Federal Register, Volume 79 Issue 142 (Thursday, July 24, 2014)

[Federal Register Volume 79, Number 142 (Thursday, July 24, 2014)]
[Notices]
[Pages 43164-43229]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-17400]

[[Page 43163]]

Vol. 79

Thursday,

No. 142

July 24, 2014

Part III

Securities and Exchange Commission

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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; Notice

Federal Register / Vol. 79 , No. 142 / Thursday, July 24, 2014 /
Notices

[[Page 43164]]

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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\
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\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.
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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

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should be directed, and determine the extent of such inquires, by
considering whether such individuals are likely to have knowledge
regarding:
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\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.
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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\
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\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.
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7. The auditor should inquire of the audit committee,\7\ or its
chair, regarding:
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\7\ The term ``audit committee'' has the same meaning as the
term used in Auditing Standard No. 16, Communications with Audit
Committees.
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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\
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\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.
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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.
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\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.
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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.
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\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
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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\
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\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
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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\
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\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).
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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
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\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.
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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

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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.
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\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
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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.
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\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.
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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\
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\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.
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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
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\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.
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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\
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\19\ See paragraphs 30-31 of Auditing Standard No. 14.
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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\
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\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

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company's belief that'' does not change the auditor's
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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:
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\21\ See Auditing Standard No. 16 regarding the timing of the
communications to the audit committee.
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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

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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''

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

[[Page 43169]]

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.)

[[Page 43170]]

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

[[Page 43171]]

(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

[[Page 43172]]

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.
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\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).
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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

[[Page 43173]]

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\
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\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.
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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.
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\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'').
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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\
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\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 . . . .''
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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\
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\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.
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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\
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\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).
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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\
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\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.
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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\

[[Page 43174]]

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.
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\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.
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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\
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\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.
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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.
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\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.
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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.
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\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).
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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\
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\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.
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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\
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\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.
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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

[[Page 43175]]

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\
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\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.
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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.
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\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.
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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\
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\57\ Section D discusses the Board's consideration of the
economic impacts regarding the standard and amendments in greater
detail.
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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

[[Page 43176]]

to the standard and amendments.\58\ Some of the more significant of
these include:
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\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.
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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.
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\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.
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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

[[Page 43177]]

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

[[Page 43178]]

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

[[Page 43179]]

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 conducted on
terms equivalent to those prevailing in an arm's-length transaction.
Other new requirements in the other amendments complement the
requirements in the standard and amendments through improvements to the
auditor's: (i) communications with a predecessor auditor; (ii)
procedures during the period subsequent to the balance sheet date
through the date of the auditor's report; and (iii) procedures during
reviews of interim financial information. These and the other
amendments being adopted by the Board are discussed in greater detail
in Section C.
The Board is adopting the other amendments substantially as
reproposed, with only minor clarifying changes. More detail regarding
those changes is included in Section C.
(b) Statutory Basis
The statutory basis for the proposed rules is Title I of the Act.

B. Board's Statement on Burden on Competition

Not applicable. The Board's consideration of the economic impacts
of the standard and amendments are discussed in Section D.

C. Board's Statement on Comments on the Proposed Rules Received From
Members, Participants or Others

The Board released the proposal for public comment on February 28,
2012. The Board received 37 written comment letters relating to the
proposal. The Board discussed the proposal with the SAG on May 17,
2012.
The Board released the reproposal for public comment on May 7,
2013. The Board received 24 written comment letters relating to the
reproposal. The Board discussed the reproposal with the SAG on May 15,
2013.
The Board has carefully considered all comments received. The
Board's response to the comments it received on the reproposal and the
changes made to the rules in response to the comments received are
discussed below. Additionally, below is a comparison of the objective
and key requirements of the proposed rules with the analogous standards
of the International Auditing and Assurance Standards Board (``IAASB'')
and the Auditing Standards Board (``ASB'') of the AICPA.
1. Discussion of the Proposed Rules and Comments Received
Introduction
After considering the comments received, the Board is adopting the
standard and amendments substantially as reproposed, except for certain
clarifications and changes that are being made largely in response to
comments.
A recurring theme from comments received on both the proposal and
reproposal dealt with including additional discussion and examples in
the standard and amendments. Several commenters requested that the
Board include additional discussion and examples contained in the
proposing and reproposing releases in the text of the standard and
amendments. Some commenters suggested that not including additional
discussion and examples could affect the consistency of implementation
and the initial and recurring implementation costs.
The Board considered these comments and determined, as it has done
in other projects, to include performance requirements in the standard
and amendments and to provide additional discussion and examples
primarily in an appendix to its adopting release. As noted in the
reproposal, this approach promotes a clear separation between the
required procedures and the Board's additional discussion regarding the
application of the standard and amendments. To assist auditors in
implementing the standard and amendments, the discussion below includes
additional discussion and examples previously included in the proposing
and reproposing releases, modified to address the standard and
amendments being adopted by the Board.
The discussion below relates to: Auditing Standard No. 18, Related
Parties; Amendments to Certain PCAOB Auditing Standards Regarding
Significant Unusual Transactions; Other Amendments to PCAOB Auditing
Standards; Audits of Brokers and Dealers; and Effective Date.
Auditing Standard No. 18, Related Parties
Commenters generally supported the Board's standard-setting efforts
to strengthen the existing auditing standard, with many commenters
noting that the reproposed standard could have a positive impact on
audit quality. Many commenters also suggested changes for further
improving the reproposed standard, including some clarifications and
editorial suggestions.
The Board is adopting the standard, substantially as reproposed,
but is making certain revisions to clarify and refine various aspects
of the standard. The most significant changes include:
Clarifying the Scope of the Auditor's Inquiries Regarding
Related Party Transactions (Paragraph 5): Paragraph 5 of the standard
includes a revision to clarify the scope of the auditor's inquiries of
management to include transactions with its related parties that were
modified during the period under audit.
Including Examples of Others Within the Company of Whom
the Auditor Might Inquire (Paragraph 6): A footnote has been added to
paragraph 6 of the standard to provide examples of others within the
company that the auditor might inquire of regarding the company's
relationships and transactions with related parties.
Providing Direction Regarding Timing of Communications
(Paragraph 8): Paragraph 8 of the standard includes a revision that
notes that the communication to engagement team members pursuant to
paragraph 8 can be more effective when it occurs at an early stage of
the audit.
Providing Direction Regarding Intercompany Accounts
(Paragraph 13): A note has been added to paragraph 13 of the standard
to clarify that the procedures performed by the auditor should address
the risks of material misstatement associated with the company's
intercompany accounts.
Clarifying the Auditor's Responsibility for Evaluating the
Company's Identification of its Related Parties (Paragraph 14):
Paragraph 14 includes revisions to highlight that the auditor's
evaluation of a company's identification of its related parties
includes performing procedures to test the accuracy and completeness of
the related parties and relationships and transactions with related
parties identified by the company, and that

[[Page 43180]]

such evaluation takes into account the information gathered during the
audit.
Clarifying the Auditor's Responsibility Regarding Appendix
A (Paragraph 14): Language has been added to paragraph 14 and Appendix
A (referred to in paragraph 14) to clarify that Appendix A contains
examples of information and sources of information that may be gathered
during the audit.
Expanding the Examples Contained in Appendix A (Appendix
A): The examples of sources of information contained in Appendix A of
the standard have been expanded to include the company's ``disclosures
contained on the company's Web site'' (in addition to the company's
disclosures in SEC filings, which is already included as an example in
Appendix A).
Clarifying the Procedures Performed If the Auditor
Identifies a Related Party or Relationship or Transaction with a
Related Party Previously Undisclosed to the Auditor (Paragraph 16):
Paragraph 16 includes a number of clarifications, the most significant
of which include revisions clarifying that paragraph 16 requires the
auditor to perform initial procedures intended to help the auditor
understand and evaluate the nature of the undisclosed related party or
relationship or transaction with a related party identified by the
auditor. Taking into account the information gathered from performing
those procedures, the auditor then performs additional procedures to
evaluate any broader implications for the audit.
The following sections discuss the standard being adopted by the
Board, the existing standard, significant comments received, and the
Board's responses, including a description of the changes from the
reproposed standard. The following sections also include additional
discussion and examples that could be useful to auditors in
implementing the standard. The sections are organized by the following
topical areas:

Introduction (Paragraph 1)
Objective (Paragraph 2)
Performing Risk Assessment Procedures to Obtain an
Understanding of the Company's Relationships and Transactions with Its
Related Parties (Paragraphs 3-9)
Identifying and Assessing Risks of Material Misstatement
(Paragraph 10)
Responding to the Risks of Material Misstatement (Paragraphs
11-13)
Evaluating Whether the Company Has Properly Identified Its
Related Parties and Relationships and Transactions with Related Parties
(Paragraphs 14-16)
Evaluating Financial Statement Accounting and Disclosures
(Paragraphs 17-18)
Communications with the Audit Committee (Paragraph 19)
Introduction (Paragraph 1 of the Standard)

Discussion of Paragraph 1 of Auditing Standard No. 18

Paragraph 1 of the standard states that the 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.
A footnote to paragraph 1 of the standard provides that the auditor
should look to the requirements of the SEC 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 (which is referred to as a ``framework neutral'' approach).\65\
---------------------------------------------------------------------------

\65\ For SEC filings that include financial statements prepared
in accordance with or reconciled to U.S. Generally Accepted
Accounting Principles (``GAAP''), see, e.g., Financial Accounting
Standards Board's (``FASB'') Accounting Standards Codification Topic
850, Related Party Disclosures. For SEC filings that include
financial statements prepared in accordance with International
Financial Reporting Standards, as issued by the International
Accounting Standards Board (``IFRS''), see, e.g., International
Accounting Standard No. 24, Related Party Disclosures.
---------------------------------------------------------------------------

In contrast to the specific required procedures contained in the
standard, AU sec. 334 provides guidance on procedures that the auditor
should consider to identify related party relationships and
transactions, and to satisfy himself concerning the required financial
statement accounting and disclosures.\66\ The standard also improves
upon the existing standard by using a framework neutral approach. The
existing standard, on the other hand, refers the auditor to the
definition of a related party contained in GAAP.
---------------------------------------------------------------------------

\66\ See AU secs. 334.01-.02.
---------------------------------------------------------------------------

After considering all comments received, the Board is adopting
paragraph 1 of the standard as reproposed.
Objective (Paragraph 2 of the Standard)

Discussion of Paragraph 2 of Auditing Standard No. 18

Paragraph 2 of the standard states that 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. A footnote refers the auditor to other
relevant standards, including paragraphs 30-31 of Auditing Standard No.
14, Evaluating Audit Results, and paragraph .04 of AU sec. 411, The
Meaning of Present Fairly in Conformity with Generally Accepted
Accounting Principles.
The intent of the objective is to focus the auditor on the end
result--obtaining 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.
In contrast, the existing standard does not specifically describe
an objective for the auditor's work regarding a company's relationships
and transactions with its related parties.

Discussion of Comments Received on Paragraph 2 of the Reproposed
Standard

The Board considered all comments received, including the following
significant comments:
Including the Consideration of ``Fraud'' as an Explicit Objective:
A few commenters recommended that the objective of the standard refer
to the risk of fraud as an explicit objective of the standard. The
Board considered similar comments received on the proposal in
developing its reproposal. As noted in the reproposal, related party
transactions warrant special attention by the auditor, in part, because
of their historic association with material misstatements that are
associated with fraudulent financial reporting. The standard requires
the auditor to perform specific procedures intended to provide for
heightened scrutiny of the company's identification of, accounting for,
and disclosure of its related parties and relationships and
transactions with related parties. Since some related party
transactions may be routine and occur in the ordinary course of
business, the Board determined to take a risk-based approach that
aligns with and builds upon its risk assessment standards.\67\ The risk
assessment standards emphasize that the auditor's responsibilities for
assessing and responding to fraud are an integral part of the audit
process rather than a separate, parallel process. In the Board's view,
this represents an effective and efficient audit approach. This is in

[[Page 43181]]

contrast to the approach taken in the existing standard, which 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.\68\
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\67\ See Auditing Standards Related to the Auditor's Assessment
of and Response to Risk and Related Amendments to Other PCAOB
Standards, PCAOB Release 2010-004 (August 5, 2010).
\68\ AU sec. 334.06.
---------------------------------------------------------------------------

Incorporating Materiality into the Objective: A few commenters
recommended including a reference to materiality in the objective of
the standard. The Board considered these comments but noted that
auditing standards require the auditor to design and perform audits to
identify material misstatements. Also, direction regarding the
auditor's considerations of materiality already is contained in
Auditing Standard No. 11, Consideration of Materiality in Planning and
Performing an Audit.
The Board is adopting paragraph 2 of the standard as reproposed,
except for an additional reference to paragraph 30 of Auditing Standard
No. 14 that has been added to footnote 2.
Performing Risk Assessment Procedures To Obtain an Understanding of the
Company's Relationships and Transactions With Its Related Parties
(Paragraphs 3 Through 9 of the Standard)

Discussion of Paragraphs 3 Through 9 of Auditing Standard No. 18

Paragraph 3 of the standard builds upon the foundational risk
assessment requirements contained in Auditing Standard No. 12,
Identifying and Assessing Risks of Material Misstatement. Chiefly,
paragraph 3 of the standard requires the auditor to perform specific
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.\69\
---------------------------------------------------------------------------

\69\ In addition, the other amendments make a conforming
amendment to Auditing Standard No. 12.
---------------------------------------------------------------------------

Understanding the nature and business purpose (or the lack thereof)
of a company's relationships and transactions with its related parties
is important for the auditor's evaluation of the company's accounting
for and disclosure of related party transactions because a company's
relationships and transactions with its related parties could pose
increased risks of material misstatement. For example, to improve the
appearance of its financial condition, a company and a related party
could attempt to ``dress up'' the appearance of the company's balance
sheet at period end by agreeing to have the company temporarily pay
down its related party debt prior to the balance sheet date while
having an undisclosed side agreement to subsequently borrow the same or
a comparable amount shortly after period end.
Paragraph 3 further provides that the procedures to be performed to
obtain an understanding of the company's relationships and transactions
include: (i) procedures to obtain an understanding of the company's
process; (ii) performing inquiries; and (iii) communicating with the
audit engagement team and other auditors.
The existing standard suggests some similar procedures for the
auditor's consideration. For example, the existing standard states in
AU sec. 334.05 that, in determining the scope of work to be performed
with respect to possible transactions with related parties, the auditor
should obtain an understanding of management responsibilities and the
relationship of each component of the entity to the total entity. AU
sec. 334.05 further states that the auditor should consider controls
over management activities and the business purpose served by the
various components of the entity. AU sec. 334.09 states that, after
identifying related party transactions, the auditor should apply the
procedures that the auditor considers necessary to obtain satisfaction
concerning the purpose, nature, and extent of these transactions and
their effect on the financial statements. Additionally, paragraph 71 of
Auditing Standard No. 12 states that one factor to be considered in
determining whether a risk represents a significant risk is whether the
risk involves significant transactions with related parties.

Obtaining an Understanding of the Company's Process (Paragraph 4 of the
Standard)

Paragraph 4 of the standard also aligns with and builds upon the
requirements in Auditing Standard No. 12. Auditing Standard No. 12
requires the auditor to obtain a sufficient understanding of each
component of internal control over financial reporting to: (i) identify
the types of potential misstatement; (ii) assess the factors that
affect the risks of material misstatement; and (iii) design further
audit procedures.\70\ Paragraph 4 of the standard requires that, in
conjunction with obtaining an understanding of internal control over
financial reporting, the auditor obtain an understanding of the
controls that management has established to: (i) identify related
parties and relationships and transactions with related parties; (ii)
authorize and approve transactions with related parties; and (iii)
account for and disclose relationships and transactions with related
parties in the financial statements.
---------------------------------------------------------------------------

\70\ See paragraph 18 of Auditing Standard No. 12.
---------------------------------------------------------------------------

Obtaining an understanding of the company's controls, including its
policies and procedures, is important to an auditor's consideration of
the risks that a company's relationships and transactions with related
parties may pose for material misstatement of the company's financial
statements. The standard recognizes that material features of
companies' policies and procedures for the review, approval, or
ratification of related party transactions will vary depending on both
the size and complexity of the company and the types of transactions
covered by such policies and procedures. The standard should not be
read to imply that such policies and procedures should be in writing or
adhere to any particular framework.
AU sec. 334, issued before the adoption of the risk assessment
standards, is similar, but not as specific. Among other things, AU sec.
334.05 states that, in determining the scope of work to be performed
with respect to possible transactions with related parties, the auditor
should obtain an understanding of management responsibilities. AU sec.
334.05 further states that the auditor should consider controls over
management activities.

Performing Inquiries (Paragraphs 5 Through 7 of the Standard)

Briefly, paragraphs 5 through 7 of the standard require the auditor
to make specific inquiries of: (i) company management; (ii) others
within the company likely to have additional knowledge regarding the
company's related parties or relationships or transactions with the
company's related parties; and (iii) the company's audit committee.
Appropriately focused inquiries can inform the auditor's
understanding of the nature of the relationships between the company
and its related parties, and the terms and business purposes (or the
lack thereof) of transactions involving related parties. In addition,
inquiries can assist the auditor in determining the extent of audit
procedures that should be performed to determine whether the company
has identified its related parties and relationships and transactions
with its related parties.
The inclusion of the phrase ``(or the lack thereof)'' throughout
the standard

[[Page 43182]]

and amendments is intended to promote a questioning and skeptical
approach by the auditor when obtaining an understanding of the business
purpose of related party transactions. Sharpening the auditor's focus
on evaluating the business purpose of related party transactions is
particularly appropriate in view of the risk of material misstatement
involving related party transactions.\71\ The importance of identifying
transactions that appear to lack a business purpose also is reinforced
in other parts of the standard. For example, the standard requires the
auditor to communicate to the audit committee the identification of
significant related party transactions that appear to the auditor to
lack a business purpose.
---------------------------------------------------------------------------

\71\ See, e.g., paragraph 15 of FASB Statement No. 57, Related
Parties, which states ``[w]ithout disclosure to the contrary, there
is a general presumption that transactions reflected in financial
statements have been consummated on an arm's-length basis between
independent parties. However, that presumption is not justified when
related party transactions exist because the requisite conditions of
competitive, free-market dealings may not exist. Because it is
possible for related party transactions to be arranged to obtain
certain results desired by the related parties, the resulting
accounting measures may not represent what they usually would be
expected to represent.''
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Paragraph 5 contains a list of inquiries of management that consist
of basic information that the auditor should obtain as part of
obtaining an understanding of the company's financial relationships and
transactions with its related parties, such as the names of the
company's related parties and the nature of the company's relationships
and transactions with those related parties. A footnote to paragraph 5
refers the auditor to AU sec. 333, Management Representations, and
notes that obtaining such representations from management complements
the performance of procedures in paragraph 5 and is not a substitution
for those inquiries.
Paragraph 6 provides that the auditor also inquire of others within
the company regarding their knowledge of the same matters that are the
subject of the auditor's inquiries of management pursuant to paragraph
5 of the standard.
A footnote to paragraph 6 states that 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 resource director or
person in equivalent position. These examples of ``others'' included in
the standard are not intended to imply that these individuals could not
also be members of ``management'' for a particular company.
The inquiries required in paragraph 6 provide an opportunity for
the auditor to corroborate the information obtained from management.
Paragraph 6 does not, however, require the auditor to inquire of others
within the company regarding matters that the auditor does not believe
are reasonably within their knowledge.
Paragraph 7 of the standard provides that the auditor also should
make inquiries of the company's audit committee, or its chair,
regarding the audit committee's understanding of the company's
relationships and transactions with related parties, focusing on those
that are significant to the company.\72\ Additionally, the standard
provides that the auditor should inquire as to whether any member of
the audit committee has concerns regarding the company's relationships
or transactions with related parties. The inquiries of the audit
committee, or its chair, pursuant to paragraph 7 of the standard work
in concert with the auditor's communications with the audit committee
pursuant to paragraph 19 of the standard to provide an opportunity for
the auditor to corroborate management's responses. The audit committee
communication requirements in the standard are intended to provide the
auditor with a forum to discuss sensitive areas that potentially may
involve the financial interests of members of the company's management.
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\72\ Paragraph 8 of Auditing Standard No. 16, Communications
with Audit Committees, also requires the auditor to make certain
inquiries of the audit committee.
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The inquiries in paragraphs 5 through 7 of the standard could be
performed at the same time as the inquiries about the risks of material
misstatement, including fraud risks, that are performed as part of the
auditor's risk assessment, as required by paragraphs 54 through 58 of
Auditing Standard No. 12. These inquiries also would provide an
opportunity for the auditor to discuss, as appropriate, the company's
financial relationships and transactions with its executive officers
with the audit committee, or its chair, as part of the auditor's
procedures to obtain an understanding of the company's relationships
and transactions with its related parties.
In contrast to the new requirements contained in the standard, the
existing standard describes a variety of specific audit procedures for
the auditor's consideration in determining the existence of related
parties.\73\ These specific procedures include requesting from
appropriate management personnel the names of all related parties and
inquiring whether there were any transactions with these parties during
the period. The existing standard has no audit committee communication
requirement. The procedures in paragraph 5 through 7 of the standard
provide more specific procedures for the auditor regarding the use of
inquiries of management and others.
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\73\ See AU sec. 334.07.
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Communicating With the Audit Engagement Team and Other Auditors
(Paragraphs 8 and 9 of the Standard)

Paragraphs 8 and 9 of the standard require the auditor to
communicate to engagement team members and, if applicable, other
auditors, 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. A footnote
to paragraph 8 states that 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. That footnote also refers the auditor to paragraph 5
of Auditing Standard No. 10, Supervision of the Audit Engagement. If
the auditor is using the work of another auditor, paragraph 9 of the
standard further requires the auditor to make certain inquiries 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.\74\
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\74\ The standard does not include a specific requirement for
the auditor to make similar inquires of engagement team members
because existing standards already require engagement team members
to bring relevant matters to the attention of the audit engagement
partner. See, e.g., paragraph 5 of Auditing Standard No. 10.
---------------------------------------------------------------------------

Communicating information to engagement team members regarding a
company's related parties and relationships and transactions with
related parties might increase the likelihood that the engagement team
will identify related parties or relationships or transactions with
related parties previously undisclosed to the auditor by management.
Effective communication to engagement team members might also highlight
evidence

[[Page 43183]]

that corroborates or contradicts information provided by management
about relationships and transactions with related parties.
Additionally, effective communication to engagement team members could
enhance the auditor's understanding of the company's relationships and
transactions with its related parties.
Examples of matters regarding related parties that the engagement
team might discuss include: (i) Information that could indicate the
existence of related parties or relationships or transactions with
related parties previously undisclosed to the auditor; (ii) sources of
information that could indicate the existence of related parties or
relationships or transactions with related parties previously
undisclosed to the auditor; (iii) how entities controlled by management
(e.g., variable interest entities) might be used to facilitate earnings
management; and (iv) how transactions between the company and a known
business partner of a member of management could be arranged to
facilitate fraudulent financial reporting or asset misappropriation.
In addition, under PCAOB standards, a principal auditor may use the
work and reports of other auditors who have audited the financial
statements of one or more subsidiaries, divisions, branches,
components, or investments included in the company's financial
statements.\75\ Exchanging relevant information about related parties
with the other auditor can assist the principal auditor in
understanding the overall nature of the company's relationships and
transactions with related parties and in identifying related parties or
relationships or transactions with related parties previously
undisclosed to the auditor.
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\75\ See paragraph .01 of AU sec. 543, Part of Audit Performed
by Other Independent Auditors.
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AU sec. 334.08 contains audit procedures intended to provide
guidance for identifying material transactions that may be indicative
of the existence of previously unidentified related party
relationships. One such procedure is to provide audit personnel
performing segments of the audit, or auditing and reporting separately
on the accounts of related components of the reporting entity, with the
names of known related parties so that they may become aware of
transactions with such parties during their audits. Further, AU sec.
334.07.g., suggests a number of audit procedures for determining the
existence of related party relationships, including making inquiries of
other auditors of related entities concerning their knowledge of
existing relationships and the extent of management involvement in
material transactions. Finally, paragraph .13 of AU sec. 9334, Related
Parties: Auditing Interpretations of Section 334, states that the
principal auditor and the other auditor should obtain from each other
the names of known related parties and that, ordinarily, the exchange
should be made at an early stage of the audit. In contrast to the
suggested procedures provided in the existing standard, the standard
provides specific procedures for the auditor regarding this topic.

Discussion of Comments Received on Paragraphs 3 Through 9 of the
Reproposed Standard

The Board considered all comments received, including the following
significant comments:
Inquiring Regarding ``Modifications'' to Related Party
Transactions: One commenter stated that modifications to transactions
with related parties during the period may give rise to a risk of
material misstatement. This commenter suggested clarifying the scope of
paragraph 5.d. of the reproposed standard by adding the word
``modified'' after the phrase ``the transactions entered into.'' This
change would clarify that the auditor's inquiries regarding the
company's related party transactions entered into during the audit
period would include inquiries regarding any such transactions that
were modified during that period. The Board considered this comment and
agreed that this would be a useful change. The Board has made a change
to paragraph 5.d. to reflect the commenter's suggestion.
Providing Additional Direction Regarding the Auditor's Inquiries:
Two commenters recommended including additional direction regarding the
auditor's inquiries. One commenter suggested providing further
direction on the nature and extent of the auditor's inquiries. Another
commenter suggested that the Board provide examples of others within
the company of whom the auditor might inquire to clarify the intent of
the requirement in paragraph 6. The Board considered these comments and
has added a new footnote to paragraph 6. That new footnote states that
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.\76\ The
Board declined to add more specific requirements because determining
the nature and extent of the auditor's inquiries is an area that would
benefit from the auditor's consideration of the facts and circumstances
of the audit.
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\76\ These examples of ``others'' had been included in the
proposed standard but were removed from the reproposal because the
Board did not wish to suggest that the auditor should make inquiries
of each of these individuals in all instances. Additionally, one
commenter on the proposal observed that some of the ``others'' might
also be members of management in some companies. However, in view of
comments indicating that additional examples in the standard would
be helpful, the Board believes that these examples could be useful
to auditors, and including them in a footnote to the standard should
avoid the notion that these examples in and of themselves impose
requirements.
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Timing of the Auditor's Communications: At the SAG discussion, a
suggestion was made to include direction regarding the timing of the
auditor's communication to the engagement team. The Board considered
this comment, noting that, similar to the approach under the existing
standard, this communication would generally occur at an early stage of
the audit as it would be performed in conjunction with the risk
assessment procedures.\77\ Further, the proposing release had noted
that communicating information about related parties at an early stage
of the audit would benefit such discussions and should continue
throughout the audit. The Board has revised the footnote to paragraph 8
of the standard to indicate that this communication can be more
effective when it occurs at an early stage of the audit.
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\77\ See AU sec. 9334.13.
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The Board is adopting paragraphs 3 through 9 of the standard
substantially as reproposed, except for, as described above: (i)
Revising item d. of paragraph 5 to clarify that auditors' inquiries
include inquiries regarding any transactions that were modified during
the period; (ii) adding a footnote to paragraph 6 that includes
examples of others within the company to whom the auditor may address
inquiries; and (iii) revising the footnote to paragraph 8 to indicate
that the communication can be more effective when it occurs at an early
stage of the audit. Identifying and Assessing Risks of Material
Misstatement (Paragraph 10 of the Standard)

Discussion of Paragraph 10 of Auditing Standard No. 18

Paragraph 10 of the standard aligns with the risk assessment
requirements contained in Auditing Standard No. 12, which require the
auditor to identify

[[Page 43184]]

and assess the risks of material misstatement at the financial
statement level and the assertion level. Paragraph 10 of the standard
states that 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. A
footnote to paragraph 10 refers the auditor to paragraph 59 of Auditing
Standard No. 12.
The clause ``including whether the company has properly identified,
accounted for, and disclosed its related parties and relationships and
transactions with related parties'' in paragraph 10 is intended to
highlight, among other things, that the auditor's assessment of risk
includes a focus on risks related to the company's less than complete
identification of its related parties or relationships or transactions
with related parties. Such a focus helps support the auditor's
evaluation of whether the company has properly identified its related
parties and relationships and transactions with related parties.
Due to their nature, transactions with related parties might
involve difficult measurement and recognition issues that can lead to
errors in financial statements, for example, when terms are not
properly considered in accounting determinations. Related parties might
also buy or sell goods or services at prices that differ significantly
from prevailing market prices or offer unusual rights of return or
extended payment terms.
Additionally, as previously discussed, under the risk assessment
standards, the auditor is required to determine whether any of the
identified and assessed risks of material misstatement are fraud risks
or other significant risks.\78\ The standard does not mandate that all
related party transactions be presumed to be or deemed to be
significant risks or designated as a fraud risk. Under the risk
assessment approach, the auditor's assessment is based on the facts and
circumstances of the audit, including the facts and circumstances of a
company's relationships and transactions with related parties. However,
depending on the facts and circumstances, assessed risks of material
misstatement associated with related parties and relationships and
transactions with related parties might also represent fraud risks or
other significant risks. AU sec. 316, Consideration of Fraud in a
Financial Statement Audit, provides examples of fraud risk factors,
including some concerning related parties.\79\
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\78\ See paragraphs 59.f., 70, and 71 of Auditing Standard No.
12.
\79\ See AU sec. 316.85.A.2, Section a., under
``Opportunities.''
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The complexity of a transaction is a factor considered by auditors
when assessing risks of material misstatement associated with related
party transactions. Further, when the substance of a related party
transaction differs materially from its form, or when a company's
related parties operate through an extensive and complex range of
relationships and structures, heightened scrutiny is warranted. For
example, depending upon the facts and circumstances, the creation of a
variable interest entity in which the company's economic interest (its
obligation to absorb losses or its right to receive benefits) is
disproportionately greater than the company's stated power might
represent a fraud risk or other significant risk, especially in the
presence of other fraud risk factors.\80\ Examples of fraud risk
factors regarding related parties that individually, or in combination
with other fraud risk factors, might indicate the existence of a fraud
risk, include significant related party transactions not in the
ordinary course of business or with related entities not audited or
audited by another firm.\81\
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\80\ Paragraph 10 of Auditing Standard No. 12 states that
obtaining an understanding of the nature of the company includes
understanding the company's significant investments, including
equity method investments, joint ventures and variable interest
entities.
\81\ The amendments regarding significant unusual transactions
separate this example into two examples--(i) related party
transactions that are also significant unusual transactions and (ii)
significant transactions with related parties whose financial
statements are not audited or are audited by another firm.
---------------------------------------------------------------------------

The existence of dominant influence is another factor considered by
auditors when assessing the risks of material misstatement. Related
parties, due to their ability to control or significantly influence,
may be in a position to prevent a company from pursuing its own
separate interests. Identifying the risks of material misstatement
associated with dominant influence can assist the auditor's assessment
of the risks of material misstatement. AU sec. 316.85 already describes
the principle of dominant influence in the example of a fraud risk
factor by stating that the ineffective monitoring of management as a
result of domination of management by a single person or small group,
without compensating controls, provides an opportunity for management
to engage in fraudulent financial reporting.
Examples of factors that may signal dominant influence exerted by a
related party include:
Significant transactions are referred to the related party
for approval;
There is little or no debate among management and the
board of directors regarding business proposals initiated by the
related party; or
The related party played a leading role in starting the
company and continues to play a leading role in managing the company,
even if the related party is no longer formally part of management or
the board of directors.
The existence of dominant influence by itself, or in the presence
of other fraud risk factors (e.g., use of an intermediary whose
involvement serves no apparent business purpose), might indicate the
existence of a fraud risk.
The other amendments to PCAOB auditing standards complement the
requirements of paragraph 10 by amending AU sec. 316.85.A.2 to include
the exertion of dominant influence by or over a related party as an
example of a fraud risk factor. The other amendment to AU sec.
316.85.A.2 expands that concept to encompass all related parties
outside of management of the company. The amendments do not define
dominant influence, as doing so might result in some auditors being
overly focused on the definition itself, instead of focusing on the red
flags associated with dominant influence that might create risks of
material misstatement at the financial statement level.
AU sec. 334 does not provide specific guidance for the auditor
regarding the identification and assessment of risks of material
misstatement associated with related party transactions. In fact, AU
sec. 334.06 provides that, in the absence of evidence to the contrary,
transactions with related parties should not be assumed to be outside
the ordinary course of business.\82\
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\82\ Thus, AU sec. 334.06 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.
---------------------------------------------------------------------------

Discussion of Comments Received on Paragraph 10 of the Reproposed
Standard

The Board considered all comments received, including the following
significant comments:
Referencing Information Obtained From Past Audits: One commenter
recommended requiring the auditor to determine that there were no
changed circumstances for material related party

[[Page 43185]]

transactions previously authorized and approved. Another commenter
suggested including a reference to the requirements pertaining to
information obtained from past audits contained in the risk assessment
standards both to improve the effectiveness of the audit process and to
remind auditors of their responsibility regarding the information
previously obtained regarding ongoing matters.
The Board considered these comments, noting that paragraph 10
requires that, in identifying and assessing the risks 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 through 9 and the risk
assessment procedures required by Auditing Standard No. 12, which
address information obtained from past audits.\83\ Thus, the auditor is
already required to take such information obtained from past audits
into account in identifying and assessing risks of material
misstatement. Further, the revisions made to item d. of paragraph 5,
which require the auditor to inquire of management regarding
transactions with related parties modified during the period under
audit, should assist the auditor in identifying transactions for which
the auditor would not be able to rely on information obtained from past
audits.
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\83\ Paragraphs 41 through 45 of Auditing Standard No. 12 note
that the auditor's risk assessment procedures require the auditor to
consider information from the client acceptance and retention
evaluation, audit planning activities, past audits, and other
engagements.
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The Board is adopting paragraph 10 of the standard as reproposed.
Responding to the Risks of Material Misstatement (Paragraphs 11 through
13 of the Standard).

