On June 10, 2014, the Public Company Accounting Oversight Board (the “PCAOB”) adopted Auditing Standard No. 18 (“Standard No. 18”), which amends and supplements existing auditing standards regarding related party transactions, significant unusual transactions and financial relationships and transactions with executive officers. Standard No. 18 also expands the required communications that an auditor must make to the audit committee related to these areas. Standard No. 18 is aimed at strengthening auditor performance requirements in areas that have historically represented increased risks of material misstatement in a company’s financial statements. The changes under the new standard largely convert the prior discretionary guidance for auditors into specific mandatory procedures.

Related Party Transactions. Standard No. 18 supersedes existing Auditing Standard Section 334,Related Parties (“Standard No. 334”). Standard No. 18 is intended to strengthen auditor performance requirements for identifying, assessing and responding to the risks of material misstatements associated with a company’s relationships and transactions with its related parties. Standard No. 18 requires auditors to perform specific procedures to understand the nature of a relationship between a company, its related parties and the terms and business purpose of the transaction, including:

• reading underlying documents and evaluating if the terms are consistent with other evidence about the business purpose of the transaction with the related party;
• determining whether the transaction was authorized and approved in line with company policies and procedures, or if exemptions were otherwise granted; and
• evaluating the financial capacities of the other parties involved in these transactions, including with respect to uncollected balances, guarantees, and other obligations.

Although Standard No. 334 addressed some of the same matters as Standard No. 18 addresses, Standard No. 18 will require auditors to conduct additional and more thorough procedures regarding related party relationships and transactions. Standard No. 18 contains specific directions related to the following audit procedures that are to be performed:

• evaluating whether the company properly identified all related party relationships and transactions;
• performing additional specific procedures if it is determined that an undisclosed related party relationship or transaction exists with the company; and
• requiring auditors to communicate with the audit committee (or its chair) to obtain certain information during the risk assessment, and to update the committee on the final evaluation of the company’s identification of, accounting for, and disclosure of, its relationships and transactions with related parties.

Significant Unusual Transactions. Standard No. 18 now defines significant unusual transactions as significant transactions that are outside the normal course of business for the company or that otherwise appear to be unusual due to their timing, size, or nature. Auditors are now required to perform specific procedures to identify significant unusual transactions, to understand and evaluate the business purpose of these transactions, and to consider additional factors in evaluating whether these transactions may have been entered into for purposes of engaging in fraudulent financial reporting or concealing misappropriation of assets.

Some key changes include:

• improving requirements for identifying significant unusual transactions by requiring auditors to make inquiries of management and others within the company on the nature and business purpose of the company’s significant unusual transactions;
• improving the auditor’s evaluation of significant unusual transactions by including basic procedures that are more in-depth and designed to help auditors identify red flags;
• expanding the factors that auditors must consider in evaluating the business purpose of significant unusual transactions, and whether such transactions were entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets; and
• requiring the auditor to evaluate whether the financial statements contain the appropriate information for a fair presentation of the significant unusual transactions necessary to comply with the applicable financial reporting framework.

Financial Relationships and Transactions with Executive Officers. Standard No. 18 requires auditors to perform certain procedures during risk assessment to obtain an understanding of the company’s financial relationships and transactions with executive officers. The changes are intended to, among other things, increase the auditor’s awareness of the compensation of executive officers. For example, auditors may read proxy statements and other relevant regulatory filings that relate to the company’s financial relationship and transactions with its executive officers. However, Standard No. 18 does not require auditors to assess the reasonableness of executive compensation arrangements. Auditors, if appropriate, may make inquiries to the chair of the compensation committee (or its equivalent) and any compensation consultants regarding the compensation structure for executive officers. Auditors can also inquire into policies and procedures regarding the authorization and approval of executive officer expense reimbursements.

Audit Committee Communications. Standard No. 18 also requires auditors to engage in additional communications with audit committees. These new communication requirements will require an auditor to communicate to the audit committee in connection with every audit:

• the identification of each related party or relationship or transaction that was previously undisclosed to the auditor;
• any significant related party transaction that was not authorized or approved in accordance with the company’s established policies and procedures and any significant related party transaction that was granted an exception to those policies and procedures;
• the inclusion of any statement in the financial statements that a related party transaction was conducted on terms equivalent to those in an arm’s-length transaction and the evidence obtained by the auditor to support or contradict such an assertion; and
• the identification of any significant related party transaction appearing to lack a business purpose.

In addition, the amendments to the standards for significant unusual transactions under Standard No. 18 requires an auditor to communicate to the audit committee the auditor’s understanding of the business purpose (or lack thereof) of significant unusual transactions.

Implications. In light of the requirements of Standard No. 18, companies should ensure the following:

• management should familiarize themselves with the requirements of Standard No. 18 to ensure that they can adequately assist the auditors by providing the necessary information during the audit in a timely manner;
• that appropriate authorizations and approvals are in place and documented for related party transactions;
• review disclosure about related party transactions being entered into on an arm’s length basis and ensure there is evidence to support such assertion;
• review policies and procedures regarding the review, approval and ratification of related party transactions to determine whether any changes are required;
• that audit committees are briefed about Standard No. 18 and the requirements for auditors to conduct inquiries of the audit committee regarding related party transactions and significant unusual transactions; and
• that compensation committees are briefed about Standard No. 18 and the requirements for auditors to review financial relationships with related parties.

Effective and Compliance Dates. Standard No. 18 remains subject to the approval of the Securities and Exchange Commission (the “SEC”). Subject to such approval, the PCAOB anticipates that Standard No. 18 will be effective for audits of financial statements for fiscal years beginning on or after December 15, 2014. The PCAOB has also recommended to the SEC that Standard No. 18 apply to emerging growth companies.¹

For additional information regarding Standard No. 18, please contact one of the attorneys listed below: