[Federal Register Volume 79, Number 207 (Monday, October 27, 2014)]
[Notices]
[Pages 63988-63991]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-25432]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-73396; File No. PCAOB-2014-01]


Public Company Accounting Oversight Board; Order Granting 
Approval of Proposed Rules on Auditing Standard No. 18, Related 
Parties, Amendments to Certain PCAOB Auditing Standards Regarding 
Significant Unusual Transactions, and Other Amendments to PCAOB 
Auditing Standards

October 21, 2014.

I. Introduction

    On July 10, 2014, the Public Company Accounting Oversight Board 
(the ``Board'' or the ``PCAOB'') filed with the Securities and Exchange 
Commission (the ``Commission''), pursuant to Section 107(b) \1\ of the 
Sarbanes-Oxley Act of 2002 (the ``Sarbanes-Oxley Act'') and Section 
19(b) \2\ of the Securities Exchange Act of 1934 (the ``Exchange 
Act''), proposed rules to adopt Auditing Standard No. 18, Related 
Parties, amendments to certain PCAOB auditing standards regarding 
significant unusual transactions, and other amendments to PCAOB 
auditing standards, including required procedures to obtain an 
understanding of a company's financial relationships and transactions 
with its executive officers (collectively, the ``Proposed Rules'').\3\ 
The Proposed Rules were published for comment in the Federal Register 
on July 24, 2014.\4\ At the time the notice was issued, the Commission 
designated a longer period to act on the Proposed Rules, until October 
22, 2014.\5\ The Commission received three comment letters in response 
to the notice.\6\ This order approves the Proposed Rules.
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    \1\ 15 U.S.C. 7217(b).
    \2\ 15 U.S.C. 78s(b).
    \3\ The Board originally proposed in February 2012 (``Original 
Proposal'') and reproposed in May 2013 (``Reproposal'') what became 
the Proposed Rules.
    \4\ See Release No. 34-72643 (July 18, 2014), 79 FR 43163 (July 
24, 2014).
    \5\ Ibid.
    \6\ See letters to the Commission from Suzanne H. Shatto, dated 
July 23, 2014 (``Shatto Letter''); Tom Quaadman, Vice President, 
Center for Capital Markets Competitiveness, U.S. Chamber of 
Commerce, dated July 28, 2014 (``Chamber Letter''); and Deloitte & 
Touche LLP, dated August 11, 2014 (``Deloitte Letter'').
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II. Description of the Proposed Rules

    Related party transactions, significant unusual transactions, and a 
company's financial relationships and transactions with its executive 
officers are included together in the Proposed Rules because the PCAOB 
believes the auditor's efforts in these 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 information that indicates that a related party or 
relationship or transaction with a related party previously undisclosed 
to the auditor might exist.

1. Related Parties

    Auditing Standard No. 18 will supersede AU section 334, Related 
Parties (``AU sec. 334''), which primarily contains the existing 
requirements for auditing relationships and transactions with related 
parties. AU sec. 334 provides guidance and examples of procedures for 
the auditor's consideration in identifying and evaluating related party 
transactions. Auditing Standard No. 18 includes some auditing concepts 
and procedures from AU sec. 334, but 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 by, among other 
things, requiring 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 required to be performed in 
conjunction with the auditor's risk assessment procedures pursuant to 
Auditing Standard No. 12, Identifying and Assessing Risks of Material 
Misstatement.
     Evaluate whether the company has properly identified its 
related parties and relationships and transactions with its related 
parties. 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 is required to perform procedures necessary to determine 
whether undisclosed relationships or transactions with related parties 
in fact exist.
     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.\7\
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    \7\ Auditing Standard No. 12 defines a significant risk as a 
``risk of material misstatement that requires special audit 
consideration.''
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     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

[[Page 63989]]

the company's relationships and transactions with related parties.

