A little over a year ago the PCAOB issued new Auditing Standard No. 18, which enhanced auditor performance standards in three significant areas of a company’s audit:

• Company relationships and transactions with related parties,
• “Significant unusual transactions,” and
• Company relationships and transactions with its executive officers.

These three areas were selected because of the frequency with which they generate material misstatements in a company’s financial statements or outright financial fraud.

AS 18 took effect for audits of fiscal years beginning on or after December 15, 2014, which means that it applies to the current 2015 audit cycle. However, it appears that a significant number of companies have not yet fully informed their audit committees about the enhancements, nor have many legal departments determined what steps should be taken to be sure the company is in compliance and the audit goes smoothly.

What changed?

The new rules are designed to strengthen auditor requirements for identifying, assessing and responding to the risks of material misstatements.

Related Party Transactions. AS 18 requires auditors to:

• Understand the company’s relationships and transactions with its related parties, including the nature of the relationships and the terms and business purposes of the transaction;
• Evaluate whether the company has properly identified its related party relationships and transactions, using procedures to test the accuracy and completeness of management’s efforts in that regard;
• Perform certain procedures (a) if the auditors find a previously undisclosed relationship or transaction and (b) regarding each related party transaction that is required to be disclosed in the financial statements or is determined to be of a significant risk; and
• Communicate to the audit committee the auditor’s evaluation of the foregoing.

Significant Unusual Transactions. Auditors are now required to:

• Perform procedures to identify significant unusual transactions and then understand and evaluate the business purpose thereof; and
• Consider whether such transactions may have been entered into for fraudulent financial reporting purposes or to conceal the misappropriation of assets.       

Relationships and Transactions with Executive Officers. AS 18 also requires auditors to perform procedures to understand the company’s financial relationships and transactions with its executive officers. The objective is to heighten auditor attention to the incentives that executives may have to achieve certain financial results, though auditors are not intended to assess the reasonableness of, or make recommendations regarding, compensation arrangements.

Legal Department/Corporate Governance Action Steps.

Companies should anticipate enhanced auditor scrutiny in these key areas of the audit. Basically, auditors will be carefully reviewing internal controls and procedures to determine if appropriate processes are in place to identify unusual circumstances and properly evaluate risks.

Looking at this from a corporate governance perspective, companies should:

• Confirm that all necessary authorizations are properly worded and effective,
• Brief the audit committee regarding the new audit procedures and communications,
• Evaluate whether existing relationships and transactions can withstand the enhanced scrutiny and whether any modifications or additional documentation is in order,
• Confirm that proper internal procedures are in place to identify all such relationships and transactions and prepare any necessary disclosures, and
• Modify the company’s related party policy to the extent necessary to ensure the foregoing.