Discussion of Paragraphs 11 Through 13 of Auditing Standard No. 18

Paragraph 11 of the standard aligns with the requirement in
Auditing Standard No. 13, The Auditor's Responses to the Risks of
Material Misstatement, for the auditor to design and implement audit
responses that address the identified and assessed risks of material
misstatement. Paragraph 11 states that this includes designing and
performing audit procedures that address the risks of material
misstatement associated with related parties and relationships and
transactions with related parties. Footnotes to paragraph 11 refer the
auditor to relevant paragraphs of the risk assessment standards. A note
to paragraph 11 refers the auditor to the new requirements in
paragraphs .66-.67A of AU sec. 316 for related party transactions that
are also significant unusual transactions.
AU sec. 334 also provides guidance to the auditor regarding audit
procedures to evaluate identified related party transactions. For
example, AU sec. 334.09 provides that, after identifying related party
transactions, the auditor should apply the procedures the auditor
considers necessary to obtain satisfaction concerning the purpose,
nature, and extent of these transactions and their effect on the
financial statements. The procedures should be directed toward
obtaining and evaluating sufficient appropriate evidential matter and
should extend beyond inquiry of management. AU sec. 334.09 includes
procedures that should be considered and footnote 6 of AU sec. 334.09
provides that, until the auditor understands the business sense of
material transactions, he cannot complete his audit.\84\ AU sec. 334.10
includes other procedures that the auditor should consider when the
auditor believes it necessary to fully understand a particular
transaction, and notes that those procedures might not otherwise be
deemed necessary to comply with generally accepted auditing standards.
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\84\ AU sec. 411.06 requires the auditor to consider whether the
substance of a transaction differs materially from its form when
evaluating whether the financial statements have been presented
fairly in accordance with the applicable financial reporting
framework. Understanding the ``business sense'' of material
transactions is encompassed by this consideration.
---------------------------------------------------------------------------

Transactions With Related Parties Required To Be Disclosed in the
Financial Statements or Determined To Be a Significant Risk (Paragraph
12 of the Standard)

Briefly, paragraph 12 of the standard requires the auditor to
perform certain basic procedures (supplemented by more in-depth
procedures commensurate with the auditor's evaluation of the company's
facts and circumstances) regarding related party transactions that are
either required to be disclosed in the financial statements or
determined to be a significant risk.\85\
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\85\ The SEC expects that auditors will provide ``heightened
scrutiny'' of a company's related party transactions. See SEC
Accounting and Auditing Enforcement Release (``AAER'') No. 3427, In
the Matter of the Application of Wendy McNeeley, CPA, at 10-12
(December 13, 2012), which 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.
---------------------------------------------------------------------------

Focusing the auditor's attention on related party transactions that
are required to be disclosed in the financial statements or determined
to be a significant risk is intended to make the auditor's evaluation
of whether the company's related party transactions are properly
accounted for and disclosed most effective.
One important focus of the procedures required by paragraph 12 is
the auditor's evaluation of the business purpose (or the lack thereof)
of the related party transactions that are required to be disclosed or
determined to be a significant risk. The procedures in paragraph 12 are
designed to work with the procedures in paragraphs 3 through 9 to
provide the auditor with additional information to understand and
assess the business purpose (or the lack thereof) of the targeted
related party transactions that are subject to paragraph 12.
Understanding the business purpose of related party transactions is an
important consideration in assessing and responding to risks of
material misstatement and requires the auditor to understand other
factors underlying the transaction. For example, although a company may
assert that it has utilized a related party transaction to achieve a
particular goal, the company may, in fact, have used the transaction
for some other purpose.\86\ Obtaining an understanding of the terms and
business purpose of a related party transaction includes understanding
why the company entered into the transaction with a related party
versus an unrelated party. A business purpose that appears inconsistent
with the nature of the company's business might represent a fraud risk
factor.
---------------------------------------------------------------------------

\86\ For example, a broker or dealer might use related party
transactions to make the size of their operations appear smaller to
avoid regulatory requirements.
---------------------------------------------------------------------------

Performing Basic Procedures: Paragraphs 12.a.-d. contains the basic
procedures to be applied to related party transactions that are either
required to be disclosed in the financial statements or determined to
be a significant risk. Paragraph 12.a. requires the auditor to read the
underlying documentation relating to the company's related party
transaction(s) 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. This requirement, together with the other
requirements in paragraphs 12.b.-d., require the auditor to evaluate
appropriate information regarding the transaction, including, for
example, the executed contract, and to

[[Page 43186]]

consider whether the contract and other underlying documentation is
appropriately authorized and approved, and is consistent with
explanations from inquiries of management and others. The auditor also
considers how that information compares to other available audit
evidence. For example, when evaluating the responses to inquiries of
management and others, the auditor takes into account information
obtained from other sources. Such sources could include, for example,
SEC filings that include a description of the registrant's policies and
procedures for the review, approval, or ratification of ``related
person'' transactions or that identify any ``related person''
transaction where such policies and procedures did not require review,
approval or ratification or where such policies and procedures were not
followed.\87\
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\87\ See Instruction 1 to Item 404(a) of SEC Regulation S-K for
the definition of ``related person.'' Disclosure requirements
regarding ``related persons'' in Regulation S-K may differ from
``related party'' disclosures. See also, Securities Act Release No.
33-8732A, Executive Compensation and Related Person Disclosure
(August 29, 2006), http://www.sec.gov/rules/final/2006/33-8732afr.pdf.
---------------------------------------------------------------------------

In particular, paragraph 12.d. of the standard requires the auditor
to evaluate the financial capability of the related party with respect
to significant uncollected balances, loan commitments, supply
arrangements, guarantees, and other obligations. This requirement
applies only to items that are individually or collectively
significant. Obtaining evidence to evaluate the financial capability of
a related party can inform the auditor's evaluation of the business
purpose (or the lack thereof), including whether the substance of that
transaction differs materially from its form.\88\
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\88\ See, e.g., McCurdy v. SEC, 396 F.3d 1258, 1261 (D.C. Cir.
2005), noting that ``among transactions calling for close inspection
are related-party transactions, including transactions between a
company and its officers or directors. Such dealings are viewed with
extreme skepticism in all areas of finance . . . . The reason for
this is apparent: Although in an ordinary arms-length transaction,
one may assume that parties will act in their own economic self-
interest, this assumption breaks down when the parties are related.
A company that would perform a thorough credit-risk assessment
before extending a loan might not do so if the loan were to one of
its officers or directors.''
---------------------------------------------------------------------------

Performing Other Procedures: Paragraph 12.e. requires the auditor
to supplement the basic required procedures contained in paragraphs
12.a.-d. with more in-depth procedures commensurate with the auditor's
evaluation of the company's facts and circumstances. This approach
provides the auditor with the opportunity to scale the audit based on
the auditor's judgment regarding other procedures that are necessary to
address the identified and assessed risks of material misstatement.
This requires the auditor to make a determination about what procedures
are needed to evaluate the accounting and disclosure of the related
party transactions. For example, related party transactions might pose
valuation and measurement issues that are not present in arm's-length
transactions. Consequently, the auditor's tests regarding valuation of
a receivable from an entity under common control might be more
extensive than for a trade receivable of the same amount from an
unrelated party because the common controlling parties may be motivated
to obscure the substance of the transaction.
The procedures contained in paragraph 12.e. are designed to work
with other procedures that the auditor performs during the audit to
address the relevant assertions associated with each related party
transaction that requires disclosure.\89\ For example, if a company
makes a material purchase of property, plant and equipment from an
unconsolidated related party, the auditor could inspect the asset to
obtain audit evidence that supports management's assertion regarding
the existence of the asset. Further, the auditor might examine
underlying documents supporting the transfer of title and ownership to
obtain audit evidence that supports management's assertion regarding
its rights and obligations.
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\89\ See paragraph 8 of Auditing Standard No. 13, which requires
the auditor to design and perform audit procedures in a manner that
addresses the assessed risks of material misstatement for each
relevant assertion of each significant account and disclosure. This
includes designing and performing audit procedures in a manner that
addresses the assessed risks of material misstatement associated
with related parties and relationships and transactions with related
parties. See also, paragraph 17 of Auditing Standard No. 13, which
states that tests of controls must be performed in the audit of
financial statements for each relevant assertion for which
substantive procedures alone cannot provide sufficient appropriate
audit evidence and when necessary to support the auditor's reliance
on the accuracy and completeness of financial information used in
performing other audit procedures.
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The economic substance of a related party transaction may differ
materially from its form. AU sec. 411.06 requires that the auditor
consider whether the substance of a transaction differs materially from
its form when evaluating whether the financial statements have been
presented fairly in accordance with the applicable financial reporting
framework. Thus, the procedures performed pursuant to paragraph 12.e.
are intended to address the auditor's concerns about whether the
substance of a related party transaction differs materially from its
form. For example, evaluating the collectability of receivables due
from companies owned or controlled by officers of the company under
audit might include questions beyond evaluating the financial
capability of the related party to pay.
Examples of other procedures that might be appropriate for the
auditor to perform pursuant to paragraph 12.e., depending on the nature
of the transaction and the risks of material misstatement of the
financial statements, include:
Inquiring directly of the related party regarding the
business purpose of the transaction;
Inspecting information in the possession of the related
party or other parties to the transaction, if available;
Reading public information regarding the related party and
the transaction, if any;
Reading the financial statements or other relevant
financial information obtained from the related party, if available, to
understand how the related party accounted for the transaction;
Confirming the terms of the transaction with other parties
with knowledge of the transaction (e.g., banks, guarantors, agents, or
attorneys), if any;
Determining whether there are any side agreements or other
arrangements (either written or oral) with the related party, including
confirming that none exist, if appropriate;
Evaluating the transferability and value of collateral
provided by the related party, if any; and
Performing procedures at the related party, if possible.
In certain circumstances, an auditor may decide to perform audit
procedures at the related party in order to obtain sufficient
appropriate audit evidence to support the auditor's opinion. The
auditor, however, may not be able to perform procedures at the related
party's premises because the related party may not allow the auditor to
perform such procedures. However, in all cases the auditing standards
require the auditor to obtain sufficient appropriate audit evidence to
support his or her audit opinion.\90\
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\90\ Paragraph 2 of the standard states that 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. As provided by paragraph
14 of the standard, the auditor's evaluation should be supported by
auditing procedures and evidence obtained from procedures performed
during the audit, including procedures designed to test the accuracy
and completeness of the related parties and relationships and
transactions with related parties disclosed by the company to the
auditor.

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[[Page 43187]]

Aggregating Transactions for Disclosure: Accounting principles
applicable to the company may allow the aggregation of related party
transactions that require disclosure (e.g., by type of related party
transaction). A note to paragraph 12 of the standard addresses the
auditor's responsibility for aggregated related party disclosures. That
note states that, 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 of the standard 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. The Board notes that a ``selection of
transactions'' could be the selection of one transaction from the
aggregation in the appropriate circumstances.
Existing standards require the auditor to design and perform audit
procedures in a manner that addresses the assessed risks of material
misstatement for each relevant assertion of each significant account
and disclosure.\91\ AU sec. 334.08-.09 contains procedures that the
auditor should consider performing when responding to risks arising
from related party relationships and transactions and directs the
auditor to apply the procedures the auditor considers necessary to
obtain satisfaction concerning the purpose, nature, and extent of
identified related party transactions and their effect on the financial
statements, noting that those procedures should extend beyond inquiry
of management.
---------------------------------------------------------------------------

\91\ See paragraph 8 of Auditing Standard No. 13.
---------------------------------------------------------------------------

Intercompany Accounts (Paragraph 13 of the Standard)

Paragraph 13 of the standard requires the auditor to perform
procedures on intercompany account balances as of concurrent dates,
even if fiscal years of the respective companies differ. This
requirement is based on the procedure in the existing standard, AU sec.
334.09.e., which requires the auditor to consider arranging for the
audits of intercompany account balances to be performed as of
concurrent dates, even if the fiscal years differ, and for the
examination of specified, important, and representative related party
transactions by the auditors for each of the parties, with appropriate
exchange of relevant information. Other existing standards also
reference the importance of the auditor's review of consolidating
accounts.\92\
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\92\ See, e.g., paragraph .10 of AU sec. 543, Part of Audit
Performed by Other Independent Auditors, and paragraphs .28-.34 of
AU sec. 332, Auditing Derivative Instruments, Hedging Activities,
and Investments in Securities.
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A new note to paragraph 13 states that the procedures performed
should address the risks of material misstatement associated with the
company's intercompany accounts. Discussion of the Comments Received on
Paragraphs 11 through 13 of Auditing Standard No. 18. The Board
considered all comments received, including the following significant
comments:
Evaluating the Financial Capability of the Related Party: One
commenter recommended that the standard should require the auditor to
consider evaluating the financial capability of a related party and
that the standard should include appropriate alternative procedures if
information regarding the related party's financial capability is not
readily available. Another commenter stated that the evaluation of the
financial capability of the related party should not result in
significant additional time by management or the auditor. The Board
considered these comments noting that auditors are currently performing
procedures to evaluate the financial capability of counterparties in a
variety of audit areas today, regardless of whether the counterparty is
a related party. For example, auditors might examine the company's
support regarding the financial capability of another party as part of
evaluating the company's decision to recognize revenue on a particular
transaction.
Performing Procedures on Intercompany Balances: Some commenters
recommended providing additional direction, including specific
procedures that the auditor should perform pursuant to paragraph 13.
One commenter recommended requiring the auditor to determine the
business purpose for intercompany transactions, and whether the
transactions have ``economic substance.''
The Board considered these comments, noting that the preparation of
consolidated financial statements could involve complex matters
regarding intercompany transactions. For example, a company could
consolidate a subsidiary that has a different year-end. The risks of
material misstatement with intercompany transactions could include not
only the risks associated with intercompany account balances, but also
the resulting effect on the consolidated financial statements, after
elimination of such balances. The procedures performed pursuant to
paragraph 13 should address the risks of material misstatement. Those
procedures could include examining account reconciliations and material
transactions, regardless of their timing. The procedures performed
pursuant to paragraphs 3 through 9 apply to intercompany transactions
and include inquiring of management regarding the business purpose of
the transaction and the business purpose for entering into the
transaction. Some intercompany transactions might give rise to
significant risks of material misstatement that are subject to the
procedures in paragraph 12.
The Board considered including additional direction regarding
intercompany transactions, but noted that such direction could be
viewed as making the requirement unnecessarily prescriptive, which
could result in unnecessary costs. However, to remind auditors of the
need to address the potential risks of material misstatement, the Board
added a note to paragraph 13, which states that the procedures
performed should address the risks of material misstatement associated
with the company's intercompany accounts. Further, based on comments
received, the header preceding paragraph 13 has been revised to refer
to ``Intercompany Accounts.''
The Board is adopting paragraphs 11 through 13 of the standard,
substantially as reproposed, except for changing the header to
paragraph 13 and adding a new note to paragraph 13, discussed above.
Evaluating Whether the Company Has Properly Identified Its Related
Parties and Relationships and Transactions with Related Parties
(Paragraphs 14 through 16 and Appendix A of the Standard)

Discussion of Paragraphs 14 Through 16 and Appendix A of Auditing
Standard No. 18

Briefly, paragraphs 14 through 16 of the standard address the
auditor's evaluation of whether the company has properly identified its
related parties and relationships and transactions with related
parties. Appendix A includes 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.
Paragraph 14 of the standard requires the auditor to evaluate
whether the company has properly identified its

[[Page 43188]]

related parties and relationships and transactions with related
parties. Paragraph 14 states that 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. Paragraph 14 also states that 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. Paragraph 14
further requires that, as part of that 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.
Paragraph 14 of the standard focuses the auditor on a key aspect of
the objective by requiring the auditor to evaluate whether the company
has properly identified its related parties and relationships and
transactions with related parties. Paragraph 14 recognizes that the
company is responsible for the preparation of its financial statements,
including, in the first instance, the identification of the company's
related parties and relationships and transactions with related
parties, and that the auditor begins the audit with information
obtained from the company. While paragraph 14 of the standard
anticipates that the auditor would start his or her work regarding
related parties with the names of related parties and relationships and
transactions with related parties identified by the company, the
auditor may not merely rely on management's representations \93\ as to
the accuracy and completeness of the information provided to the
auditor. While management has the primary responsibility for preparing
the company's financial statements, the auditor should be sensitive
throughout the audit to the possibility that management may not have
informed the auditor of all related parties or relationships or
transactions with related parties.
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\93\ To further assist the auditor's efforts in identifying
related parties, the other amendments include a complementary
provision that expands existing management representations contained
in AU sec. 333 to state that the company has provided the names of
all related parties and all relationships and transactions with its
related parties to the auditor. However, the auditor may not solely
rely on management's representations.
---------------------------------------------------------------------------

Paragraph 14 also recognizes that the auditor's procedures to
evaluate whether the company has properly identified its related
parties should extend beyond the inquiries pursuant to paragraphs 5
through 7 of the standard. Evaluating 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 related parties and relationships and
transactions with related parties identified by the company.
A note to paragraph 14 of the standard refers the auditor to
Appendix A, which describes 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. Many of the
examples contained in Appendix A of the standard are contained in AU
secs. 334.07-.08. The standard does not require an auditor to perform
procedures with respect to each source of information referenced in
Appendix A. The information and sources relevant to a particular audit
would depend on the facts and circumstances of the audit and, thus, not
all of the information or sources of information in Appendix A would
need to be considered in every audit. However, other auditing
standards, or the performance of auditing procedures in other areas,
may impose requirements on the auditor to perform auditing procedures
with respect to certain of those sources (for example, reading
confirmation responses and responses to inquiries of the company's
lawyers).\94\ Appendix A also states that the examples contained in
that Appendix are not intended to represent a comprehensive listing.
---------------------------------------------------------------------------

\94\ See, e.g., AU sec. 330, The Confirmation Process, and AU
sec. 337, Inquiry of a Client's Lawyer Concerning Litigation,
Claims, and Assessments.
---------------------------------------------------------------------------

Paragraph 14 precludes the auditor's reliance on the company's
identification of its related parties without the auditor taking
additional steps, including following up on possible contradictory
information gathered during the audit. Thus, while the standard does
not require the auditor to search public information indiscriminately
to identify a company's related parties, the standard does anticipate
that the auditor will take additional steps, including following up on
inconsistencies or red flags that arise during the audit. For example,
the auditor might review public documents for information regarding a
company's related parties and transactions with related parties,
particularly when such information is readily available.\95\
Additionally, a review of relevant available public information might
be appropriate in situations in which information comes to the
auditor's attention that suggests that related parties previously
undisclosed to the auditor might exist.
---------------------------------------------------------------------------

\95\ Paragraph 11 of Auditing Standard No. 12 requires that as
part of obtaining an understanding of the company the auditor should
consider reading public information about the company relevant to
the evaluation of the likelihood of material financial statement
misstatements.
---------------------------------------------------------------------------

In general, the steps performed by the auditor to evaluate whether
the company has properly identified its related parties and
relationships and transactions with related parties include: (i)
Performing risk assessment 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; (ii) identifying and
assessing risks associated with a company's relationships and
transactions with its related parties, including whether the company
has properly identified its related parties and relationships and
transactions with related parties; (iii) designing and performing audit
procedures that address and respond to the risks of material
misstatement associated with the company's related parties and
transactions, including procedures to test the accuracy and
completeness of the related parties and relationships and transactions
with related parties identified by the company; and (iv) performing
specific procedures that address related party relationships or
transactions identified by the auditor that were previously undisclosed
by company management. Performing these procedures should position the
auditor to obtain sufficient evidence to provide reasonable assurance
to support the auditor's opinion.
The approach in paragraph 14 also considers that the auditor's
efforts to identify and evaluate a company's significant unusual
transactions and obtain an understanding of a company's financial
relationships and transactions with its executive officers might assist
the auditor in identifying information that might indicate that related
parties or relationships or transactions with related parties
previously undisclosed to the auditor might exist.
Also, the amendments to AU sec. 560, Subsequent Events, require
that during the ``subsequent period'' the auditor inquire regarding
whether there have been any changes in the company's related parties
and whether the company has entered into any

[[Page 43189]]

significant new related party transactions. This could inform the
auditor's evaluation of the company's identification of its related
parties and relationships and transactions with related parties.
Pursuant to paragraph 15 of the standard, 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 then performs the procedures necessary to
determine whether previously undisclosed relationships or transactions
with related parties, in fact, exist. The standard requires that these
procedures extend beyond inquiry of management.
Pursuant to paragraph 16 of the standard, 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
perform certain procedures targeted at enhancing the auditor's
understanding of the previously undisclosed related party or
relationship or transaction. The procedures contained in paragraph 16
are intended to focus the auditor on (i) obtaining additional
information and evaluating the related party or relationship or
transaction with a related party that the auditor has identified, and
(ii) assessing the impact of the new information on all aspects of the
audit.
Specifically, the procedures contained in paragraph 16 require that
if the auditor determines that an undisclosed related party or
relationship or transaction 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;
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 the 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;
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; and
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.
A footnote to paragraph 16 refers the auditor to 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.
Another footnote refers the auditor to 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 assessment.
As described above, the procedures required by paragraphs 16.a.-e.
are performed to obtain the information necessary to evaluate the
related party or relationship or transaction with a related party
previously undisclosed to the auditor that the auditor has determined
exists. Significantly, because of the potential for fraud, paragraph
16.b. of the standard requires the auditor to evaluate why the related
party or relationship or transaction with a related party was
previously undisclosed to the auditor. If the related party transaction
is either required to be disclosed or is determined to be a significant
risk, the auditor is required to perform the procedures in paragraph 12
of the standard.
Paragraph 16.f. requires the auditor to take into account the
information gathered from the procedures in paragraph 16.a.-e.
regarding the relationship or transaction identified by the auditor to
assess the impact on the audit. For example, paragraph 16.f.iii.
requires the auditor to reassess the implications for the audit if the
company's nondisclosure indicates that fraud or an illegal act may have
occurred.
Determining that a related party transaction that was previously
undisclosed to the auditor exists could have significant implications
for the audit. This information contradicts representations made by
management to the auditor and may contradict the auditor's preliminary
assessment of whether the company has properly identified its related
parties and relationships and transactions with related parties.
Identifying such contradictory information requires the auditor to
reassess the risk of material misstatement and perform additional
procedures as necessary if such reassessment results in a higher risk.
The auditor takes the information gathered from performing the
procedures set forth in paragraph 16 into account when evaluating
whether the company has properly identified its related parties and
relationships and transactions with related parties pursuant to
paragraph 14 of the standard.
In contrast to the approach set forth in paragraphs 14 through 16,
the existing standard contains a variety of procedures that are less
specific and focused. For example, AU sec. 334.05 alerts the auditor to
the fact that business structure and operating style are occasionally
deliberately designed to obscure related party transactions. AU sec.
334.05 states that, in determining the scope of work to be performed
with respect to possible transactions with related parties, the auditor
should obtain an understanding of management responsibilities and the
relationship of each component to the total entity and should consider
controls over management activities, and the business purpose served by
the various components of the entity. AU sec. 334.07 states that
determining the existence of transactions with related parties beyond
those that are clearly evident requires the application of specific
audit procedures and provides

[[Page 43190]]

examples of such procedures. AU sec. 334.07 further states that the
auditor should place emphasis on testing material transactions with
parties the auditor knows are related to the reporting entity. AU sec.
334.08 includes procedures that are intended to provide guidance for
identifying material transactions with parties known to be related and
for identifying material transactions that may be indicative of the
existence of previously undetermined relationships.

Discussion of the Comments Received on Paragraphs 14 Through 16 and
Appendix A of the Reproposed Standard

The Board considered all comments received, including the following
significant comments:
Clarifying the Auditor's Responsibility Regarding Appendix A: Many
commenters recommended clarifying the auditor's responsibilities for
the examples of information and sources of information contained in
Appendix A. Some of the commenters recommended including clarifying
language regarding the scope of the auditor's responsibilities with
respect to Appendix A; others suggested qualifying language stating
that the auditor is not required to perform procedures with respect to
each type or source of information referenced in Appendix A.
The Board considered these comments, noting that Appendix A is
intended to provide examples of information and sources of information
and does not provide a comprehensive or mandatory listing. Further,
other auditing standards may impose requirements on the auditor to
perform procedures regarding the examples contained in Appendix A.
Accordingly, the suggested qualifying language would not be
appropriate. The Board, however, made certain revisions intended to
clarify the applicability of Appendix A by revising the note in
paragraph 14 and similar language in Appendix A to state that Appendix
A contains examples of information and sources of information that the
auditor may gather during the audit.
Clarifying the Auditor's Responsibility for Evaluating the
Company's Identification of Its Related Parties: Many commenters
recommended a number of clarifications to paragraph 14 of the
reproposed standard. Several commenters recommended incorporating
footnote 14 into paragraph 14 of the reproposed standard to clarify
that the auditor's evaluation of the company's identification of its
related parties and relationships and transactions with related parties
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. Other commenters
recommended clarification regarding the extent of the auditor's
evaluation in paragraph 14 and whether it is based on the information
gathered during the audit.
In response to these comments, the Board made a number of
clarifications. Specifically, the Board incorporated footnote 14 of the
reproposed standard into paragraph 14 to clarify that the auditor's
evaluation requires the auditor to perform procedures to test the
accuracy and completeness of the company's identification.
Additionally, the revisions give more prominence to the requirement and
clarify that, in performing the evaluation required by paragraph 14,
the auditor takes into account the information gathered during the
audit. This revision, in conjunction with the clarifications to the
note regarding the examples and sources of information contained in
Appendix A (discussed below), is intended to further describe the
auditor's responsibilities for evaluating the company's identification
of its related parties and relationships and transactions with its
related parties.
Examples Included in Appendix A: A few commenters suggested
revisions to the examples of information or sources of information
contained in Appendix A to the standard. The Board considered these
comments, noting that Appendix A contains examples of information and
sources of information that the auditor may gather during the audit and
does not represent a comprehensive listing. The Board revised Appendix
A to include ``disclosures contained on the company's Web site'' (in
addition to the company's disclosures in SEC filings, which is already
included as an example in Appendix A) as another example of a source 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.
Verifying the Ownership Structure Between the Company and Its
Related Parties: One commenter stated that verifying the ownership
structure between the company and its related parties may be one of the
most difficult aspects of an audit. That commenter recommended that the
Board outline procedures for verifying the ownership structure between
the company and the related parties disclosed to the auditor by
management, including the levels of direct and indirect control, and
changes in those levels during the period under audit. The Board
considered this comment, noting that determining the procedures for
verifying these matters (for example, determining whether the company
or its management is able to exercise significant influence over
another entity) requires an evaluation of the facts and circumstances.
Additionally, in making such a determination, the auditor's response
should address the risks of material misstatement.\96\ Including
additional direction in a context that is so heavily facts and
circumstances driven could make the standard unnecessarily complex and
prescriptive, making it potentially more difficult to apply.\97\
---------------------------------------------------------------------------

\96\ The auditor may also be required to perform procedures on
these matters by other auditing standards, such as AU sec. 332.
\97\ See, e.g., Canadian Public Accountability Board, Auditing
in Foreign Jurisdictions CPAB Special Report (2012) http://www.cpab-ccrc.ca/en/topics/PublicSpecialReports/Pages/default.aspx, which
noted that the existence of related parties and transactions are
more likely to represent an audit risk for operations in foreign
jurisdictions when the legal or regulatory environment requires
reliance on complex business structures or when dominant
shareholders are involved in the operations of the business. That
report also noted that because the identification of related parties
may also be more difficult in foreign jurisdictions, it is important
that auditors have a heightened sensitivity to possible related-
party transactions by performing procedures to determine the
ownership and management structure of significant customers and
suppliers.
---------------------------------------------------------------------------

Setting Appropriate Expectations Regarding the Auditor's
Responsibilities: Some commenters stated that the extent of the
auditor's procedures necessary for evaluating management's
identification of its related parties and relationships did not take
into account the responsibility of management. One commenter
recommended including additional context, similar to that contained in
International Standard on Auditing No. 550, Related Parties, to
recognize that the nature of related party transactions could
compromise the auditor's ability to detect material misstatements
associated with related parties, even though the audit is properly
planned and performed. Another commenter stated that the objective
appears to require performance of procedures equivalent to a forensic
engagement to uncover all related parties and transactions.
The Board considered these comments and did not agree that
additional changes were necessary to address the appropriate
expectations for the auditor's responsibilities with respect to
identifying related parties and relationships and transactions with

[[Page 43191]]

related parties.\98\ Additionally, the Board had already taken note of
commenters' requests to clarify its proposal to focus the auditor's
attention first on information provided by management and is also
adopting revisions to AU sec. 333 to provide for additional written
representations by management pertaining to its related parties.
Moreover, the Board declined to pursue an alternative that would have
designated related party transactions as fraud risks, which would have
resulted in more forensic-type procedures. Instead, the Board's
approach overall to the auditor's responsibility to identify a
company's related parties has been targeted and risk-based, requiring
heightened scrutiny in areas that have historically represented high
risk of material misstatement. The Board believes this approach
appropriately recognizes the auditor's existing responsibilities for
the identification of related parties and relationships and
transactions with related parties in a cost-sensitive way.
---------------------------------------------------------------------------

\98\ For example, the auditor's responsibility to perform
procedures to identify related party transactions that are material
to the financial statements is reflected in Section 10A(a) of the
Exchange Act.
---------------------------------------------------------------------------

Applicability of Paragraph 16 to Related Party Transactions
Identified by the Auditor That Are ``Clearly Trivial'': Several
commenters recommended that the procedures required by paragraph 16
should not be required if the related party transaction identified by
the auditor is ``clearly trivial,'' as that term is described in
Auditing Standard No. 14.\99\ Those commenters generally noted that
such an approach would avoid unnecessary work.
---------------------------------------------------------------------------