2. Significant Unusual Transactions

    Existing auditing requirements regarding significant unusual 
transactions are principally contained in AU section 316, Consideration 
of Fraud in a Financial Statement Audit (``AU sec. 316'').\8\ 
Specifically, AU sec. 316 requires the auditor, if he or she becomes 
aware of significant unusual transactions during the course of the 
audit, to gain an understanding of the business rationale of such 
transactions and consider whether that rationale suggests the 
transactions may have been entered into to engage in, or conceal, 
fraud. The amendments regarding significant unusual transactions are 
intended to improve AU sec. 316 and other PCAOB auditing standards by, 
among other things:
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    \8\ See AU secs. 316.66-.67.
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     Requiring the auditor to perform procedures to identify 
significant unusual transactions;
     Requiring 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
     Adding 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.
    In addition to targeted enhancements to AU sec. 316, the amendments 
regarding significant unusual transactions would revise Auditing 
Standard No. 12 and Auditing Standard No. 13, The Auditor's Responses 
to the Risks of Material Misstatement. These amendments include some 
changes intended to enhance the complementary linkages between the 
auditor's work relating to significant unusual transactions and related 
party transactions. 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.\9\
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    \9\ The Proposed Rules 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.''
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3. Other Amendments

    Additional 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.\10\ 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.
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    \10\ The PCAOB notes that the other amendments do not change the 
existing requirement in its risk assessment standards for the 
auditor to consider obtaining an understanding of compensation 
arrangements with senior management as part of obtaining an 
understanding of the company. Rather, the Board states that the 
population for the procedures required by the other amendments is 
the list of ``executive officers,'' as defined in Rule 3b-7 of the 
Exchange Act or included on Schedule A of Form BD, as applicable, 
while the existing requirement continues to apply to what may be a 
larger population of a company's management. 17 CFR 240.3b-7 and 17 
CFR 249.501.
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    In response to requests for clarification received by the PCAOB as 
part of its comment process, the Proposed Rules 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 Commission believes the PCAOB's clarification is 
responsive and appropriate since such assessments would have resulted 
in a significant unintended change to the current objectives of the 
audit, which are focused on risks of material misstatement of the 
financial statements.
    In addition to the amendments relating to financial relationships 
and transactions with executive officers, the Board adopted amendments 
to revise other auditing standards to conform them to the Proposed 
Rules and, where appropriate, include new requirements that complement 
the Proposed Rules. For example, the Board adopted amendments to AU 
section 333, Management Representations (``AU sec. 333''), to require a 
representation that management has made available to the auditor the 
names of all related parties and relationships and transactions with 
related parties. Additionally, among others, the Board adopted 
amendments to AU sec. 333 to require a written representation from 
management that there are no side agreements or other arrangements 
(either written or oral) undisclosed to the auditor. Other new 
requirements complement the requirements in the Proposed Rules through 
improvements to the auditor's: (i) Communications with a predecessor 
auditor; (ii) procedures during the period subsequent to the balance-
sheet date, but prior to the issuance of the financial statements; and 
(iii) procedures during reviews of interim financial information.
    The PCAOB has proposed application of its Proposed Rules to audits 
of all issuers, including audits of emerging growth companies 
(``EGCs''),\11\ as discussed in Section IV. below. The Proposed Rules 
also would apply to audits of SEC-registered brokers and dealers.\12\ 
The Proposed Rules would be effective for audits of financial 
statements for fiscal years beginning on or after December 15, 2014, 
including reviews of interim financial information within these fiscal 
years.
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    \11\ The term ``emerging growth company'' is defined in Section 
3(a)(80) of the Exchange Act. 15 U.S.C. 78c(a)(80).
    \12\ On July 30, 2013, the Commission adopted amendments to 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. 17 CFR 240.17a-5. See Broker-Dealer 
Reports, Release No. 34-70073, (July 30, 2013), 78 FR 51910 (August 
21, 2013), available at http://www.sec.gov/rules/final/2013/34-70073.pdf.
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III. Comment Letters

    As noted above, the Commission received three comment letters 
concerning the Proposed Rules. Two commenters expressed support for the 
Proposed Rules.\13\ One of these commenters also expressed a desire for 
an earlier effective date.\14\ The final commenter raised concerns 
regarding the substance of the PCAOB's economic analysis and 
consideration of cost-benefit analysis upon EGCs.\15\
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    \13\ See Shatto Letter and Deloitte Letter.
    \14\ See Shatto Letter, which also raised a number of other 
points with respect to brokers and dealers, but those points are 
outside the scope of the PCAOB's Proposed Rules.
    \15\ See Chamber Letter.
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1. Effective Date

    The PCAOB describes the rationale as to the effective date, which 
was established to allow for sufficient time for registered firms to 
incorporate the new requirements into methodologies, guidance, audit 
programs, and staff training. The Commission believes the Proposed 
Rules' effective date is not unreasonable in order to provide 
sufficient time for proper implementation by registered firms.

