The Board is recommending that the SEC determine that the standard
and amendments should apply to audits of

EGCs. To assist the SEC in making this determination, the Board is
providing information herein specifically related to audits of EGCs.
    The discussion below includes information regarding: (i) The Need
for the Standard and Amendments; (ii) The Baseline (encompassing both
existing requirements and audit practices); (iii) The Board's Approach
and Consideration of Alternatives; (iv) The Economic Impacts of the
Standard and Amendments, including Benefits and Costs; and (v) Economic
Considerations Pertaining to Audits of EGCs, including Efficiency,
Competition, and Capital Formation.
Need for the Standard and Amendments
Introduction
    Investors are often widely dispersed and significant in number and
thus must rely on management to operate and control the company. As a
result, investors possess less information about the company than the
company's management, a situation that can be described as information
asymmetry \143\ between investors and management. Management prepares
the company's financial statements that investors use to evaluate a
company's financial performance and management's stewardship of the
company. An audit provides investors with independent, reasonable
assurance that the company's financial statements are fairly presented,
in accordance with the relevant accounting framework, and comply with
applicable requirements.
---------------------------------------------------------------------------

    \143\ Information asymmetry refers to situations involving two
or more parties in a relationship in which one party has more, or
better, information than the other party. For more information on
matters related to the separation of ownership and control of
companies and the implications on financial markets, see, e.g.,
Adolph A. Berle and Gardiner C. Means, The Modern Corporation and
Private Property, 2 Harcourt, Brace and World, New York passim
(1967); Michael C. Jensen and William H. Meckling, Theory of the
Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3
Journal of Financial Economics 305 passim (1976); and Paul M. Healy
and Krishna G. Palepu, Information Asymmetry, Corporate Disclosure,
and the Capital Markets: A Review of the Empirical Disclosure
Literature, 31 Journal of Accounting and Economics 405 passim
(2001).
---------------------------------------------------------------------------

    A key objective of PCAOB standards is to improve the likelihood
that the auditor will detect material misstatements in company
financial statements, whether due to error or fraud.\144\ The auditor,
as a gatekeeper \145\ in the financial reporting system, can mitigate
risks of material misstatement in the financial statements and, thus,
risks to investors arising out of their reliance on misstated financial
statements, by focusing appropriate auditing effort in areas that
warrant heightened scrutiny. Increased attention by the auditor should,
in the Board's view, increase the likelihood of the auditor identifying
material misstatements.
---------------------------------------------------------------------------

    \144\ Strengthening the requirements for auditing in the
critical areas should similarly promote improved performance on
audits of broker-dealer financial statements. The approach set forth
in the standard should direct auditors to devote more time to areas
requiring heightened scrutiny. The auditor's enhanced focus on these
areas should improve the reliability of information used in
regulatory oversight, which, in turn, should enhance investor
protection.
    \145\ According to the SEC, ``The federal securities laws, to a
significant extent, make independent auditors ``gatekeepers'' to the
public securities markets. These laws require, or permit us to
require, financial information filed with us to be certified (or
audited) by independent public accountants. Without an opinion from
an independent auditor, the company cannot satisfy the statutory and
regulatory requirements for audited financial statements and cannot
sell its securities to the public. The auditor is the only
professional that a company must engage before making a public
offering of securities and the only professional charged with the
duty to act and report independently from management.'' See SEC
Securities Act Release No. 33-7870, Proposed Rule: Revision of the
Commission's Auditor Independence Requirements (June 30, 2000) at
Section II.A. See also, SEC Securities Act Release No. 33-7919,
Final Rule: Revision of the Commission's Auditor Independence
Requirements (November 21, 2000) at Section III.A.
---------------------------------------------------------------------------

    In considering the need to improve existing auditing standards
relating to the critical areas, the Board took into account a variety
of factors. Most significantly, the Board considered the need for the
standard and amendments against the backdrop of several decades of
financial reporting frauds involving related party transactions,
significant unusual transactions and financial relationships and
transactions with executive officers. Prominent corporate scandals
involving these critical areas include many that served as a catalyst
for the enactment of the Act.\146\ The critical areas addressed by the
standard and amendments have continued to be contributing factors in
more recent enforcement cases.\147\ These corporate scandals undermine
investor confidence and have resulted in significant losses to
investors, as well as the loss of many jobs.\148\ As discussed below,
the Board's oversight activities indicate that auditors' scrutiny of
these critical areas continues to be an area of concern.
---------------------------------------------------------------------------

    \146\ The following illustrative list provides examples of
prominent corporate scandals that involve the critical areas. The
following list is not all-inclusive and, in some cases, examples
involve more than one critical area: (i) With respect to related
party transactions: Hollinger, Inc., see SEC Complaint, SEC,
Plaintiff v. Conrad M. Black, F. David Radler and Hollinger, Inc.
(November 15, 2004); MCA Financial Corporation, see SEC AAER No.
2076, In The Matter of Grant Thornton LLP, Doeren Mayhew & Co. P.C.,
Peter M. Behrens, CPA, Marvin J. Morris, CPA, and Benedict P.
Rybicki, CPA, Respondent (August 5, 2004); and Adelphia
Communications Corporation, see SEC AAER No. 1599, SEC v. Adelphia
Communications Corporation, John J. Rigas, Timothy J. Rigas, Michael
J. Rigas, James P. Rigas, James R. Brown, and Michael C. Mulcahey,
02 Civ. 5776 (KW) (S.D.N.Y.) (July 24, 2002); (ii) with respect to
significant unusual transactions: Enron Corporation, see SEC
Spotlight on Enron, https://www.sec.gov/spotlight/enron.htm; Refco,
Inc., see SEC Complaint, SEC, Plaintiff, v. Phillip R. Bennett,
Defendant (February 19, 2008); and (iii) with respect to financial
relationships and transactions with executive officers: Tyco
International, Ltd., see SEC AAER No. 3010, SEC v. L. Dennis
Kozlowski, Mark H. Swartz, and Mark A. Belnick, 02-CV-7312 (RWS)
(S.D.N.Y. filed Sept. 12, 2002) (July 14, 2009); WorldCom, Inc., see
Restoring Trust, Report to The Hon. Jed S. Rakoff The United States
District Court for the Southern District of New York On Corporate
Governance for the Future of MCI (August 2003) at 17-19.
Additionally, Section 704 of the Act directed the SEC to study
enforcement actions over the five years preceding its enactment ``to
identify areas of issuer financial reporting that are most
susceptible to fraud, inappropriate manipulation, or inappropriate
earnings management'' (the ``SEC Section 704 Study''). As part of
the study, the SEC examined 227 enforcement matters and found that
23 cases included the failure to disclose related party
transactions. See Report Pursuant to Section 704 of the Sarbanes-
Oxley Act of 2002 (January 24, 2003) at 6.
    \147\ See, e.g., SEC AAER No. 3447, SEC v. Keyuan
Petrochemicals, Inc. and Aichun Li (February 28, 2013), and SEC AAER
No. 3385, SEC v. China Natural Gas, Inc. and Qinan Ji (May 14,
2012).
    \148\ For example, Enron Corporation was the nation's largest
natural gas and electric marketer, with reported annual revenue of
more than $150 billion. When it filed for bankruptcy on December 2,
2001, its stock price had dropped in less than a year from more than
$80 per share to less than $1. See SEC Settles Civil Fraud Charges
Filed Against Richard A. Causey, Former Enron Chief Accounting
Officer; Causey Barred From Acting as an Officer or Director of a
Public Company SEC Litigation Release No. 19996 (February 9, 2007).
---------------------------------------------------------------------------

