PCAOB Cracks Down on Fraud; A new PCAOB standard will require auditors to probe more deeply into related-party deals, unusual transactions and executive pay.

June 11, 2014

CFO.com | US

PCAOB Cracks Down on Fraud

A new PCAOB standard will require auditors to probe more deeply into related-party deals, unusual transactions and executive pay.

David M. Katz

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Citing “decades of financial reporting frauds,” the Public Company Accounting Oversight Board yesterday issued new rules aimed at tightening auditor scrutiny of corporate related-party deals, “significant unusual transactions,” and executive compensation.

“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 PCAOB said in its introduction to Auditing Standard No. 18 and amendments to other existing rules. The board acknowledged a number of times that its current standards aren’t tough enough about requiring auditors to prioritize their scrutiny of corporate risks of material misstatement.

Subject to approval by the Securities and Exchange Commission, the new rules will become effective for audits of financial statements for fiscal years beginning on or after December 15, 2014. That includes reviews of interim financials within those fiscal years.

The existing standard governing audits of corporate related-party deals hasn’t been “substantively updated” since it was issued in 1983, the PCAOB noted, and the new standard supersedes it. A company’s transactions with related parties “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,” according to the standard.  “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.”

Concerning their clients’ deals with related parties, the new rule requires auditors to follow procedures aimed at getting them to focus on transactions that must be disclosed in corporate financials or those deemed “a significant risk.” The new procedures, which, for example, require auditors to obtain “an understanding of the terms and business purposes  (or the lack thereof) of related-party transactions,” are aimed at helping auditors identify red flags of potential material misstatements.

Recollecting Enron

Recalling the the 2001 financial reporting fraud at Enron, which included the use of complex structured arrangements to hide illegal financing deals, the PCAOB also noted that “significant unusual transactions that are close to period end may be entered into to obscure a company’s financial position or operating results.”

In addition to such “window-dressing” transactions, companies might do business with “counterparties that are willing to structure transactions to achieve desired accounting results,” according to the board. “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.”

Among other things, the rules about significant unusual transactions will now require the auditor to perform procedures to identify them and to understand and evaluate their business purpose or the lack of one. The PCAOB has also added factors for auditors to think about when they evaluate whether such transactions “have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.”

The board also issued amendments to its current rules governing auditor responsibility to scrutinize company financial relationships and transactions with their executive officers, including executive pay. These arrangements “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 amendments require auditors to take steps to understand executive pay and other arrangements with executives. The new procedures aim “to heighten the auditor’s attention to incentives or pressures for the company to achieve a particular financial position or operating result,” according to the board.

At the same time, auditors will not be required to “include an assessment of the appropriateness or reasonableness of executive compensation arrangements,” the PCAOB pointed out.