2. Economic Analysis

    One commenter raised concerns regarding the substance of the 
PCAOB's economic analysis and its consideration

[[Page 63990]]

of EGCs. The commenter stated that it expressed these concerns in 
previous comment letters to the PCAOB, and in its opinion, those 
concerns have not been considered or addressed by the PCAOB. This 
commenter's principal concerns are addressed below.
     In its comment letter on the Original Proposal, the 
commenter stated that the proposal did not contain a cost-benefit 
analysis.
    The Board presented, and sought comment on, an economic analysis in 
the Reproposal. Further, in response to comments on the economic 
analysis provided in the Reproposal, the Board revised its analysis as 
presented in its release accompanying the Proposed Rules (``Final Rule 
Release'').
     In its comment letter on the Reproposal, the commenter 
stated that the economic analysis was composed of a number of 
assertions that were generic and speculative in nature, and were not 
linked to the elements of the proposal.
    In the economic analysis provided in the Final Rule Release, the 
Board refined the analysis included with the Reproposal, including by 
linking the elements of the analysis closer to the elements of the 
Proposed Rules. Specifically, the Board's refined analysis set forth: 
(1) A description of the need for the standard-setting, and how the 
Proposed Rules address the need; (2) the baseline to consider the 
economic impacts of the Proposed Rules; (3) the Board's approach and 
consideration of alternatives; (4) the economic impacts of the Proposed 
Rules including benefits, costs, effects on different categories of 
audit firms and smaller companies, and responses to comments received 
on the economic analysis included with the Reproposal; and (5) economic 
considerations pertaining to audits of EGCs, including efficiency, 
competition and capital formation. The Board also acknowledged 
challenges in considering the economic impacts, such as the challenges 
of quantifying the economic impact of changes to audit standards, and 
explained how the Board addressed those challenges.
     In its comment letter on the Reproposal, the commenter 
stated that the economic analysis fails to explicitly articulate any 
appropriate economic baseline against which to measure the proposed 
requirements' likely economic impact.
    The Board presented an economic baseline within Appendix 5 of the 
Final Rule Release, which the Board used in its economic analysis as a 
benchmark for comparing against the Proposed Rules. The Board's 
discussion of the baseline includes both existing requirements and 
current audit practices, where the latter is determined based on 
information from the Board's oversight activities, including its 
inspection findings. The Board's analysis of the baseline shows that 
audit practices associated with the areas addressed by the Proposed 
Rules are inconsistent across firms.
     In its comment letter on the Reproposal, the commenter 
stated that the Reproposal contains no substantive analysis of the 
economic impact of the proposed requirements on EGCs, EGCs vis-
[agrave]-vis other companies, or companies generally.
    The economic analysis presented in the Final Rule Release presents 
the Board's economic considerations of the Proposed Rules both for 
companies generally and specifically for EGCs. Broadly, the Board 
believes that the areas addressed by the Proposed Rules are challenging 
areas warranting additional audit effort and focus. The Board notes 
that EGCs will incur some incremental costs because costs may be 
disproportionately higher for smaller companies, including EGCs.\16\ 
However, the Board notes that EGCs may benefit more from the Proposed 
Rules because, as compared to non-EGCs, related party transactions are 
more common and there is a higher likelihood for control deficiencies, 
which may result in a higher risk of material misstatement associated 
with related party transactions.
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    \16\ See Section IV below for further information regarding the 
PCAOB's EGC analysis.
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    The analysis includes the relevant views of those who commented on 
the Reproposal on the economic effects of the Proposed Rules on EGCs. 
Further, the Board notes that the Proposed Rules are designed to 
mitigate cost impacts by aligning the auditor's efforts with the risk 
assessment standards and providing opportunities for a scaled approach 
depending on the size and complexity of the company being audited. The 
Board states that this alignment with risk assessment allows auditors 
to integrate audit effort where appropriate and thereby avoid 
unnecessary audit effort. Finally, the Board's analysis takes into 
account the view from certain commenters on the Reproposal that it may 
be more costly not to apply the Proposed Rules to audits of EGCs 
because it would require firms to maintain two audit methodologies. The 
Commission believes that the Board's economic analysis reasonably 
addresses the comment raised, and as discussed further in Section IV, 
based on the analysis submitted, the Commission believes the 
information in the record is sufficient for the Commission to make the 
requested EGC determination in relation to the Proposed Rules.
     In its comment letter on the Reproposal, the commenter 
stated that the Reproposal does not adequately address potential 
alternatives.
    The Final Rule Release discussed the Board's consideration of 
alternatives to the Proposed Rules. In response to the commenter's 
suggestion that the Reproposal did not discuss why PCAOB Staff Audit 
Practice Alert No. 5, Auditor Considerations Regarding Significant 
Unusual Transactions (``Practice Alert''),\17\ was inadequate, the 
Board stated that the Practice Alert 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 Practice Alert only 
highlights circumstances for auditor consideration, it did not alter 
audit requirements with respect to significant unusual transactions. 
The Board concluded, based in part on the results of its oversight 
activities following the issuance of the Practice Alert, that it was 
appropriate to develop standards with more specific requirements to 
promote heightened scrutiny in the areas addressed by the Proposed 
Rules. Further, the Board stated that the need to improve the existing 
standards in these areas, including alignment with the Board's risk 
assessment standards, cannot be adequately addressed through staff 
interpretations of existing standards.
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    \17\ See http://pcaobus.org/Standards/QandA/04-07-2010_APA_5.pdf
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    In response to the commenter's statement that the Board did not 
analyze why it chose not to converge the Proposed Rules with similar 
standards of the International Auditing and Assurance Standards Board 
(``IAASB'') and the Auditing Standards Board of the American Institute 
of Certified Public Accountants (``ASB''), the Board states in its 
Final Rule Release that it 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.\18\ The Board, however, determined that the areas 
addressed by the Proposed Rules require heightened scrutiny, and, thus, 
the Proposed Rules