    Additionally, the Board considered: (i) Input from the SAG; (ii)
studies that suggested the need to improve existing auditing standards
to address areas that could pose increased risks of material
misstatement; (iii) the actions of other standard setters, such as the
IAASB and the ASB of the AICPA, who had revised their auditing
standards in certain analogous areas in 2008 and 2011, respectively;
and (iv) information obtained through the Board's oversight activities.
The Board also considered input from commenters on its

proposal \149\ and reproposal.\150\ Commenters were broadly supportive
of the Board's standard-setting efforts and generally agreed that
improvements to the existing auditing standards were appropriate.\151\
---------------------------------------------------------------------------

    \149\ See the proposing release, which included: (i) An auditing
standard, Related Parties (``proposed standard''); (ii) amendments
to certain PCAOB auditing standards regarding significant unusual
transactions (``proposed amendments regarding significant unusual
transactions''); and (iii) other amendments to PCAOB auditing
standards (``other proposed amendments''). Collectively, these are
referred to as the ``proposed standard and amendments.''
    \150\ See the reproposing release, which included: (i) An
auditing standard, Related Parties (``reproposed standard''); (ii)
amendments to certain PCAOB auditing standards regarding significant
unusual transactions (``reproposed amendments regarding significant
unusual transactions''); and (iii) other proposed amendments to
PCAOB auditing standards (``other reproposed amendments'').
Collectively, these are referred to as the ``reproposed standard and
amendments.''
    \151\ Section C provides additional discussion of the standard
and amendments, as well as discussion of significant comments
received and the Board's consideration of such comments.
---------------------------------------------------------------------------

The Need for Improved Requirements in the Critical Areas
    The following discussion describes the need for improvements to
existing auditing requirements in each critical area. As more fully
described below, the Board believes that its existing standards do not
contain sufficient required procedures and are not sufficiently risk-
based in critical areas that warrant heightened scrutiny. Increased
auditor attention to the critical areas should, in the Board's view,
increase the likelihood of the auditor identifying material
misstatements.
    Relationships and Transactions With Related Parties: The auditor's
attention to a company's transactions with its related parties is
important because the substance of such transactions may differ
materially from their form.\152\ A related party relationship provides
the parties with the ability to negotiate transactions on terms that
may not be available to other parties on an arm's-length basis. Such
non-arm's length transactions potentially provide more of an
opportunity for management to act in its own interests,\153\ rather
than in the interests of the company and its investors and, in some
instances, such transactions have been used to facilitate financial
statement fraud and asset misappropriation.\154\ Related party
transactions also may involve difficult measurement and recognition
issues that can lead to errors in financial statements.
---------------------------------------------------------------------------

    \152\ For example, to improve the appearance of its financial
condition, a company and a related party could attempt to ``dress
up'' the appearance of the company's balance sheet at period end by
agreeing to have the company temporarily pay down its related party
debt prior to the balance sheet date while having an undisclosed
side agreement to subsequently borrow the same or a comparable
amount shortly after period end.
    \153\ See, e.g., paragraph 15 of FASB Statement No. 57, Related
Parties, which states ``[w]ithout disclosure to the contrary, there
is a general presumption that transactions reflected in financial
statements have been consummated on an arm's-length basis between
independent parties. However, that presumption is not justified when
related party transactions exist because the requisite conditions of
competitive, free-market dealings may not exist. Because it is
possible for related party transactions to be arranged to obtain
certain results desired by the related parties, the resulting
accounting measures may not represent what they usually would be
expected to represent.''
    \154\ As noted above, the SEC Section 704 Study identified areas
of issuer financial reporting that are most susceptible to fraud,
inappropriate manipulation or inappropriate earnings management. As
part of that study, the SEC examined 227 enforcement matters and
found that 23 cases included the failure to disclose related party
transactions. See SEC Section 704 Study.
---------------------------------------------------------------------------

    The importance to investors of the auditing of related party
transactions was emphasized by the U.S. Congress in 1995 through the
enactment of Section 10A of the Exchange Act, which requires that each
audit of financial statements of an issuer include ``procedures
designed to identify related party transactions that are material to
the financial statements or otherwise require disclosure therein.''
\155\ Additionally, SEC actions have identified related party
transactions as warranting heightened scrutiny by auditors.\156\
---------------------------------------------------------------------------

    \155\ Section 10A(a)(2) of the Exchange Act, 15 U.S.C. 78j-
1(a)(2).
    \156\ See, e.g., SEC AAER No. 3427, In the Matter of the
Application of Wendy McNeely, CPA, at 10-12 (December 13, 2012),
which states, in part, that the SEC and the courts have repeatedly
held that related party transactions require heightened scrutiny by
auditors. See also McCurdy v. SEC, 396 F3d 1258, 1261 (D.C. Cir.
2005) (citing Howard v. SEC, 376 F3d 1136, 1149 (D.C. Cir. 2004)
noting that related-party transactions ``are viewed with extreme
skepticism in all areas of finance,'' aff'g James Thomas McCurdy,
CPA, 57 S.E.C. 277 (2004)).
---------------------------------------------------------------------------

    The Board's existing standard for the auditing of related party
transactions, AU sec. 334, Related Parties,\157\ was issued in 1983,
and has not been substantively revised since then. Among other things,
AU sec. 334 has not been revised to align with the Board's risk
assessment standards, which provide an overall framework for the
auditor's assessment of and response to the risks of material
misstatement. Additionally, as discussed below, the existing standard
does not reflect an approach that promotes heightened scrutiny by the
auditor of a company's relationships and transactions with related
parties.
---------------------------------------------------------------------------

    \157\ AU sec. 334 is one of the Board's interim auditing
standards. Shortly after the Board's inception, the Board adopted
the existing standards of the AICPA, as in existence on April 16,
2003, on an initial, transitional basis. See Establishment of
Interim Professional Auditing Standards, PCAOB Release No. 2003-006
(April 18, 2003).
---------------------------------------------------------------------------