\99\ Paragraph 10 of Auditing Standard No. 14 states that
``clearly trivial'' is not another expression for ``not material.''
Paragraph 10 also states that matters that are clearly trivial will
be of a smaller order of magnitude than the materiality level
established in accordance with Auditing Standard No. 11, and will be
inconsequential, whether taken individually or in aggregate and
whether judged by any criteria of size, nature, or circumstances.
Paragraph 10 further states that when there is any uncertainty about
whether one or more items is clearly trivial, the matter is not
considered trivial.
---------------------------------------------------------------------------

The Board considered these comments, noting that the auditor might
not be able to determine if the previously undisclosed transaction
identified by the auditor is ``clearly trivial'' without the
information that would be obtained from the procedures in paragraph
16.a.-d. of the reproposed standard.'' For example, inquiring of
management regarding why the transaction was not disclosed to the
auditor and evaluating that explanation would be important to
determining whether the transaction is ``clearly trivial.'' Further,
taking into account information regarding a related party transaction
identified by the auditor that is ``clearly trivial'' generally would
not significantly impact the auditor's evaluation of the matters in
paragraphs 16.f-h. of the reproposed standard.\100\
---------------------------------------------------------------------------

\100\ Paragraphs 16.f-h. of the reproposed standard are now
contained in paragraphs 16.f.i-iii. of the standard.
---------------------------------------------------------------------------

The use of the phrase ``clearly trivial'' could also result in
other consequences. For example, providing such an exception could
inappropriately focus the auditor's evaluation on quantitative
considerations to the detriment of qualitative considerations and might
allow management an opportunity to influence the auditor's evaluation.
In addition, providing such an exception could create confusion
regarding paragraph 16.h. of the reproposed standard (paragraph
16.f.iii of the standard), which refers to Section 10A of the Exchange
Act. Section 10A of the Exchange Act applies to information indicating
that fraud or another illegal act has or might have occurred, whether
or not perceived to have a material effect on the financial statements
of the company.
However, after considering these comments, the Board did make
revisions to paragraph 16 to clarify that the procedures performed
pursuant to paragraph 16 focus the auditor on obtaining additional
information both by (i) performing the initial procedures in paragraph
16.a.-e. so that the auditor can evaluate the nature and potential
impact of the previously undisclosed related party or relationship or
transaction that the auditor has identified, and (ii) performing
additional procedures to evaluate the implications for the audit,
including the auditor's risk assessment, taking into account the
information gathered from performing the procedures in paragraph 16.a.-
e. These revisions should clarify the auditor's approach.
The Board also made technical changes to paragraph 16.h. of the
reproposed standard to more closely align with the corresponding
requirement contained in paragraph 23 of Auditing Standard No. 14.
Paragraph 23 of Auditing Standard No. 14 states that if the auditor
becomes aware of information indicating that fraud or another illegal
act has occurred or might have occurred, he or she also must determine
his or her responsibilities under AU secs. 316.79-.82, AU sec. 317,
Illegal Acts by Clients, and Section 10A of the Exchange Act, 15 U.S.C.
78j-1.
As revised, if the auditor determines that a related party or
relationship or transaction with a related party previously undisclosed
to the auditor exists, the auditor is required to perform certain
initial procedures. Those procedures required by paragraphs 16.a.-e.
focus the auditor on obtaining additional information and evaluating
the related party or relationship or transaction with a related party
that the auditor has identified. A footnote to paragraph 16.b. refers
the auditor to 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. After performing the procedures in paragraph
16.a.-e., the auditor performs the procedures in paragraphs 16.f.i-iii.
of the standard taking into account the information previously gathered
by the auditor, to assess the broader impact of the auditor's findings
on the audit.
``Other'' Related Parties Previously Undisclosed to the Auditor:
One commenter recommended that paragraph 16 be clarified to include
that the auditor also inquire of management about the possible
existence of transactions with other undisclosed related parties. The
Board considered this comment, noting that while this inquiry was not
explicitly stated, assessing whether there are other undisclosed
related parties is a component of the auditor's response once a related
party or a relationship or transaction with a related party previously
undisclosed to the auditor by management has been identified by the
auditor.
Inquiring of management regarding the identification of the
possible existence of transactions with other undisclosed related
parties and relationships and transactions with related parties,
including whether there are any other undisclosed related parties,
would generally be encompassed in the auditor's procedures performed in
discharging the auditor's responsibilities once the auditor has
determined that a related party or relationship or transaction with a
related party previously undisclosed to the auditor exists. Based on
the auditor's reassessment of risk, the auditor performs additional
procedures that would include such inquiries, but also would extend
beyond inquiring of management.
Significantly, paragraph 16.f.ii. of the standard \101\ requires
the auditor to reassess the risks of material misstatement and perform
additional procedures as necessary, if such

[[Page 43192]]

reassessment results in a higher risk. This would include procedures
designed to address the risk of transactions with other undisclosed
related parties.
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\101\ Paragraph 16.g. of the reproposed standard is now
contained in paragraph 16.f.ii. of the standard.
---------------------------------------------------------------------------

To clarify the auditor's responsibilities regarding other
undisclosed related parties, the Board added a new footnote to
paragraph 16 that refers the auditor to 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.
The Board is adopting paragraphs 14 through 16 and Appendix A as
reproposed, with the following changes:
a. Revising paragraph 14 to highlight that the auditor performs
procedures to test the accuracy and completeness of management's
identification, taking into account information gathered during the
audit;
b. Clarifying in the note to paragraph 14 that Appendix A contains
examples of information and sources of information that the auditor may
gather during the audit;
c. Revising Appendix A to include a new example, ``disclosures
contained on the company's Web site'';
d. Revising paragraph 16 to clarify that the auditor performs the
procedures in 16.f.i.-iii., taking into account the information
gathered from performing the procedures in paragraph 16.a.-e.;
e. Adding a new footnote to paragraph 16.f.ii., referring to
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; and
f. Revising paragraph 16.f.iii. to more closely align with
paragraph 23 of Auditing Standard No. 14, which states if the auditor
becomes aware of information indicating that fraud or another illegal
act has occurred or might have occurred, he or she also 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 (Paragraphs
17 and 18 of the Standard)

Discussion of Paragraphs 17 and 18 of Auditing Standard No. 18

Paragraph 17 of the standard aligns with requirements in Auditing
Standard No. 14 to require the auditor to evaluate whether related
party transactions have been properly accounted for and disclosed in
the financial statements. Paragraph 17 states that 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. A footnote to paragraph 17 refers the auditor to
paragraphs 30 and 31 of Auditing Standard No. 14.
The auditor's evaluation of a company's accounting and disclosure
of relationships and transactions with related parties is important to
the protection of investor interests because the substance of related
party transactions might differ materially from their form.
Furthermore, related party transactions not only may involve difficult
measurement and recognition issues, but may also be used to engage in
financial statement fraud and conceal misappropriation of assets.
Paragraph 17 is intended to align the auditor's evaluation with the
objective of the standard and to focus the auditor on both the
accounting and disclosure of the company's relationships and
transactions with related parties. Footnote 1 to paragraph 1 of the
standard states that the auditor should look to the requirements of the
SEC for the company under audit with respect to the accounting
principles applicable to that company. Unlike the existing standard,
paragraph 17 of the standard does not include a separate requirement to
evaluate whether the substance of a related party transaction differs
materially from its form because that evaluation is part of the
auditor's evaluation of whether the financial statements have been
presented fairly in conformity with the applicable financial reporting
framework pursuant to AU sec. 411.06.
Consistent with the existing standard, evaluating substance over
form does not require the auditor to challenge the appropriateness of
the accounting standards. However, financial statements may not be
presented fairly if they do not include information about the matters
that affect their use, understanding, and interpretation.\102\ For
example, to improve the appearance of its financial condition, a
company and a related party could attempt to ``dress up'' the
appearance of the company's balance sheet at period-end. Some period-
end ``window-dressing'' transactions might involve side agreements
undisclosed to the auditor, while others might represent transactions
that the auditor is aware of, in which management placed more emphasis
on the need for a particular accounting treatment than on the
underlying economic substance of the transaction.
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\102\ See AU sec. 411.04.
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AU sec. 334 requires the auditor to consider whether sufficient
appropriate evidence has been obtained to understand each related party
relationship, as well as the effect of each material related party
transaction on the financial statements. The existing standard states
that the auditor should view related party transactions within the
framework of existing pronouncements, placing primary emphasis on the
adequacy of disclosure. Further, AU sec. 334.02 states that the auditor
should be aware that the substance of a particular transaction could be
significantly different from its form and that financial statements
should recognize the substance of particular transactions rather than
merely their legal form. Additionally, Auditing Standard No. 14
describes the auditor's responsibility for evaluating the presentation
of financial statements, including disclosures, more generally.
Auditing Standard No. 14 requires the auditor to evaluate whether the
financial statements are presented fairly, in all material respects, in
conformity with the applicable financial reporting framework.\103\
Furthermore, AU sec. 411.06 requires the auditor to consider whether
the substance of transactions or events differs materially from their
form when evaluating whether the financial statements have been
presented fairly in accordance with the applicable financial reporting
framework.
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\103\ See paragraph 30 of Auditing Standard No. 14.
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Assertions That Transactions With Related Parties Were Conducted on
Terms Equivalent to Those Prevailing in Arm's-Length Transactions
(Paragraph 18 of the Standard)

Paragraph 18 of the standard states that 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

[[Page 43193]]

obtained supports or contradicts management's assertion.
Financial reporting frameworks permit management to assert that a
related party transaction that is required to be disclosed in the
financial statements was conducted on terms equivalent to those
prevailing on an arm's-length basis only when support for such an
assertion exists. Management's refusal to modify such a disclosure when
support for that statement does not exist represents a departure from
GAAP and IFRS. Such a misstatement would require the auditor to express
either a qualified or adverse opinion on the financial statements. A
decision by management to remove, at the auditor's request, such an
assertion from the financial statements due to management's inability
to provide the auditor with sufficient appropriate audit evidence might
affect the auditor's assessment of internal control over financial
reporting.
The requirements in paragraph 18 of the standard are complemented
by the other amendments to AU sec. 333, which require the auditor to
obtain written representations from management when management has
asserted that a transaction with a related party was conducted on terms
equivalent to those prevailing in an arm's-length transaction.
AU sec. 334 includes requirements regarding the auditor's
evaluation of assertions that related party transactions occurred on
terms equivalent to those occurring on an arm's-length basis. AU sec.
334.12 notes the difficulty in substantiating such representations and
states that, except for routine transactions, it will generally not be
possible to determine whether a particular transaction would have taken
place if the parties had not been related, or assuming it would have
taken place, what the terms and manner of settlement would have been.
AU sec. 334 also states that if such a representation is included in
the financial statements and the auditor believes that the
representation is unsubstantiated by management, the auditor should
express a qualified or adverse opinion because of a departure from
GAAP, depending on materiality.
After considering all comments received, the Board is adopting
paragraphs 17 and 18 of the standard as reproposed, except for the
addition of a reference to paragraph 30 of Auditing Standard No. 14 in
footnote 19 to paragraph 17.
Communications With the Audit Committee (Paragraph 19 of the Standard)

Discussion of Paragraph 19 of Auditing Standard No. 18

Paragraph 19 of the standard requires the auditor to 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 its related parties, as well as other significant
matters arising from the audit regarding the company's relationships
and transactions with related parties.
Both the auditor and the audit committee benefit from a meaningful
exchange of information regarding significant risks of material
misstatement in the financial statements and other matters that may
affect the integrity of the company's financial reports, including
matters arising from a company's relationships and transactions with
related parties.
Paragraph 19 of the standard is intended to work in tandem with
paragraph 7 of the standard. The inquiries of the audit committee, or
its chair, pursuant to paragraph 7, can be more effective when they
occur at an earlier point in the audit, when the auditor is obtaining
an understanding of the company's relationships and transactions with
its related parties. This can avoid situations where the auditor's
communications regarding a company's relationships and transactions
with its related parties might first occur at the end of the audit.
This is consistent with Auditing Standard No. 16, which anticipates
timely and robust communications between the auditor and the audit
committee throughout the audit. These communications also provide an
opportunity for the auditor to corroborate the information obtained
from management regarding the company's relationships and transactions
with its related parties.
The communication required by paragraph 19 of the standard provides
an opportunity for the auditor to communicate information obtained
during the audit relevant to those earlier inquiries pursuant to
paragraph 7. For example, the auditor might discuss relationships or
transactions with related parties that are significant to the company
that were not previously discussed with the audit committee, or its
chair. The auditor also would communicate significant matters to the
audit committee if the auditor encountered these matters during the
review of interim financial information.\104\
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\104\ See paragraph .34 of AU sec. 722, Interim Financial
Information.
---------------------------------------------------------------------------

In all cases, the auditor's communications with the audit committee
pursuant to paragraph 19 of the standard would cover all the items
listed in paragraphs 19.a.-e., to the extent applicable. Such
communications involve matters such as the identification of related
parties and relationships and transactions with related parties that
were previously undisclosed to the auditor, which, as described in the
paragraph below, may be of particular interest and concern to the audit
committee. Thus, the auditor's communications pursuant to paragraph 19
are not intended to be done only when an exception is identified by the
auditor. Doing so would not provide for the proactive communication
that should occur with the audit committee regarding what the auditor
found as a result of the auditor's evaluation of the company's
identification of, accounting for, and disclosure of, its relationships
and transactions with its related parties. Further, these
communications cannot be made by management as the communication
requirements involve communication of the auditor's evaluation of
certain matters and management is not in a position to communicate the
auditor's evaluation and views.
As noted in paragraph 19, the auditor's communications to the audit
committee may not be limited to only those examples of significant
matters included in paragraph 19 of the standard. For example, in
evaluating the company's identification of, accounting for, and
disclosure of its relationships and transactions with related parties,
the auditor might identify other significant matters that might be of
interest to the audit committee, such as concerns over the company's
process for identifying related parties and relationships and
transactions with related parties.
AU sec. 334 does not include specific requirements regarding the
auditor's communication with the audit committee. Other existing
auditing standards, however, require that the auditor communicate
significant matters to the audit committee, including those encountered
during a review of interim financial information.\105\
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\105\ See Auditing Standard No. 16 and AU sec. 722.34.

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[[Page 43194]]

Discussion of the Comments Received on Paragraph 19 of the Reproposed
Standard

The Board considered all comments received, including the following
significant comments:
Communicating Significant Matters: Many commenters recommended
revising paragraph 19.a. of the reproposed standard to allow for
additional auditor judgment. Some of these commenters suggested that
paragraph 19.a. of the reproposed standard be revised to only require
the communication of ``significant'' related parties or relationship or
transactions with related parties that were previously undisclosed to
the auditor.
The Board considered these comments and believes that communicating
all related party relationships and transactions previously undisclosed
to the auditor to the audit committee is beneficial. For example, such
communications could inform the audit committee of such matters that
management had previously concealed from the audit committee as well as
from the auditor. While the auditor determines the impact of the
identification of a related party relationship or transaction on the
audit, these communications can inform the audit committee of matters
that might be important to their oversight of management and the
financial reporting process. Further, this communication also serves as
an opportunity to corroborate management's explanation regarding why
the related party transaction was undisclosed to the auditor.
Form of the Communications: At the SAG discussion, the point was
raised as to whether the auditor's communications with the audit
committee should be communicated in writing or orally. The Board
considered this comment, noting that paragraph 19 of the standard is
aligned with the requirements in Auditing Standard No. 16, which
includes specific requirements on the nature and timing of auditor
communications with the audit committee. Paragraph 25 of Auditing
Standard No. 16 states that generally the communications can be made
orally or in writing.\106\
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\106\ Paragraph 25 of Auditing Standard No. 16 also states that
the auditor must document the communications in the work papers,
whether such communications took place orally or in writing.
---------------------------------------------------------------------------

The Board is adopting paragraph 19 of the standard as reproposed.

Amendments to Certain PCAOB Auditing Standards Regarding Significant
Unusual Transactions

Significant unusual transactions can present increased risks of
material misstatement of the financial statements due to fraud or
error. The amendments regarding significant unusual transactions being
adopted by the Board improve the existing standards regarding the
auditor's identification and evaluation of a company's significant
unusual transactions.
Many commenters generally supported the Board's efforts to
strengthen the existing standards regarding significant unusual
transactions. A few commenters noted that the improvements could have a
positive impact on audit quality. However, some commenters suggested
certain revisions to clarify and refine the reproposed amendments
regarding significant unusual transactions.
After considering the comments received, the Board is adopting the
amendments regarding significant unusual transactions substantially as
reproposed, with certain minor revisions that include:
Clarifying the Phrase ``Infrequent or Significant Unusual
Transactions'' in the Amendments to AU sec. 722 (Identifying
Significant Unusual Transactions): The amendments to Appendix B of AU
sec. 722 include revisions to clarify that the ``occurrence of
infrequent transactions'' and the ``occurrence of significant unusual
transactions'' are separate examples; and
Clarifying the Auditor's Evaluation of Identified
Significant Unusual Transactions in the Amendments to Paragraph .67 of
AU sec. 316 (Evaluating Significant Unusual Transactions): The
amendments to AU sec. 316.67 include revisions to clarify that, in
considering the business purpose (or the lack thereof) of the
significant unusual transaction, the auditor should evaluate whether
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 following sections describe the amendments regarding
significant unusual transactions being adopted by the Board and
existing requirements, as well as discuss the significant comments
received and Board responses, where applicable. The sections are
organized by the following topical areas:

Identifying Significant Unusual Transactions
Evaluating Significant Unusual Transactions
Identifying Significant Unusual Transactions

Discussion of the Amendments Regarding Identifying Significant Unusual
Transactions

The amendments regarding identifying significant unusual
transactions: (i) align the description of significant unusual
transactions in the Board's auditing standards; (ii) enhance the
requirements for identifying a company's significant unusual
transactions; and (iii) revise and add to the examples of fraud risk
factors described in AU sec. 316.

Aligning the Descriptions of Significant Unusual Transactions

Amendments to AU sec. 316.66: The amendments regarding significant
unusual transactions revise 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. This description is
consistent with the existing description in paragraph 71.g. of Auditing
Standard No. 12. The amendments to AU sec. 316.66 also state that
significant unusual transactions may be used to engage in fraudulent
financial reporting or conceal misappropriation of assets.
Conforming Amendments: The amendments regarding significant unusual
transactions also make conforming changes to introduce a uniform
description of ``significant unusual transaction'' throughout the
Board's standards. Specifically, the amendments align the terminology
in: (i) Paragraph 14 of Auditing Standard No. 5, An Audit of Internal
Control Over Financial Reporting That Is Integrated with An Audit of
Financial Statements; (ii) paragraph 12 of Auditing Standard No. 9,
Audit Planning; (iii) paragraph 13 of Auditing Standard No. 12; (iv)
paragraph 15.c. of Auditing Standard No. 13; (v), paragraph .85.A.2 of
AU sec. 316; and (vi) AU sec. 722.55.B1.
In general, the description of a significant unusual transaction
included in the amendments permits the auditor flexibility in applying
the description to different companies of different sizes and in
different industries. The description of a significant unusual
transaction is designed so that the auditor determines whether a
transaction is a significant unusual transaction based on the specific
facts

[[Page 43195]]

and circumstances of the company under audit.
A significant unusual transaction does not necessarily need to
occur infrequently. Whether a transaction constitutes a significant
unusual transaction should be based upon the specific facts and
circumstances. The timing or frequency of transactions is only one
element to be considered in determining whether a transaction is a
significant unusual transaction.

Enhancing Requirements for Identifying Significant Unusual Transactions

Existing requirements relating to the auditor's consideration of
fraud in a financial statement audit recognize that during an 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.\107\ The risk assessment standards also anticipate that
the auditor might come across 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. For example,
paragraph 71.g. of Auditing Standard No. 12 states that one factor that
should be evaluated for the auditor's determination of which risks are
significant risks is whether the risk involves significant transactions
outside the normal course of business or that otherwise appear to be
unusual due to their timing, size, or nature.
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\107\ See AU secs. 316.66-.67.
---------------------------------------------------------------------------

The amendments include changes to existing standards that require
the performance of procedures as part of the auditor's risk assessment
process to identify significant unusual transactions. As discussed
below, these procedures include: (i) Inquiring of management and
others; (ii) understanding controls relating to significant unusual
transactions; and (iii) taking into account other information obtained
during the audit.
Inquiring of Management and Others (Paragraphs 56-57 of Auditing
Standard No. 12): The amendments regarding significant unusual
transactions build on existing requirements in Auditing Standard No. 12
that require the auditor to make inquiries of management and others
within the company about the risks of material misstatement.\108\
Specifically, the amendments regarding significant unusual transactions
revise paragraph 56.a. of Auditing Standard No. 12 to require the
auditor to inquire of company management regarding 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.
The amendments regarding significant unusual transactions also revise
paragraphs 56.b. and 56.c. of Auditing Standard No. 12 to require the
auditor to inquire of the audit committee and internal audit personnel
(if applicable), respectively, regarding whether the company has
entered into any significant unusual transactions.
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\108\ See paragraphs 56 and 57 of Auditing Standard No. 12.
---------------------------------------------------------------------------

The amendments regarding significant unusual transactions also
amend paragraph 57 of Auditing Standard No. 12, which currently
requires that the auditor inquire of others within the company about
their views regarding fraud risks and includes the example of employees
involved in initiating, recording, or processing complex or unusual
transactions. The amendments add significant unusual transactions as an
example of a complex or unusual transaction to paragraph 57 of Auditing
Standard No. 12.
Inquiring of management and others within the company regarding the
existence of significant unusual transactions as part of the auditor's
risk assessment procedures is an important step--but not the only
step--in the auditor's identification of significant unusual
transactions. The auditor might determine that there are significant
unusual transactions despite management's assertion that there are no
significant unusual transactions (e.g., through other procedures
performed during the audit, such as reading minutes of the board of
directors meetings and performing journal entry testing).
Understanding Controls Relating to Significant Unusual Transactions
(Paragraph 73A of Auditing Standard No. 12): Auditing Standard No. 12
requires that the auditor obtain a sufficient understanding of each
component of internal control over financial reporting to: (i) Identify
the types of potential misstatements; (ii) assess the factors that
affect the risks of material misstatement; and (iii) design further
audit procedures.\109\
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\109\ See paragraph 18 of Auditing Standard No. 12.
---------------------------------------------------------------------------

The amendments regarding significant unusual transactions build on
the risk assessment standards by adding paragraph 73A to Auditing
Standard No. 12. That paragraph requires the auditor to obtain an
understanding of the controls 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 through 40, 72, and 73 of
Auditing Standard No. 12.
Taking into Account Other Information Obtained During the Audit (AU
sec. 316.66): The amendments regarding significant unusual transactions
add a note to AU sec. 316.66 stating that the auditor's identification
of significant unusual transactions should take into account
information obtained from: (i) The risk assessment procedures required
by Auditing Standard No. 12 (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 (ii) other procedures
performed during the audit (e.g., reading minutes of the board of
directors meetings and performing journal entry testing).
Examples of those procedures include:
Reading minutes of meetings of the board of directors and
its committees; \110\
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\110\ See AU sec. 560.12.c. and AU sec. 722.18.a.
---------------------------------------------------------------------------

Reading periodic and current reports, and other relevant
company filings with the SEC and other regulatory agencies; \111\
---------------------------------------------------------------------------

\111\ See paragraph 11 of Auditing Standard No. 12, which
requires the auditor to consider reading public information about
the company relevant to the evaluation of the likelihood of material
financial statement misstatements as part of obtaining an
understanding of the company.
---------------------------------------------------------------------------

Inspecting confirmation responses and responses to
inquiries of the company's lawyers; \112\
---------------------------------------------------------------------------

\112\ See paragraph .06 of AU sec. 337.
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Obtaining an understanding of the company's selection and
application of accounting principles, including related disclosures
(e.g., reading accounting policy manuals and technical memoranda
prepared by or for management); \113\
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\113\ See paragraph 7.c. of Auditing Standard No. 12.
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Performing analytical procedures during the audit; \114\
and
---------------------------------------------------------------------------

\114\ See paragraphs 46 through 48 of Auditing Standard No. 12.
---------------------------------------------------------------------------

Performing journal entry testing, including inquiring of
individuals involved in the financial reporting process about
inappropriate or unusual activity relating to the processing of journal
entries and other adjustments as required by existing standards.\115\
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\115\ See AU secs. 316.58 through 62.

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[[Page 43196]]

Also, the auditor might identify significant unusual transactions
when examining information gathered during the audit. For example, an
auditor might identify a significant unusual transaction by scanning a
population of invoices for unusual items when determining a sample of
items to be tested. By doing so, the auditor might identify an unusual
item in terms of dollar amount, the date on which the item was shipped
(e.g., on a Sunday when the shipping department is closed), or an
unusually high concentration of transactions during a given time
period.
Appendix A to the standard includes 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. These examples could
also be helpful in identifying significant unusual transactions.
The amendments add a second note to AU sec. 316.66 that states that
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.
Also, the amendments to AU sec. 560 require that during the
``subsequent period'' the auditor inquire regarding whether the company
has entered into any significant unusual transactions. This could
inform the auditor's identification of a company's significant unusual
transactions.
Improving the auditor's identification of significant unusual
transactions also can inform the auditor's evaluation of whether the
company has properly identified its related parties and relationships
and transactions with related parties, as a significant unusual
transaction might also be a related party transaction previously
undisclosed to the auditor.

Revising and Adding to the Examples of Fraud Risk Factors

The amendments regarding significant unusual transactions also
revise certain examples of fraud risk factors contained in AU sec. 316.
For example, AU sec. 316.85A.2 notes that significant related party
transactions not in the ordinary course of business or with related
entities not audited or audited by another firm can provide
opportunities to engage in fraudulent financial reporting. The
amendments regarding significant unusual transactions separate that
existing example into two distinct examples, namely: (i) Related party
transactions that are also significant unusual transactions (e.g., a
significant related party transaction outside the normal course of
business); and (ii) significant transactions with related parties whose
financial statements are not audited or are audited by another firm.
The amendments also add contractual arrangements lacking a business
purpose as an example of a fraud risk factor.

Discussion of the Comments Received on the Reproposed Amendments
Regarding Identifying Significant Unusual Transactions

The Board considered all comments received, including the following
significant comments:
Identifying Significant Unusual Transactions Is the Auditor's
Responsibility: One commenter noted that the reproposed procedures for
identifying significant unusual transactions (performing inquiries,
understanding controls, and taking other information into account) are
performed as part of the auditor's risk assessment process rather than
to enable the auditor to perform an initial identification of
significant unusual transactions--which, in that commenter's view, is
the role of management. That commenter suggested clarifying that
management is responsible for identifying the company's significant
unusual transactions, consistent with the changes regarding a company's
related parties. Another commenter stated that, as the size and
complexity of a company increases, the likelihood of an auditor being
able to identify significant unusual transactions diminishes
proportionately.
The Board considered these comments, noting that the determination
of whether a transaction is a significant unusual transaction is the
responsibility of the auditor. The auditor takes management's responses
to inquiries and other procedures into account when identifying
significant unusual transactions. However, the information provided by
management is not the sole consideration. The auditor's procedures for
identifying significant unusual transactions are performed as part of
the auditor's risk assessment, and the auditor's procedures should be
sufficient to identify risks of material misstatement of the financial
statements, based on the size and complexity of the company.
Clarifying the Phrase ``Infrequent or Significant Unusual
Transactions'' in the Amendments to AU sec. 722: AU sec. 722.55
contains examples of situations about which the auditor would
ordinarily inquire of management when conducting a review of interim
financial information. A few commenters suggested revisions to clarify
the reproposed amendment to the tenth bullet of AU sec. 722.55, which
as reproposed stated ``the occurrence of infrequent or significant
unusual transactions.'' In response to comments, the Board revised the
tenth bullet into two separate items: one bullet relating to the
occurrence of infrequent transactions and the other relating to the
occurrence of significant unusual transactions.
The Board is adopting the amendments regarding the identification
of significant unusual transactions substantially as reproposed, except
for the revision to AU sec. 722 discussed above.
Evaluating Significant Unusual Transactions

Discussion of the Amendments Regarding Evaluating Significant Unusual
Transactions

The amendments regarding the evaluation of significant unusual
transactions address the following areas: (i) evaluating the business
purpose (or the lack thereof) of significant unusual transactions; (ii)
evaluating the accounting and disclosure of significant unusual
transactions; and (iii) other matters regarding significant unusual
transactions.