[[Page 63991]]

contain auditing requirements that are not reflected in the analogous 
standards of the IAASB and the ASB. Further, the Commission notes that 
the Board has received similar comments in the past and has thus 
previously addressed its consideration of the work of other standard-
setters generally. \19\ The Commission also addressed similar comments 
in connection with its consideration of other rules proposed by the 
PCAOB.\20\ As it relates to the Proposed Rules, the Commission notes 
the PCAOB's efforts to consider the analogous standards of the IAASB 
and the ASB. Thus, while the Commission continues to encourage the 
PCAOB to consider the work of other standard-setters, there remain a 
variety of reasons why the Board's standards may differ from the 
standards of the IAASB and ASB, and we believe the Board has provided a 
reasonable explanation for the differences here.
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    \18\ For examples of similar audit procedures and requirements, 
see footnote 86 on page A5-46 of the Final Rule Release. 
Additionally, Appendix 6 of the Final Rule Release compares certain 
significant differences between the objective and certain key 
requirements of the Proposed Rules and analogous standards of the 
IAASB and the ASB.
    \19\ For example, in the Board's adopting release for its risk 
assessment standards it stated the following:
    ``[B]ecause the Board's standards must be consistent with the 
Board's statutory mandate, differences will continue to exist 
between the Board's standards and the standards of the IAASB and 
ASB, e.g., when the Board decides to retain an existing requirement 
in PCAOB standards that is not included in IAASB or ASB standards. 
Also, certain differences are often necessary for the Board's 
standards to be consistent with relevant provisions of the federal 
securities laws or other existing standards or rules of the Board. 
Also, the Board's standards-setting activities are informed by and 
developed to some degree, in response to observations from its 
oversight activities.''
    See PCAOB Release No. 2010-004, August 5, 2010, pp. A10-91--A10-
92 (internal footnotes omitted).
    \20\ See Release No. 34-63606 (December 23, 2010), 75 FR 82417 
(December 30, 2010) and Release No. 34-68453 (December 17, 2012), 77 
FR 75689 (December 21, 2012).
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     Finally, in its comment letter to the Commission, the 
commenter recommended ``that the SEC return the [Proposed Rules] to the 
PCAOB for a cost benefit analysis that complies with the [Jumpstart Our 
Business Startups] Act and allows stakeholders to understand the costs 
and benefits . . .'' Further, the commenter stated that the Proposed 
Rules add to audit complexity and raise doubt that the proposed 
requirements would be cost-benefit effective.
    The Commission notes that the Board provided a detailed qualitative 
analysis that took into account the views of commenters. As the Board 
explained, there was limited research and data available regarding 
economic costs and benefits of the Proposed Rules, making reliable 
quantification difficult. Further, as part of the Board's process 
through its issuance of the Original Proposal and the Reproposal, the 
Board requested empirical data regarding costs and benefits specific to 
the Proposed Rules, and commenters did not provide any. The Commission 
observes that Section 103(a)(3)(C) of the Sarbanes-Oxley Act, the 
relevant statutory provision added by the Jumpstart our Business 
Startups (``JOBS'') Act, does not require a detailed, quantitative 
cost-benefit analysis.\21\ Consistent with the responses to the 
commenter's specific concerns enumerated above, the Board states that 
it designed the Proposed Rules to minimize complexity by aligning the 
auditor's efforts with the risk assessment standards and providing 
opportunities for a scaled approach depending on the size and 
complexity of the company being audited.
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    \21\ See National Association of Manufacturers v. SEC, 748 F.3d 
359, 369 (D.C. Cir. 2014) (stating that ``[a]n agency. . . need not 
conduct a `rigorous, quantitative economic analysis' unless the 
statute explicitly directs it to do so''), partially overruled on 
other grounds by American Meat Institute v. U.S. Department of 
Agriculture, 760 F.3d 18 (D.C. Cir. 2014) (en banc).
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IV. The PCAOB's EGC Request