    AU sec. 334 provides guidance for the auditor, rather than
explicitly requiring the performance of specific procedures.\158\ For
example, AU sec. 334 includes examples of procedures that the auditor
could perform, and indicates that such procedures may not be required
in every audit. Such an approach can lead to inadequate auditor effort
in an area that historically has posed increased risks of material
misstatement. Additionally, the existing standard suggests that related
party transactions need not be considered by the auditor as outside the
ordinary course of business for a company, unless the auditor is aware
of evidence to the contrary. As a result, the auditor may not exercise
sufficient professional skepticism in an area that Congress and the SEC
have indicated requires heightened scrutiny.
---------------------------------------------------------------------------

    \158\ See discussion of The Baseline for a detailed discussion
of the existing requirements applicable to the critical areas.
---------------------------------------------------------------------------

    The need to revise and strengthen AU sec. 334 has been supported by
a number of prominent studies, including studies conducted by the
auditing profession prior to the enactment of the Act and the
establishment of the Board. For example, the AICPA recommended, after
studying over 200 cases reported by their members in which allegations
of an audit failure were made, that ``required audit procedures be
broadened to help ensure the auditor gains a more complete
understanding of related party transactions, including the business
aspects of transactions.'' \159\
---------------------------------------------------------------------------

    \159\ The Quality Control Inquiry Committee of the AICPA's SEC
Practice Section issued a report (the ``QCIC Report'') making this
recommendation in 2002. See AICPA SEC Practice Section, Memo To
Managing Partners of SECPS Member Firms, ``Recommendations for the
Profession Based on Lessons Learned from Litigation'' (October
2002), which includes the QCIC Report as an attachment.
---------------------------------------------------------------------------

    Additionally, the Board considered a synthesis of the academic
literature on auditing related party transactions that states that
various high profile frauds demonstrate how related party transactions
can be used to mislead users of financial statements.\160\ The authors
find that related party transactions are as common in companies alleged
to have committed fraud as in companies in which no fraud has been
detected. However, the authors also find that ``. . . when fraud does
exist, the presence of related party transactions is one of the top
reasons

cited for audit failures.'' \161\ The authors conclude that the
findings in academic literature, combined with the significance of
related party transactions in corporate scandals, ``are consistent with
the PCAOB's reconsideration of auditing of related party
transactions.'' \162\
---------------------------------------------------------------------------

    \160\ See Elizabeth A. Gordon, Elaine Henry, Timothy J. Louwers,
and Brad J. Reed, Auditing Related Party Transactions: A Literature
Overview and Research Synthesis, Accounting Horizons 21 (1): 81-102
(2007).
    \161\ Id. at 82.
    \162\ Id. at 81. A subsequent study conducted by the same
authors analyzes 43 SEC enforcement actions against auditors related
to the examination of related party transactions and identified
audit practice issues in that area. The authors found that the
majority of this sample involved inadequate examination of the
related party transaction by the auditor. Although the authors
concluded that the audit failures described in these SEC cases were
more likely attributable to a lack of professional skepticism and
due professional care than deficiencies in the existing standards,
the authors provide suggestions to improve audit practice regarding
the auditing of related party transactions. Among other things, the
authors suggest that auditors use guidance published by the AICPA in
a 2001 ``Related Party Transaction Toolkit'' that suggests that the
auditor should perform many of the procedures described as guidance
in AU sec. 334 to determine the existence of related parties and
identify transactions with known related parties. See Timothy J.
Louwers, Elaine Henry, Brad J. Reed, and Elizabeth A. Gordon,
Deficiencies in Auditing Related-Party Transactions: Insights from
AAERs, Current Issues in Auditing 2 (2): A10-A16 (2008).
---------------------------------------------------------------------------

    While the Board recognizes that transactions with related parties
are also used for legitimate purposes, including the efficient
procurement of resources,\163\ the Board has concluded that the
auditing of related party transactions warrants heightened scrutiny.
Notably, the Board has observed, through its oversight activities,
deficiencies in the auditing of related party transactions,
particularly with respect to audits of smaller public companies.
Additionally, as prominent corporate scandals over the past several
decades illustrate, issues involving the scrutiny of related party
transactions also arise in the audits of large public companies.
---------------------------------------------------------------------------

    \163\ See Elizabeth A. Gordon, Elaine Henry, and Darius Palia,
Related Party Transactions and Corporate Governance 9 Advances in
Financial Economics 1-27, (2004).
---------------------------------------------------------------------------

    As a result of these and other considerations discussed throughout
this release, the Board has determined that there is a need to improve
its existing auditing standard regarding related parties. In the
Board's view, AU sec. 334 does not contain sufficient required
procedures, is not risk-based, and does not promote the necessary
heightened scrutiny of related party transactions.
    Significant Unusual Transactions: The identification and evaluation
of a company's significant unusual transactions is important to the
audit because such transactions can create complex accounting and
financial disclosure issues that create risks of error. Additionally,
in some cases, significant unusual transactions have been used to
engage in fraudulent financial reporting. For example, significant
unusual transactions that are close to period end may be entered into
to obscure a company's financial position or operating results (e.g.,
so-called ``window-dressing''). Others may involve counterparties that
are willing to structure transactions to achieve desired accounting
results. In such cases, company management may place more emphasis on
the need for a particular accounting treatment than on the underlying
economic substance of the transaction.
    The Board has considered studies that highlight the risks of
material misstatements associated with a company's significant unusual
transactions. For example, the Report Prepared by the Permanent
Subcommittee on Investigations of the Committee on Governmental Affairs
found that ``some U.S. financial institutions and public companies have
been misusing structured finance vehicles . . . to carry out sham
transactions that have no legitimate business purpose and mislead
investors, analysts, and regulators about companies' activities, tax
obligations, and true financial condition.'' \164\ Another study
attributed an increased risk of financial misstatement to transactions
in which the substance of the transactions might differ materially from
their form.\165\
---------------------------------------------------------------------------

    \164\ See Senate Committee on Governmental Affairs, Permanent
Subcommittee on Investigations of the Committee on Governmental
Affairs, Fishtail, Bacchus, Sundance, and Slapshot: Four Enron
Transactions Funded and Facilitated by U.S. Financial Institutions
(January 2, 2003), http://www.gpo.gov/fdsys/pkg/CPRT-107SPRT83559/pdf/CPRT-107SPRT83559.pdf.
    \165\ See SEC Report and Recommendations Pursuant to Section
401(c) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-
Balance Sheet Implications, Special Purpose Entities, and
Transparency of Filings by Issuers (June 15, 2005), http://sec.gov/news/studies/soxoffbalancerpt.pdf.
---------------------------------------------------------------------------

