PCAOB Adopts Auditing Standard No. 18

Public Companies

By John Null

Schneider Downs intern Justin Bucci contributed to this article.

Recently the PCAOB adopted Auditing Standard No. 18 “Related Parties”, which will go into effect, subject to approval by the SEC, for audits of fiscal years beginning on or after December 15, 2014.

The new standard compels auditors to obtain an improved understanding of a company’s relationships and transactions with its related parties as part of their audit risk assessment process. Recent inspection results and enforcement activities suggest that there are continuing weaknesses in auditors' scrutiny of such transactions.

The new standard places emphasis on the auditor’s focus in three distinct areas. First, auditors will need to perform procedures (and communicate results to the audit committee) to test the accuracy and completeness of management’s identification of related parties, determine whether the relationships have been properly identified and disclosed, and obtain an understanding of the transaction terms.

Second, the new standard clarifies the use of the term “significant unusual transaction” 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 new standard requires specific audit procedures that are designed to improve the auditor's identification and evaluation of these transactions, as well as obtain an understanding and evaluate the business purpose (or lack thereof) of the identified transactions.  Auditors will read the underlying documentation relating to significant unusual transactions and evaluate whether the terms and other information about the transaction are consistent with explanations from inquiries. Then, determine whether the transaction has been authorized and approved in accordance with the company's established policies and procedures. Finally, auditors will evaluate 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 fraudulent financial reporting or misappropriation of assets.

Finally, auditors will need to obtain an understanding of the company’s financial relationships and transactions with its executive officers. Focus will be put on the auditor’s consideration of the company’s pressures or incentives to achieve particular financial results. Auditors will also need to gain an understanding of compensation arrangements with senior management and how they are affected by operating results. This heightened level of scrutiny acknowledges that the company's executive officers are a group that can exert influence over the company's accounting decisions and financial reporting.

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