Evaluating the Business Purpose (or the Lack Thereof) of Significant
Unusual Transactions

The amendments regarding significant unusual transactions
strengthen the auditor's evaluation of whether the business purpose (or
the lack thereof) for significant unusual transactions indicates that
those transactions were entered into to engage in fraud.
Existing AU sec. 316.66 requires that once an auditor becomes aware
of significant unusual transactions, the auditor should gain an
understanding of the business rationale for such transactions and
whether that rationale (or the lack thereof) suggests that the
transaction may have been entered into to engage in fraudulent
financial reporting or to conceal the misappropriation of assets.
Existing AU sec. 316.67 identifies several matters that the auditor
should consider in understanding the business rationale for those
transactions.
The amendments build on the existing requirements in AU secs.
316.66-.67 and include additional

[[Page 43197]]

procedures to more specifically focus the auditor's attention on
critically evaluating whether the business purpose (or the lack
thereof) for significant unusual transactions indicates that such
transactions may have been entered into to engage in fraudulent
financial reporting or to conceal the misappropriation of assets.
Those improvements are accomplished through: (i) revisions to AU
sec. 316.66; (ii) adding AU sec. 316.66A; and (iii) revisions to AU
sec. 316.67. Each of those amendments is discussed in further detail
below.
Revisions to AU sec. 316.66: Because a company might use a
significant unusual transaction to engage in fraudulent financial
reporting or to obscure the company's financial position or operating
results, existing standards require the auditor to perform procedures
to evaluate significant unusual transactions identified by the auditor
and discuss the auditor's evaluation of such transactions with the
audit committee.\116\ The amendments to AU sec. 316.66 are intended to
improve the auditor's evaluation of significant unusual transactions,
including the auditor's evaluation of the business purpose (or the lack
thereof), and whether the transactions have been appropriately
accounted for and adequately disclosed in the company's financial
statements, by requiring the auditor to perform specific procedures to
evaluate significant unusual transactions. Improving the auditor's
evaluation of significant unusual transactions should also result in a
more meaningful exchange of information between the auditor and the
audit committee.
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\116\ See AU secs. 316.66-.67 and paragraph 13.d. of Auditing
Standard No. 16.
---------------------------------------------------------------------------

Adding AU sec. 316.66A: The amendments regarding evaluating
significant unusual transactions add a new paragraph to AU sec. 316,
paragraph AU sec. 316.66A, which requires that the auditor 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 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; and
d. Performing other procedures as necessary depending on the
identified and assessed risks of material misstatement.
A footnote to item c. of the amendments to AU sec. 316.66A also
states that 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.
Item d. of the amendments to AU sec. 316.66A provides an
opportunity for the auditor to scale the audit by supplementing the
basic required procedures with more in-depth procedures commensurate
with the auditor's evaluation of the company's facts and circumstances.
Those procedures should: (i) Address the assessed risks of material
misstatement; (ii) provide an understanding of the business purpose (or
the lack thereof) that is sufficient to evaluate whether the
transaction was entered into to commit fraudulent financial reporting
or misappropriate assets; and (iii) provide the auditor with sufficient
audit evidence to evaluate whether the financial statement accounting
and disclosure requirements have been met.
Examples of other procedures that might be appropriate, depending
on the nature of the significant unusual transaction and the risks of
material misstatement of the financial statements, include:
Inquiring directly of the other party regarding the
business purpose of the transaction;
Reading public information regarding the transaction and
the parties to the transaction, if available;
Reading the financial statements or other relevant
financial information obtained from other parties involved in the
transaction, if available, to understand how the other party accounted
for the transaction;
Evaluating the transferability and value of collateral
provided by the other party, if any;
Confirming the terms of the transaction with other parties
with knowledge of the transaction (e.g., banks, guarantors, agents, or
attorneys), if any; and
Confirming whether there are any side agreements or other
arrangements (either written or oral) with the other party.
The amendments regarding significant unusual transactions were
designed to establish basic procedures for the auditor to identify and
evaluate significant unusual transactions and allow the auditor to
assess risks and respond to risks based on the facts and circumstances,
including the size and complexity of the company and the assessed
significance of the identified risks of material misstatement in the
financial statements.
Significant unusual transactions, like all transactions, are
subject to the requirements contained in AU sec. 411.06, which requires
that the auditor consider whether the substance of a transaction
differs materially from its form when evaluating whether the financial
statements have been presented fairly in accordance with the applicable
financial reporting framework. That evaluation encompasses an
understanding of the ``business sense'' of material transactions, which
was referred to in footnote 6 of AU sec. 334.
Existing standards require that the auditor design and perform
audit procedures in a manner that addresses the assessed risks of
material misstatement for each relevant assertion of each significant
account and disclosure.\117\ This includes designing and performing
audit procedures in a manner that addresses the assessed risks of
material misstatement associated with significant unusual transactions.
The procedures contained in AU sec. 316.66A work in conjunction with
the procedures that the auditor performs during the audit to address
the relevant assertions associated with each significant unusual
transaction.
---------------------------------------------------------------------------

\117\ See also paragraph 8 of Auditing Standard No. 13.
---------------------------------------------------------------------------

Revisions to AU sec. 316.67: The amendments regarding significant
unusual transactions also require the auditor to evaluate certain
matters when evaluating whether the business purpose (or the lack
thereof) of a significant unusual transaction suggests that the
transaction may have been entered into to engage in fraudulent
financial reporting or to conceal the misappropriation of assets. The
amendments incorporate the list of matters currently in AU sec. 316.67
and add the following matters:
The transaction lacks commercial or economic substance, or
is part of a larger series of connected, linked, or otherwise
interdependent arrangements

[[Page 43198]]

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; \118\ and
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\118\ See Section II.C. of Securities Act Release No. 33-8056,
Commission Statement about Management's Discussion and Analysis of
Financial Condition and Results of Operations (January 22, 2002),
http://www.sec.gov/rules/other/33-8056.htm.
---------------------------------------------------------------------------

The transaction enables the company to achieve certain
financial targets.
These additional matters are intended to improve the auditor's
evaluation of the business purpose (or the lack thereof) for
significant unusual transactions, including whether they may have been
entered into to engage in fraudulent financial reporting or to conceal
the misappropriation of assets. For example, considering whether a
transaction enables the company to achieve certain financial targets is
an important consideration when evaluating whether that transaction has
been entered into to engage in fraudulent financial reporting or to
conceal the misappropriation of assets. These additional matters also
represent areas that may be relevant to the auditor's evaluation of
whether the financial statements contain the information regarding the
significant unusual transaction essential for a fair presentation in
conformity with the applicable financial reporting framework.
Including these additional matters in the auditor's evaluation of a
significant unusual transaction can also assist the auditor in the
identification of related parties or relationships or transactions with
related parties previously undisclosed to the auditor because it
focuses the auditor on the substance of the relationship or
transaction. For example, relationships such as those with entities
managed by former officers, interlocking directors/ownership,
significant customers and suppliers, competitors, strategic alliances
or partnerships, or collaborative arrangements could represent matters
that involve related parties or relationships or transactions with
related parties previously undisclosed to the auditor. Further, a
related party could be involved in a significant unusual transaction
either directly or indirectly, through the use of an intermediary whose
involvement in the transaction appears to serve no apparent business
purpose.
A footnote to AU sec. 316.67 references the requirement, contained
in paragraph 16 of the standard, that the auditor 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.
Evaluating the Accounting and Disclosure of Significant Unusual
Transactions
The amendments add a new paragraph to AU sec. 316, paragraph .67A,
to require the auditor to evaluate whether significant unusual
transactions that the auditor has identified have been properly
accounted for and disclosed in the financial statements. AU sec.
316.67A further states that this includes evaluating whether the
financial statements contain the information regarding significant
unusual transactions essential for a fair presentation in conformity
with the applicable financial reporting framework. A footnote directs
the auditor to paragraphs 30 and 31 of Auditing Standard No. 14, which
address the auditor's evaluation of the presentation of the financial
statements, including the disclosures.
A note to AU sec. 316.67A states that, in evaluating whether the
financial statements contain the information regarding significant
unusual transactions essential for a fair presentation in accordance
with the financial reporting framework, the auditor considers
management's disclosure regarding significant unusual transactions in
other parts of the company's SEC filing containing the audited
financial statements in accordance with AU sec. 550, Other Information
in Documents Containing Audited Financial Statements.
Other Matters Regarding Significant Unusual Transactions
The amendments regarding significant unusual transactions also make
a number of other related amendments, including adding a new paragraph,
paragraph 11A, to Auditing Standard No. 13 and making a conforming
amendment to Auditing Standard No. 16.
The new paragraph 11A to Auditing Standard No. 13 reminds auditors
that significant unusual transactions can affect the risks of material
misstatement due to error or fraud, and that 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
the reproposed amendments to AU secs. 316.66-.67A regarding significant
unusual transactions.
The amendments regarding significant unusual transactions also
amend the auditor communication requirements in Auditing Standard No.
16. The amendments revise paragraph 13.d. of Auditing Standard No. 16
to refer to the ``business purpose (or the lack thereof)'' instead of
the ``business rationale'' of a significant unusual transaction. In the
Board's view improving the auditor's identification and evaluation of
significant unusual transactions should enhance the quality of the
auditor's discussions with the audit committee.
Discussion of the Comments Received on the Reproposed Amendments
Regarding Evaluating Significant Unusual Transactions
The Board considered all comments received, including the following
significant comments:
Clarifying the Auditor's Evaluation of Identified Significant
Unusual Transactions: One commenter suggested several clarifying
revisions to the factors in AU sec. 316.67 that are relevant to the
auditor's evaluation of whether the business purpose (or the lack
thereof) of a significant unusual transaction indicates that the
transaction may have been entered into to engage in fraud. For example,
that commenter suggested revising the fourth bullet to state ``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.'' The Board considered these
suggestions and agrees that emphasizing that a related party might be
involved in a significant unusual transaction in place of the company
is an important clarification, and has revised AU sec. 316.67,
accordingly.
Understanding Economic Substance Versus Commercial Substance: One
commenter stated that reproposed AU sec. 316.67 did not distinguish
``commercial substance'' (a term used in connection with accounting for
nonmonetary transactions) from ``economic substance'' (a doctrine
governing all transactions). That commenter suggested revising this
factor in AU 316.67 so that ``commercial substance'' is understood to
only refer to nonmonetary transactions. The Board considered this
comment, noting that the auditor's evaluation does not impose

[[Page 43199]]

accounting requirements on the auditor as the standard and amendments
follow a ``framework neutral'' approach.
Understanding ``Financial Targets'': A few commenters suggested
improving the auditor's evaluation of whether a significant unusual
transaction enables the company to achieve certain financial targets
pursuant to AU sec. 316.67, by including required procedures to obtain
an understanding of the company's financial targets. The Board
considered these comments noting that the auditor's understanding of a
company's financial targets is already informed by information obtained
during the auditor's risk assessment process.\119\ The procedures to
obtain an understanding of the company's financial relationships and
transactions with its executive officers required by the other
amendments to Auditing Standard No. 12 further inform the auditor's
understanding. The information obtained from such procedures informs
the auditor's evaluation of whether a company's significant unusual
transaction enables the company to achieve certain financial targets.
---------------------------------------------------------------------------

\119\ See paragraphs 16 and 17 of Auditing Standard No. 12.
---------------------------------------------------------------------------

The Board is adopting the amendments regarding the evaluation of
significant unusual transactions substantially as reproposed, except
for the revisions discussed above to AU sec. 316.67 and the addition of
a reference to paragraph 30 of Auditing Standard No. 14 in footnote 25B
of AU sec. 316.67A.
Other Amendments to PCAOB Auditing Standards
The Board is also adopting other amendments to PCAOB auditing
standards, including: (i) Amendments regarding a company's financial
relationships and transactions with its executive officers; (ii) other
new requirements that complement the standard and amendments; and (iii)
amendments that conform other auditing standards to the standard and
amendments being adopted by the Board, including conforming amendments
that revise the references to the Board's superseded auditing standard,
AU sec. 334.
After considering the comments received, the Board is adopting the
other amendments substantially as reproposed. The Board is, however,
making a number of minor clarifications in response to comments. These
include:
Clarifying the Auditor's Inquiries of Management (AU sec.
560): The amendments to paragraph 12 of AU sec. 560 include revisions
to clarify that the auditor should inquire regarding both whether there
have been any changes in the company's related parties and whether
there have been any significant new related party transactions; and
Revising the First Illustrative Letter in AU sec. 722 (AU
sec. 722): The amendments to AU sec. 722 include revisions to clarify
that the auditor should obtain a representation from management that
management has provided ``all financial records and related data,
including the names of all related parties and all relationship and
transactions with related parties'' whether the auditor is using the
first illustrative letter or the second illustrative letter contained
in AU sec. 722.
The following sections describe the other amendments being adopted
by the Board and existing requirements, as well as discuss the
significant comments received and Board responses, including revisions
made, where applicable. The sections are organized by the following
areas:
Auditing Standard No. 12, Identifying and Assessing Risks
of Material Misstatement
AU sec. 315, Communications Between Predecessor and
Successor Auditors
AU sec. 316, Consideration of Fraud in a Financial
Statement Audit
AU sec. 333, Management Representations
AU sec. 560, Subsequent Events
AU sec. 722, Interim Financial Information
Auditing Standard No. 12, Identifying and Assessing Risks of Material
Misstatement
Discussion of the Amendments to Auditing Standard Auditing Standard No.
12
In some circumstances, a company's financial relationships and
transactions with its executive officers can create risks of material
misstatement that relate pervasively to the financial statements. The
other amendments to Auditing Standard No. 12 require the auditor to
perform specific procedures to obtain an understanding of a company's
financial relationships and transactions with its executive officers as
part of the auditor's risk assessment.
As described in the following sections, the other amendments to
Auditing Standard No. 12: (i) Add a new paragraph, paragraph 10A, to
Auditing Standard No. 12; (ii) revise paragraph 11 of Auditing Standard
No. 12; and (iii) make a related conforming amendment to the risk
assessment standards.
Paragraph 10A of Auditing Standard No. 12: The other amendments add
paragraph 10A to Auditing Standard No. 12 to require the auditor to
perform procedures to obtain an understanding of the company's
financial relationships and transactions with its executive officers.
Paragraph 10A states that those procedures should be designed to
identify risks of material misstatement and should include, but not be
limited to: (i) Reading the employment and compensation contracts
between the company and its executive officers; and (ii) reading the
proxy statements and other relevant company filings with the SEC and
other regulatory agencies that relate to the company's financial
relationships and transactions with its executive officers. The other
amendments are intended to assist the auditor in identifying and
assessing risks associated with a company's financial relationships and
transactions with its executive officers. The other amendments
anticipate that the additional procedures to be performed would
contribute to the auditor's consideration of fraud in a financial
statement audit pursuant to AU sec. 316, which recognizes certain
incentives and pressures on management to commit fraud as examples of
fraud risk factors.\120\
---------------------------------------------------------------------------

\120\ See AU sec. 316.85, which provides examples of fraud risk
factors that could result in incentives and pressures to commit
fraud, including available information that indicates that
management's or the board of directors' personal financial situation
is threatened by the entity's financial performance arising from:
(i) Significant financial interests in the entity; (ii) significant
portions of their compensation (e.g., bonuses, stock options, and
earn-out arrangements) being contingent upon achieving aggressive
targets for stock price, operating results, financial position, or
cash flow; or (iii) personal guarantees of debts of the entity.
---------------------------------------------------------------------------

Performing procedures to obtain an understanding of a company's
financial relationships and transactions with its executive officers
assists the auditor in understanding whether those relationships and
transactions affect the risks of material misstatement.\121\ For

[[Page 43200]]

example, the auditor could consider whether the company's internal
control over financial reporting is designed and operating to address
the risk that management might seek accounting results solely to boost
certain executive officers' compensation. This understanding could also
assist the auditor in determining areas where management bias might
occur (for example, certain accounting estimates, including fair value
measurements).
---------------------------------------------------------------------------

\121\ For example, a May 2010 academic study that examined SEC
accounting and auditing enforcement releases 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. 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. See M. Beasley, J. Carcello,
D. Hermanson, and T. 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.
---------------------------------------------------------------------------

Reading proxy statements and other relevant company filings with
the SEC that are available to the auditor can provide the auditor with
relevant information regarding a company's financial relationships and
transactions with its executive officers that informs the auditor's
understanding of the company. In addition, the risk assessment
standards require that the auditor consider reading public information
about the company, for example, SEC filings.\122\
---------------------------------------------------------------------------

\122\ See paragraph 11 of Auditing Standard No. 12.
---------------------------------------------------------------------------

The information obtained regarding a company's financial
relationships and transactions with its executive officers, in
conjunction with other information obtained during the risk assessment
process (e.g., information about company performance measures),\123\
could be used to identify account balances that are likely to be
affected and that could have a significant effect on the financial
statements. That information could be used by the auditor to identify
and assess risks of material misstatement due to fraud and to design
appropriate audit responses. In addition, obtaining an understanding of
a company's financial relationships and transactions with its executive
officers could identify information that indicates the existence of
related party relationships or transactions previously undisclosed to
the auditor.
---------------------------------------------------------------------------

\123\ See paragraphs 16 and 17 of Auditing Standard No. 12.
---------------------------------------------------------------------------

The amendments to paragraph 10A are not intended to call into
question the policies and procedures of the company with respect to its
compensation arrangements with executive officers, but rather to assist
the auditor in identifying and assessing risks of material misstatement
associated with those financial relationships and transactions. Such
risks could include unrecognized compensation, self-dealing or other
conflicts of interest, or possible illegal acts. If present, these
conditions may call into question the integrity of management's
representations or represent violations of the company's established
policies and procedures. In addition, these procedures could identify
potential instances of management override of internal controls that
could inform the auditor whether others in the company are willing to
challenge management or whether management might be dominating others
in the company.
The purpose of the procedures in paragraph 10A is to further the
auditor's risk assessment rather than to require the auditor to
determine the appropriateness of a company's compensation agreements
with its executive officers. The amendments would not require the
auditor to assess the appropriateness of the compensation of executive
officers. The procedures performed are intended to occur in the context
of the auditor's process for assessing the risks of material
misstatement of the company's financial statements.
The other amendments do not change the existing requirement in
paragraph 10 of Auditing Standard No. 12 to consider obtaining an
understanding of compensation arrangements with senior management. The
population for the procedures required by paragraph 10A of the other
amendments is the list of ``executive officers,'' as defined in SEC
Rule 3b-7 or included on Schedule A of Form BD,\124\ while the existing
requirement in paragraph 11 of Auditing Standard No. 12 continues to
apply to what may be a larger population of a company's management.
---------------------------------------------------------------------------

\124\ See Exchange Act Rule 3b-7, 17 CFR 240.3b-7, and Schedule
A of Form BD. See generally Item 401(b) of Regulation S-K, 17 CFR
229.401(b).
---------------------------------------------------------------------------

The term ``senior management'' is not a defined term in Auditing
Standard No. 12. For certain companies or brokers or dealers, senior
management might be the same population as its executive officers.
Further, the individuals the company considers to be its ``senior
management'' may differ among issuers and among broker-dealers. The
existing standard anticipates that a company's or broker's or dealer's
facts and circumstances may affect the composition of its ``senior
management.'' The auditor could: (i) Gain an understanding of the
compensation arrangements with a larger group of ``senior management''
under Auditing Standard No. 12 in order to obtain an understanding of
the company and then (ii) perform the procedures under the other
reproposed amendments regarding the financial arrangements with a
smaller group of ``executive officers.''
The other amendments do not require the auditor to evaluate the
company's identification of its ``executive officers,'' for SEC filing
and other regulatory purposes. In the Board's view, the SEC rules cited
in the amendments provide a definition of the term ``executive
officers'' that provides sufficient direction to auditors.\125\
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\125\ See Item 401(b) of Regulation S-K, 17 CFR 229.401(b). For
a discussion of ``executive officer'' for foreign private issuers,
see the discussion in this section titled ``Identifying the
Executive Officers of Foreign Private Issuers.''
---------------------------------------------------------------------------

Amendments to Paragraph 11: The other amendments also include other
changes designed to strengthen the auditor's consideration of the risks
of material misstatement associated with financial relationships and
transactions with its executive officers.
For example, the amendments to Auditing Standard No. 12 amend
paragraph 11 of Auditing Standard No. 12 to require the auditor to
consider making inquiries regarding the structuring of the company's
compensation for executive officers to 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.
An auditor performing this inquiry could take into account other
available audit evidence, such as disclosures in SEC filings that: (i)
describe the company's compensation policies and practices that present
material risks to the company \126\ and (ii) disclose fees paid to
compensation consultants, in certain circumstances.\127\ An auditor
performing this inquiry could inquire of the audit committee, or its
chair, regarding its views on executive officer compensation at the
same time the auditor makes inquiries regarding how the audit committee
exercises oversight of the company's assessment of fraud risks and the
establishment of controls to address fraud risks as required by
paragraph 56.b.(4) of Auditing Standard No. 12.
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\126\ See Securities Act Release No. 33-9089, Proxy Disclosure
Enhancements (December 16, 2009), http://www.sec.gov/rules/final/2009/33-9089.pdf.
\127\ See Item 407(e)(3)(iii) of Regulation S-K.
---------------------------------------------------------------------------

In addition, the amendments to paragraph 11 of Auditing Standard
No. 12 also require the auditor to consider performing procedures to
obtain an understanding of established policies and procedures
regarding the authorization and approval of executive officer expense
reimbursements.

[[Page 43201]]

Based on the auditor's assessment of risk, the auditor might
determine that additional procedures are necessary. For example, the
auditor might read available reports from the internal audit function
that contain an evaluation of the expense report process. In other
cases, the auditor might determine that it is necessary to inspect
executive officer expense reimbursement documentation for unusual
items.
Conforming Amendment to the Risk Assessment Standards: The other
amendments include a conforming amendment to Auditing Standard No. 12.
The change aligns Auditing Standard No. 12 with the requirement in
paragraph 3 of the standard, which states that the procedures in
paragraphs 4 through 9 of the standard are performed in conjunction
with the risk assessment procedures required by Auditing Standard No.
12. That amendment removes the note to the final bullet of paragraph 10
of Auditing Standard No. 12.

Discussion of the Comments Received on the Reproposed Amendments to
Auditing Standard No. 12

The Board considered all comments received, including the following
significant comments:
Revisions Included in Paragraph 10A of the Reproposed Amendments:
Commenters who commented on the revisions included in paragraph 10A of
the reproposed amendments to Auditing Standard No. 12 generally were
supportive of the revisions to the reproposed amendments. Some
commenters stated that it is sufficiently clear that the auditor: (i)
should obtain an understanding of the company's financial relationships
and transactions with its executive officers as part of the auditor's
risk assessment; and (ii) is not required to assess the appropriateness
of executive officer compensation. One commenter stated that the
reproposed amendments addressed their concerns regarding the proposed
amendments. Another commenter recommended including additional language
stating that the amendments are not intended to call into question the
policies and procedures of the company. The Board considered these
comments and believes that the revisions contained in the reproposed
amendments sufficiently acknowledge that the auditor is not required to
assess the appropriateness or reasonableness of compensation
arrangements with executive officers.
Alternatives to Reading Each Compensation Arrangement: One
commenter expressed their support for the auditor to obtain an
understanding of compensation arrangements with the company's executive
officers. That commenter suggested including further clarification to
these amendments, including, for example, considering whether such an
understanding could be achieved by the auditor assessing the company's
internal control over such arrangements as opposed to reading each
compensation arrangement. The Board considered this comment, but noted
that the purpose of these procedures is to obtain information regarding
individuals who perform specific functions at the company, as part of
the auditor's risk assessment. Relying on a company's process may not
provide the information necessary for the auditor to identify
incentives and pressures that may result in risks of material
misstatement. Further, reading the documents underlying the financial
relationships and transactions with a company's executive officers
could identify information that indicates that related parties or
relationships or transactions with related parties previously
undisclosed to the auditor might exist and also informs the auditor's
evaluation of whether a significant unusual transaction enables the
company to achieve financial targets as part of the auditors evaluation
pursuant to AU sec. 316.67.
Identifying the ``Executive Officers'' of Foreign Private Issuers:
One commenter expressed concern that the auditor would need to
determine which individuals fall within the definition of ``executive
officers'' if foreign private issuers do not identify ``executive
officers'' in their filings with the SEC. The Board considered this
comment and determined not to make revisions.
The auditor's risk assessment procedures with respect to a
company's financial relationships and transactions with its executive
officers begins with the company's identification of its executive
officers. These procedures do not require the auditor to evaluate the
company's identification of its executive officers for SEC filing or
other regulatory purposes. The company's identification of its
executive officers is generally available from its SEC filings or other
company information.
For example, foreign private issuers might identify their executive
officers in their SEC filings:
Some foreign private issuers currently disclose their
``executive officers'' in their filings with the SEC (e.g., some
foreign private issuers simply disclose ``executive officers'' in Form
20-F, and some foreign private issuers voluntarily file their annual
report on Form 10-K and disclose their executive officers).
Some home country filing requirements require a foreign
company to determine executive officers using a similar definition to
Rule 3b-7. For example, in Canada, National Instrument 51-102,
Continuous Disclosure Obligations states that ``executive officer
means, for a reporting issuer, an individual who is (a) a chair, vice-
chair or president; (b) a vice-president in charge of a principal
business unit, division or function including sales, finance or
production; or (c) performing a policy-making function in respect of
the issuer.'' Canadian foreign private issuers are also required to
disclose such individuals in annual information filings with the SEC.
Further, the individuals comprising a company's ``[d]irectors and
senior management'' determined pursuant to item F. of the General
Instructions to Form 20-F would include, among others, those
individuals who, on the basis of title or policy making function,
qualify as ``executive officers'' under Rule 3b-7.
In addition, foreign private issuers might identify their executive
officers for a number of other reasons, for example:
If more than 50% of a foreign company's voting securities
are held by U.S residents, the company must determine its eligibility
to be a ``foreign private issuer'' by considering, among other things,
whether the majority of its ``executive officers'' or directors are
U.S. citizens or residents.\128\
---------------------------------------------------------------------------

\128\ ``Foreign private issuer'' is defined in Rule 405 of
Regulation C under the Securities Act of 1933 and Rule 3b-4(c) under
the Exchange Act.
---------------------------------------------------------------------------

A foreign private issuer listed on the New York Stock
Exchange (``NYSE'') would need to identify its executive officers for
purposes of complying with Section 303A.12(b), Certification
Requirements of the NYSE Listed Company Manual, which requires that
each listed company chief executive officer must promptly notify the
NYSE in writing after any executive officer of the listed company
becomes aware of any non-compliance with any applicable provisions of
Section 303A of the NYSE Listed Company Manual.
Although the Board did not revise the amendments to Auditing
Standard No. 12 for this comment, the Board's consideration of this
comment did prompt a change to the amendments to AU sec. 316.81A to
include a reference to Item 16F of Form 20-F to remind auditors of
foreign private issuers of their responsibilities.
Performing Procedures Relating to Individuals Outside of the
Company's Executive Officers: Some commenters

[[Page 43202]]

suggested that the auditor's procedures should not be limited to
``executive officers,'' because compensation arrangements with persons
outside the definition of ``executive officers'' (e.g., the most highly
compensated individuals, or individuals holding a material block of
stock options that are in a position to influence the company) also
might create incentives and pressures that could create risks of
material misstatement.
The Board considered these comments, noting that the intent of the
amendments was to sharpen the auditor's focus on a company's financial
relationships and transactions with individuals that could pose
increased risks of material misstatement because of the ability of
those individuals to have direct involvement in the company's financial
reporting. However, the amendments do not change the existing
requirement that the auditor consider obtaining an understanding of the
compensation arrangements with what may be a larger group of
individuals, a company's senior management. The Board agrees that
financial relationships with individuals outside of a company's
executive officers also may warrant the auditor's attention. However,
obtaining an understanding of the compensation arrangements with
individuals outside of management should be based upon the company's
facts and circumstances.
Expanding the Examples of Executive Officer Compensation: One
commenter suggested including in the amendments a discussion of the
basic components of many of today's executive compensation plans and
requiring the auditor to read and understand each of the documents
underlying those common components. The Board considered this comment
but did not make changes, noting that the requirement to obtain an
understanding of the company's financial relationships and transactions
with its executive officers is intended to provide an overarching
requirement for the auditor that can be applied to all companies as
part of the auditor's risk assessment procedures and apply to companies
of different size and complexity. Additionally, the Board notes that
the auditor might have an overall understanding of the issues pertinent
to compensation arrangements with the company's executive officers due
to the existing responsibility under Auditing Standard No. 12 to
consider obtaining an understanding of the compensation arrangements
with the company's senior management.
The Board is adopting the amendments to Auditing Standard No. 12 as
reproposed.
AU sec. 315, Communications Between Predecessor and Successor Auditors
Discussion of the Amendments to AU sec. 315
The Board is adopting amendments to AU sec. 315, Communications
Between Predecessor and Successor Auditors. AU sec. 315 provides
guidance on communications between predecessor and successor auditors
when a change of auditors is in process or has taken place, but does
not specifically address a company's relationships or transactions with
its related parties or its significant unusual transactions. AU sec.
334 notes that determining the existence of relationships with related
parties requires the application of audit procedures that may include
inquiring of predecessor auditors concerning their knowledge of
existing relationships and the extent of management involvement in
material transactions.\129\
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\129\ See AU sec. 334.07.g. and AU secs. 9334.12-.13.
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The amendments to AU sec. 315 require the auditor to make inquiries
regarding the predecessor auditor's understanding of the company's
relationships and transactions with related parties and significant
unusual transactions. The amendments also include within the successor
auditor's review of the predecessor auditor's working papers any
documentation regarding relationships and transactions with related
parties and significant unusual transactions.
Inquiring of a predecessor auditor regarding the company's
relationships and transactions with related parties and significant
unusual transactions can assist the successor auditor in determining
whether to accept the engagement. Such inquiries also can benefit the
successor auditor in obtaining an understanding of the company's
relationships and transactions with its related parties and in
identifying significant unusual transactions.
After considering all comments received, the Board is adopting the
amendments to AU sec. 315 as reproposed.
AU sec. 316, Consideration of Fraud in a Financial Statement Audit
Discussion of the Amendments to AU sec. 316
The amendments to AU sec. 316 expand the discussion in the standard
regarding certain audit requirements contained in Section 10A of the
Exchange Act. The amendments emphasize the auditor's responsibility to
investigate and disclose possible fraud to management, the audit
committee and, upon the satisfaction of certain conditions, the SEC,
consistent with the auditor's responsibility under Section 10A of the
Exchange Act.
Improving the auditor's identification and evaluation of
significant unusual transactions could lead to more instances of
auditors becoming aware of indications that fraud or another illegal
act has or may have occurred.
In addition, the other amendments to AU sec. 316 also add a new
example of a fraud risk factor, the exertion of dominant influence by
or over a related party.
The Board's consideration of the comments received regarding the
amendments to paragraph 10A of Auditing Standard No. 12, regarding the
audits of foreign private issuers, prompted a change to the amendments
to AU sec. 316.81A. Specifically, to assist auditors of foreign private
issuers with their responsibility when there is a change in a
registrant's certifying accountants, a reference to Item 16F of Form
20-F in the amendments to AU sec. 316.81A has been included.
After considering all comments received, the Board is adopting the
amendments to AU sec. 316 as reproposed, except for adding a reference
to Item 16F of Form 20-F to AU sec. 316.81A.
AU sec. 333, Management Representations

Discussion of the Amendments to AU sec. 333

The amendments to AU sec. 333 require that the auditor obtain
certain written representations each interim period regarding a
company's relationships and transactions with its related parties. AU
sec. 333 currently requires auditors to obtain written representations
from management for the periods covered by the auditor's report. That
standard addresses representations covering financial statements;
completeness of information; recognition, measurement, and disclosure;
and subsequent events. Additionally, AU sec. 333 currently requires the
auditor to obtain a representation regarding the recognition,
measurement, and disclosure of related party transactions.
The amendments to AU sec. 333.06 require that the auditor obtain
written representations from management indicating that management has
disclosed to the auditor the names of all of the company's related
parties and all relationships and transactions with related parties.
The standard also amends AU sec. 333.06 to require the

[[Page 43203]]

auditor to obtain a written representation from management that there
are no side agreements or other arrangements (either written or oral)
undisclosed to the auditor.
Side agreements or other arrangements (either written or oral)
undisclosed to the auditor could represent a risk of material
misstatement of the financial statements for both related party and
significant unusual transactions. For example, the lack of an arm's-
length relationship in related party transactions can raise questions
about whether all transaction terms have been disclosed to the auditor.
Similarly, significant unusual transactions occurring close to the end
of the period that pose difficult substance over form questions also
could involve side agreements or other arrangements undisclosed to the
auditor. The existence of implicit or informal understandings (either
written or oral) could have a significant impact on the financial
accounting and disclosure of relationships and transactions with
related parties and significant unusual transactions.
In addition, the amendments to AU sec. 333 require that the auditor
obtain written representations from management in situations in which
the financial statements include an assertion by management that
transactions with related parties were conducted on terms equivalent to
those prevailing in an arm's-length transaction. This requirement
complements the auditor's evaluation, required by paragraph 18 of the
standard, when management has asserted that a transaction with a
related party was conducted on terms equivalent to those prevailing in
an arm's-length transaction.
After considering all comments received, the Board is adopting the
amendments to AU sec. 333 as reproposed.
AU sec. 560, Subsequent Events

Discussion of the Amendments to AU sec. 560

AU sec. 560 currently requires the auditor to perform auditing
procedures with respect to the period after the balance-sheet date for
the purpose of ascertaining the occurrence of subsequent events that
may require adjustment or disclosure essential to a fair presentation
of the financial statements in conformity with generally accepted
accounting principles.\130\ AU sec. 560 currently does not require the
auditor to inquire regarding the company's relationships and
transactions with its related parties and its significant unusual
transactions.
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\130\ See AU sec. 560.12.
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The amendments to AU sec. 560.12 require that during the
``subsequent period'' the auditor inquire regarding related party
transactions and significant unusual transactions. Events or
transactions that occur subsequent to the balance sheet date, but prior
to the issuance of the financial statements, may have a material effect
on the financial statements. Making specific inquiries during the
``subsequent period'' regarding a company's relationships and
transactions with its related parties and its significant unusual
transactions can benefit the auditor's identification of matters that
might require disclosure in the financial statements.

Discussion of the Comments Received on the Reproposed Amendments to AU
sec. 560

The Board considered all comments received, including the following
significant comment:
Clarifying the Auditor's Inquiries of Management: One commenter
recommended revising the inquiry in item v. of the reproposed
amendments to AU sec. 560.12 to clarify that there are two separate
inquiries. The Board considered this comment and in the interest of
clarity, revised the reproposed amendments to place each inquiry into a
separate bullet.
The Board is adopting the amendments to AU sec. 560 substantially
as reproposed, with the clarifying change noted above.
AU sec. 722, Interim Financial Information

Discussion of Amendments to Auditing Standard No. 12

AU sec. 722 currently requires the auditor to inquire of management
that has responsibility for financial and accounting matters concerning
unusual or complex matters that might have an effect on the interim
financial information. Generally, the amendments to AU sec. 722 require
that the auditor obtain certain written representations each interim
period regarding a company's relationships and transactions with its
related parties. The other amendments revise AU sec. 722 to be
consistent with the amendments to AU sec. 333 that require the auditor
to obtain written representations each interim period regarding the
company's related parties and the absence of side agreements or other
arrangements.

Discussion of the Comments Received on the Reproposed Amendments to AU
sec. 722

The Board considered all comments received, including the following
significant comment:
Revising the First Illustrative Letter in AU sec. 722: One
commenter recommended that a change that had been made in the
reproposal to expand item 2.a. of the second illustrative letter of AU
sec. 722 should also be made to the corresponding item in the first
illustrative representation letter. That commenter recommended that
item 2.a. in the first illustrative letter be revised to state that
management has made available to the auditor ``all financial records
and related data, including the names of all related parties and all
relationships and transactions with related parties.'' The Board
considered this comment and made the revisions suggested by the
commenter so that the letters were consistent.
The Board is adopting the amendments to AU sec. 722 substantially
as reproposed, with the clarification discussed above.
Audits of Brokers and Dealers
Section 982 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act \131\ provided the Board with oversight authority with
respect to audits of brokers and dealers that are registered with the
SEC. On July 30, 2013, the SEC adopted amendments to SEC Rule 17a-5
under the Exchange Act to require, among other things, that audits of
brokers' and dealers' financial statements be performed in accordance
with the standards of the PCAOB for fiscal years ending on or after
June 1, 2014.\132\
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\131\ Public Law 111-203, 124 Stat. 1376 (July 21, 2010).
\132\ See Rule 17a-5, 17 CFR 240.17a-5 SEC, Broker-Dealer
Reports, Exchange Act Release No. 34-70073, (July 30, 2013), 78
Federal Register 51910 (August 21, 2013), http://www.sec.gov/rules/final/2013/34-70073.pdf.
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In its reproposal, the Board solicited comment regarding whether
there were specific issues relating to audits of brokers and dealers of
which the Board should be aware. Commenters did not provide examples of
specific audit issues, but did provide views on the applicability of
the standard and amendments to audits of brokers and dealers. For
example, many commenters stated that the reproposed standard and
amendments should apply to audits of brokers and dealers and provided
various rationales. Some commenters noted that the financial reporting
risks that the reproposal is designed to target also exist at these
entities and in some

[[Page 43204]]

cases more prevalently. Other commenters noted that the scalability of
the standard and amendments allow the auditor to focus on the specifics
of the company, making the standard and amendments appropriate for
audits of brokers and dealers.
Further, at the May 17, 2012 SAG meeting, the point was raised that
a robust auditing standard on related parties was important for both
regulators of brokers and dealers and for users of their financial
statements. Several scenarios were discussed by which related party
transactions might be improperly used by brokers and dealers, including
scenarios where the brokers and dealers could use related party
transactions to: (i) Overpay for goods and services and disguise
capital withdrawals; (ii) avoid the imposition of higher capital
requirements and capital charges; (iii) structure a broker's or
dealer's business model to appear smaller; and (iv) transfer customer
assets to parties that are not approved custodians.
Additionally, the results of the Board's oversight activities
regarding audits of brokers and dealers have identified deficiencies
regarding the auditor's efforts in the area of related parties,
suggesting that this is an area warranting heightened scrutiny.\133\
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\133\ See The Report on the Progress of the Interim Inspection
Program Related to Audits of Brokers and Dealers (August 20, 2012)
and the Second Report on the Progress of the Interim Inspection
Program Related to Audits of Brokers and Dealers (August 19, 2013).
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The standard and amendments, if approved by the SEC, will be
applicable to all audits performed pursuant to PCAOB standards,
including audits of brokers and dealers.
Effective Date
The Board determined that the standard and amendments will be
effective, subject to approval by the SEC, for audits of financial
statements for fiscal years beginning on or after December 15, 2014,
including reviews of interim financial information within those fiscal
years.
In determining the effective date, the Board considered the
comments received. Many commenters noted that the effective date in the
reproposing release was reasonable, if the final standard and
amendments were approved three to four months prior to the effective
date contemplated in the reproposing release. Those commenters
generally indicated that this would have allowed sufficient time for
firms to incorporate the new requirements into their methodologies,
guidance, audit programs, and staff training. Given the date of the
adoption of the standard and amendments, the Board determined that the
standard and amendments should be applicable, subject to SEC approval,
to audits of financial statements for fiscal years beginning on or
after December 15, 2014.
One commenter recommended that the amendments to AU sec. 722 become
effective in the first interim period following the first annual period
that the standard and amendments are effective. The Board considered
this comment but noted that the amendments to AU sec. 722, which
encompass inquiries of and representations from management, are
designed to complement the standard and amendments. Performing those
procedures for reviews of interim financial information during the
first year of implementation (the fiscal year beginning on or after
December 15, 2014) can inform the auditor's efforts in these critical
areas for the audit performed during the first year of implementation.

2. Comparison of the Objective and Key Requirements of the Proposed
Rules With the Analogous Standards of the International Auditing and
Assurance Standards Board and the Auditing Standards Board of the
American Institute of Certified Public Accountants

Introduction
This comparison, which was prepared for informational purposes
only, compares certain significant differences between the objective
and certain key requirements of the standard and amendments with the
analogous standards of the IAASB and the ASB of the AICPA.
This comparison is not a summary of, or a substitute for, the
standard or the amendments. This comparison may not represent the views
of the IAASB or the ASB regarding the interpretations of their
standards.
The analogous standards of the IAASB discussed in this comparison
include:
International Standard on Auditing 550, Related Parties
(``ISA 550'');
International Standard on Auditing 210, Agreeing the Terms
of Audit Engagements (``ISA 210'');
International Standard on Auditing 240, The Auditor's
Responsibilities Relating to Fraud in an Audit of Financial Statements
(``ISA 240'');
International Standard on Auditing 315, Identifying and
Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment (``ISA 315'');
International Standard on Auditing 510, Initial Audit
Engagements-Opening Balances (``ISA 510'');
International Standard on Auditing 560, Subsequent Events
(``ISA 560'');
International Standard on Auditing 580, Written
Representations (``ISA 580'');
International Standard on Auditing 600, Special
Considerations--Audits of Group Financial Statements (Including the
Work of Component Auditors) (``ISA 600''); and
International Standard on Review Engagements 2410, Review
of Interim Financial Information Performed by the Independent Auditor
of the Entity, (``ISRE 2410'').
The analogous standards of the ASB discussed in this comparison
include:
AU-C Section 550, Related Parties (``AU-C Section 550'');
AU-C Section 210, Terms of Engagement (``AU-C Section
210'');
AU-C Section 240, Consideration of Fraud in a Financial
Statement Audit (``AU-C Section 240'');
AU-C Section 315, Understanding the Entity and Its
Environment and Assessing the Risks of Material Misstatement (``AU-C
Section 315'');
AU-C Section 510, Opening Balances--Initial Audit
Engagements, Including Reaudit Engagements (``AU-C Section 510'');
AU-C Section 560, Subsequent Events and Subsequently
Discovered Facts (``AU-C Section 560'');
AU-C Section 580, Written Representations (``AU-C Section
580'');
AU-C Section 600, Special Considerations--Audits of Group
Financial Statements (Including the Work of Component Auditors) (``AU-C
Section 600''); and
AU-C Section 930, Interim Financial Information (``AU-C
Section 930'').\134\
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\134\ These AU-C sections are contained in Statement on Auditing
Standards No. 122, Statement on Auditing Standards: Clarification
and Recodification (``SAS No. 122''). In October 2011, the ASB
adopted SAS No. 122, which contains 39 clarified SASs with ``AU-C''
section numbers for each clarified SAS. The ``AU-C'' is a temporary
identifier to avoid confusion with references to existing ``AU''
sections in AICPA Professional Standards.
---------------------------------------------------------------------------

This comparison is organized in the following sections: The
auditing standard; the amendments regarding significant unusual
transactions; and the other amendments to PCAOB auditing
standards.\135\ This comparison does not

[[Page 43205]]

cover the application and explanatory material in the analogous
standards of the IAASB or ASB.\136\
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\135\ This comparison does not cover the requirements contained
in the risk assessment standards. Appendix 11 of PCAOB Release No.
2010-004, Auditing Standards Related to Auditor's Assessment of and
Response to Risk and Related Amendments to PCAOB Standards, contains
a comparison of the objectives and requirements of those standards
with the analogous standards of the IAASB and the ASB.
\136\ Paragraph A59 of International Standard on Auditing 200,
Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with International Standards on Auditing, states
that the Application and Other Explanatory Material section of the
ISAs ``does not in itself impose a requirement,'' but ``is relevant
to the proper application of the requirements of an ISA.'' Paragraph
A63 of AU-C Section 200, Overall Objectives of the Independent
Auditor and the Conduct of an Audit in Accordance with Generally
Accepted Auditing Standards, states that although application and
other explanatory material ``does not in itself impose a
requirement, it is relevant to the proper application of the
requirements of an AU-C section.''
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Auditing Standard, Related Parties
Introduction (Paragraph 1 of the Standard)
PCAOB
The standard refers auditors to the requirements of the SEC 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. The standard does not
include a definition for an arm's-length transaction.
IAASB
Paragraph 10(b) of ISA 550 defines a related party as a party that
is either:
i. A related party as defined in the applicable financial reporting
framework; or
ii. Where the applicable financial reporting framework establishes
minimal or no related party requirements:
a. A person or other entity that has control or significant
influence, directly or indirectly through one or more intermediaries,
over the reporting entity;
b. Another entity over which the reporting entity has control or
significant influence, directly or indirectly through one or more
intermediaries; or
c. Another entity that is under common control with the reporting
entity through having:
(i) Common controlling ownership;
(ii) Owners who are close family members; or
(iii) Common key management.
However, entities that are under common control by a state (that
is, a national, regional or local government) are not considered
related unless they engage in significant transactions or share
resources to a significant extent with one another.
ISA 550 also defines an arm's-length transaction as a transaction
conducted on such terms and conditions as between a willing buyer and a
willing seller who are unrelated and are acting independently of each
other and pursuing their own best interests.
ASB
AU-C Section 550 defines a related party as that term is defined in
generally accepted accounting principles. AU-C Section 550 also
contains a definition of arm's-length transaction that is similar to
the definition in ISA 550.
Objective (Paragraph 2 of the Standard)
PCAOB
Paragraph 2 of the standard states that the auditor's objective 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.
IAASB
Paragraph 9 of ISA 550 states that the objectives of the auditor
are:
(a) Irrespective of whether the applicable financial reporting
framework establishes related party requirements to obtain an
understanding of related party relationships and transactions
sufficient to be able:
i. To recognize fraud risk factors, if any, arising from related
party relationships and transactions that are relevant to the
identification and assessment of the risks of material misstatement due
to fraud; and
ii. To conclude, based on the audit evidence obtained, whether the
financial statements, insofar as they are affected by those
relationships and transactions:
a. Achieve fair presentation (for fair presentation frameworks); or
b. Are not misleading (for compliance frameworks); and
(b) In addition, where the applicable financial reporting framework
establishes related party requirements, to obtain sufficient
appropriate audit evidence about whether related party relationships
and transactions have been appropriately identified, accounted for and
disclosed in the financial statements in accordance with the framework.
ASB
Paragraph 9 of AU-C Section 550 contains a similar objective to the
objective in ISA 550 for fair presentation frameworks.
Performing Risk Assessment Procedures To Obtain an Understanding of the
Company's Relationships and Transactions With Its Related Parties
(Paragraphs 3-9 of the Standard)
PCAOB
Paragraph 3 of the standard requires that the auditor 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. Paragraph 3 of the standard states that
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).
A note to paragraph 3 of the standard states that 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.
Another note to paragraph 3 of the standard states that performing
the risk assessment procedures described in paragraphs 4-9 of the
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.
IAASB
Paragraph 11 of ISA 550 states that as part of the risk assessment
procedures and related activities required by ISA 315 and ISA 240, the
auditor shall perform the audit procedures and related activities set
out in paragraphs 12-17 of ISA 550 to obtain information relevant to
identifying the risks of material misstatement associated with related
party relationships and transactions.

[[Page 43206]]

ASB
AU-C Section 550 contains similar requirements to those in ISA 550.

Obtaining an Understanding of the Company's Process (Paragraph 4 of the
Standard)

PCAOB
Paragraph 4 of the standard requires that in conjunction with
obtaining an understanding of internal control over financial
reporting, the auditor obtain an understanding of the company's process
for:
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.
IAASB
Paragraph 14 of ISA 550 requires that the auditor shall inquire of
management and others within the entity, and perform other risk
assessment procedures considered appropriate, to obtain an
understanding of the controls, if any, that management has established
to:
a. Identify, account for, and disclose related party relationships
and transactions in accordance with the applicable financial reporting
framework;
b. Authorize and approve significant transactions and arrangements
with related parties; and
c. Authorize and approve significant transactions and arrangements
outside the normal course of business.
ASB
Paragraph 15 of AU-C Section 550 contains similar requirements to
those in ISA 550.

Performing Inquiries (Paragraphs 5-7 of the Standard)

PCAOB
Paragraph 5 of the standard requires the auditor to inquire of
management regarding:
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.
Paragraph 6 of the standard requires the auditor to inquire of
others within the company regarding their knowledge of the matters in
paragraph 5 of the standard. Paragraph 6 also requires the auditor to
identify others within the company to whom inquiries should be
directed, and determine the extent of such inquires, by considering
whether such individuals are likely to have knowledge regarding:
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.
Paragraph 7 of the standard requires the auditor to inquire of the
audit committee, or its chair, regarding:
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.
IAASB
Paragraph 13 of ISA 550 requires the auditor to inquire of
management regarding:
a. The identity of the entity's related parties, including changes
from the prior period;
b. The nature of the relationships between the entity and these
related parties; and
c. Whether the entity entered into any transactions with these
related parties during the period and, if so, the type and purpose of
the transactions.
ASB
Paragraph 14 of AU-C Section 550 contains similar requirements to
those in ISA 550.
Identifying and Assessing Risks of Material Misstatement (Paragraph 10
of the Standard)
PCAOB
Paragraph 10 of the standard aligns with the existing requirements
for the auditor to identify and assess the risks of material
misstatement at the financial statement level and the assertion level.
Paragraph 10 states that 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 or relationships or transactions with related parties.
Paragraph 59 of Auditing Standard No. 12 requires that the auditor
identify which risks are significant risks. Further, paragraph 71 of
Auditing Standard No. 12 provides factors that the auditor should
evaluate in determining which risks are significant risks. Those
factors include: (i) whether the risk involves significant transactions
with related parties; (ii) whether the risk involves significant
transactions that are outside the normal course of business; and (iii)
whether the risk is a fraud risk. The amendments regarding significant
unusual transactions revise paragraph .85A.2 of AU sec. 316,
Consideration of Fraud in a Financial Statement Audit, to state that a
related party transaction that is also a significant unusual
transaction (e.g., a significant related party transaction outside the
normal course of business) is an example of a fraud risk factor.
A note to paragraph 10 of the standard states that, 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 the standard and
from performing the risk assessment procedures required by Auditing
Standard No. 12.
IAASB and ASB
Paragraph 18 of ISA 550 and paragraph 19 of AU-C Section 550
require that the auditor identify and assess the risks of material
misstatement associated with related party relationships and
transactions and determine whether any of those risks are

[[Page 43207]]

significant risks. ISA 550 and AU-C Section 550 require the auditor to
treat identified significant related party transactions outside the
normal course of business as giving rise to significant risks.
Responding to the Risks of Material Misstatement (Paragraphs 11-13 of
the Standard)
PCAOB
Paragraph 11 of the standard aligns with existing requirements that
the auditor design and implement audit responses that address the
identified and assessed risks of material misstatement. Paragraph 11 of
the standard states that 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.
A note to paragraph 11 of the standard states that the auditor
should look to the requirements of AU secs. 316.66-.67A for related
party transactions that are also significant unusual transactions (for
example, significant related party transactions outside the normal
course of business). That note further states that 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.
IAASB
Paragraph 20 of ISA 550 requires that the auditor designs and
performs further audit procedures to obtain sufficient appropriate
audit evidence about the assessed risks of material misstatement
associated with related party relationships and transactions. These
audit procedures shall include those required by paragraphs 21-24 of
ISA 550.
ASB
Paragraph 21 of AU-C Section 550 contains similar requirements to
those in ISA 550.
Transactions With Related Parties Required to Be Disclosed in the
Financial Statements or Determined to Be a Significant Risk (Paragraph
12 of the Standard)
PCAOB
Paragraph 12 of the standard requires that 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;
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; and
e. Perform other procedures as necessary to address the identified
and assessed risks of material misstatement.
A note to paragraph 12 of the standard states that 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.
IAASB
Paragraph 23 of ISA 550 requires that for identified significant
related party transactions outside the entity's normal course of
business, the auditor shall:
a. Inspect the underlying contracts or agreements, if any, and
evaluate whether:
i. The business rationale (or lack thereof) of the transactions
suggests that they may have been entered into to engage in fraudulent
financial reporting or to conceal misappropriation of assets;
ii. The terms of the transactions are consistent with management's
explanations; and
iii. The transactions have been appropriately accounted for and
disclosed in accordance with the applicable financial reporting
framework; and
b. Obtain audit evidence that the transactions have been
appropriately authorized and approved.
ASB
Paragraph 24 of AU-C Section 550 contains similar requirements to
those in ISA 550.
Evaluating Whether the Company Has Properly Identified Its Related
Parties and Relationships and Transactions With Related Parties
(Paragraphs 14-16 of the Standard)
PCAOB
Paragraph 14 of the standard requires that the auditor 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 information gathered
during the audit. Paragraph 14 requires that as part of that
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.
A note to paragraph 14 of the standard states that 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.
Other PCAOB auditing standards might impose requirements relating
to the sources of information that could indicate that related parties
or relationships or transactions with related parties previously
undisclosed to the auditor might exist (e.g., reading confirmation
responses and responses to inquiries of the company's lawyers).\137\
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\137\ See, e.g., AU sec. 330, The Confirmation Process, and AU
sec. 337, Inquiry of a Client's Lawyer Concerning Litigation,
Claims, and Assessments.
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Paragraph 15 of the standard requires that 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.
Paragraph 15 also states that those

[[Page 43208]]

procedures should extend beyond inquiry of management.
Paragraph 16 of the standard describes the procedures that the
auditor is required to perform if the auditor determines that a related
party or relationship or transaction with a related party previously
undisclosed to the auditor exists. Paragraph 16 of the standard
requires that the auditor:
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;
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 the 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;
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; and
(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.
IAASB and ASB
Paragraph 15 of ISA 550 requires the auditor to remain alert,
during the audit, when inspecting records or documents, for
arrangements or other information that may indicate the existence of
related party relationships or transactions that management has not
previously identified or disclosed to the auditor. Paragraph 15 of ISA
550 further requires that, in particular, the auditor inspect the
following for indications of the existence of related party
relationships or transactions that management has not previously
identified or disclosed to the auditor:
(a) Bank and legal confirmations obtained as part of the auditor's
procedures;
(b) Minutes of meetings of shareholders and of those charged with
governance; and
(c) Such other records and documents as the auditor considers
necessary in the circumstances of the entity.
Paragraph 21 of ISA 550 requires that if the auditor identifies
arrangements or information that suggests the existence of related
party relationships or transactions that management has not previously
identified or disclosed to the auditor, the auditor shall determine
whether the underlying circumstances confirm the existence of those
relationships and transactions.
Paragraph 22 of ISA 550 requires that if the auditor identifies
related parties or significant related party transactions that
management has not previously identified or disclosed to the auditor,
the auditor shall:
a. Promptly communicate the relevant information to the other
members of the engagement team;
b. Where the applicable financial reporting framework establishes
related party requirements;
(i) Request management to identify all transactions with the newly
identified related parties for the auditor's further evaluation;
(ii) Inquire as to why the entity's controls over related party
relationships and transactions failed to enable the identification or
disclosure of the related party relationships or transactions;
c. Perform appropriate substantive audit procedures relating to
such newly identified related parties or significant related party
transactions;
d. Reconsider the risk that other related parties or significant
related party transactions may exist that management has not previously
identified or disclosed to the auditor and perform additional audit
procedures as necessary; and
e. If the nondisclosure by management appears intentional (and
therefore indicative of a risk of material misstatement due to fraud),
evaluate the implications for the audit.
ASB
AU-C Section 550 contains similar requirements to those in ISA 550.
Evaluating Financial Statement Accounting and Disclosures (Paragraphs
17-18 of the Standard)
PCAOB
Paragraph 17 of the standard aligns with the existing requirement
that the auditor evaluate whether related party transactions have been
properly accounted for and disclosed in the financial statements.
Paragraph 17 states that 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.
IAASB
Paragraph 25 of ISA 550 requires that in forming an opinion on the
financial statements, the auditor shall evaluate:
a. Whether the identified related party relationships and
transactions have been appropriately accounted for and disclosed in
accordance with the applicable financial reporting framework; and
b. Whether the effects of the related party relationships and
transactions:
(i) Prevent the financial statements from achieving fair
presentation (for fair presentation frameworks); or
(ii) Cause the financial statements to be misleading (for
compliance frameworks).
ASB
Paragraph 26 of AU-C Section 550 contains similar requirements to
the requirements in ISA 550 for fair presentation frameworks.
Assertions That Transactions With Related Parties Were Conducted on
Terms Equivalent to Those Prevailing in Arm's-Length Transactions
(Paragraph 18 of the Standard)
PCAOB
Paragraph 18 of the standard requires that 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

[[Page 43209]]

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.
A note to paragraph 18 of the standard further states that 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.
IAASB
Paragraph 24 of ISA 550 states that if management has made an
assertion in the financial statements to the effect that a related
party transaction was conducted on terms equivalent to those prevailing
in an arm's length transaction, the auditor shall obtain sufficient
appropriate audit evidence about the assertion.
ASB
Paragraph 25 of AU-C Section 550 contains similar requirements to
those in ISA 550.
Communications With the Audit Committee (Paragraph 19 of the Standard)
PCAOB
Paragraph 19 of the standard requires that the auditor 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. Paragraph 19 of the standard
also requires that the auditor communicate other significant matters
arising from the audit regarding the company's relationships and
transactions with related parties including, but not limited to:
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.
IAASB
Paragraph 27 of ISA 550 requires that the auditor communicate with
those charged with governance significant matters arising during the
audit in connection with the entity's related parties.
ASB
Paragraph 27 of AU-C Section 550 contains similar requirements to
those in ISA 550.
Amendments to Certain PCAOB Auditing Standards Regarding Significant
Unusual Transactions
Identifying Significant Unusual Transactions
PCAOB
The amendments to paragraph 56.a. of Auditing Standard No. 12
require the auditor to inquire of management regarding 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 involve related
parties. The amendments regarding significant unusual transactions to
paragraph 56.b. of Auditing Standard No. 12 require that the auditor
inquire of the audit committee or equivalent, or its chair, regarding
whether the company has entered into any significant unusual
transactions. The amendments regarding significant unusual transactions
to paragraph 56.c. of Auditing Standard No. 12 require similar
inquiries of internal audit personnel.
A note to AU sec. 316.66 states that 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.
That note refers the auditor to paragraphs 14-16 of Auditing
Standard No. 18. That note further states that Appendix A of the
standard includes examples of such information and examples of sources
of such information.
IAASB and ASB
ISA 315, ISA 550, AU-C Section 315, and AU-C Section 550 do not
contain similar requirements for the auditor to those in the PCAOB's
amendments described above.
Evaluating Significant Unusual Transactions
PCAOB
The amendments regarding significant unusual transactions add
paragraph .66A to AU sec. 316. That paragraph requires the auditor to
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. AU sec. 316.66A requires
that those procedures include the following:
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 appropriately
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; and
d. Performing other procedures as necessary depending on the
identified and assessed risks of material misstatement.
The amendments to AU sec. 316.67 require that the auditor 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.
The amendments require that, in making that evaluation, the auditor
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;
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

[[Page 43210]]

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.
Further, the amendments add paragraph 11A to Auditing Standard No.
13. That paragraph requires that 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.
The amendments to AU sec. 316.67A require that the auditor evaluate
whether significant unusual transactions identified by the auditor have
been properly accounted for and disclosed in the financial statements.
IAASB
Paragraph 16 of ISA 550 requires that if the auditor identifies
significant transactions outside the entity's normal course of business
when performing the audit procedures required by paragraph 15 or
through other audit procedures, the auditor shall inquire of management
about:
(a) The nature of these transactions; and
(b) Whether related parties could be involved.
Paragraph 32(c) of ISA 240 requires the auditor to evaluate whether
the business rationale (or the lack thereof) of a significant
transaction outside the normal course of business suggests that the
transaction may have been entered into to engage in fraudulent
financial reporting or to conceal misappropriation of assets. Paragraph
23 of ISA 550 requires the auditor to perform certain procedures for
identified significant related party transactions outside the entity's
normal course of business.
ASB
AU-C Section 550 and AU-C Section 240 contain similar requirements
to those in ISA 550 and ISA 240.
Other Amendments to PCAOB Auditing Standards
Auditing Standard No. 12, Identifying and Assessing Risks of Material
Misstatement
PCAOB
The other amendments to paragraph 10A of Auditing Standard No. 12
require that to assist in obtaining information for identifying and
assessing risks of material misstatement of the financial statements
associated with a company's 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 SEC and other regulatory agencies
that relate to the company's financial relationships and transactions
with its executive officers. The other amendments to Auditing Standard
No. 12 also include a definition of executive officer that aligns with
definitions used in SEC filings.
In addition, the other amendments amend paragraph 11 of Auditing
Standard No. 12 to require the auditor to consider:
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
Obtaining an understanding of the company's established
policies and procedures regarding the authorization and approval of
executive officer expense reimbursements.
IAASB and ASB
ISA 315 and AU-C Section 315 do not contain similar requirements
for the auditor to those in the PCAOB's amendments described above.
AU sec. 315, Communications Between Predecessor and Successor Auditors
PCAOB
The other amendments to other PCAOB Auditing Standards amend AU
sec. 315, Communications Between Predecessor and Successor Auditors, to
require the auditor to inquire of the predecessor auditor regarding the
predecessor auditor's understanding of the nature of the company's
relationships and transactions with related parties and significant
unusual transactions. The other amendments also require the successor
auditor to review documentation regarding related parties and
significant unusual transactions.
IAASB and ASB
Neither ISA 210 and ISA 510, nor AU-C Section 210 and AU-C Section
510 contain similar requirements to those in the PCAOB's amendments
described above.
AU sec. 316, Consideration of Fraud in a Financial Statement Audit
PCAOB
The other amendments to AU sec. 316.81A describe the auditor's
responsibility, under certain conditions, to disclose possible fraud to
the SEC 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 on Form
8-K 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 (the ``Exchange Act'') relating to
an illegal act that the auditor concludes has a material effect on the
financial statements.
IAASB and ASB
ISA 240 and AU-C Section 240 do not inform the auditor of certain
obligations under Section 10A of the Exchange Act, which is applicable
to auditors of U.S. public companies registered with the PCAOB.

[[Page 43211]]

AU sec. 333, Management Representations
PCAOB
The other amendments to AU sec. 333, Management Representations,
require that the auditor obtain written representations from management
that there are no side agreements or other arrangements (either written
or oral) undisclosed to the auditor. The other amendments to AU sec.
333 also require the auditor to obtain written representation from
management 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.
IAASB and ASB
Neither ISA 580 and ISRE 2410, nor AU-C Section 580, and AU-C
Section 930 contain similar requirements to those in the PCAOB's
amendments described above.
AU sec. 560, Subsequent Events
PCAOB
The other amendments amend paragraph .12 of AU sec. 560, Subsequent
Events, to require that during the ``subsequent period'' the auditor
inquire of and discuss with officers and other executives having
responsibility for financial and accounting matters (limited where
appropriate to major locations) as to:
Whether there have been any changes in the company's
related parties;
Whether there have been any significant new related party
transactions; and
Whether the company has entered into any significant
unusual transactions.
IAASB and ASB
ISA 560 and AU-C Section 560 do not contain similar requirements to
those in the PCAOB's amendments described above.
AU sec. 722, Interim Financial Information
PCAOB
The other amendments to AU sec. 722, Interim Financial Information,
require that the auditor obtain written representations from management
that there are no side agreements or other arrangements (either written
or oral) undisclosed to the auditor. The other amendments to AU sec.
722 also require the auditor to obtain written representations from
management when management has made an assertion that a transaction
with a related party was conducted on terms equivalent to those
prevailing in arm's-length transactions.
IAASB
ISA 550 and ISRE 2410 do not contain similar requirements to those
in the PCAOB's amendments described above.
ASB
AU-C Section 550 and AU-C Section 930 do not contain similar
requirements to those in the PCAOB's amendments described above.