    Additionally, SEC enforcement actions have highlighted the need for
the auditor to scrutinize complex unusual transactions, including
understanding their underlying economic purpose.\166\ Other SEC cases
have addressed instances in which structured transactions obscured the
economic substance of transactions that had a material impact on the
company's financial statements.\167\
---------------------------------------------------------------------------

    \166\ See, e.g., SEC AAER No. 2775, In the Matter of Michael
Lowther, CPA, Respondent (January 28, 2008), which discusses the
2001 financial reporting fraud at Enron, which included the use of
complex structured transactions to obscure the economic substance of
certain financing transactions that had a material impact on Enron's
financial statements.
    \167\ See, e.g., SEC AAER No. 1631, In the Matter of Dynegy,
Inc., Respondent (September 24, 2002). In that action, the
Commission determined that Dynegy entered into two massive ``round-
trip'' electricity transactions, that is, simultaneous, pre-arranged
buy-sell trades at the same price, terms and volume, in which
neither Dynegy nor its trading counterparty earned a profit or
incurred a loss and that such transactions lacked economic
substance.
---------------------------------------------------------------------------

    The risk assessment standards require the auditor to consider the
risks of material misstatement posed by significant unusual
transactions as part of the auditor's risk assessment during the
financial statement audit.\168\ However, the auditing requirements
regarding significant unusual transactions are principally contained in
AU sec. 316, Consideration of Fraud in a Financial Statement
Audit.\169\ That standard provides that the auditor considers the risks
of fraud relating to a significant transaction outside the normal
course of business for a company if the auditor ``becomes aware'' of
such a transaction.\170\ There is no express requirement in AU sec.
316, however, for the auditor to perform specific procedures to
identify such transactions or to obtain the information necessary to
evaluate the accounting for and disclosure of such transactions, which
are key considerations in promoting the auditor's heightened scrutiny
of a company's significant unusual transactions.
---------------------------------------------------------------------------

    \168\ See, e.g., paragraph 71.g. of Auditing Standard No. 12,
Identifying and Assessing Risks of Material Misstatement.
    \169\ See paragraphs .66-.67 of AU sec. 316.
    \170\ See discussion of The Baseline for a more detailed
discussion of the existing standards applicable to the critical
areas.
---------------------------------------------------------------------------

    The Board's staff identified areas of potential weaknesses in the
auditor's consideration of significant unusual transactions and in
April 2010 issued Staff Audit Practice Alert No. 5, Auditor
Considerations Regarding Significant Unusual Transactions.\171\ That
alert discusses a range of auditor practice issues pertaining to
significant unusual transactions, including the auditor's understanding
of transactions close to period end that pose difficult substance over
form issues. Similarly, the IAASB staff issued guidance in August 2010
that addressed the auditing of significant unusual or highly complex
transactions.\172\
---------------------------------------------------------------------------

    \171\ See Staff Audit Practice Alert No. 5, Auditor
Considerations Regarding Significant Unusual Transactions (April 7,
2010).
    \172\ See IAASB Staff Questions and Answers, Auditor
Considerations Regarding Significant Unusual or Highly Complex
Transactions (August 2010).
---------------------------------------------------------------------------

    As a result of these and other considerations discussed throughout

this release, the Board has determined that there is a need to improve
its existing auditing standards regarding significant unusual
transactions. In the Board's view, the existing standards in this area
do not contain sufficient required procedures to promote the heightened
scrutiny necessary for the auditor to identify and evaluate
transactions that may be used to intentionally obscure a company's
financial results or that may result in erroneous financial reporting.
    Financial Relationships and Transactions with Executive Officers:
Understanding a company's relationships and transactions with its
executive officers is important to an auditor because a company's
executive officers are generally in a position to determine or
influence a company's accounting and disclosures. A company's financial
relationships and transactions with its executive officers (e.g.,
executive compensation) can create incentives and pressures for
executive officers to meet financial targets, which can result in risks
of material misstatement of a company's financial statements.
Additionally, a company's executive officers, because of their role in
the financial reporting process, are in a unique position to commit
fraud.\173\
---------------------------------------------------------------------------

    \173\ See, for example, AU sec. 316.08.
---------------------------------------------------------------------------

    Cases involving fraudulent financial reporting illustrate how a
company's financial relationships and transactions with its executive
officers can create incentives and pressures that can result in risks
of material misstatement, including fraud risks.\174\ Research that
analyzed SEC AAERs from 1998 to 2007 also identified potential
motivations for engaging in fraudulent financial reporting that relate
to a company's financial targets.\175\ For example, the study noted
that the most commonly cited motivations for fraud included the need
to: (i) Meet internal or external earnings expectations of analysts and
others; (ii) meet internally set financial targets or make the company
look better; (iii) conceal the company's deteriorating financial
condition; (iv) increase the stock price; (v) bolster financial
position for pending equity or debt financing; (vi) increase management
compensation through achievement of bonus targets and through enhanced
stock appreciation; and (vii) cover up assets misappropriated for
personal gain. The cited motivations support a conclusion that a
company's financial relationships and transactions with its executive
officers can create incentives and pressures that can result in risks
of material misstatement to a company's financial statements. That
study noted that the chief executive officer and/or the chief financial
officer were named in 89 percent of the cases involving fraudulent
financial reporting brought by the SEC during that period.
---------------------------------------------------------------------------

    \174\ For example, over the last decade, the SEC has brought a
number of cases where management allegedly manipulated compensation
expense recognized in the financial statements, while simultaneously
obtaining additional compensation for themselves through options
backdating. See SEC Spotlight on Stock Options Backdating, which
lists AAERs, Commission speeches and testimony, Commission staff
speeches, testimony and letters; and non-SEC documents relating to
stock options backdating, http://www.sec.gov/spotlight/optionsbackdating.htm.
    \175\ See Mark S. Beasley, Joseph V. Carcello, Dana R.
Hermanson, and Terry L. Neal, 2010. Fraudulent Financial Reporting
1998-2007: An Analysis of U.S. Public Companies, Committee of
Sponsoring Organizations of the Treadway Commission (May 2010) at 3,
http://www.coso.org/documents/COSOFRAUDSTUDY2010_001.pdf.
---------------------------------------------------------------------------

    Under the Board's risk assessment standards, the auditor is
required to consider obtaining an understanding of compensation
arrangements with the company's ``senior management'' as part of
obtaining an understanding of the company.\176\ In the Board's view
this continues to be an important consideration for the auditor during
the risk assessment process. However, the Board's risk assessment
standards require the auditor to ``consider'' performing procedures to
obtain an understanding of certain compensation arrangements as part of
``obtaining an understanding of the company'' during the auditor's
overall risk assessment, but does not require the performance of
specific procedures to obtain such an understanding.\177\ Most
significantly, the Board's risk assessment standards do not require the
auditor to perform specific procedures to obtain an understanding of
financial relationships and transactions with executive officers, which
can motivate or affect company accounting or reporting decisions.
---------------------------------------------------------------------------

