PCAOB Calls for More Scrutiny of Related-Party Transactions

Auditors are getting new orders from regulators to sniff out business deals with insiders and to probe unusual transactions, including executive compensation deals, looking for terms and conditions that suggest something could be amiss.

The Public Company Accounting Oversight Board is proposing a new auditing standard that would give auditors more pointed direction to consider the risk of fraud when companies do business with “related parties,” such as subsidiaries or other connected entities, shareholders, executive officers, and close family members. The proposal also directs auditors to look more carefully at significant unusual transactions (those that appear to be outside the normal course of business for the company) as well as executive compensation agreements for any hints that might suggest the potential for manipulation or fraud.

The standard is meant to target common abuses that have led to countless corporate financial failures and enforcement actions over the past decade and more—from Enron, WorldCom, and others that led to the passage of Sarbanes-Oxley, to Lehman Brothers and its period-end window dressing, to recent actions involving Chinese companies listing on U.S. exchanges. “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,” PCAOB member Daniel Goelzer said in supporting the proposal. “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.”

The proposed standard would instruct auditors to be more direct with management in gathering information on related parties or those who have close ties to the company, and any business deals they may have reached. It also would tell auditors to discuss such transactions with the audit committee, to study them more carefully to understand the business purpose for them, and to assure the accounting is correct and the disclosures are adequate. Even further, it would require auditors to study executive compensation agreements and consider ways senior executives might be motivated to manipulate accounting results to meet performance targets.

Peter Bible, partner-in-charge of the public companies group at audit firm EisnerAmper and a former chief accounting officer for General Motors, says he's glad to see a new standard developing in this area. “This is a good thing for the board to take on,” he says. He hopes the standard ultimately will redefine “related party” to include not just parties with voting control or ownership interests, but also those with any significant measure of economic influence over the company, such as powerful customers or suppliers.

“I saw it tenfold at GM,” he says. “It wasn't always fraud in the classic terms, but it was helping someone achieve an accounting result, and doing it because you want to get business from a company.”

Michael Scanlon, a partner with law firm Gibson, Dunn & Crutcher, is most intrigued by the proposal's focus on executive compensation. “There's a fair degree of push here to drill down further into compensation structures for executives,” he said. “That's not something you typically think of as a related-party issue.” He expects the proposal will spark dialogue over the classic cost-benefit equation—with auditors sure to spend more time on an audit, and therefore charge more money—to meet the proposed requirements.

“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.”

—Daniel Goelzer,

Member,

PCAOB

Companies are required under various accounting rules contained in Generally Accepted Accounting Principles to disclose close relationships behind business deals and assure the accounting is clean; likewise, auditors must follow standards to scrutinize those disclosures and the related accounting. However, inspection findings and enforcement actions make it clear that not all auditors are following the rules as closely as they should, said Goelzer. While the root causes of failures often tie back to a lack of skepticism, training, or competence on the part of auditors, the standards themselves could also be improved, he said. The proposed standard would serve primarily to replace AU Section 334: Related Parties and amend or build upon various other existing rules.

Problems with related-party transactions certainly aren't new, says Mark Beasley, accounting professor at North Caroline State University and co-author of a study examining fraudulent financial reporting published by the Committee of Sponsoring Organizations. “When there is potential in a transaction for influence or bias, the auditing profession has seen related-party transactions as something to look at,” he says. “That link has been recognized for a while.” The COSO study found that companies that engaged in fraud also generally had more related-party transactions, heightening the risk around such transactions.

RELATED PARTIES PROPSAL

Below is a brief summary of the PCAOB's proposed auditing standard, Related Parties:

AU sec. 334 and other PCAOB auditing standards describe procedures for the

auditor''s evaluation of a company's relationships and transactions with its related

parties. An underlying premise of AU sec. 334 is that management is required by

applicable accounting principles to identify a company's related parties and to disclose material related-party transactions. AU sec. 334 describes procedures to assist the

auditor in determining the existence of related parties, identifying transactions with

related parties, examining the substance of identified related party transactions, and

evaluating financial statement disclosures.

The proposed standard would strengthen existing audit procedures for

identifying, assessing, and responding to the risks of material misstatement associated

with a company's related party transactions. Among other things, the proposed standard

would:

Align with and build upon the foundational requirements in the Board's standards

on risk assessment;

Require the auditor to perform procedures to identify the company's related

parties, obtain an understanding of the nature of the relationships between the

company and its related parties, and understand the terms and business

purposes of the types of transactions involving related parties;

Require the auditor to perform specific procedures for each related party

transaction, or type of related party transaction, that is either required to be

disclosed or determined to be a significant risk;

RELEASE

Require the auditor to evaluate whether information that comes to the auditor's

attention during the audit indicates that undisclosed related parties or

relationships or transactions with related parties might exist;

Require the auditor to perform specific procedures if the auditor determines that

related parties or relationships or transactions with related parties previously

undisclosed to the auditor exist; and

Require the auditor to communicate to the audit committee, in a timely manner

and prior to the issuance of the auditor's report, the auditor's evaluation of the

company's identification of, accounting for, and disclosure of its relationships and

transactions with related parties.

Source: PCAOB.

Audit regulators have clamped down on some of the problems that result from related-party or significant unusual transactions, says Scanlon, with examples of major abuses now becoming more dated. Still, there are cases involving big players and plenty more involving smaller companies and smaller firms to suggest problems persist, he says.

Ralph de Martino, chair of the corporate practice at law firm Cozen O'Connor, says he sees the problem most prevalent today in the 40 or so recent delistings, stock suspensions, and other actions involving companies from emerging markets, especially China. “Many of those circumstances involve, at least in part, related-party transactions,” he says.

Where companies have strong disclosure controls, internal controls, and audit committees, the risk of problems with related parties should be minimized, he says, yet those are the areas that tend to be lacking in smaller companies in emerging markets. “We see cases where boards are not educated in U.S. governance or U.S. law, and board members are basically working for the chairman,” he says.

While the proposed standard outlines specific new procedures for auditors, the board is trying to strike a balance with the standard between prescriptive requirements and principles, says Dee Mirando-Gould, a director at consulting firm MorganFranklin and a former associate chief auditor at the PCAOB. “A lot of the standards are going for more rigor around what the auditor needs to do, but if you make it too prescriptive, people worry it will become a checklist,” she says.

The PCAOB has been studying problems with related parties and unusual transactions for some time, including discussions with the Standing Advisory Group since 2004, but the standard-setting process has moved much more slowly than for other standards. Mirando-Gould speculated the standard saw many changes over the years as concerns about unusual transactions and executive compensation crept into the conversation and as board members have come and gone. “I know there was a lot of research going on with this project,” she said.