D. Economic Considerations, Including for Audits of Emerging Growth
Companies

This discussion describes the Board's approach in adopting the
standard and amendments as well as the Board's consideration of the
economic impacts of the standard and amendments, including economic
considerations pertinent to audits of EGCs.\138\ Additionally, this
discussion summarizes the views of commenters with respect to the
economic impacts of the standard and amendments.
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\138\ Section 3(a)(80) of the Exchange Act defines the term
``emerging growth company.''
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Introduction and Statutory Background
The Board is adopting the standard and amendments pursuant to its
authority under the Act.\139\ The standard and amendments must be
approved by the Commission before they are effective. Pursuant to
Section 107(b)(3) of the Act, the Commission shall approve a proposed
standard if it finds that the standard is ``consistent with the
requirements of [the] Act and the securities laws, or is necessary or
appropriate in the public interest or for the protection of
investors.''
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\139\ Public Law 107-204. Pursuant to Section 101 of the Act,
the mission of the Board 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. Section 103 of the Act authorizes the Board to adopt
auditing standards for use in public company audits ``as required by
this Act or the rules of the [U.S. Securities and Exchange]
Commission, or as may be necessary or appropriate in the public
interest or for the protection of investors.'' In addition, Section
982 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(the ``Dodd-Frank Act'') expanded the authority of the PCAOB to
oversee the audits of registered brokers and dealers, as defined in
the Exchange Act. See Public Law 111-203.
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In the Board's view, the adoption of the standard and amendments is
in the public interest and contributes to investor protection by
establishing specific auditor performance requirements designed to
heighten the auditor's attention to areas associated with risks of
fraudulent financial reporting and that may also involve risks of
error. New required audit procedures are intended to improve the
auditor's identification, understanding, and evaluation of transactions
in the critical areas, which can pose difficult measurement,
recognition, and disclosure issues due to factors such as transaction
structure, complexity, and/or relationship to company financial
targets. Additionally, the standard and amendments establish audit
committee communication requirements designed to promote and enhance
communications and understanding between the auditor and the audit
committee.
The auditor's heightened scrutiny of transactions in the critical
areas, and the enhanced understanding of such transactions both by the
auditor and the audit committee, should improve the quality of the
audit and also may result in improvements in companies' accounting and
disclosures in these areas. Additionally, the new requirements are
aligned with the Board's risk assessment standards \140\ and reflect a
cohesive audit approach that should improve the auditor's risk-based
consideration of the critical areas, as well as provide opportunities
for efficient implementation.
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\140\ In 2010, the Board adopted eight auditing standards to
establish a framework for the auditor's assessment of and response
to the risks of material misstatement in an audit (the ``risk
assessment standards''), which reflect the Board's view of the
auditor's fundamental approach to the audit. The risk assessment
standards 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).
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The Act was amended by Section 104 of the Jumpstart Our Business
Startups Act JOBS Act \141\ to provide that any additional rules
adopted by the Board subsequent to April 5, 2012, do not apply to the
audits of EGCs unless the SEC ``determines that the application of such
additional requirements is necessary or appropriate in the public
interest, after considering the protection of investors and whether the
action will promote efficiency, competition, and capital formation.''
\142\ As a result, if the standard and amendments are approved by the
SEC, they will be subject to a separate determination by the SEC
regarding their applicability to audits of EGCs.
---------------------------------------------------------------------------

\141\ Public Law 112-106 (April 5, 2012).
\142\ See Section 103(a)(3)(C) of the Act, as added by Section
104 of the JOBS Act.
---------------------------------------------------------------------------

The Board is recommending that the SEC determine that the standard
and amendments should apply to audits of

[[Page 43212]]

EGCs. To assist the SEC in making this determination, the Board is
providing information herein specifically related to audits of EGCs.
The discussion below includes information regarding: (i) The Need
for the Standard and Amendments; (ii) The Baseline (encompassing both
existing requirements and audit practices); (iii) The Board's Approach
and Consideration of Alternatives; (iv) The Economic Impacts of the
Standard and Amendments, including Benefits and Costs; and (v) Economic
Considerations Pertaining to Audits of EGCs, including Efficiency,
Competition, and Capital Formation.
Need for the Standard and Amendments
Introduction
Investors are often widely dispersed and significant in number and
thus must rely on management to operate and control the company. As a
result, investors possess less information about the company than the
company's management, a situation that can be described as information
asymmetry \143\ between investors and management. Management prepares
the company's financial statements that investors use to evaluate a
company's financial performance and management's stewardship of the
company. An audit provides investors with independent, reasonable
assurance that the company's financial statements are fairly presented,
in accordance with the relevant accounting framework, and comply with
applicable requirements.
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\143\ Information asymmetry refers to situations involving two
or more parties in a relationship in which one party has more, or
better, information than the other party. For more information on
matters related to the separation of ownership and control of
companies and the implications on financial markets, see, e.g.,
Adolph A. Berle and Gardiner C. Means, The Modern Corporation and
Private Property, 2 Harcourt, Brace and World, New York passim
(1967); Michael C. Jensen and William H. Meckling, Theory of the
Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3
Journal of Financial Economics 305 passim (1976); and Paul M. Healy
and Krishna G. Palepu, Information Asymmetry, Corporate Disclosure,
and the Capital Markets: A Review of the Empirical Disclosure
Literature, 31 Journal of Accounting and Economics 405 passim
(2001).
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A key objective of PCAOB standards is to improve the likelihood
that the auditor will detect material misstatements in company
financial statements, whether due to error or fraud.\144\ The auditor,
as a gatekeeper \145\ in the financial reporting system, can mitigate
risks of material misstatement in the financial statements and, thus,
risks to investors arising out of their reliance on misstated financial
statements, by focusing appropriate auditing effort in areas that
warrant heightened scrutiny. Increased attention by the auditor should,
in the Board's view, increase the likelihood of the auditor identifying
material misstatements.
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\144\ Strengthening the requirements for auditing in the
critical areas should similarly promote improved performance on
audits of broker-dealer financial statements. The approach set forth
in the standard should direct auditors to devote more time to areas
requiring heightened scrutiny. The auditor's enhanced focus on these
areas should improve the reliability of information used in
regulatory oversight, which, in turn, should enhance investor
protection.
\145\ 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.
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In considering the need to improve existing auditing standards
relating to the critical areas, the Board took into account a variety
of factors. Most significantly, the Board considered the need for the
standard and amendments against the backdrop of several decades of
financial reporting frauds involving related party transactions,
significant unusual transactions and financial relationships and
transactions with executive officers. Prominent corporate scandals
involving these critical areas include many that served as a catalyst
for the enactment of the Act.\146\ The critical areas addressed by the
standard and amendments have continued to be contributing factors in
more recent enforcement cases.\147\ These corporate scandals undermine
investor confidence and have resulted in significant losses to
investors, as well as the loss of many jobs.\148\ As discussed below,
the Board's oversight activities indicate that auditors' scrutiny of
these critical areas continues to be an area of concern.
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\146\ The following illustrative list provides examples of
prominent corporate scandals that involve the critical areas. The
following list is not all-inclusive and, in some cases, examples
involve more than one critical area: (i) With respect to related
party transactions: Hollinger, Inc., see SEC Complaint, SEC,
Plaintiff v. Conrad M. Black, F. David Radler and Hollinger, Inc.
(November 15, 2004); MCA Financial Corporation, see SEC AAER No.
2076, In The Matter of Grant Thornton LLP, Doeren Mayhew & Co. P.C.,
Peter M. Behrens, CPA, Marvin J. Morris, CPA, and Benedict P.
Rybicki, CPA, Respondent (August 5, 2004); and Adelphia
Communications Corporation, see SEC AAER No. 1599, SEC v. Adelphia
Communications Corporation, John J. Rigas, Timothy J. Rigas, Michael
J. Rigas, James P. Rigas, James R. Brown, and Michael C. Mulcahey,
02 Civ. 5776 (KW) (S.D.N.Y.) (July 24, 2002); (ii) with respect to
significant unusual transactions: Enron Corporation, see SEC
Spotlight on Enron, https://www.sec.gov/spotlight/enron.htm; Refco,
Inc., see SEC Complaint, SEC, Plaintiff, v. Phillip R. Bennett,
Defendant (February 19, 2008); and (iii) with respect to financial
relationships and transactions with executive officers: Tyco
International, Ltd., see SEC AAER No. 3010, SEC v. L. Dennis
Kozlowski, Mark H. Swartz, and Mark A. Belnick, 02-CV-7312 (RWS)
(S.D.N.Y. filed Sept. 12, 2002) (July 14, 2009); WorldCom, Inc., see
Restoring Trust, Report to The Hon. Jed S. Rakoff The United States
District Court for the Southern District of New York On Corporate
Governance for the Future of MCI (August 2003) at 17-19.
Additionally, 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'' (the ``SEC Section 704 Study''). As part of
the study, the SEC examined 227 enforcement matters and found that
23 cases included the failure to disclose related party
transactions. See Report Pursuant to Section 704 of the Sarbanes-
Oxley Act of 2002 (January 24, 2003) at 6.
\147\ See, e.g., SEC 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).
\148\ For 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 SEC Litigation Release No. 19996 (February 9, 2007).
---------------------------------------------------------------------------

Additionally, the Board considered: (i) Input from the SAG; (ii)
studies that suggested the need to improve existing auditing standards
to address areas that could pose increased risks of material
misstatement; (iii) the actions of other standard setters, such as the
IAASB and the ASB of the AICPA, who had revised their auditing
standards in certain analogous areas in 2008 and 2011, respectively;
and (iv) information obtained through the Board's oversight activities.
The Board also considered input from commenters on its

[[Page 43213]]

proposal \149\ and reproposal.\150\ Commenters were broadly supportive
of the Board's standard-setting efforts and generally agreed that
improvements to the existing auditing standards were appropriate.\151\
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\149\ 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 (``proposed amendments regarding significant unusual
transactions''); and (iii) other amendments to PCAOB auditing
standards (``other proposed amendments''). Collectively, these are
referred to as the ``proposed standard and amendments.''
\150\ 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 (``reproposed amendments regarding significant
unusual transactions''); and (iii) other proposed amendments to
PCAOB auditing standards (``other reproposed amendments'').
Collectively, these are referred to as the ``reproposed standard and
amendments.''
\151\ Section C provides additional discussion of the standard
and amendments, as well as discussion of significant comments
received and the Board's consideration of such comments.
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The Need for Improved Requirements in the Critical Areas
The following discussion describes the need for improvements to
existing auditing requirements in each critical area. As more fully
described below, the Board believes that its existing standards do not
contain sufficient required procedures and are not sufficiently risk-
based in critical areas that warrant heightened scrutiny. Increased
auditor attention to the critical areas should, in the Board's view,
increase the likelihood of the auditor identifying material
misstatements.
Relationships and Transactions With Related Parties: The auditor's
attention to a company's transactions with its related parties is
important because the substance of such transactions may differ
materially from their form.\152\ A related party relationship provides
the parties with the ability to negotiate transactions on terms that
may not be available to other parties on an arm's-length basis. Such
non-arm's length transactions potentially provide more of an
opportunity for management to act in its own interests,\153\ rather
than in the interests of the company and its investors and, in some
instances, such transactions have been used to facilitate financial
statement fraud and asset misappropriation.\154\ Related party
transactions also may involve difficult measurement and recognition
issues that can lead to errors in financial statements.
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\152\ For example, to improve the appearance of its financial
condition, a company and a related party could attempt to ``dress
up'' the appearance of the company's balance sheet at period end by
agreeing to have the company temporarily pay down its related party
debt prior to the balance sheet date while having an undisclosed
side agreement to subsequently borrow the same or a comparable
amount shortly after period end.
\153\ See, e.g., paragraph 15 of FASB Statement No. 57, Related
Parties, which states ``[w]ithout disclosure to the contrary, there
is a general presumption that transactions reflected in financial
statements have been consummated on an arm's-length basis between
independent parties. However, that presumption is not justified when
related party transactions exist because the requisite conditions of
competitive, free-market dealings may not exist. Because it is
possible for related party transactions to be arranged to obtain
certain results desired by the related parties, the resulting
accounting measures may not represent what they usually would be
expected to represent.''
\154\ As noted above, the SEC Section 704 Study identified areas
of issuer financial reporting that are most susceptible to fraud,
inappropriate manipulation or inappropriate earnings management. As
part of that study, the SEC examined 227 enforcement matters and
found that 23 cases included the failure to disclose related party
transactions. See SEC Section 704 Study.
---------------------------------------------------------------------------

The importance to investors of the auditing of related party
transactions was emphasized by the U.S. Congress in 1995 through the
enactment of Section 10A of the Exchange Act, which requires that each
audit of financial statements of an issuer include ``procedures
designed to identify related party transactions that are material to
the financial statements or otherwise require disclosure therein.''
\155\ Additionally, SEC actions have identified related party
transactions as warranting heightened scrutiny by auditors.\156\
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\155\ Section 10A(a)(2) of the Exchange Act, 15 U.S.C. 78j-
1(a)(2).
\156\ See, e.g., SEC AAER No. 3427, In the Matter of the
Application of Wendy McNeely, CPA, at 10-12 (December 13, 2012),
which states, in part, that the SEC and the 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 S.E.C. 277 (2004)).
---------------------------------------------------------------------------

The Board's existing standard for the auditing of related party
transactions, AU sec. 334, Related Parties,\157\ was issued in 1983,
and has not been substantively revised since then. Among other things,
AU sec. 334 has not been revised to align with the Board's risk
assessment standards, which provide an overall framework for the
auditor's assessment of and response to the risks of material
misstatement. Additionally, as discussed below, the existing standard
does not reflect an approach that promotes heightened scrutiny by the
auditor of a company's relationships and transactions with related
parties.
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\157\ 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 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).
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AU sec. 334 provides guidance for the auditor, rather than
explicitly requiring the performance of specific procedures.\158\ For
example, AU sec. 334 includes examples of procedures that the auditor
could perform, and indicates that such procedures may not be required
in every audit. Such an approach can lead to inadequate auditor effort
in an area that historically has posed increased risks of material
misstatement. Additionally, the existing standard suggests that related
party transactions need not be considered by the auditor as outside the
ordinary course of business for a company, unless the auditor is aware
of evidence to the contrary. As a result, the auditor may not exercise
sufficient professional skepticism in an area that Congress and the SEC
have indicated requires heightened scrutiny.
---------------------------------------------------------------------------

\158\ See discussion of The Baseline for a detailed discussion
of the existing requirements applicable to the critical areas.
---------------------------------------------------------------------------

The need to revise and strengthen AU sec. 334 has been supported by
a number of prominent studies, including studies conducted by the
auditing profession prior to the enactment of the Act and the
establishment of the Board. For example, the AICPA recommended, after
studying over 200 cases reported by their members in which allegations
of an audit failure were made, 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 transactions.'' \159\
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\159\ The Quality Control Inquiry Committee of the AICPA's SEC
Practice Section issued a report (the ``QCIC Report'') making this
recommendation in 2002. 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.
---------------------------------------------------------------------------

Additionally, the Board considered a synthesis of the academic
literature on auditing related party transactions that states that
various high profile frauds demonstrate how related party transactions
can be used to mislead users of financial statements.\160\ The authors
find that related party transactions are as common in companies alleged
to have committed fraud as in companies in which no fraud has been
detected. However, the authors also find that ``. . . when fraud does
exist, the presence of related party transactions is one of the top
reasons

[[Page 43214]]

cited for audit failures.'' \161\ The authors conclude that the
findings in academic literature, combined with the significance of
related party transactions in corporate scandals, ``are consistent with
the PCAOB's reconsideration of auditing of related party
transactions.'' \162\
---------------------------------------------------------------------------

\160\ See Elizabeth A. Gordon, Elaine Henry, Timothy J. Louwers,
and Brad J. Reed, Auditing Related Party Transactions: A Literature
Overview and Research Synthesis, Accounting Horizons 21 (1): 81-102
(2007).
\161\ Id. at 82.
\162\ Id. at 81. A subsequent study conducted by the same
authors analyzes 43 SEC enforcement actions against auditors related
to the examination of related party transactions and identified
audit practice issues in that area. The authors found that the
majority of this sample involved inadequate examination of the
related party transaction by the auditor. Although the authors
concluded that the audit failures described in these SEC cases were
more likely attributable to a lack of professional skepticism and
due professional care than deficiencies in the existing standards,
the authors provide suggestions to improve audit practice regarding
the auditing of related party transactions. Among other things, the
authors suggest that auditors use guidance published by the AICPA in
a 2001 ``Related Party Transaction Toolkit'' that suggests that the
auditor should perform many of the procedures described as guidance
in AU sec. 334 to determine the existence of related parties and
identify transactions with known related parties. See Timothy J.
Louwers, Elaine Henry, Brad J. Reed, and Elizabeth A. Gordon,
Deficiencies in Auditing Related-Party Transactions: Insights from
AAERs, Current Issues in Auditing 2 (2): A10-A16 (2008).
---------------------------------------------------------------------------

While the Board recognizes that transactions with related parties
are also used for legitimate purposes, including the efficient
procurement of resources,\163\ the Board has concluded that the
auditing of related party transactions warrants heightened scrutiny.
Notably, the Board has observed, through its oversight activities,
deficiencies in the auditing of related party transactions,
particularly with respect to audits of smaller public companies.
Additionally, as prominent corporate scandals over the past several
decades illustrate, issues involving the scrutiny of related party
transactions also arise in the audits of large public companies.
---------------------------------------------------------------------------

\163\ See Elizabeth A. Gordon, Elaine Henry, and Darius Palia,
Related Party Transactions and Corporate Governance 9 Advances in
Financial Economics 1-27, (2004).
---------------------------------------------------------------------------

As a result of these and other considerations discussed throughout
this release, the Board has determined that there is a need to improve
its existing auditing standard regarding related parties. In the
Board's view, AU sec. 334 does not contain sufficient required
procedures, is not risk-based, and does not promote the necessary
heightened scrutiny of related party transactions.
Significant Unusual Transactions: The identification and evaluation
of a company's significant unusual transactions is important to the
audit because such transactions can create complex accounting and
financial disclosure issues that create risks of error. Additionally,
in some cases, significant unusual transactions have been used to
engage in fraudulent financial reporting. For example, significant
unusual transactions that are close to period end may be entered into
to obscure a company's financial position or operating results (e.g.,
so-called ``window-dressing''). Others may involve counterparties that
are willing to structure transactions to achieve desired accounting
results. In such cases, company management may place more emphasis on
the need for a particular accounting treatment than on the underlying
economic substance of the transaction.
The Board has considered studies that highlight the risks of
material misstatements associated with a company's significant unusual
transactions. For example, the Report Prepared by the Permanent
Subcommittee on Investigations of the Committee on Governmental Affairs
found that ``some U.S. financial institutions and public companies have
been misusing structured finance vehicles . . . to carry out sham
transactions that have no legitimate business purpose and mislead
investors, analysts, and regulators about companies' activities, tax
obligations, and true financial condition.'' \164\ Another study
attributed an increased risk of financial misstatement to transactions
in which the substance of the transactions might differ materially from
their form.\165\
---------------------------------------------------------------------------

\164\ See Senate Committee on Governmental Affairs, Permanent
Subcommittee on Investigations of the Committee on Governmental
Affairs, Fishtail, Bacchus, Sundance, and Slapshot: Four Enron
Transactions Funded and Facilitated by U.S. Financial Institutions
(January 2, 2003), http://www.gpo.gov/fdsys/pkg/CPRT-107SPRT83559/pdf/CPRT-107SPRT83559.pdf.
\165\ See SEC Report and Recommendations Pursuant to Section
401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-
Balance Sheet Implications, Special Purpose Entities, and
Transparency of Filings by Issuers (June 15, 2005), http://sec.gov/news/studies/soxoffbalancerpt.pdf.
---------------------------------------------------------------------------

Additionally, SEC enforcement actions have highlighted the need for
the auditor to scrutinize complex unusual transactions, including
understanding their underlying economic purpose.\166\ Other SEC cases
have addressed instances in which structured transactions obscured the
economic substance of transactions that had a material impact on the
company's financial statements.\167\
---------------------------------------------------------------------------

\166\ See, e.g., SEC AAER No. 2775, In the Matter of Michael
Lowther, CPA, Respondent (January 28, 2008), which discusses the
2001 financial reporting fraud at Enron, which included the use of
complex structured transactions to obscure the economic substance of
certain financing transactions that had a material impact on Enron's
financial statements.
\167\ See, e.g., SEC AAER No. 1631, In the Matter of Dynegy,
Inc., Respondent (September 24, 2002). In that action, the
Commission determined that Dynegy entered into two massive ``round-
trip'' electricity transactions, that is, simultaneous, pre-arranged
buy-sell trades at the same price, terms and volume, in which
neither Dynegy nor its trading counterparty earned a profit or
incurred a loss and that such transactions lacked economic
substance.
---------------------------------------------------------------------------

The risk assessment standards require the auditor to consider the
risks of material misstatement posed by significant unusual
transactions as part of the auditor's risk assessment during the
financial statement audit.\168\ However, the auditing requirements
regarding significant unusual transactions are principally contained in
AU sec. 316, Consideration of Fraud in a Financial Statement
Audit.\169\ That standard provides that the auditor considers the risks
of fraud relating to a significant transaction outside the normal
course of business for a company if the auditor ``becomes aware'' of
such a transaction.\170\ There is no express requirement in AU sec.
316, however, for the auditor to perform specific procedures to
identify such transactions or to obtain the information necessary to
evaluate the accounting for and disclosure of such transactions, which
are key considerations in promoting the auditor's heightened scrutiny
of a company's significant unusual transactions.
---------------------------------------------------------------------------

\168\ See, e.g., paragraph 71.g. of Auditing Standard No. 12,
Identifying and Assessing Risks of Material Misstatement.
\169\ See paragraphs .66-.67 of AU sec. 316.
\170\ See discussion of The Baseline for a more detailed
discussion of the existing standards applicable to the critical
areas.
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The Board's staff identified areas of potential weaknesses in the
auditor's consideration of significant unusual transactions and in
April 2010 issued Staff Audit Practice Alert No. 5, Auditor
Considerations Regarding Significant Unusual Transactions.\171\ That
alert discusses a range of auditor practice issues pertaining to
significant unusual transactions, including the auditor's understanding
of transactions close to period end that pose difficult substance over
form issues. Similarly, the IAASB staff issued guidance in August 2010
that addressed the auditing of significant unusual or highly complex
transactions.\172\
---------------------------------------------------------------------------

\171\ See Staff Audit Practice Alert No. 5, Auditor
Considerations Regarding Significant Unusual Transactions (April 7,
2010).
\172\ See IAASB Staff Questions and Answers, Auditor
Considerations Regarding Significant Unusual or Highly Complex
Transactions (August 2010).
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As a result of these and other considerations discussed throughout

[[Page 43215]]

this release, the Board has determined that there is a need to improve
its existing auditing standards regarding significant unusual
transactions. In the Board's view, the existing standards in this area
do not contain sufficient required procedures to promote the heightened
scrutiny necessary for the auditor to identify and evaluate
transactions that may be used to intentionally obscure a company's
financial results or that may result in erroneous financial reporting.
Financial Relationships and Transactions with Executive Officers:
Understanding a company's relationships and transactions with its
executive officers is important to an auditor because a company's
executive officers are generally in a position to determine or
influence a company's accounting and disclosures. A company's financial
relationships and transactions with its executive officers (e.g.,
executive compensation) can create incentives and pressures for
executive officers to meet financial targets, which can result in risks
of material misstatement of a company's financial statements.
Additionally, a company's executive officers, because of their role in
the financial reporting process, are in a unique position to commit
fraud.\173\
---------------------------------------------------------------------------

\173\ See, for example, AU sec. 316.08.
---------------------------------------------------------------------------

Cases involving fraudulent financial reporting illustrate how a
company's financial relationships and transactions with its executive
officers can create incentives and pressures that can result in risks
of material misstatement, including fraud risks.\174\ Research that
analyzed SEC AAERs from 1998 to 2007 also identified potential
motivations for engaging in fraudulent financial reporting that relate
to a company's financial targets.\175\ For example, the study noted
that the most commonly cited motivations for fraud included the need
to: (i) Meet internal or 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. The cited motivations support a conclusion that a
company's financial relationships and transactions with its executive
officers can create incentives and pressures that can result in risks
of material misstatement to a company's financial statements. That
study noted that the chief executive officer and/or the chief financial
officer were named in 89 percent of the cases involving fraudulent
financial reporting brought by the SEC during that period.
---------------------------------------------------------------------------

\174\ For example, over the last decade, the SEC has brought a
number of cases where management allegedly manipulated compensation
expense recognized in the financial statements, while simultaneously
obtaining additional compensation for themselves through options
backdating. See SEC Spotlight on Stock Options Backdating, which
lists AAERs, Commission speeches and testimony, Commission staff
speeches, testimony and letters; and non-SEC documents relating to
stock options backdating, http://www.sec.gov/spotlight/optionsbackdating.htm.
\175\ See Mark S. Beasley, Joseph V. Carcello, Dana R.
Hermanson, and Terry L. Neal, 2010. 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.
---------------------------------------------------------------------------

Under the Board's risk assessment standards, the auditor is
required to consider obtaining an understanding of compensation
arrangements with the company's ``senior management'' as part of
obtaining an understanding of the company.\176\ In the Board's view
this continues to be an important consideration for the auditor during
the risk assessment process. However, the Board's risk assessment
standards require the auditor to ``consider'' performing procedures to
obtain an understanding of certain compensation arrangements as part of
``obtaining an understanding of the company'' during the auditor's
overall risk assessment, but does not require the performance of
specific procedures to obtain such an understanding.\177\ Most
significantly, the Board's risk assessment standards do not require the
auditor to perform specific procedures to obtain an understanding of
financial relationships and transactions with executive officers, which
can motivate or affect company accounting or reporting decisions.
---------------------------------------------------------------------------

\176\ See paragraph 11 of Auditing Standard No. 12.
\177\ See discussion of The Baseline for a detailed discussion
of the existing standards applicable to the critical areas.
---------------------------------------------------------------------------

As a result of these and other considerations discussed throughout
this release, the Board has determined that there is a need to improve
its existing risk assessment standards relating to the auditor's
consideration of a company's financial relationships and transactions
with its executive officers. In the Board's view, its risk assessment
standards in this area are not sufficiently targeted to promote
heightened scrutiny of potential risks of material misstatement arising
from a company's financial relationships and transactions with its
executive officers, in view of the unique role played by the company's
executive officers in the company's financial reporting process.
How the Standard and Amendments Address the Need
The Board has determined to improve its requirements relating to
identifying, understanding, and addressing certain areas that are
widely acknowledged to represent increased risks of material
misstatement in company financial statements. As more fully discussed
below, these improvements are intended to strengthen the audit of the
company's financial statements by improving the auditor's ability to
identify and address such risks. In the Board's view, a more focused
approach with specific performance requirements should foster the
heightened scrutiny that the Board believes is warranted in the
critical areas. Such an approach should help mitigate the information
asymmetry between company management and investors.
The following sections describe key aspects of the standard and
amendments being adopted by the Board, with a focus on how they address
the need for improvement described above.\178\
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\178\ A section-by-section discussion of the standard and
amendments is located in Section C.
---------------------------------------------------------------------------

Auditing Standard No. 18, Related Parties: The Board is superseding
AU sec. 334 and adopting a new standard that establishes specific
procedures intended to strengthen auditor performance requirements
regarding the auditing of related party transactions. The new
requirements establish specific procedures, rather than the approach in
the existing standard, which provides guidance and example procedures
for the auditor's consideration.
The standard reflects the following key improvements from the
existing standard:
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 risks of material misstatement associated with a
company's relationships and transactions with its related parties.
Specifically, the standard focuses on those related party transactions
that require disclosure in the financial statements or that are
determined to be a significant risk. The basic procedures are designed
to assist the auditor in identifying red flags that indicate potential
risks of material misstatement. The standard also requires more in-
depth procedures that are designed to be scalable and

[[Page 43216]]

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: The standard
is designed to align with and build upon the risk assessment standards.
The 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: 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.
Emphasizing a Complementary Audit Approach: The standard
specifically requires the auditor to take into account other work
performed during the audit, for example, information gathered with
respect to significant unusual transactions, when evaluating the
company's identification of its related party transactions.
Adding Audit Committee Communications: AU sec. 334 does
not mention communications with audit committees regarding related
party transactions. The standard being adopted by the Board anticipates
two-way communication between the auditor and the audit committee
regarding such transactions. This reflects the fact that the new
performance requirements contained in the standard and amendments
relate to sensitive areas of the audit that potentially involve the
interests of company management and, thus, warrant discussion with the
audit committee. Specifically, the auditor is required to make
inquiries of the audit committee (or its chair) when the auditor is
obtaining an understanding of the company, which should occur during
the auditor's risk assessment. During these initial communications, the
auditor obtains information regarding a company's significant related
party transactions and any such relationships or transactions that are
of concern to members of the audit committee. The standard further
requires that the auditor communicate to the audit committee regarding
the auditor's overall evaluation of the company's identification of,
accounting for, and disclosure of its relationships and transactions
with related parties, including any significant matters the auditor
identified during the audit. Among other things, the matters to be
communicated related to the auditor's evaluation include the
identification of any related parties (or relationships or transactions
with related parties) that were previously undisclosed to the auditor.
Amendments Regarding Significant Unusual Transactions: In this
area, the Board is: (i) Revising AU sec. 316; (ii) making targeted
amendments to certain risk assessment standards (e.g., Auditing
Standards Nos.12 and 13); and (iii) making related changes to other
PCAOB auditing standards. These amendments include specific procedures
designed to improve the auditor's identification and evaluation of a
company's significant unusual transactions. Among other things, they
require the auditor to perform specific procedures to (i) identify
significant unusual transactions and (ii) obtain an understanding of
the business purpose (or the lack thereof) of the company's significant
unusual transactions, including whether the transaction was entered
into to engage in fraud. In the Board's view, adding specific
procedures promotes audit quality by providing the auditor with more
insight into the nature of a company's significant unusual
transactions, which should enable the auditor to better evaluate
whether the financial statements are fairly stated.
The amendments regarding significant unusual transactions are
designed to improve existing Board standards in the following key
respects:
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 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.
Enhancing Attention to the Business Purpose (or the Lack
Thereof) of Significant Unusual Transactions: The amendments to AU
secs. 316.66-.67 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 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 by emphasizing that
existing requirements include evaluating whether the financial
statements contain the information essential for a fair presentation of
the financial statements in conformity with the applicable financial
reporting framework.
Emphasizing a Complementary Audit Approach: The amendments
regarding significant unusual transactions specifically require the
auditor to take into account other work performed during the audit, for
example, information gathered with respect to related party
transactions, when identifying significant unusual transactions.
Enhancing Audit Committee Communications: The amendments
regarding significant unusual transactions are intended to improve the
quality of the auditor's communications with the audit committee
regarding the business purpose (or the lack thereof) of significant
unusual transactions.\179\
---------------------------------------------------------------------------

\179\ See, e.g., paragraph 13.d of Auditing Standard No. 16,
Communications with Audit Committees.
---------------------------------------------------------------------------

Conforming Descriptions of Significant Unusual
Transactions: The amendments introduce a uniform description of
``significant unusual transactions'' throughout the Board's standards.