    \176\ See paragraph 11 of Auditing Standard No. 12.
    \177\ See discussion of The Baseline for a detailed discussion
of the existing standards applicable to the critical areas.
---------------------------------------------------------------------------

    As a result of these and other considerations discussed throughout
this release, the Board has determined that there is a need to improve
its existing risk assessment standards relating to the auditor's
consideration of a company's financial relationships and transactions
with its executive officers. In the Board's view, its risk assessment
standards in this area are not sufficiently targeted to promote
heightened scrutiny of potential risks of material misstatement arising
from a company's financial relationships and transactions with its
executive officers, in view of the unique role played by the company's
executive officers in the company's financial reporting process.
How the Standard and Amendments Address the Need
    The Board has determined to improve its requirements relating to
identifying, understanding, and addressing certain areas that are
widely acknowledged to represent increased risks of material
misstatement in company financial statements. As more fully discussed
below, these improvements are intended to strengthen the audit of the
company's financial statements by improving the auditor's ability to
identify and address such risks. In the Board's view, a more focused
approach with specific performance requirements should foster the
heightened scrutiny that the Board believes is warranted in the
critical areas. Such an approach should help mitigate the information
asymmetry between company management and investors.
    The following sections describe key aspects of the standard and
amendments being adopted by the Board, with a focus on how they address
the need for improvement described above.\178\
---------------------------------------------------------------------------

    \178\ A section-by-section discussion of the standard and
amendments is located in Section C.
---------------------------------------------------------------------------

    Auditing Standard No. 18, Related Parties: The Board is superseding
AU sec. 334 and adopting a new standard that establishes specific
procedures intended to strengthen auditor performance requirements
regarding the auditing of related party transactions. The new
requirements establish specific procedures, rather than the approach in
the existing standard, which provides guidance and example procedures
for the auditor's consideration.
    The standard reflects the following key improvements from the
existing standard:
     Adding Basic Requirements: AU sec. 334 suggests procedures
for the auditor's consideration, noting that not all of them may be
required in every audit. The standard requires basic procedures for the
auditor's response to risks of material misstatement associated with a
company's relationships and transactions with its related parties.
Specifically, the standard focuses on those related party transactions
that require disclosure in the financial statements or that are
determined to be a significant risk. The basic procedures are designed
to assist the auditor in identifying red flags that indicate potential
risks of material misstatement. The standard also requires more in-
depth procedures that are designed to be scalable and

commensurate with the company's facts and circumstances.
     Enhancing Procedures to Obtain an Understanding of the
Company's Relationships and Transactions With Its Related Parties:
Unlike AU sec. 334, which includes limited direction for obtaining an
understanding of the company's relationships and transactions with its
related parties, the standard requires the performance of specific
procedures in this area, including obtaining an understanding of the
terms and business purposes (or the lack thereof) of related party
transactions.
     Aligning With the Risk Assessment Standards: The standard
is designed to align with and build upon the risk assessment standards.
The procedures are intended to be performed in conjunction with the
procedures performed during the auditor's risk assessment.
     Improving the Auditor's Focus on Accounting: AU sec. 334
states that the auditor should place primary emphasis on the adequacy
of disclosure of related party transactions. The standard requires that
the auditor evaluate both the accounting for, and disclosure of,
related party transactions.
     Emphasizing a Complementary Audit Approach: The standard
specifically requires the auditor to take into account other work
performed during the audit, for example, information gathered with
respect to significant unusual transactions, when evaluating the
company's identification of its related party transactions.
     Adding Audit Committee Communications: AU sec. 334 does
not mention communications with audit committees regarding related
party transactions. The standard being adopted by the Board anticipates
two-way communication between the auditor and the audit committee
regarding such transactions. This reflects the fact that the new
performance requirements contained in the standard and amendments
relate to sensitive areas of the audit that potentially involve the
interests of company management and, thus, warrant discussion with the
audit committee. Specifically, the auditor is required to make
inquiries of the audit committee (or its chair) when the auditor is
obtaining an understanding of the company, which should occur during
the auditor's risk assessment. During these initial communications, the
auditor obtains information regarding a company's significant related
party transactions and any such relationships or transactions that are
of concern to members of the audit committee. The standard further
requires that the auditor communicate to the audit committee regarding
the auditor's overall evaluation of the company's identification of,
accounting for, and disclosure of its relationships and transactions
with related parties, including any significant matters the auditor
identified during the audit. Among other things, the matters to be
communicated related to the auditor's evaluation include the
identification of any related parties (or relationships or transactions
with related parties) that were previously undisclosed to the auditor.
    Amendments Regarding Significant Unusual Transactions: In this
area, the Board is: (i) Revising AU sec. 316; (ii) making targeted
amendments to certain risk assessment standards (e.g., Auditing
Standards Nos.12 and 13); and (iii) making related changes to other
PCAOB auditing standards. These amendments include specific procedures
designed to improve the auditor's identification and evaluation of a
company's significant unusual transactions. Among other things, they
require the auditor to perform specific procedures to (i) identify
significant unusual transactions and (ii) obtain an understanding of
the business purpose (or the lack thereof) of the company's significant
unusual transactions, including whether the transaction was entered
into to engage in fraud. In the Board's view, adding specific
procedures promotes audit quality by providing the auditor with more
insight into the nature of a company's significant unusual
transactions, which should enable the auditor to better evaluate
whether the financial statements are fairly stated.
    The amendments regarding significant unusual transactions are
designed to improve existing Board standards in the following key
respects:
     Improving Requirements for Identifying Significant Unusual
Transactions: The amendments regarding significant unusual transactions
require the performance of specific procedures intended to improve the
auditor's identification of significant unusual transactions, for
example, by amending Auditing Standard No. 12 to require the auditor to
make inquiries of management and others.
     Improving the Auditor's Evaluation of Significant Unusual
Transactions: The amendments to AU secs. 316.66-.67A include basic
procedures for obtaining information for evaluating significant unusual
transactions. The basic procedures include: (i) Reading the underlying
documentation relating to significant unusual transactions and
evaluating whether the terms and other information about the
transaction are consistent with explanations from inquiries and other
audit evidence about the business purpose (or the lack thereof) of the
transaction; (ii) determining whether the transaction has been
authorized and approved in accordance with the company's established
policies and procedures; and (iii) evaluating the financial capability
of the other parties to the transaction with respect to significant
uncollected balances, guarantees, and other obligations.
     Enhancing Attention to the Business Purpose (or the Lack
Thereof) of Significant Unusual Transactions: The amendments to AU
secs. 316.66-.67 enhance the auditor's evaluation of the business
purpose of significant unusual transactions by, among other things,
expanding the factors considered by the auditor in evaluating whether
the business purpose (or the lack thereof) indicates that such
transactions may have been entered into to engage in fraudulent
financial reporting or conceal misappropriation of assets.
     Emphasizing Accounting and Disclosure: The amendments
regarding significant unusual transactions to AU sec. 316.67A are
intended to heighten the auditor's attention to accounting matters
relative to significant unusual transactions by emphasizing that
existing requirements include evaluating whether the financial
statements contain the information essential for a fair presentation of
the financial statements in conformity with the applicable financial
reporting framework.
     Emphasizing a Complementary Audit Approach: The amendments
regarding significant unusual transactions specifically require the
auditor to take into account other work performed during the audit, for
example, information gathered with respect to related party
transactions, when identifying significant unusual transactions.
     Enhancing Audit Committee Communications: The amendments
regarding significant unusual transactions are intended to improve the
quality of the auditor's communications with the audit committee
regarding the business purpose (or the lack thereof) of significant
unusual transactions.\179\
---------------------------------------------------------------------------

