The Public Company Accounting Oversight Board adopted a new auditing standard Tuesday, along with amendments to other auditing standards, to require auditors to pay more attention to three critical areas of the audit: related-party transactions, significant unusual transactions, and a company’s financial relationships and transactions with its executive officers.

The PCAOB said it took the action Tuesday because these transactions and relationships could pose an increased risk of material misstatement in company financial statements. The board determined that its existing requirements in these critical areas do not contain sufficient required procedures and are not sufficiently risk-based. In addition, the board's inspection and enforcement activities indicate that there are continuing weaknesses in auditors' scrutiny in these areas.

“The new auditing standard and amendments we adopted today address transactions and relationships that have been contributing factors in a number of financial reporting frauds,” said PCAOB chairman James R. Doty in a statement. “Subjecting these areas to enhanced auditor scrutiny may help avert corporate failures and avoid harm to investors.”

During an open meeting Tuesday, Doty pointed out that related-party transactions brought down Enron, and significant unusual transactions entered into just to “dress up the books” nearly “destroyed” another company, Dynegy.

“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,” he said. “Given this background, auditors ought to be highly focused on risks related to related party transactions, and many are.  But our inspections have found that others miss opportunities to do so, by approaching existing requirements in a mechanistic way and failing to probe opaque or incomplete disclosures.”

PCAOB member Steven Harris pointed out that other companies had also committed similar abuses during the financial scandals of the early 2000s. “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. “One need only consider the financial reporting scandals that led to the passage of the Sarbanes-Oxley Act of 2002 to understand that such transactions have the potential to pose significant risk to investors and undermine confidence in the audit. Company insiders at the now defunct Enron Corporation, Tyco International Ltd., and Adelphi Communications Corporation, to name just a few, used related-party transactions to disguise the true financial condition of their companies.”

The board initially proposed the standard and amendments on February 28, 2012, and reproposed them on May 7, 2013. Commenters widely supported the PCAOB’s efforts to improve its auditing standards in the three critical areas, the board pointed out. After considering comments received on the reproposal, the board voted Tuesday to adopt the standard and amendments substantially as they had been reproposed.

Auditing Standard No. 18, Related Parties, requires specific audit procedures for the auditor's evaluation of a company's identification of, accounting for, and disclosure of transactions and relationships between a company and its related parties. The new standard supersedes the board's interim auditing standard, AU sec. 334, Related Parties.

The amendments regarding significant unusual transactions include specific audit procedures that are designed to improve the auditor's identification and evaluation of such transactions, and to enhance the auditor's understanding of their business purposes.

Other amendments to PCAOB auditing standards include, among other things, specific audit procedures requiring the auditor to obtain, during the risk assessment process, an understanding of a company's financial relationships and transactions with its executive officers.

“The new performance requirements for auditors are designed to provide a cohesive audit approach to three challenging areas that warrant additional auditor effort and focus," said PCAOB chief auditor and director of professional standards Martin F. Baumann. “Given the potential risks of material misstatement from these types of company transactions and relationships, investors will benefit from auditors' comprehensive and consistent examination of them.”

All the new auditing standards and amendments to PCAOB standards adopted by the board are being submitted to the Securities and Exchange Commission for approval. If approved, the SEC also determines if the new requirements would apply to audits of emerging growth companies. 

The new standard and amendments will be effective, subject to SEC approval, for audits of financial statements for fiscal years beginning on or after Dec. 15, 2014, including reviews of interim financial information within these fiscal years.

The final rule and board statements from the open meeting will be available on the PCAOB Web site under Rulemaking Docket No. 038. An archive of the webcast and a podcast of the Board meeting also will be available later on the PCAOB’s Web site. A fact sheet on the adopted standard and amendments is also available.

The Center for Audit Quality issued a statement in support of the new standard and said it should also apply to Emerging Growth Companies, a category created under the JOBS Act of 2012, which exempts public companies with total annual gross revenues of less than $1 billion from a number of auditing and accounting standards until the end of the fiscal year following the fifth anniversary of their IPO.

"The CAQ continues to support the PCAOB’s efforts to improve audit quality through strengthening the requirements relating to the auditor’s evaluation of a company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties,” said CAQ executive director Cindy Fornelli in a statement. “We recognize the board for its efforts throughout the process to examine the potential costs and benefits of the standard and implementation issues. The CAQ believes that the final standard and amendments should be applicable to the audits of Emerging Growth Companies. This will avoid bifurcation of the rules applied to financial statement audits performed in accordance with PCAOB standards, which could be confusing to investors and other stakeholders."