[[Page 43217]]

Amendments Regarding Financial Relationships and Transactions With
Executive Officers: The Board is revising Auditing Standard No. 12 to
require the auditor to perform specific procedures during the risk
assessment process to obtain an understanding of the company's
financial relationships and transactions with its executive officers.
In doing so, the auditor would consider, among other things, the
potential for increased risks of material misstatement that could arise
out of the company's compensation arrangements with its executive
officers.\180\
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\180\ The population of the company's ``executive officers'' is
determined by reference to SEC rules and forms. See Section C--Other
Amendments to PCAOB Auditing Standards for a discussion of the
applicable definition of the term ``executive officer.''
---------------------------------------------------------------------------

The revisions improve the existing audit requirements by requiring
the auditor to perform specific procedures to obtain an understanding
of a company's financial relationships and transactions with its
executive officers, as part of the auditor's risk assessment.
Specifically, the amendments revise Auditing Standard No. 12 to state
that the auditor ``should perform'' specified procedures to obtain an
understanding of the company's financial relationships and transactions
with its ``executive officers'' as part of the auditor's risk
assessment.
As noted previously, under the existing risk assessment standards,
the auditor is required to ``consider'' obtaining an understanding of
compensation arrangements with senior management as part of obtaining
an understanding of the company during the auditor's risk
assessment.\181\ The Board's standards currently do not explicitly
require that the auditor obtain information regarding incentives or
pressures for the company's executive officers to achieve a particular
financial position or operating result as a result of performance based
compensation arrangements. The Board has determined to supplement its
existing requirements, and has determined that the requirement that the
auditor ``should perform'' procedures relating to executive officer
compensation arrangements is appropriate to promote heightened
scrutiny.
---------------------------------------------------------------------------

\181\ See paragraph 11 of Auditing Standard No. 12.
---------------------------------------------------------------------------

In the Board's view, a focus on the company's executive officers
during the risk assessment process is appropriate in that they
generally play a key role in the company's accounting decisions and in
a company's financial reporting. However, the new required procedures
do not require the auditor to make a determination regarding the
appropriateness of a company's compensation agreements with its
executive officers.
The Baseline
To consider the economic impacts (including likely benefits and
costs) of the standard and amendments, a ``baseline'' has been
identified that can be used as a benchmark against which the standard
and amendments can be compared. The baseline, described below, includes
existing requirements and also considers audit practices.
Existing Requirements
The auditor's overall responsibility to perform a risk-based audit
is contained in the Board's risk assessment standards, Auditing
Standards Nos. 8 through 15, which became effective for auditors in
December 2010.\182\ Among other things, the risk assessment standards
require the auditor to consider the risks of material misstatement,
whether due to error or fraud, throughout the audit.\183\
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\182\ See PCAOB Release 2010-004 (August 5, 2010).
\183\ More generally, auditors are required to comply with all
standards of the PCAOB, including existing requirements to perform
the audit with due professional care, and to obtain sufficient
appropriate audit evidence to support the audit opinion. See, e.g.,
AU sec. 230, Due Professional Care in the Performance of Work, and
Auditing Standard No. 15, Audit Evidence.
---------------------------------------------------------------------------

The existing requirements that the Board is strengthening through
adoption of the standard and amendments are discussed below.
Relationships and Transactions With Related Parties: The risk
assessment standards anticipate that the auditor will consider certain
risks inherent in significant transactions with related parties in
determining the significant risks of the audit \184\ and in
establishing the materiality level for the audit of the financial
statements.\185\ However, the existing auditing requirements relating
to relationships and transactions with related parties are contained
primarily in AU sec. 334, one of the Board's interim standards.
---------------------------------------------------------------------------

\184\ See paragraph 71.e. of Auditing Standard No. 12.
\185\ See paragraph 7 of Auditing Standard No. 11, Consideration
of Materiality in Planning and Performing an Audit, which states
that lesser amounts of misstatements could influence the judgment of
a reasonable investor because of qualitative factors, e.g., because
of the sensitivity of circumstances surrounding misstatements, such
as conflicts of interest in related party transactions.
---------------------------------------------------------------------------

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. However, as noted above, it provides guidance and examples
of procedures for the auditor's consideration, rather than specific
required procedures.
Examples of procedures in AU sec. 334 include: (i) 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); (ii) 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); and (iii) procedures the auditor
considers, as necessary, to understand the purpose, nature, and extent
of identified related party transactions (such as obtaining an
understanding of the business purpose of the transaction). Notably, AU
sec. 334 states that not all of the procedures may be required in every
audit.
AU sec. 334 states that the auditor should place primary emphasis
on the adequacy of disclosure of related party transactions.
Significantly, the existing standard also 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.\186\ 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.\187\
---------------------------------------------------------------------------

\186\ See AU sec. 334.06.
\187\ This is in contrast to the approach reflected in the
standard, which emphasizes the auditor's responsibilities for
identifying and assessing risks of material misstatement associated
with related parties and relationships and transactions with related
parties.
---------------------------------------------------------------------------

Significant Unusual Transactions: The risk assessment standards
anticipate that the auditor will consider risks of material
misstatement in a company's financial statements, including those posed
by significant unusual transactions.\188\ However, the more specific
auditing requirements regarding significant unusual transactions are
principally contained in AU sec. 316.\189\ 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

[[Page 43218]]

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. However, AU sec. 316 does not specify the
procedures to perform to identify significant unusual transactions or
to obtain necessary information to understand their business purpose
(or the lack thereof).
---------------------------------------------------------------------------

\188\ See paragraph 71.g. of Auditing Standard No. 12.
\189\ See AU secs. 316.66-.67.
---------------------------------------------------------------------------

Financial Relationships and Transactions With Executive Officers:
The 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.\190\ While this encompasses a company's
executive officers, the existing standards do not specifically require
the auditor to obtain an understanding of the incentives and pressures
posed by executive officer compensation arrangements that can influence
a company's accounting and disclosures.
---------------------------------------------------------------------------

\190\ See paragraph 11 of Auditing Standard No. 12.
---------------------------------------------------------------------------

Audit Practices
The Board's understanding of audit practices is based on the
Board's general knowledge of audit firm practice arising out of
information gathered from its oversight activities, including its
inspection, enforcement, and standard-setting activities. Additionally,
the Board's understanding also has been informed by a range of studies
and other materials it considered in determining the need for
improvement of its existing standards. Based on this understanding, the
Board believes that audit practices associated with the auditor's
efforts regarding the critical areas are inconsistent.
The Board is aware that some firms have adopted audit methodologies
that require their engagement teams to perform specific procedures
regarding related party transactions not currently required by AU sec.
334. This may have occurred for a number of reasons. For example, the
analogous standards of the IAASB and ASB require the auditor to inquire
of management regarding the entity's related parties.\191\ Audit
practice also may have been impacted by guidance issued by the AICPA
encouraging auditors to perform many of the procedures suggested in AU
sec. 334 for the auditor's consideration.\192\ Additionally, some
auditors may already perform additional procedures arising out of their
consideration of the risks of significant transactions with related
parties as potential significant risks.\193\
---------------------------------------------------------------------------

\191\ See paragraph 13 of ISA 550, Related Parties, and
paragraph 14 of AU-C 550, Related Parties.
\192\ See AICPA Practice Alert No. 95-3, Auditing Related
Parties and Related-Party Transactions, which indicated the auditor
should perform most, if not all, of the examples of procedures in AU
sec. 334 for determining the existence of related parties and
identifying transactions with known related parties, and AICPA
Toolkit, Accounting and Auditing for Related Parties and Related
Party Transactions (2001).
\193\ See paragraph 71.e. of Auditing Standard No. 12.
---------------------------------------------------------------------------

Further, some auditors may already perform additional procedures
regarding significant unusual transactions as a result of robust risk
assessments and as a result of guidance from Board staff and the
IAASB.\194\ Additionally, there has been considerable interest in
issues relating to executive compensation, which may have resulted in
heightened attention to such issues by some auditors.\195\
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\194\ See Staff Audit Practice Alert No. 5 (April 7, 2010). See
also IAASB Staff Questions and Answers, Auditor Considerations
Regarding Significant Unusual or Highly Complex Transactions (August
2010).
\195\ See, e.g., Staff Audit Practice Alert No. 1, Matters
Related To Timing And Accounting For Option Grants (July 28, 2006).
---------------------------------------------------------------------------

The Board also is aware through its oversight activities that some
firms have exhibited deficient auditing practices with respect to the
critical areas. For example, the Board has identified deficiencies
regarding the auditing of related party transactions through its
triennial inspection program, which focuses on inspections of smaller
domestic audit firms. Deficiencies identified include failures to test
for undisclosed related parties or transactions with related parties,
as well as failures to obtain an understanding of the business purpose
of known related party transactions.\196\
---------------------------------------------------------------------------

\196\ See Report on 2007-2010 Inspections of Domestic Firms that
Audit 100 or Fewer Public Companies, PCAOB Release No. 2013-001, at
29 (February 25, 2013), 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.
---------------------------------------------------------------------------

Additionally, a number of the Board's settled enforcement cases
have involved related party transactions.\197\ Those PCAOB enforcement
actions have identified, among other things:
---------------------------------------------------------------------------

\197\ 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).
---------------------------------------------------------------------------

Failures to perform sufficient procedures for known
related party transactions; \198\
---------------------------------------------------------------------------

\198\ See 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) and 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).
---------------------------------------------------------------------------

Failures to address management's failure to disclose known
related party transactions; \199\ and
---------------------------------------------------------------------------

\199\ See Order Instituting Disciplinary Proceedings, Making
Findings and Imposing Sanctions: In the Matter of Turner Stone &
Company, LLP and Edward Turner, CPA, Respondents, PCAOB Release No.
2006-010 (December 19, 2006) and Order Instituting Disciplinary
Proceedings, Making Findings and Imposing Sanctions: In the Matter
of Timothy L. Steers, CPA, LLC, and Timothy L. Steers, CPA,
Respondents, PCAOB Release No. 105-2007-004 (November 14, 2007).
---------------------------------------------------------------------------

Failures to take sufficient steps to determine whether a
transaction was a related party transaction, when available information
indicated that it was.\200\
---------------------------------------------------------------------------

\200\ See Order Instituting Disciplinary Proceedings, Making
Findings and Imposing Sanctions: In the Matter of Cordovano and
Honeck, P.C. and Samuel D. Cordovano, CPA, Respondents, PCAOB
Release No. 2008-004 (December 18, 2008) and Order Instituting
Disciplinary Proceedings, Making Findings and Imposing Sanctions: In
the Matter of Clyde Bailey, P.C., and Clyde B. Bailey, CPA,
Respondents, PCAOB Release No. 2005-021 (November 22, 2005).
---------------------------------------------------------------------------

The types of deficiencies observed by the Board through its
oversight activities

[[Page 43219]]

indicate that auditor practice regarding related parties is
inconsistent under the existing auditing framework in a wide range of
areas, suggesting that this is a challenging area warranting additional
auditor effort and focus.
The Board's Approach and Consideration of Alternatives
During the standard-setting process, the Board considered a number
of alternatives and made a number of key policy choices with the goal
of improving audit quality in the critical areas, while also providing
opportunities for an efficient implementation. The following discussion
highlights alternatives and policy choices considered by the Board as
part of its economic considerations.
Consideration of Alternatives
Prior to the Board's decision to propose the standard and
amendments, the Board requested input from its SAG, as early as
2004.\201\ During these meetings, the Board engaged the SAG in a
discussion of issues relating to the auditing of related party
transactions. Additionally, the Board discussed whether and, if so,
how, to improve its existing standards in complementary areas that
might be considered to pose similar risks of material misstatement.
---------------------------------------------------------------------------

\201\ Prior to the issuance of the proposal, the SAG discussed
the topic of related parties at meetings on September 8-9, 2004,
June 21, 2007, and October 14-15, 2009. See the SAG Meeting Archive
at http://pcaobus.org/Standards/SAG/Pages/SAGMeetingArchive.aspx.
---------------------------------------------------------------------------

As part of its standard-setting process, the Board initially
considered whether new requirements were necessary. This included a
review of the Board's oversight efforts through the Board's inspection
and enforcement programs to determine the type, range, and prevalence
of audit deficiencies cited. In addition, before issuing its proposal,
the Board issued Staff Audit Practice Alert No. 5 in April 2010, which
discussed a range of auditor practice issues identified by the PCAOB
staff pertaining to significant unusual transactions.\202\
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\202\ See Staff Audit Practice Alert No. 5 (April 7, 2010).
---------------------------------------------------------------------------

Staff Audit Practice Alert No. 5 was issued to remind auditors of
the risks associated with significant unusual transactions and to
compile selected, relevant requirements from existing PCAOB auditing
standards into one document. Given that the alert only highlights
circumstances for auditor consideration, it did not alter audit
requirements with respect to significant unusual transactions.
In considering whether new requirements were necessary, the Board
assessed a range of factors, and concluded that it was appropriate to
develop standards with more specific requirements to address the
critical areas.
As part of its considerations, the Board considered whether AU sec.
334 could be amended to include new specific procedures. The Board
determined that the nature and extent of revisions necessary, including
changes to align a revised AU sec. 334 with the risk assessment
standards, would essentially result in a new standard. Thus, the Board
determined that it was appropriate to propose a new standard regarding
related parties, rather than amend the existing standard.
In considering how to address the other types of relationships and
transactions that the Board had identified as posing similar risks--
significant unusual transactions and a company's financial
relationships and transactions with executive officers--the Board
determined that issuing staff guidance could not make the changes that
were necessary to strengthen the existing audit requirements to address
the risks that had been identified in these areas. However, the Board
determined that new stand-alone standards were not necessary but that
appropriate improvements in audit quality could be achieved by
amendments to its existing audit requirements in those areas.
As the Board considered the types and extent of changes to make in
its existing standards, it considered several alternatives, including
some discussed with its SAG.\203\ Some alternatives considered
included:
---------------------------------------------------------------------------

\203\ See the SAG Meeting Archive at http://pcaobus.org/Standards/SAG/Pages/SAGMeetingArchive.aspx, for the October 14-15,
2009 SAG meeting.
---------------------------------------------------------------------------

Consideration of Related Party Transactions as Fraud Risk: In view
of the potential for increased risks of material misstatement arising
from these critical areas, the Board considered whether relationships
and transactions with related parties should be presumed to be a fraud
risk. Under existing auditing standards, this approach would require
auditors to devote considerable audit effort to identifying and
evaluating relationships and transactions with related parties, in all
instances. However, the Board recognizes that many related party
transactions might not, in fact, represent fraud risks or other
significant risks, a view that was further informed by discussions with
the SAG.\204\ Accordingly, as such an alternative could have resulted
in potentially unnecessary audit effort, the Board determined to take a
targeted approach that would focus on the auditor obtaining sufficient
information to identify, assess, and respond to transactions that pose
increased risks of material misstatement, while, at the same time
aligning the new requirements with the risk assessment standards.
---------------------------------------------------------------------------

\204\ See SAG Meeting Archive for the October 14-15, 2009 SAG
meeting.
---------------------------------------------------------------------------

Consideration of Relationships and Transactions Posing Similar
Risks: The Board also considered whether to address relationships and
transactions that might fall outside the definition of a ``related
party'' but that might pose similar risks. After obtaining input from
the SAG regarding this approach,\205\ the Board decided that the
auditor should consider transactions that might pose similar risks,
such as a company's significant unusual transactions, because these
transactions not only may involve related parties previously
undisclosed to the auditor but also could pose increased risks of
material misstatement. Additionally, the Board concluded that linking
the auditor's efforts regarding related parties and significant unusual
transactions should help auditors ``connect the dots'' between these
areas.
---------------------------------------------------------------------------

\205\ Id.
---------------------------------------------------------------------------

The Board's Approach and Choices Considered in Developing the Board's
Standard and Amendments
The following discussion describes key policy choices considered by
the Board as it developed the standard and amendments, and as the Board
moved from its proposal to its reproposal and then to the adoption of
the standard and amendments. In developing the standard and amendments,
the Board determined to develop an audit approach that would promote
heightened scrutiny in the critical areas, but that would also provide
opportunity for efficient implementation. Key policy choices included:
Aligning With the Risk Assessment Standards: In the Board's view,
its overall risk assessment approach promotes a cohesive audit, with
opportunities to integrate audit effort where appropriate, and
positions the auditor to identify areas in which there may be increased
risks of material misstatement in company financial statements. Such an
approach could also serve to minimize audit costs. The Board, thus,
determined that its new requirements should be explicitly aligned with
its risk assessment standards. In response to comments on its proposal,
the Board took steps in its reproposal to more closely align the

[[Page 43220]]

reproposed standard and amendments with its risk assessment standards.
Those who commented on this aspect of the reproposal generally agreed
that the revisions improved the alignment with the risk assessment
standards. This risk assessment focus is retained in the standard and
amendments being adopted by the Board.
Providing Opportunity for a Scaled Approach: Similar to the risk
assessment standards, the Board determined that the standard should
reflect a scaled approach, which establishes basic required procedures
that are supplemented by more in-depth procedures that are commensurate
with the company's facts and circumstances. 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.
Most commenters, including several large audit firms, agreed that
the reproposed standards and amendments provide a scaled approach,
permitting the auditor to vary the level of audit work in proportion to
the nature and number of a company's relationships and transactions
with related parties and significant unusual transactions. Some of
these commenters supported the Board's view that the level of audit
effort will vary in proportion to the number and nature of a company's
related party relationships and transactions, its significant unusual
transactions, its financial relationships and transactions with
executive officers, and the company's process to identify such matters.
Another commenter stated that an audit approach that begins with basic
procedures, and supplements them with more in-depth procedures as
needed, is a scalable approach that allows the auditor to focus on the
significant risks, regardless of the size or nature (e.g., broker or
dealer or EGC) of the issuer. A few commenters, however, objected to
the concept of basic required procedures and advocated for an approach
that would leave the determination of the procedures necessary to the
auditor's judgment.
The Board considered commenter views and determined that requiring
the auditor to perform basic procedures in areas that could pose
increased risks of material misstatement would heighten attention by
the auditor to such areas and also provide a basis for the auditor to
identify red flags that require further attention. However, as
discussed below, the Board did revise certain aspects of its proposal
to permit additional auditor judgment in certain areas of the audit
that it determined appropriate.
Addressing Complementary Audit Areas: The Board determined that the
standard and amendments should include linkages that would address
risks of material misstatement arising from complementary areas of the
audit. 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.
This linked approach encourages the auditor to ``connect the dots''
between different aspects of the audit, which could improve audit
effectiveness, as well as provide opportunities for efficient
implementation. In its reproposal, the Board made revisions to improve
the linkages 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 determined to
include some existing auditing concepts and procedures in its proposal.
This approach was intended to permit audit firms to build on existing
methodologies and training. Further, this approach could minimize the
costs of implementing the standard and amendments. In its reproposal,
the Board sought comment on such issues. Several audit firms who
commented on the reproposal 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 and amendments would not be unduly burdensome.
Additionally, commenters raised a variety of policy choices for
consideration by the Board, including the following: \206\
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\206\ Additionally, see Appendix 4 of the reproposing release
for discussion more generally of the Board's response to significant
comments received on the Board's February 28, 2012 proposal.
---------------------------------------------------------------------------

Expanding Auditor Judgment: In response to comments, the Board made
some changes to allow for additional auditor judgment than originally
provided for in the proposal. For example, in its proposal, any related
party relationships or transactions not previously disclosed to the
auditor would have been considered to be a significant risk and would
have required the auditor to perform specific procedures in response.
Some commenters stated that an undisclosed related party transaction
could be inconsequential in nature and, in such circumstances, treating
the transaction as a significant risk and performing all of the
procedures set forth in the proposed standard would be unnecessary.
Other commenters suggested it might be appropriate to perform some, but
not all, of the related procedures in the proposed standard. After
consideration of comments, the Board removed the proposed requirement
that the auditor always treat undisclosed related party transactions as
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 being 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, 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 clarified
approach taken in the Board's reproposal recognizes that the company is
responsible, in the first instance, 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 has been retained in the
standard being adopted by the Board. Additionally, in response to other
comments made regarding the reproposed standard, several other
clarifying changes have been made in this area. Those changes include
emphasizing more prominently the auditor's responsibility to perform
procedures to test the accuracy and completeness of the company's
identification of its related parties, and that in doing so, the
auditor takes into account the information gathered during the audit.
Clarifying the Requirements Regarding a Company's Financial
Relationships and Transactions With Its Executive Officers: The Board
made two key policy choices relating to the amendments pertaining to a
company's financial relationships and transactions with its executive
officers: (i) The relationship of the amendments to the risk assessment
process; and (ii) the

[[Page 43221]]

appropriate scope of the population for the auditor's required
procedures.
As discussed previously, the Board determined to supplement its
existing risk assessment requirements regarding a company's financial
relationships and transactions with its executive officers. As
proposed, the other amendments provided that the auditor should perform
procedures to obtain an understanding of a company's financial
relationships and transactions with its executive officers. While some
commenters were fully supportive of this requirement and recognized
that it did not represent a radical departure from existing standards,
other commenters expressed concern that this would require the auditor
to make an assessment regarding the appropriateness or reasonableness
of executive compensation arrangements. In its reproposal, the Board
clarified that these procedures would be performed as part of the risk
assessment process and explicitly stated that its amendment does not
require the auditor to make any determination regarding the
appropriateness or reasonableness of the company's compensation
arrangements with its executive officers. Commenters who addressed this
area of the Board's reproposal generally indicated that the revisions
were appropriate. The amendments being adopted by the Board retain the
approach taken in its reproposal.
Additionally, the Board also considered the appropriate population
for the auditor's consideration of financial relationships and
transactions. The Board determined that the auditor's consideration of
a company's financial relationships and transactions need not extend to
the company's entire senior management population, but that a focus on
a potentially smaller group within that population--executive
officers--was appropriate. This focus is appropriate because a
company's executive officers generally are in a unique position to
determine the company's accounting and financial statement disclosures.
In considering the appropriate population for the auditor's
consideration, the Board took note of a range of diverse comments,
including those from commenters who advocated that the auditor's
procedures should include a broader group than the company's executive
officers; others who stated that the auditor's focus on a company's
executive officers was the most appropriate group; and another who
argued for a narrower group, for example, a company's ``named executive
officers,'' (``NEOs''). Under SEC rules, NEOs generally consist of five
individuals--the principal executive officer, the principal financial
officer, and the next three most highly paid executive officers of a
company as of the end of the most recently completed fiscal year.\207\
The Board considered the use of the NEO approach, but determined that
it might focus the auditor's attention on highly paid individuals (with
high compensation due to activity unrelated to financial reporting),
rather than individuals with more direct involvement in the financial
reporting process.
---------------------------------------------------------------------------

\207\ See Item 402(a)(3) of Regulation S-K.
---------------------------------------------------------------------------

After considering these comments, the Board determined that a
company's executive officers is the most appropriate population for the
auditor's efforts.\208\ In the Board's view, this targeted approach
could serve to limit potentially unnecessary audit effort and related
costs.
---------------------------------------------------------------------------

\208\ In considering the appropriate population for the
auditor's inquiry, the Board took note of a study that indicated
that the median number of ``executive officers'' for the Standard
and Poor's 500 is 8 (the mean is 8.71), and the median number of
executive officers for the Russell 2000 is 5 (the mean is 6.12). See
Broc Romanek, Study: Benchmarking the Number of ``Executive
Officers,'' The Corporate Counsel.net and LogixData (March 2, 2011).
---------------------------------------------------------------------------

The Economic Impacts of the Standard and Amendments, Including Benefits
and Costs
This section contains a discussion of the economic impacts
considered as the standard and amendments were developed, including
consideration of likely benefits and costs.
At present, there is limited data and research available regarding
the economic impact of discrete changes to auditing standards.\209\ As
a result, many of the benefits and costs discussed below are difficult
to quantify reliably. The resulting benefits to investors, markets, and
others from more reliable financial reporting are complex and not
capable of reliable quantification at this time. Likewise, limited, if
any, public data exists to forecast the costs of performing additional
audit procedures in the critical areas or the spillover effect on
companies. Therefore, the economic discussion below is qualitative in
nature.
---------------------------------------------------------------------------

\209\ The Board established a Center for Economic Analysis to,
among other things, promote and encourage academic research relating
to the role of the audit in capital formation and investor
protection. See PCAOB Announces Center for Economic Analysis,
(November 6, 2013) http://pcaobus.org/News/Releases/Pages/11062013_CenterEconomicAnalysis.aspx.
---------------------------------------------------------------------------

The Board's consideration of the impacts of the standard and
amendments, as with all aspects of the Board's standard-setting
process, takes into account commenters' views.\210\ As part of the
standard-setting process, the Board asked commenters to provide
information, as well as empirical data, regarding both benefits and
costs, and other effects related to the reproposed standard and
amendments. In response, commenters provided views regarding whether
the standard and amendments would improve audit quality, as well as
their views regarding potential audit costs and implementation issues.
However, commenters did not provide empirical data.\211\
---------------------------------------------------------------------------

\210\ The comment letters are available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket038Comments.aspx.
\211\ Additionally, Section C provides detail regarding the
Board's consideration of significant comments received relating to
the specific requirements of the standard and amendments.
---------------------------------------------------------------------------

In general, commenters largely supported the Board's standard-
setting efforts, and agreed that the existing standards should be
improved in the critical areas. Commenters also generally agreed that
the standard and amendments could benefit audit quality. Some
commenters also noted the standard and amendments could result in
improvements in the auditor's: (i) Identification of material
misstatements; (ii) risk assessment for the audit; and (iii)
application of professional skepticism. In addition, benefits noted
also included improvements to audit committee communications and
company financial statement disclosures.
Commenters who addressed potential costs provided qualitative
information that was generally consistent with the discussion of
potential costs in the reproposing release. While commenters noted that
there would be some increased costs, they did not provide data
regarding the extent of such costs. However, commenters generally
agreed that the standard and amendments were appropriate and should
apply to audits of companies of all types and sizes.
Commenters also provided views on issues relating to scalability
and costs. For example, one commenter stated that the reproposed
standard and amendments would not require significant incremental
management or auditor resources, but the amount of resources required
could be meaningfully greater for companies with a significant number
of related party transactions or significant unusual transactions. In
general, the Board would not expect there to be significant cost
implications for audits of companies that do not have complex or
extensive: (i) Relationships or transactions with related parties; (ii)

[[Page 43222]]

significant unusual transactions; or (iii) financial relationships and
transactions with the company's executive officers.
The following sections include a description of the Board's
consideration of: Benefits; Costs; Smaller Audit Firms and Smaller
Companies; and Other Economic Considerations.
Benefits
The Board believes that the standard and amendments will benefit
investors by requiring auditors to focus appropriate auditing effort on
areas that represent increased risks and, thus, warrant heightened
scrutiny during the audit. As noted previously, to the extent that the
standard and amendments improve the likelihood that the auditor will
detect material misstatements in the financial statements, audit
quality will be improved in ways that should also improve financial
statement accounting and disclosures, which should in turn reduce the
information asymmetry between investors and company management.
The standard and amendments take a targeted approach that is
intended to focus the auditor's attention on accounting and disclosures
relating to potentially complex and risky relationships and
transactions that historically have been associated with cases
involving fraudulent financial reporting. The magnitude and number of
such cases, which have resulted in significant losses to investors,
underscore the benefits to investors of strengthening the existing
auditing requirements in these areas. Increased focus on the critical
areas by auditors should increase the probability of auditors detecting
potential fraudulent or erroneous financial reporting \212\ and should
also deter fraudulent financial reporting because management will be
aware that auditors are likely to expend additional effort assessing
the economic substance of transactions in the critical areas.
---------------------------------------------------------------------------

\212\ See Mark Zimbelman, The Effects of SAS No. 82 on Auditors
Planning Decisions, 35 Journal of Accounting Research, 75 passim
(1997).
---------------------------------------------------------------------------

Existing auditing standards addressing the critical areas largely
provide guidance and examples of procedures, rather than requiring
specific procedures. This can result in inadequate and inconsistent
application of existing standards, as well as the auditor's failure to
perform sufficient procedures in the critical areas, which warrant
heightened scrutiny. Rather than providing examples of procedures that
may not be required in every audit, the standard and amendments require
the auditor to perform specific procedures. The new specific
requirements in the standard and amendments are designed to assist the
auditor in identifying red flags that warrant heightened scrutiny. The
performance of basic required procedures should increase the
probability of the auditor uncovering events that impact investors,
such as fraud and material errors, and provide investors with increased
confidence regarding the reliability of the audited financial
statements.
Additionally, the standard and amendments take a wholistic view of
the audit by requiring the auditor to consider the links and
relationships between a company's related party transactions and
significant unusual transactions. For example, the auditor's work in
identifying and evaluating significant unusual transactions should
assist the auditor in identifying and evaluating related parties, or
transactions with related parties previously undisclosed to the
auditor. Emphasizing the complementary nature of the auditor's efforts
regarding these areas should help the auditor to ``connect the dots''
between different aspects of the audit. The complementary approach is
intended to enhance audit efficiency as well as audit effectiveness in
that it may increase the probability of the auditor's uncovering
potential material fraud or error in a company's financial statements.
Likewise, the standard and amendments are aligned with the Board's
risk assessment standards and, thus, should enhance the auditor's
overall risk assessment more generally by making the auditor more
effective in identifying and assessing risks of material misstatement
in the critical areas, and in designing and performing better audit
procedures to address such risks. Additionally, the standard and
amendments feature a scaled approach that requires the auditor to
supplement the basic required procedures with more in-depth procedures
in response to risks identified. Alignment with the risk assessment
standards and the use of a scaled approach promotes a cohesive audit
approach that should contribute to improved audit quality and provide
opportunities for efficient implementation.
The auditor's heightened attention to transactions in the critical
areas also could result in the auditor obtaining more information about
the company's financial position. For example, the standards and
amendments emphasize the auditor's understanding of the business
purpose (or the lack thereof) of transactions in the critical areas. A
better understanding of the business purpose should better position the
auditor to understand and address such transactions, which often pose
difficult measurement and recognition issues, due to factors such as
transaction structure, complexity, and/or relationship to company
financial targets. Such an approach should promote audit quality by
providing the auditor with more insight into the nature of transactions
in the critical areas, which could allow the auditor to better evaluate
whether the financial statements are fairly stated.
The auditor's increased attention to the critical areas also may
result in increased attention by companies to their accounting and
disclosures, which could result in higher quality financial reporting.
Higher quality financial reporting improves the quality of information
available to the market and reduces information asymmetry between
investors and company management. Improving the quality of financial
reporting can reduce investors' uncertainty about the information being
provided in company financial statements, foster increased public
confidence in the financial markets, and enhance capital formation and
the efficiency of capital allocation decisions. Research shows that
decreasing the level of information asymmetry reduces the cost of
capital for issuers.\213\ In addition, if management produces more
accurate disclosures, research shows that this increased quality of
disclosures to financial statement users also reduces the cost of
capital.\214\
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\213\ See David Easley and Maureen O'Hara, 2004. Information and
the Cost of Capital. The Journal of Finance 59 (4): 1553-1583.
\214\ See Richard A. Lambert, Christian Leuz, and Robert E.
Verrecchia, 2012. Information Asymmetry, Information Precision, and
the Cost of Capital. Review of Finance 16 (1): 1-29.
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Further, new audit committee communication requirements would
promote communications regarding, and improve the auditor's
understanding of, the critical areas. For example, the auditor's
understanding of related party transactions would be informed by an
initial audit committee communication during the risk assessment that
is intended to help the auditor identify the company's significant
related party transactions, as well as to inform the auditor of any
concerns audit committee members may have regarding the company's
relationships or transactions with its related parties. Later in the
audit, the auditor is required to discuss with the audit committee the
auditor's evaluation of the company's identification of, accounting
for, and disclosure of, the company's related

[[Page 43223]]

party transactions, including any that were previously undisclosed to
the auditor. In addition, improving the auditor's understanding of: (i)
The business purpose (or the lack thereof) of a company's significant
unusual transactions and (ii) a company's financial relationships and
transactions with its executive officers, can enhance already existing
required audit committee communications related to significant unusual
transactions and significant risks.
These improved communication requirements should result in both
auditors and audit committees becoming better informed and thus better
equipped to fulfill their respective roles in the company's financial
reporting. Through these communications, the auditor becomes better
informed about the company, enabling the auditor to be more effective
in identifying and addressing risks of material misstatement in the
company's financial statements. A better informed audit committee can
contribute to management oversight, which may lead management to
improve the company's financial reporting. As noted above, research has
indicated that improving the quality of financial reporting reduces
investors' uncertainty about the information being provided in
companies' financial reports and, thus, increases efficiency in capital
allocation and fosters capital formation. For example, increased level
and/or quality of financial reporting has been found to decrease the
cost of equity, decrease the cost of debt, and decrease bid-ask
spreads.\215\
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\215\ See Christine A. Botosan, and Marlene A. Plumlee. 2002. A
Re-examination of Disclosure Level and the Expected Cost of Equity
Capital, 40 Journal of Accounting Research 21-40, (2002), Partha
Sengupta, Corporate Disclosure Quality and the Cost of Debt., 73 The
Accounting Review 459-474, (1998), and Michael Welker, Disclosure
Policy, Information Asymmetry, and Liquidity in Equity Markets, 11
Contemporary Accounting Research 801-827 (1995), respectively.
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Commenters largely agreed with the Board that the standard and
amendments could improve audit quality. In addition, specific benefits
suggested by commenters included: (i) Higher quality financial
statement disclosures; (ii) improving investors' confidence in audited
financial statements; (iii) improving the audit's effectiveness and
informational value; (iv) more relevant consideration of issues facing
the company; (v) increasing audit committee knowledge; and (vi)
improving the audit committees' abilities to fulfill their duties.
Additionally, another commenter stated that management may be more
attentive to written procedures and responsibilities for related party
transactions as a result of the reproposed standard. Specific comments
in each area include:
Relationships and Transactions With Related Parties: Many
commenters stated that the reproposed standard would improve the
auditor's overall understanding of a company's relationships and
transactions with its related parties. Some commenters suggested that
obtaining such an understanding would: (i) Assist the auditor in
obtaining sufficient appropriate audit evidence and increase the
likelihood of identifying material misstatements; and (ii) enhance the
exercise of professional skepticism in the performance of the audit.
Significant Unusual Transactions: A few commenters
suggested that requiring procedures to improve the auditor's
identification and evaluation of a company's significant unusual
transactions could improve audit quality by: (i) Increasing the
likelihood of identifying material misstatements; (ii) promoting the
exercise of professional skepticism; (iii) improving financial
statement disclosures; and (iv) improving audit committees' abilities
to fulfill their duties.
Financial Relationships and Transactions with Executive
Officers: Commenters providing views on audit quality issues indicated
that obtaining an understanding of a company's financial relationships
and transactions with its executive officers could improve audit
quality by: (i) Improving the auditor's identification of risks of
material misstatement; (ii) resulting in more relevant audit testing;
and (iii) improving the auditor's assessment of fraud risk.
With respect to the baseline, the Board notes that, as described
previously, some firms may perform procedures that go beyond existing
requirements. Consequently, the application of the standard and
amendments should generate greater benefits to audits of companies
whose auditors are not currently performing a comprehensive risk-based
audit or are performing only the most cursory of procedures under AU
sec. 334. Benefits also include promoting consistency in audit
practices among audit firms by establishing auditor performance
requirements.
Costs
In general, the Board recognizes that imposing new requirements
will involve some additional audit effort and related costs, both to
audit firms and companies.
The Board anticipates costs include direct compliance costs to
auditors that will reflect changes necessary to address the
introduction of new requirements. The Board anticipates initial and
ongoing costs for audit firms will include costs for updating and
maintaining methodologies and audit programs, implementation, and staff
training. Additionally, depending on the degree of effort currently
expended by audit firms, there may be increased costs in terms of
incremental audit effort, including increased audit partner time, and
potential costs for the time of specialists to review complex
transactions.
The increased audit effort and resulting costs may be limited as
the standard and amendments are based on the Board's existing risk
assessment standards and retain many existing auditing concepts and
procedures that are common in practice today. For example, AU sec. 334
suggests procedures for the auditor's consideration, certain of which
have been incorporated into the standard as specific required
procedures. To the extent that audit firms have already incorporated
these procedures into their current practices, those firms should incur
lower costs in updating their methodologies. As a result, costs should
be greater where auditors are not currently performing a comprehensive
risk-based audit or are performing only the most cursory of procedures
under AU sec. 334. In general, audit firms that audit companies of all
sizes were supportive of the Board's efforts to improve audit quality
in the critical areas and did not raise concerns regarding costs or
provide data regarding the extent of such costs for the Board's
consideration.
To the extent that there are increased costs for auditors as a
result of the application of the standard and amendments, such costs
may be passed on, in whole, or part (or not at all), to companies and
their investors in the form of higher audit fees.\216\ The Board