    \179\ See, e.g., paragraph 13.d of Auditing Standard No. 16,
Communications with Audit Committees.
---------------------------------------------------------------------------

     Conforming Descriptions of Significant Unusual
Transactions: The amendments introduce a uniform description of
``significant unusual transactions'' throughout the Board's standards.

    Amendments Regarding Financial Relationships and Transactions With
Executive Officers: The Board is revising Auditing Standard No. 12 to
require the auditor to perform specific procedures during the risk
assessment process to obtain an understanding of the company's
financial relationships and transactions with its executive officers.
In doing so, the auditor would consider, among other things, the
potential for increased risks of material misstatement that could arise
out of the company's compensation arrangements with its executive
officers.\180\
---------------------------------------------------------------------------

    \180\ The population of the company's ``executive officers'' is
determined by reference to SEC rules and forms. See Section C--Other
Amendments to PCAOB Auditing Standards for a discussion of the
applicable definition of the term ``executive officer.''
---------------------------------------------------------------------------

    The revisions improve the existing audit requirements by requiring
the auditor to perform specific procedures to obtain an understanding
of a company's financial relationships and transactions with its
executive officers, as part of the auditor's risk assessment.
Specifically, the amendments revise Auditing Standard No. 12 to state
that the auditor ``should perform'' specified procedures to obtain an
understanding of the company's financial relationships and transactions
with its ``executive officers'' as part of the auditor's risk
assessment.
    As noted previously, under the existing risk assessment standards,
the auditor is required to ``consider'' obtaining an understanding of
compensation arrangements with senior management as part of obtaining
an understanding of the company during the auditor's risk
assessment.\181\ The Board's standards currently do not explicitly
require that the auditor obtain information regarding incentives or
pressures for the company's executive officers to achieve a particular
financial position or operating result as a result of performance based
compensation arrangements. The Board has determined to supplement its
existing requirements, and has determined that the requirement that the
auditor ``should perform'' procedures relating to executive officer
compensation arrangements is appropriate to promote heightened
scrutiny.
---------------------------------------------------------------------------

    \181\ See paragraph 11 of Auditing Standard No. 12.
---------------------------------------------------------------------------

    In the Board's view, a focus on the company's executive officers
during the risk assessment process is appropriate in that they
generally play a key role in the company's accounting decisions and in
a company's financial reporting. However, the new required procedures
do not require the auditor to make a determination regarding the
appropriateness of a company's compensation agreements with its
executive officers.
The Baseline
    To consider the economic impacts (including likely benefits and
costs) of the standard and amendments, a ``baseline'' has been
identified that can be used as a benchmark against which the standard
and amendments can be compared. The baseline, described below, includes
existing requirements and also considers audit practices.
Existing Requirements
    The auditor's overall responsibility to perform a risk-based audit
is contained in the Board's risk assessment standards, Auditing
Standards Nos. 8 through 15, which became effective for auditors in
December 2010.\182\ Among other things, the risk assessment standards
require the auditor to consider the risks of material misstatement,
whether due to error or fraud, throughout the audit.\183\
---------------------------------------------------------------------------

    \182\ See PCAOB Release 2010-004 (August 5, 2010).
    \183\ More generally, auditors are required to comply with all
standards of the PCAOB, including existing requirements to perform
the audit with due professional care, and to obtain sufficient
appropriate audit evidence to support the audit opinion. See, e.g.,
AU sec. 230, Due Professional Care in the Performance of Work, and
Auditing Standard No. 15, Audit Evidence.
---------------------------------------------------------------------------

    The existing requirements that the Board is strengthening through
adoption of the standard and amendments are discussed below.
    Relationships and Transactions With Related Parties: The risk
assessment standards anticipate that the auditor will consider certain
risks inherent in significant transactions with related parties in
determining the significant risks of the audit \184\ and in
establishing the materiality level for the audit of the financial
statements.\185\ However, the existing auditing requirements relating
to relationships and transactions with related parties are contained
primarily in AU sec. 334, one of the Board's interim standards.
---------------------------------------------------------------------------

    \184\ See paragraph 71.e. of Auditing Standard No. 12.
    \185\ See paragraph 7 of Auditing Standard No. 11, Consideration
of Materiality in Planning and Performing an Audit, which states
that lesser amounts of misstatements could influence the judgment of
a reasonable investor because of qualitative factors, e.g., because
of the sensitivity of circumstances surrounding misstatements, such
as conflicts of interest in related party transactions.
---------------------------------------------------------------------------

    AU sec. 334 recognizes that the auditor performs procedures to
identify and evaluate a company's relationships and transactions with
its related parties as part of performing an audit of financial
statements. However, as noted above, it provides guidance and examples
of procedures for the auditor's consideration, rather than specific
required procedures.
    Examples of procedures in AU sec. 334 include: (i) Procedures to
obtain information from management (such as obtaining the names of all
related parties and inquiring whether there were any transactions with
these parties during the period); (ii) procedures intended to assist
the auditor in identifying related parties that have not been disclosed
to the auditor by management (such as reviewing filings with the SEC,
reviewing company accounting records and certain invoices, and making
inquiries of other auditors); and (iii) procedures the auditor
considers, as necessary, to understand the purpose, nature, and extent
of identified related party transactions (such as obtaining an
understanding of the business purpose of the transaction). Notably, AU
sec. 334 states that not all of the procedures may be required in every
audit.
    AU sec. 334 states that the auditor should place primary emphasis
on the adequacy of disclosure of related party transactions.
Significantly, the existing standard also states that, in the absence
of evidence to the contrary, related party transactions should not be
assumed to be outside the ordinary course of business.\186\ Thus, AU
sec. 334 could be misunderstood to create a ``presumption of validity''
for the business purpose of related party transactions in situations
where experience suggests a need for heightened scrutiny.\187\
---------------------------------------------------------------------------