    Section 103(a)(3)(C) of the Sarbanes-Oxley Act provides that any 
additional rules adopted by the PCAOB subsequent to April 5, 2012 do 
not apply to the audits of EGCs, unless the Commission 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.\22\ Having considered those factors, and as 
explained further herein, the Commission finds that applying the 
Proposed Rules to audits of EGCs is necessary or appropriate in the 
public interest.
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    \22\ Section 103(a)(3)(C) of the Sarbanes-Oxley Act, as amended 
by Section 104 of the JOBS Act.
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    In proposing application of the Proposed Rules to audits of all 
issuers, including EGCs, the PCAOB requested that the Commission make 
the determination required by Section 103(a)(3)(C). To assist the 
Commission in making its determination, the PCAOB prepared and 
submitted to the Commission its own EGC analysis. The PCAOB's EGC 
analysis includes discussions of characteristics of self-identified 
EGCs and economic considerations pertaining to audits of EGCs, 
including efficiency, competition, and capital formation. In its 
analysis, the Board states, among other things, that applying the 
Proposed Rules to the audits of EGCs may be particularly pertinent 
because of the characteristics of EGCs (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 fact, the Board's oversight activities 
have identified a significant number of findings regarding related 
party transactions in audits of financial statements of smaller public 
companies, which have characteristics that are similar to EGCs.
    The PCAOB's EGC analysis was included in the Commission's public 
notice soliciting comment on the Proposed Rules.\23\ Based on the 
analysis submitted, we believe the information in the record is 
sufficient for the Commission to make the requested EGC determination 
in relation to the Proposed Rules. The Commission also takes note, in 
particular, of the PCAOB's approach to the Proposed Rules, which are 
intended to build upon existing requirements in the areas addressed by 
them; align with the auditor's efforts in complying with the risk 
assessment standards; and provide opportunities for scaling based on 
the facts, circumstances, and risks of the particular company under 
audit.
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    \23\ One comment letter, as discussed above in Section III, was 
received relating to the PCAOB's EGC analysis. See Chamber Letter.
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V. Conclusion

    The Commission has carefully reviewed and considered the Proposed 
Rules and the information submitted therewith by the PCAOB, including 
the PCAOB's EGC analysis, and the comment letters received. In 
connection with the PCAOB's filing and the Commission's review.
    A. The Commission finds that the Proposed Rules are consistent with 
the requirements of the Sarbanes-Oxley Act and the securities laws and 
are necessary or appropriate in the public interest or for the 
protection of investors; and
    B. Separately, the Commission finds that the application of the 
Proposed Rules to EGC audits 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.
    It is therefore ordered, pursuant to Section 107 of the Sarbanes-
Oxley Act and Section 19(b)(2) of the Exchange Act, that the Proposed 
Rules (File No. PCAOB-2014-01) be and hereby are approved.

    By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-25432 Filed 10-24-14; 8:45 am]
BILLING CODE 8011-01-P