Non-arm's length transactions with company insiders, or with
entities controlled by insiders, have a long and notorious history
in the annals of fraudulent financial reporting. Similarly, for
nearly a century, every accounting student has learned about the
possibilities and perils of period-end window-dressing and other
kinds of form-over-substance maneuvers intended to produce an
accounting effect rather than to promote a business purpose. And, as
the idea of pay-for-performance has become business orthodoxy during
the last several decades, the risk that accounting measures may be
manipulated to meet compensation-triggering targets has become
painfully obvious.
Competent auditors are of course already well-aware of these
risks, and competently performed audits already address them. The
hunt for transactions and relationships with friendly parties, and
for unusual transactions with material financial reporting
consequences, is — or at least should be — a key part of any audit.
Nevertheless, the Board's inspection findings, the SEC and PCAOB
enforcement dockets, and the newspaper headlines all make clear that
there is considerable room for improvement.
However, I do not think it is the case that undetected related
party dealings, or financial statements that are misleading because
they elevate form-over-substance, are principally the result of weak
auditing standards. The root causes often lie in lack of
professional skepticism, lack of proper training and technical
competence, and lack of adequate time and audit effort. I do agree,
however, that strengthening the standards in these areas is a
necessary step on the road to reducing the incidence of misleading
financial reporting and better protecting investors and increasing
their confidence.
The proposals the Board is considering seek to move auditing down
that road in several ways. For example —
- Auditors would be required to perform specific procedures to
determine whether there are related parties that management has
failed to identify. The proposal would explicitly recognize the
risk that management may fail to disclose all related party
transactions and would tell the auditor how to respond when that
occurs. The underlying theme of the proposed standard is the need
for heightened skepticism where related parties are involved.
- Similarly, auditors would be required to perform specific
procedures to identify significant unusual transactions and to
obtain an understanding of the business purpose — or lack thereof
— once such transactions are identified. The proposal would also
require the auditor to evaluate whether significant unusual
transactions have been appropriately accounted for and adequately
disclosed.
- Further, while Auditing Standard No. 12 already requires the
auditor to consider the risks of material misstatement associated
with a company's financial relationships with senior management,
the proposal would be more focused. It would expressly require the
auditor to obtain an understanding of relationships, including
compensation, with "executive officers" and, in particular, to
read executive officers' employment and compensation contracts.
The proposals would also sharpen the requirements around what the
auditor must tell the audit committee about related party and
significant unusual transactions and when the committee must be
told. For example, the proposed standard would require that the
auditor provide the audit committee with the auditor's assessment of
the company's accounting and disclosure regarding transactions with
related parties, prior to the issuance of the auditor's report. The
proposal would also require the auditor to inform the audit
committee if significant related party transactions that have not
been appropriately authorized, or that appear to lack a business
purpose, come to the auditor's attention.
In my view, these communications requirements are critical
components of what the Board is seeking to accomplish. In many
cases, the sorts of abuses these proposals address are evidence of
both a financial reporting break-down and a corporate governance
break-down. The board of directors needs to be promptly armed with
information so that it can take appropriate action.
I support issuing these proposals for comment. Of course, to make
sure that final standard setting in this area accomplishes its
investor protection goals, it is important that commenters tell the
Board what the practical effect would be on the way audits are
conducted. Also, if commenters have other ideas about ways to
strengthen auditing in these areas, I would encourage them to give
the Board their suggestions.
* * *
I want to thank the staff members who have worked on this
proposal. I particularly want to acknowledge the efforts of Deputy
Chief Auditor Greg Scates, Associate Chief Auditor Brian Degano, and
Assistant Chief Auditor Nick Grillo. They have been ably supported
with advice and input from OCA's Counsel, Karen Burgess, and by
Associate General Counsel Bob Burns and Assistant General Counsel
Nina Mojiri-Azad. Thanks to all of you for your hard work and
commitment to this important project.