    \186\ See AU sec. 334.06.
    \187\ This is in contrast to the approach reflected in the
standard, which emphasizes the auditor's responsibilities for
identifying and assessing risks of material misstatement associated
with related parties and relationships and transactions with related
parties.
---------------------------------------------------------------------------

    Significant Unusual Transactions: The risk assessment standards
anticipate that the auditor will consider risks of material
misstatement in a company's financial statements, including those posed
by significant unusual transactions.\188\ However, the more specific
auditing requirements regarding significant unusual transactions are
principally contained in AU sec. 316.\189\ Specifically, AU sec. 316.66
recognizes that during a financial statement audit, the auditor may
become aware of significant transactions that are outside the normal
course of business for the company or that otherwise appear to be
unusual given the auditor's understanding of the

company and its environment. AU sec. 316.66 requires that, if the
auditor becomes aware of significant unusual transactions during the
course of an audit, the auditor should gain an understanding of the
business rationale of such transactions and whether that rationale (or
the lack thereof) suggests that such transactions may have been entered
into to engage in fraudulent financial reporting or to conceal the
misappropriation of assets. However, AU sec. 316 does not specify the
procedures to perform to identify significant unusual transactions or
to obtain necessary information to understand their business purpose
(or the lack thereof).
---------------------------------------------------------------------------

    \188\ See paragraph 71.g. of Auditing Standard No. 12.
    \189\ See AU secs. 316.66-.67.
---------------------------------------------------------------------------

    Financial Relationships and Transactions With Executive Officers:
The risk assessment standards require the auditor to consider obtaining
an understanding of compensation arrangements with senior management
(including incentive compensation arrangements, changes or adjustments
to those arrangements, and special bonuses) as part of obtaining an
understanding of the company.\190\ While this encompasses a company's
executive officers, the existing standards do not specifically require
the auditor to obtain an understanding of the incentives and pressures
posed by executive officer compensation arrangements that can influence
a company's accounting and disclosures.
---------------------------------------------------------------------------

    \190\ See paragraph 11 of Auditing Standard No. 12.
---------------------------------------------------------------------------

Audit Practices
    The Board's understanding of audit practices is based on the
Board's general knowledge of audit firm practice arising out of
information gathered from its oversight activities, including its
inspection, enforcement, and standard-setting activities. Additionally,
the Board's understanding also has been informed by a range of studies
and other materials it considered in determining the need for
improvement of its existing standards. Based on this understanding, the
Board believes that audit practices associated with the auditor's
efforts regarding the critical areas are inconsistent.
    The Board is aware that some firms have adopted audit methodologies
that require their engagement teams to perform specific procedures
regarding related party transactions not currently required by AU sec.
334. This may have occurred for a number of reasons. For example, the
analogous standards of the IAASB and ASB require the auditor to inquire
of management regarding the entity's related parties.\191\ Audit
practice also may have been impacted by guidance issued by the AICPA
encouraging auditors to perform many of the procedures suggested in AU
sec. 334 for the auditor's consideration.\192\ Additionally, some
auditors may already perform additional procedures arising out of their
consideration of the risks of significant transactions with related
parties as potential significant risks.\193\
---------------------------------------------------------------------------

    \191\ See paragraph 13 of ISA 550, Related Parties, and
paragraph 14 of AU-C 550, Related Parties.
    \192\ See AICPA Practice Alert No. 95-3, Auditing Related
Parties and Related-Party Transactions, which indicated the auditor
should perform most, if not all, of the examples of procedures in AU
sec. 334 for determining the existence of related parties and
identifying transactions with known related parties, and AICPA
Toolkit, Accounting and Auditing for Related Parties and Related
Party Transactions (2001).
    \193\ See paragraph 71.e. of Auditing Standard No. 12.
---------------------------------------------------------------------------

    Further, some auditors may already perform additional procedures
regarding significant unusual transactions as a result of robust risk
assessments and as a result of guidance from Board staff and the
IAASB.\194\ Additionally, there has been considerable interest in
issues relating to executive compensation, which may have resulted in
heightened attention to such issues by some auditors.\195\
---------------------------------------------------------------------------

    \194\ See Staff Audit Practice Alert No. 5 (April 7, 2010). See
also IAASB Staff Questions and Answers, Auditor Considerations
Regarding Significant Unusual or Highly Complex Transactions (August
2010).
    \195\ See, e.g., Staff Audit Practice Alert No. 1, Matters
Related To Timing And Accounting For Option Grants (July 28, 2006).
---------------------------------------------------------------------------

    The Board also is aware through its oversight activities that some
firms have exhibited deficient auditing practices with respect to the
critical areas. For example, the Board has identified deficiencies
regarding the auditing of related party transactions through its
triennial inspection program, which focuses on inspections of smaller
domestic audit firms. Deficiencies identified include failures to test
for undisclosed related parties or transactions with related parties,
as well as failures to obtain an understanding of the business purpose
of known related party transactions.\196\
---------------------------------------------------------------------------

    \196\ See Report on 2007-2010 Inspections of Domestic Firms that
Audit 100 or Fewer Public Companies, PCAOB Release No. 2013-001, at
29 (February 25, 2013), http://pcaobus.org/Inspections/Documents/02252013_Release_2013_001.pdf, which states, in part,
``Inspections staff have observed deficiencies related to firms'
failures to test for undisclosed related parties or transactions
with undisclosed related parties. Some of those firms failed to
identify and address the lack of disclosure of related party
transactions in the financial statements. Inspections staff have
also identified deficiencies relating to the firms' failure to
obtain an understanding of the nature and business purpose of
transactions with related parties and to evaluate whether the
accounting for those transactions reflects their economic
substance.'' See also, Report on the PCAOB's 2004, 2005, and 2006
Inspections of Domestic Triennially Inspected Firms, PCAOB Release
No. 2007-010, at 7 (October 22, 2007), http://pcaobus.org/Inspections/Documents/2007_10-22_4010_Report.pdf.
---------------------------------------------------------------------------

    Additionally, a number of the Board's settled enforcement cases
have involved related party transactions.\197\ Those PCAOB enforcement
actions have identified, among other things:
---------------------------------------------------------------------------

