and relationships and transactions with related parties requires the auditor to perform procedures to test the accuracy and completeness of the company's identification of its related parties and relationships and transactions with its related parties. That change also provides that the auditor's evaluation takes into account the information gathered during the audit. Another change clarifies that Appendix A of the standard contains examples of information and sources of information that may be gathered by the auditor during the audit. More detail regarding the changes made to the standard is included in Section C. Amendments Regarding Significant Unusual Transactions The amendments regarding significant unusual transactions revise AU sec. 316 and other PCAOB auditing standards with the intent of strengthening the auditor's performance requirements for the identification and evaluation of significant unusual transactions. Among other things, the amendments regarding significant unusual transactions: • Require the auditor to perform procedures to identify significant unusual transactions; • Require 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 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. The amendments regarding significant unusual transactions include targeted enhancements to AU sec. 316, as well as amendments to Auditing Standard No. 12 and Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement. The amendments regarding significant unusual transactions also include conforming changes to other PCAOB auditing standards to provide for consistency in the use of the term “significant unusual transactions” throughout the Board's standards. During the reproposal process, the Board added a number of clarifying changes, including some intended to enhance the complementary linkages between the auditor's work relating to significant unusual transactions and related party transactions. This approach is maintained in the amendments being adopted by the Board. Existing Standards Regarding Significant Unusual Transactions: Existing auditing requirements regarding significant unusual transactions are principally contained in AU sec. 316. 61 Specifically, AU sec. 316.66 recognizes that during a financial statement audit, the auditor may become aware of significant transactions that are outside the normal course of business for the company or that otherwise appear to be unusual given the auditor's understanding of the company and its environment. AU sec. 316.66 requires that, if the auditor becomes aware of significant unusual transactions during the course of an audit, the auditor should gain an understanding of the business rationale of such transactions and whether that rationale (or the lack thereof) suggests that such transactions may have been entered into to engage in fraudulent financial reporting or to conceal the misappropriation of assets. In addition, the existing risk assessment standards anticipate that the auditor will consider risks of material misstatement that are posed by significant transactions that are outside the normal course of business for the company or otherwise appear unusual due to their timing, size, or nature. 62 61 See AU secs. 316.66-.67. 62 See paragraph 71.g. of Auditing Standard No. 12. Key Improvements From the Existing Standards: The amendments regarding significant unusual transactions are designed to improve existing Board standards in the following key respects: • Conforming Descriptions of Significant Unusual Transactions: The amendments regarding significant unusual transactions amend AU sec. 316.66 to describe 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 amendments regarding significant unusual transactions also include conforming changes to introduce a uniform description of “significant unusual transactions” throughout the Board's standards. • Improving Requirements for Identifying Significant Unusual Transactions: The amendments regarding significant unusual transactions require the performance of specific procedures intended to improve the auditor's identification of significant unusual transactions, for example, by amending Auditing Standard No. 12 to require the auditor to make inquiries of management and others. • Improving the Auditor's Evaluation of Significant Unusual Transactions: The amendments regarding significant unusual transactions to AU secs. 316.66-.67A include basic procedures for obtaining information for evaluating significant unusual transactions. The basic procedures include: (i) Reading the underlying documentation relating to significant unusual transactions and evaluating 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; (ii) determining whether the transaction has been authorized and approved in accordance with the company's established policies and procedures; and (iii) evaluating the financial capability of the other parties to the transaction with respect to significant uncollected balances, guarantees, and other obligations. The basic procedures are designed to assist the auditor in identifying red flags that indicate potential risks of material misstatement. Additionally, the standard requires more in-depth procedures that are designed to be scalable and commensurate with the facts and circumstances of the audit. • Enhancing Attention to the Business Purpose (or the Lack Thereof) of Significant Unusual Transactions: The amendments regarding significant unusual transactions to AU secs. 316.66-.67 are intended to enhance the auditor's evaluation of the business purpose of significant unusual transactions by, among other things, expanding the factors considered by the auditor in evaluating whether the business purpose (or the lack thereof) indicates that such transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets. • Emphasizing a Complementary Audit Approach: The amendments to AU secs. 316.66-.67A emphasize a complementary audit approach by requiring the auditor to take into account other work performed during the audit, for example, information gathered with respect to related party transactions, when identifying a company's significant unusual transactions. • Emphasizing Accounting and Disclosure: The amendments regarding significant unusual transactions to AU sec. 316.67A are intended to heighten the auditor's attention to accounting matters relative to significant unusual transactions. The new requirements emphasize that the auditor must evaluate whether the financial statements contain the information regarding significant unusual transactions essential for a fair presentation in conformity with the applicable financial reporting framework. 63 63 See paragraphs 30-31 of Auditing Standard No. 14, Evaluating Audit Results, which address the auditor's evaluation of the presentation of the financial statements, including the disclosures. Changes From the Reproposed Amendments: The Board is adopting the amendments substantially as reproposed, with some clarifying changes. More detail regarding those changes is included in Section C. Financial Relationships and Transactions With Executive Officers The other amendments are intended to provide for improved audit procedures in complementary areas, including requiring that the auditor perform procedures, as part of the auditor's risk assessment, to obtain an understanding of the company's financial relationships and transactions with its executive officers. 64 These new procedures are intended to heighten the auditor's attention to incentives or pressures for the company to achieve a particular financial position or operating result, recognizing the key role that a company's executive officers may play in the company's accounting decisions or in a company's financial reporting. 64 See Section C—Other Amendments to PCAOB Auditing Standards, for a discussion of the applicable definition of the term “executive officer.” As discussed previously, clarifications were made to the other amendments to explicitly provide that the auditor's work relating to a company's financial relationships and transactions with its executive officers does not include an assessment of the appropriateness or reasonableness of executive compensation arrangements. The Existing Standards and Key Improvements: The existing risk assessment standards require the auditor to consider obtaining an understanding of compensation arrangements with senior management (including incentive compensation arrangements, changes or adjustments to those arrangements, and special bonuses) as part of obtaining an understanding of the company. The other amendments strengthen existing requirements by requiring the auditor, as part of the audit risk assessment process, to perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers. This reflects that a company's 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. No Changes From Reproposed Amendments: The Board is adopting the amendments regarding financial relationships and transactions with executive officers as reproposed. A discussion of the comments received is included in Section C. Other Amendments to PCAOB Auditing Standards In addition to the other amendments relating to financial relationships and transactions with executive officers, the other amendments being adopted by the Board revise other auditing standards to conform them to the standard and amendments and, where appropriate, include new requirements that complement the standard and amendments regarding significant unusual transactions. For example, the other amendments include changes to AU sec. 333, relating to management's written representations to the auditor, to include a representation that management has made available to the auditor the names of all related parties and relationships and transactions with related parties. Additionally, the other amendments to AU sec. 333 require the auditor to obtain relevant written representations from management: (i) That there are no side agreements or other arrangements (either written or oral) undisclosed to the auditor, and (ii) if the company's financial statements include an assertion that transactions with related parties were condu [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2014-17400. Public record. Not legal advice.