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Auditors Get New Rules on Scrutinizing Related Parties

Tammy Whitehouse | June 10, 2014

Auditors are under new orders starting next year to take a closer look at some of the riskiest transactions involving “related parties,” or any business entity or individual who is close to senior executives or the board of directors.

The PCAOB adopted Auditing Standard No. 18, Related Parties, along with some related amendments to other auditing standards to focus auditors' attention on related party transactions, significant unusual transactions, and the company's financial relationships and transactions with senior executives. The board first introduced the standard in early 2012 and revised it following feedback in 2013 before adopting the final rules.

“Related party transactions brought down Enron, and significant unusual transactions entered into just to dress up the books nearly destroyed Dynegy,” said PCAOB Chairman James Doty during an open meeting to adopt the new rules. “Related party transactions and significant transactions that are outside the normal course of business have been a contributing factor in numerous prominent financial reporting frauds over the decades.”

PCAOB member Steve Harris said the areas targeted in the new rules have contributed to a string of financial reporting frauds beyond Enron and Dynegy, including Tyco, Adelphi and even some recent enforcement actions by the Securities and Exchange Commission against China-based companies. “One of the many changes that will occur with the adoption of these requirements is that auditors will now scrutinize more closely company transactions with close associates, shareholders, contractors, executive officers, board members and their families – because these related party transactions have historically been tied to financial reporting fraud and abuse,” he said.

AS 18 prescribes some specific audit procedures that auditors must follow in evaluating how a company identifies, accounts for, and discloses transactions and relationships between a company and its inner circle of contacts. The new rules around significant unusual transactions tell auditors what procedures to perform to properly identify and evaluate such transactions and to understand of the business purpose for them. The new package also includes audit procedures during the risk assessment process to illuminate a company's financial relationships and transactions with its executive officers.

Doty says the new rules are meant to get auditors to approach such transactions with greater skepticism. “Risk isn't just about doing more procedures in areas that matter, and less in areas that matter less,” he said. “A risk-based approach mandates not wasting the audit or nullifying the usefulness of its procedures by performing them in a mechanistic, unthinking way.”

Assuming the Securities and Exchange Commission adopts the new requirements, they will take effect with the beginning of the 2015 reporting year for calendar-year companies. They will be in force both for the annual audit as well as reviews of interim financial information.