[[Page 43224]]

is aware, however, that there may be increased costs for companies
whose auditors must change their methodologies and practices to address
the new requirements. These potential costs to companies include
increased audit fees and costs for the additional time and expense of
responding to auditor inquiries.
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\216\ It is not clear to what extent the increased auditor
performance requirements would result in increased audit fees. The
Board is aware of public reports that have analyzed historical and
aggregate data on audit fees, and which suggest that audit fees
generally have remained stable in recent years, notwithstanding the
fact that the Board and other auditing standard-setters have issued
new standards during that period. See, e.g., Audit Analytics Audit
Fees and Non-Audit Fees: An Eleven Year Trend (July 2013). Because
amendments to, and adoption of, new Board standards typically
involve discrete parts of an audit, which is not accounted for, or
priced, on a standard-by-standard basis, it is difficult to obtain
data that isolates the costs of particular new audit standards, and
that would be comparable between firms. In its reproposal, the Board
sought data that might provide information or insight into such
costs. As noted above, commenters did not provide data regarding the
extent of such costs.
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Additionally, other costs could include costs associated with
enhanced audit committee communications, to the extent the areas
addressed by the standard and amendments are not already discussed.
Company audit committees may require additional time and expense to
participate in new audit committee communication relating to related
party transactions and also may require expanded discussions relating
to significant unusual transactions. While companies may need
additional time or resources to conduct the new audit committee
communications, the standard and amendments build on, and work in
concert with, the approach taken in Auditing Standard No. 16. Thus, the
new requirements in this area provide additional substance for an
integrated meeting with the audit committee. This should not add
significantly to the time or resources companies spend with respect to
audit committee communications.
The Board also considered potential unintended consequences in
conjunction with its consideration of costs. For example, the Board
considered whether, to the extent that potential costs stemming from
the standard and amendments increase audit costs related to
transactions with related parties, this could serve as a deterrent
against their use. In such cases, any cost advantage a company may have
from engaging in related party transactions during its normal course of
operations could be reduced by higher audit-related costs.
Two commenters provided their views that the reproposed standard
and amendments could serve as a deterrent against the use of related
party transactions. One commenter suggested that requiring auditors to
obtain evidence supporting management's arm's-length assertion
regarding a related party transaction had corresponding negative
economic consequences, such as, management avoiding the use of related
party transactions. Another commenter that stated that the increased
audit effort will result in a pass through of marginally higher audit
costs to companies also noted that there could be changed behavior in
structuring transactions so that they are not related party
transactions.
The Board considered these comments and acknowledges that, as noted
in the reproposal, potential costs stemming from the standard and
amendments could increase audit costs related to transactions with
related parties, which could conceivably serve as a deterrent against
their use. While the Board recognizes this potential, the Board notes
that companies are already required to disclose material related party
transactions in their financial statements, and auditors already should
be performing some procedures, under the existing standards, with
respect to these transactions and related disclosures. Additionally, in
considering these comments, the Board notes that the requirement in the
standard for auditors to obtain evidence supporting management's arm's-
length assertion regarding a related party transaction is consistent
with the requirement in AU sec. 334.12, as applicable financial
reporting frameworks only permit an arm's-length assertion regarding a
related party transaction to be included in the financial statements
when supported by evidence.
In general, the Board's assessment of the impact of the adoption of
the standard and amendments relative to costs was informed by the fact
that commenters did not raise issues regarding costs that were
inconsistent with those described by the Board in its reproposal.
Additionally, while some commenters noted that there would be some
increased costs to audit firms and companies, they did not provide data
regarding the extent of such costs. A number of commenters suggested
that the costs of the standard and amendments were appropriate. For
example, one commenter stated that the benefits of the reproposed
standard and amendments would outweigh the associated costs. Another
commenter stated that the reproposed standard and amendments benefit
users without placing too high a burden on preparers or auditors.
However, a few commenters indicated that the costs associated with the
standard and amendments may be difficult to measure prior to
implementation.
One commenter stated that the reproposed standard and amendments
would not require significant incremental management or auditor
resources, but resources required could be meaningfully greater for
companies with a significant number of related party transactions or
significant unusual transactions. Several other commenters also
indicated that smaller audit firms might be disproportionately impacted
by the Board's reproposal. However, commenters in general noted that
the standard and amendments were appropriate for, and should apply to,
audits of companies of all types and sizes, including broker-dealers
and EGCs. As noted above, the Board received comments from a wide
spectrum of commenters, including firms that audit companies of various
sizes. Further discussion of the potential impact on smaller audit
firms and smaller companies is discussed below.
Smaller Audit Firms and Smaller Companies
The Board recognizes that the adoption of the standard and
amendments may impose disproportionally greater costs on smaller audit
firms than on larger audit firms. For example, the one-time costs to
update audit methodologies and training may represent a relatively
larger share of audit costs for smaller audit firms compared to larger
audit firms. Further, to the extent that a smaller audit firm has not
already incorporated procedures suggested by AU sec. 334 into its
current practices, such a firm would likely incur higher incremental
costs to comply with the standard and amendments.
As described above, the costs incurred by the auditor to comply
with the standard and amendments may be passed on, in whole, or in part
(or not at all), to companies and their investors in the form of
increased audit fees. To the extent this occurs, it may particularly
affect smaller companies that rely on related party transactions as
part of their business model. This point also was asserted by some
commenters on the proposal and reproposal, many of whom also noted the
particular risks posed by related party transactions engaged in by
smaller companies. Increasing the costs of audits for smaller companies
could negatively impact their profitability.
In considering this potential impact, the Board also has taken note
of its oversight findings, which indicate that the audits of smaller
companies are more frequently the subject of inspection findings and
enforcement actions that involve related party transactions.
Additionally, the Board notes that there is likely less information
available regarding smaller companies (e.g., they have fewer brokerage
research analysts, and less press coverage). Thus, while there is the
potential for greater cost impact on

[[Page 43225]]

smaller companies arising from the standard and amendments, there is
also the potential that investors in such companies would accrue
relatively larger benefits from the standard and amendments, such as a
lower cost of capital.
As noted above, the Board believes that any additional audit costs
would likely vary based on the size and complexity of the company's
transactions in the critical areas, and would be commensurate with the
risk of material misstatement arising out of such transactions. As
noted in the reproposing release, a company that has extensive
relationships and transactions with related parties or significant
unusual transactions, or that has financial relationships and
transactions with executive officers that give rise to risks of
material misstatement, could anticipate a greater increase in audit-
related costs than a company without such relationships or
transactions.\217\ Thus, the Board would not expect there to be a
significant increase in audit fees for a company that does not have
complex or extensive: (i) Relationships or transactions with related
parties; (ii) significant unusual transactions; or (iii) financial
relationships and transactions with the company's executive officers.
In addition, to the extent that some auditors are already performing
procedures similar to those in the standard and amendments, there would
be a lesser impact. However, if the auditor identifies related parties
or relationships or transactions with related parties that were
previously undisclosed to the auditor, there would be incremental
costs, as well as benefits, associated with the auditor's response to
the increased risks of material misstatement.
---------------------------------------------------------------------------

\217\ See page A4-97 of the reproposing release.
---------------------------------------------------------------------------

Other Economic Considerations
As noted above, commenters generally supported the Board's efforts
to promote audit quality in the areas addressed by the standard and
amendments. However, a few expressed concerns. For example, one
commenter acknowledged that the Board had reproposed the standard and
amendments to obtain more information regarding economic considerations
generally, but the commenter was nonetheless critical of the Board's
economic analysis in its reproposal. This commenter stated that the
Board had failed to provide adequate specifics in its reproposal
supporting the need for the standard and stated that the reproposal did
not adequately address potential alternatives to the proposed
requirements, including any rationale for not choosing to converge with
the IAASB and ASB standards, which, in that commenter's view,
introduced unnecessary complexity and cost. This same commenter also
asked why the Board thought it necessary to adopt new requirements
after the issuance of Staff Audit Practice Alert No. 5.
The Board considered the issues raised by this commenter and
believes that the need for the standard and amendments, and the
alternatives considered by the Board, have been fully described in the
Board's proposals and throughout this release. The standards and
amendments being adopted represent a targeted approach that
appropriately responds to areas of the audit that have historically
represented risks of material misstatement in company financial
statements. In the Board's view, the need to improve the Board's
existing standards addressing the critical areas, including alignment
with the Board's risk assessment standards, cannot be adequately
addressed through staff interpretations of existing standards. More
specific requirements are warranted to promote heightened scrutiny in
the critical areas. While the new auditor performance requirements will
involve some additional effort and related costs in some cases, to
avoid unnecessary audit efforts and costs, the Board developed the
standard to align with existing audit procedures that the auditor
already is required to perform as part of the auditor's risk assessment
and requires the auditor to perform procedures that are commensurate
with the risks of material misstatement.
The Board also considered the comment that the Board did not set
forth a rationale for not choosing to converge the proposed auditing
requirements with the standards of the IAASB and the ASB. As a matter
of practice, the Board regularly considers the work of other standard-
setters, such as the IAASB and the ASB, for insights as it develops its
standards. In developing the standard and amendments, the Board
considered the analogous standards of the IAASB and the ASB and
incorporated a number of similar audit procedures and requirements that
the Board believed were useful and appropriate.\218\
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\218\ For example, paragraph 5 of the standard being adopted by
the Board contains similar requirements to paragraph 13 of ISA 550
(and paragraph 14 of AU-C 550), which require the auditor to inquire
of management regarding: The identity of the entity's related
parties, including changes from the prior period; the nature of the
relationships between the entity and these related parties; and
whether the entity entered into any transactions with these related
parties during the period and, if so, the type and purpose of the
transactions.
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The Board, however, has determined that the critical areas require
heightened scrutiny and, thus, the standard and amendments contain
auditing requirements that are not reflected in the analogous standards
of the IAASB and the ASB. For example, the standard and amendments
contain requirements for the auditor to focus heightened audit
attention on the business purpose (or the lack thereof) of a company's
related party transactions.\219\ Also, in view of the importance of the
audit committee's role in the oversight of the company's financial
reporting, the standard requires the auditor to make inquiries of the
audit committee (or its chair) regarding the audit committee's
understanding of the company's related parties and transactions, as
well as regarding whether any member of the audit committee has
concerns regarding such matters. Additionally, the other amendments
require the auditor to perform risk assessment procedures to obtain an
understanding of a company's financial relationships and transactions
with its executive officers.
---------------------------------------------------------------------------

\219\ See, e.g., paragraphs 5.d., 12.a., and 19.e. of the
standard.
---------------------------------------------------------------------------

Two commenters raised concerns regarding economic considerations of
a more general nature, suggesting that the Board develop a specific
framework for considering costs and benefits more generally. The Board
has addressed these matters separately.\220\
---------------------------------------------------------------------------

\220\ See, e.g., PCAOB Strategic Plan: Improving the Quality of
the Audit for the Protection and Benefit of Investors 2013-2017
(November 26, 2103) at 5 and 13, and PCAOB Releases Staff Guidance
on Economic Analysis in PCAOB Standard Setting (May 15, 2014) http://pcaobus.org/News/Releases/Pages/05152014_Economic_Analysis.aspx.
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Finally, in its reproposal, the Board specifically asked for
comment regarding any considerations relating to efficiency,
competition and capital formation that the Board should take into
account with respect to the reproposed standard and amendments. Other
than the general comments described above, the Board did not receive
comments noting specific concerns regarding efficiency, competition and
capital formation in response to its request.
In summary, after considering these factors and public comments,
the Board believes that its new requirements reflect a reasoned
approach that considers and is intended to limit unnecessary audit
effort and related costs.

[[Page 43226]]

Economic Considerations Pertaining to Audits of EGCs, Including
Efficiency, Competition, and Capital Formation
The PCAOB has been monitoring implementation of the JOBS Act in
order to understand the characteristics of EGCs \221\ and inform the
Board's considerations regarding whether it should recommend that the
SEC apply the standard and amendments to audits of EGCs. To assist the
SEC, the Board is providing the following information regarding EGCs
that it has compiled from public sources.\222\
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\221\ Pursuant to the JOBS Act, an EGC is defined in Section
3(a)(80) of the Exchange Act. In general terms, an issuer qualifies
as an EGC if it has total annual gross revenue of less than $1
billion during its most recently completed fiscal year (and its
first sale of common equity securities pursuant to an effective
Securities Act of 1933 (the ``Securities Act'') registration
statement did not occur on or before December 8, 2011). See JOBS Act
Section 101(a), (b), and (d). Once an issuer is an EGC, the entity
retains its EGC status until the earliest of: (i) The first year
after it has total annual gross revenue of $1 billion or more (as
indexed for inflation every five years by the SEC); (ii) the end of
the fiscal year after the fifth anniversary of its first sale of
common equity securities under an effective Securities Act
registration statement; (iii) the date on which the company issues
more than $1 billion in non-convertible debt during the prior three
year period; or (iv) the date on which it is deemed to be a ``large
accelerated filer'' under the Exchange Act (generally, an entity
that has been public for at least one year and has an equity float
of at least $700 million).
\222\ To obtain data regarding EGCs, the PCAOB's Office of
Research and Analysis has reviewed registration statements and
Exchange Act reports filed with the SEC with filing dates between
April 5, 2012, and November 20, 2013, for disclosures by entities
related to their EGC status. Only those entities that have
voluntarily disclosed their EGC status have been identified. The
PCAOB has not validated these entities' self-identification as EGCs.
The information presented also does not include data for entities
that have filed confidential registration statements and have not
subsequently made a public filing.
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Characteristics of Self-Identified EGCs
As of November 20, 2013, based on the PCAOB's research, 1,227 SEC
registrants had identified themselves as EGCs in SEC filings. These
companies operate in diverse industries. The five most common Standard
Industrial Classification (``SIC'') codes applicable to these companies
are codes for: (i) Blank check companies; (ii) pharmaceutical
preparations; (iii) real estate investment trusts; (iv) prepackaged
software services; and (v) computer processing/data preparations
services.
The five SIC codes with the highest total assets as a percentage of
the total assets of the population of EGCs are codes for: (i) Federally
chartered savings institutions; (ii) real estate investment trusts;
(iii) national commercial banks; (iv) state commercial banks; and (v)
crude petroleum or natural gas. Total assets of EGCs in these five SIC
codes represent approximately 35% of the total assets of the population
of EGCs. EGCs in three of these five SIC codes (federally chartered
savings institutions, national commercial banks, and state commercial
banks) represent financial institutions and the total assets for these
three SIC codes represent approximately 22% of the total assets of the
population of EGCs.
Approximately 19% of the EGCs identified themselves in registration
statements and were not previously reporting under the Exchange Act as
of November 20, 2013. Approximately 64% of the companies that have
identified themselves as EGCs began reporting under the Exchange Act in
2012 or later. The remaining 17% of these companies have been reporting
under the Exchange Act since 2011 or earlier. Accordingly, a majority
of the companies that have identified themselves as EGCs began
reporting information under the securities laws since 2012.
Approximately 63% of the companies that have identified themselves
as EGCs and filed an Exchange Act filing with information on smaller
reporting company status indicated that they were smaller reporting
companies.\223\
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\223\ The SEC adopted its current smaller reporting company
rules in Smaller Reporting Company Regulatory Relief and
Simplification, Securities Act Release No. 33-8876 (December 19,
2007). Generally, companies qualify to be smaller reporting
companies (``SRCs'') and, therefore, have scaled disclosure
requirements if they have less than $75 million in public equity
float. Companies without a calculable public equity float will
qualify if their revenues were below $50 million in the previous
year. Scaled disclosure requirements generally reduce the compliance
burden of SRCs compared to other issuers. Notably, the only area in
which SRC requirements may be more extensive than requirements for
other issuers is with respect to the disclosure of related party
transactions. The SEC justified this difference in treatment based
on the importance of disclosing related party transactions,
particularly for issuers with lower materiality thresholds.
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Approximately 32% of the companies that have identified themselves
as EGCs provided a management report on internal control over financial
reporting. Of those companies that provided a report, approximately 46%
stated in the report that the company's internal control over financial
reporting was not effective.\224\
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\224\ For purposes of comparison, the PCAOB compared the data
compiled with respect to the population of companies that identified
themselves as EGCs with companies listed in the Russell 3000 Index
in order to compare the EGC population with the broader issuer
population. The Russell 3000 was chosen for comparative purposes
because it is intended to measure the performance of the largest
3,000 U.S. companies representing approximately 98% of the
investable U.S. equity market (as marketed on the Russell Web site).
To contrast, approximately 95% of the companies in the Russell 3000
Index provided a management report on internal control over
financial reporting. Of those companies that provided a management
report, approximately 4% stated in the report that the company's
internal control over financial reporting was not effective.
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Audited financial statements were available for nearly all of the
companies that identified themselves as EGCs.\225\ For those companies
for which audited financial statements were available and based on
information included in the most recent audited financial statements
filed as of November 20, 2013:
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\225\ Audited financial statements were available for 1,216 of
the 1,227 self-identified EGCs. Audited financial statements were
not available for some EGCs that had filed registration statements
that had not been declared effective by the SEC.
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The reported assets ranged from zero to approximately
$18.2 billion. The average and median reported assets were
approximately $184.4 million and $0.4 million, respectively.\226\
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\226\ As noted above, for purposes of comparison, the PCAOB
compared the data compiled with respect to the population of
companies that identified themselves as EGCs with companies listed
in the Russell 3000 Index in order to compare the EGC population
with the broader issuer population. The average and median reported
assets of issuers in the Russell 3000 were approximately $12.2
billion and approximately $1.6 billion, respectively. The average
and median reported revenue from the most recent audited financial
statements filed as of November 20, 2013 of issuers in the Russell
3000 were approximately $4.6 billion and $725.8 million,
respectively.
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The reported revenue ranged from zero to approximately
$962.9 million. The average and median reported revenue were
approximately $59.6 million and $3 thousand, respectively.
The average and median reported assets among companies
that reported revenue greater than zero were approximately $359.5
million and $68.1 million, respectively. The average and median
reported revenue among these companies that reported revenue greater
than zero were approximately $116.2 million and $20.7 million,
respectively.
Approximately 49% identified themselves as ``development
stage entities'' in their financial statements.\227\
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\227\ According to the Financial Accounting Standards Board
(``FASB'') standards, development stage entities are entities
devoting substantially all of their efforts to establishing a new
business and for which either of the following conditions exists:
(i) Planned principal operations have not commenced or (ii) planned
principal operations have commenced, but there has been no
significant revenue from operations. See FASB Accounting Standards
Codification Subtopic 915-10, Development Stage Entities--Overall.
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Approximately 54% had an explanatory paragraph included in
the auditor's report describing that there is substantial doubt about
the company's ability to continue as a going concern.\228\
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\228\ Approximately 1% of the population of companies in the
Russell 3000 Index have an explanatory paragraph describing that
there is substantial doubt about the company's ability to continue
as a going concern.

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[[Page 43227]]

Approximately 38% were audited by firms that are annually
inspected by the PCAOB (that is, firms that have issued auditor's
reports for more than 100 public company audit clients in a given year)
or are affiliates of annually inspected firms. Approximately 62% were
audited by triennially inspected firms (that is, firms that have issued
auditor's reports for 100 or fewer public company audit clients in a
given year) that are not affiliates of annually inspected firms.
The PCAOB's Office of Research and Analysis has reviewed
registration statements and Exchange Act reports filed with the SEC
with filing dates between April 5, 2012, and November 20, 2013, for
related party disclosures by EGCs. An analysis of 1,103 of the most
recent audited financial statements filed through November 20, 2013 of
the 1,227 self-identified EGCs indicates that approximately 68% of
these companies disclosed at least one related party relationship or
transaction.\229\
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\229\ A similar analysis of SEC filings for the population of
companies in the Russell 3000 Index found that approximately 45% of
those companies have disclosed at least one related party
relationship or transaction.
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Economic Considerations Pertaining to Audits of EGCs, Including
Comments Received
The Board's analysis of the potential economic impacts on EGCs is
based on the EGC data described above, which has been collected and
analyzed by the Board's staff. The Board's analysis is also informed by
the Board's oversight activities, as well as by the other
considerations described hereinand the release more generally.
Additionally, the Board's analysis has been informed by information
provided by commenters. The Board's discussion of potential economic
impacts on EGCs follows.
Based on the data outlined above, a majority of EGCs are smaller
public companies. EGCs also appear to be companies that are relatively
new to the SEC reporting process. This indicates that there is less
information available to investors regarding such companies relative to
the broader population of public companies. It is generally
acknowledged that investors are less informed about companies that are
smaller and newer, suggesting there is a higher degree of information
asymmetry for smaller and newer companies.
Self-identified EGCs disclosed related party relationships or
transactions at a significantly higher rate as compared to companies in
the Russell 3000 Index. The data also suggests that EGCs are more
likely than the population of companies in the Russell 3000 Index to
have a management report on internal control over financial reporting
stating that the company's internal control over financial reporting
was not effective. The higher propensity of EGCs to engage in related
party transactions coupled with an increased likelihood for control
deficiencies suggests that applying the standard in audits of EGCs is
particularly relevant.
Given the characteristics of EGCs as newer and smaller companies,
some might assume that EGCs would have operations that are less
complex. However, this may not be true for many EGCs. Audits of EGCs
appear to reflect a wide range of complexity and risk. For example, 580
of the 1,227 companies that have identified themselves as EGCs did not
recognize revenue in the most recently filed financial statements.
Financial institutions represent at least 22% of the total assets of
EGCs. Given the nature of the operations of financial institutions,
these EGCs could engage in transactions that involve complex accounting
and financial statement disclosure issues.
Further, the data presented above indicates that for 54% of the
EGCs the auditor's report on the most recent audited financial
statements includes an explanatory paragraph describing that there is
substantial doubt about the company's ability to continue as a going
concern, as compared to 1% for the population of companies in the
Russell 3000 Index.
Thus, applying the standard and amendments to the audits of EGCs
may be particularly pertinent because of the characteristics of EGCs
described above (e.g., potential for higher rates of material
weaknesses in internal control, use of related party transactions, and
substantial doubt about the company's ability to continue as a going
concern).
In the reproposal, the Board specifically sought comment on the
application of the reproposed standard and amendments to audits of
EGCs. Commenters generally considered the requirements of the standard
to be applicable and appropriate to companies of varying sizes and
industries. All those who commented on the applicability of the
standard and amendments to EGCs stated that the reproposed standard and
amendments should be applicable to audits of EGCs. Those commenters
provided various reasons, including that the risks regarding related
parties, significant unusual transactions and financial relationships
and transactions with executive officers are the same, if not greater
at EGCs and that EGCs may enter into such matters more frequently than
non-EGCs.
No commenters stated that the reproposed standard and amendments
should not apply to audits of EGCs. One commenter, however, was
concerned that the reproposal did not contain a substantive analysis of
the economic impacts of the proposed requirements on EGCs. This
commenter acknowledged, however, that after the enactment of the JOBS
Act, the Board reproposed the standard and amendments to seek comment
and obtain additional information regarding the economic impacts on
EGCs.
Some commenters stated that the reproposed standard is scalable for
application to audits of EGCs. One commenter stated that firm
implementation costs should not differ when implementing the reproposed
standard for audits of EGCs or other issuers; however, increased
recurring costs may fall relatively disproportionately on EGCs. One
commenter stated that the implementation and training costs that a firm
would incur would not depend upon whether the reproposed standard is
applicable to EGCs and there should be little or no additional costs to
apply the reproposed standard to EGCs. Another commenter noted that
although smaller companies (some of which may be EGCs) may engage in
more related party transactions compared to other companies, which will
result in higher audit costs, the costs are commensurate with the risks
of material misstatement.
Some commenters noted that regardless of the applicability to
audits of EGCs, firms would perform the same procedures for all audits.
One commenter suggested that it would be more costly not to apply the
reproposed standard and amendments to audits of EGCs as this would, in
the commenter's view, require firms to maintain two methodologies. One
commenter stated that it would perform the same procedures for audits
of EGCs, regardless of the applicability of the reproposed standard and
amendments to audits of EGCs, as the cost to develop and maintain two
separate methodologies and the related training would be cost-
prohibitive. One commenter, representing a committee, stated that the
standard should be applicable to audits of EGCs. However, that
commenter also noted that its committee members had a mixed response;
some believed the standard ought to be universally applicable, as a
``carve-out'' for EGGs would be more costly, but a minority believed
that a carve out would be easy to implement.

[[Page 43228]]

One commenter suggested that applying different rules to financial
statement audits performed in accordance with PCAOB standards could be
confusing to investors and other stakeholders.
The standard and amendments are designed to improve the auditor's
efforts regarding a company's relationships and transactions with its
related parties, significant unusual transactions and financial
relationships and transactions with its executive officers. As
previously discussed, a significant number of the Board's oversight
findings from its inspections and enforcement programs regarding
related party transactions involve smaller public companies, which have
characteristics that are similar to EGCs.
Thus, enhanced auditor consideration of the areas addressed in the
standard and amendments may be particularly important to investors in
EGCs given that: (i) Information asymmetry may be more pronounced at
EGCs; (ii) there is the potential for greater reliance by EGCs on
related party transactions; and (iii) there is a significant number of
findings regarding related party transactions in audits of financial
statements of smaller companies identified through PCAOB oversight
activities.
Improving the auditor's efforts in the areas addressed in the
standard and amendments should promote audit quality in ways that also
should improve financial statement accounting and disclosure, which in
turn should improve financial reporting, reduce information asymmetry,
and reduce the company's cost of capital. These benefits should accrue
to all types of companies, including EGCs.
EGCs will incur some incremental costs in connection with auditor
compliance with the standard and amendments. As noted earlier, these
costs may be disproportionately higher for smaller companies, including
EGCs, relative to the broader population of public companies. The
additional audit-related costs, as discussed above, could conceivably
serve as a deterrent against the use of related party transactions by
EGCs. Likewise, additional audit-related costs may deter certain EGCs
from entering public markets, if those costs weigh heavily on their
potential profitability. To the extent that EGCs tend to be smaller and
newer companies, the enhanced audit performance requirements may place
a disproportionately higher burden on them, which may impact their
profitability and competitiveness. As noted above, however, no
commenter stated that the reproposed standard and amendments should not
apply to audits of EGCs and no commenter discussed the impact on
competitiveness of EGCs.
The standard and amendments are designed to mitigate cost impacts
by aligning the auditor's efforts with the risk assessment standards
and providing opportunities for a scaled approach. This allows auditors
to integrate the audit to avoid unnecessary audit effort.
Additionally, in its reproposal, the Board specifically asked for
comment regarding any considerations regarding efficiency, competition
and capital formation that the Board should take into account when
determining whether to recommend to the SEC the application of the
reproposed standard and amendments to audits of EGCs. No commenter
expressed concerns regarding efficiency, competition and capital
formation with respect to the application of the reproposed standard
and amendments to audits of EGCs.
Recommendation
The Board believes that the standard and amendments will advance
investor protection and promote audit quality. In addition, more
effective audits and more informed communications between the auditor
and the audit committee should enhance the quality of a company's
financial reporting.
Additionally, the Board believes that its new requirements reflect
a reasoned approach to considering and limiting unnecessary audit
effort and related costs. Many commenters agreed that the reproposed
standard and amendments would lead to improvements in audit quality,
with many commenters stating that the requirements of the reproposed
standard and amendments should be applicable to, and were appropriate
for, companies of different sizes and industries.
The JOBS Act was enacted after the Board issued its proposing
release. Subsequently, the Board issued a reproposal, in part to
request comment specifically on matters relating to the application of
the standard and amendments to audits of EGCs. A variety of commenters
noted particular risks posed by related party transactions pertinent to
small companies, including EGCs. In addition, all those commenters who
commented with respect to the applicability of the standard and
amendments to EGCs stated that the standard and amendments should be
applicable to audits of EGCs.
Based on data available to the Board regarding EGCs, it appears
that a wide range of entities, of differing sizes and industries,
identify themselves as EGCs. One key difference between EGCs and the
broader population of public companies would appear to be the length of
time that EGCs have been subject to Exchange Act reporting
requirements. Based on the information available to the Board, while
there may be additional costs and potential competitive impacts on
EGCs, there also may be additional benefits from enhanced scrutiny in
the areas addressed by the standard and amendments. Given these
considerations, there does not appear to be a compelling reason to
treat audits of EGCs differently from the audits of other companies.
For the reasons explained above, the Board believes that the
standard and amendments are in the public interest and, after
considering the protection of investors and the promotion of
efficiency, competition, and capital formation, recommends that the
standard and amendments should apply to audits of EGCs. Accordingly,
the Board recommends that the Commission determine that it is necessary
or appropriate in the public interest, after considering the protection
of investors and whether the action will promote efficiency,
competition, and capital formation, to apply the standard and
amendments to audits of EGCs. The Board stands ready to assist the
Commission in considering any comments the Commission receives on these
matters during the Commission's public comment process.

III. Date of Effectiveness of the Proposed Rules and Timing for
Commission Action

Pursuant to Section 19(b)(2)(A)(ii) of the Exchange Act, and based
on its determination that an extension of the period set forth in
Section 19(b)(2)(A)(i) of the Exchange Act is appropriate in light of
the PCAOB's request that the Commission, pursuant to Section
103(a)(3)(C) of the Sarbanes-Oxley Act, determine that the proposed
rules apply to audits of emerging growth companies, as defined in
Section 3(a)(80) of the Exchange Act, the Commission has determined to
extend to October 22, 2014 the date by which the Commission should take
action on the proposed rules.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed
rules are consistent with the requirements of Title I of the Act.
Comments may be submitted by any of the following methods:

[[Page 43229]]

Electronic Comments

Use the Commission's Internet comment form (http://www.sec.gov/rules/pcaob.shtml); or
Send an email to [email protected]. Please include
File Number PCAOB-2014-01 on the subject line.

Paper Comments

Send paper comments in triplicate to Kevin M. O'Neill,
Deputy Secretary, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number PCAOB-2014-01. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/pcaob.shtml). Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rules that are filed
with the Commission, and all written communications relating to the
proposed rules between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for Web site viewing and printing in
the Commission's Public Reference Room, 100 F Street NE., Washington,
DC 20549-1090, on official business days between the hours of 10:00
a.m. and 3:00 p.m. Copies of such filing will also be available for
inspection and copying at the principal office of the PCAOB. All
comments received will be posted without charge; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly. All
submissions should refer to File Number PCAOB-2014-01 and should be
submitted on or before August 14, 2014.

For the Commission, by the Office of the Chief Accountant, by
delegated authority.\230\
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\230\ 17 CFR 200.30-11(b)(2).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-17400 Filed 7-23-14; 8:45 am]
BILLING CODE 8011-01-P