    \197\ See, e.g., Order Instituting Disciplinary Proceedings,
Making Findings, and Imposing Sanctions: In the Matter of P. Parikh
& Associates, Ashok B. Rajagiri, CA, Sandeep P. Parikh, CA, and
Sundeep P S G Nair, CA, Respondents, PCAOB Release No. 105-2013-002
(April 24, 2013); Order Instituting Disciplinary Proceedings, Making
Findings, and Imposing Sanctions: In the Matter of Jaspers + Hall,
PC, Thomas M. Jaspers, CPA, and Patrick A. Hall, CPA, Respondents,
PCAOB Release No. 105-2008-002 (October 21, 2008); Order Instituting
Disciplinary Proceedings, Making Findings, and Imposing Sanctions:
In the Matter of Williams & Webster, P.S., Kevin J. Williams, CPA,
and John G. Webster, CPA, Respondents, PCAOB Release No. 105-2007-1
(June 12, 2007); and Order Instituting Disciplinary Proceedings,
Making Findings, and Imposing Sanctions: In the Matter of Kenny H.
Lee CPA Group, Inc., and Kwang Ho Lee, CPA, Respondents, PCAOB
Release No. 105-2005-022 (November 22, 2005).
---------------------------------------------------------------------------

     Failures to perform sufficient procedures for known
related party transactions; \198\
---------------------------------------------------------------------------

    \198\ See Order Instituting Disciplinary Proceedings, Making
Findings and Imposing Sanctions: In the Matter of Kenny H. Lee CPA
Group, Inc., and Kwang Ho Lee, CPA, Respondents, PCAOB Release No.
105-2005-022 (November 22, 2005) and Order Instituting Disciplinary
Proceedings, Making Findings and Imposing Sanctions: In the Matter
of Williams & Webster, P.S., Kevin J. Williams, CPA, and John G.
Webster, CPA, Respondents, PCAOB Release No. 105-2007-1 (June 12,
2007).
---------------------------------------------------------------------------

     Failures to address management's failure to disclose known
related party transactions; \199\ and
---------------------------------------------------------------------------

    \199\ See Order Instituting Disciplinary Proceedings, Making
Findings and Imposing Sanctions: In the Matter of Turner Stone &
Company, LLP and Edward Turner, CPA, Respondents, PCAOB Release No.
2006-010 (December 19, 2006) and Order Instituting Disciplinary
Proceedings, Making Findings and Imposing Sanctions: In the Matter
of Timothy L. Steers, CPA, LLC, and Timothy L. Steers, CPA,
Respondents, PCAOB Release No. 105-2007-004 (November 14, 2007).
---------------------------------------------------------------------------

     Failures to take sufficient steps to determine whether a
transaction was a related party transaction, when available information
indicated that it was.\200\
---------------------------------------------------------------------------

    \200\ See Order Instituting Disciplinary Proceedings, Making
Findings and Imposing Sanctions: In the Matter of Cordovano and
Honeck, P.C. and Samuel D. Cordovano, CPA, Respondents, PCAOB
Release No. 2008-004 (December 18, 2008) and Order Instituting
Disciplinary Proceedings, Making Findings and Imposing Sanctions: In
the Matter of Clyde Bailey, P.C., and Clyde B. Bailey, CPA,
Respondents, PCAOB Release No. 2005-021 (November 22, 2005).
---------------------------------------------------------------------------

    The types of deficiencies observed by the Board through its
oversight activities

indicate that auditor practice regarding related parties is
inconsistent under the existing auditing framework in a wide range of
areas, suggesting that this is a challenging area warranting additional
auditor effort and focus.
The Board's Approach and Consideration of Alternatives
    During the standard-setting process, the Board considered a number
of alternatives and made a number of key policy choices with the goal
of improving audit quality in the critical areas, while also providing
opportunities for an efficient implementation. The following discussion
highlights alternatives and policy choices considered by the Board as
part of its economic considerations.
Consideration of Alternatives
    Prior to the Board's decision to propose the standard and
amendments, the Board requested input from its SAG, as early as
2004.\201\ During these meetings, the Board engaged the SAG in a
discussion of issues relating to the auditing of related party
transactions. Additionally, the Board discussed whether and, if so,
how, to improve its existing standards in complementary areas that
might be considered to pose similar risks of material misstatement.
---------------------------------------------------------------------------

    \201\ Prior to the issuance of the proposal, the SAG discussed
the topic of related parties at meetings on September 8-9, 2004,
June 21, 2007, and October 14-15, 2009. See the SAG Meeting Archive
at http://pcaobus.org/Standards/SAG/Pages/SAGMeetingArchive.aspx.
---------------------------------------------------------------------------

    As part of its standard-setting process, the Board initially
considered whether new requirements were necessary. This included a
review of the Board's oversight efforts through the Board's inspection
and enforcement programs to determine the type, range, and prevalence
of audit deficiencies cited. In addition, before issuing its proposal,
the Board issued Staff Audit Practice Alert No. 5 in April 2010, which
discussed a range of auditor practice issues identified by the PCAOB
staff pertaining to significant unusual transactions.\202\
---------------------------------------------------------------------------

    \202\ See Staff Audit Practice Alert No. 5 (April 7, 2010).
---------------------------------------------------------------------------

    Staff Audit Practice Alert No. 5 was issued to remind auditors of
the risks associated with significant unusual transactions and to
compile selected, relevant requirements from existing PCAOB auditing
standards into one document. Given that the alert only highlights
circumstances for auditor consideration, it did not alter audit
requirements with respect to significant unusual transactions.
    In considering whether new requirements were necessary, the Board
assessed a range of factors, and concluded that it was appropriate to
develop standards with more specific requirements to address the
critical areas.
    As part of its considerations, the Board considered whether AU sec.
334 could be amended to include new specific procedures. The Board
determined that the nature and extent of revisions necessary, including
changes to align a revised AU sec. 334 with the risk assessment
standards, would essentially result in a new standard. Thus, the Board
determined that it was appropriate to propose a new standard regarding
related parties, rather than amend the existing standard.
    In considering how to address the other types of relationships and
transactions that the Board had identified as posing similar risks--
significant unusual transactions and a company's financial
relationships and transactions with executive officers--the Board
determined that issuing staff guidance could not make the changes that
were necessary to strengthen the existing audit requirements to address
the risks that had been identified in these areas. However, the Board
determined that new stand-alone standards were not necessary but that
appropriate improvements in audit quality could be achieved by
amendments to its existing audit requirements in those areas.
    As the Board considered the types and extent of changes to make in
its existing standards, it considered several alternatives, including
some discussed with its SAG.\203\ Some alternatives considered
included:
---------------------------------------------------------------------------

    \203\ See the SAG Meeting Archive at http://pcaobus.org/Standards/SAG/Pages/SAGMeetingArchive.aspx, for the October 14-15,
2009 SAG meeting.
---------------------------------------------------------------------------

    Consideration of Related Party Transactions as Fraud Risk: In view
of the potential for increased risks of material misstatement arising
from these critical areas, the Board considered whether relationships
and transactions with related parties should be presumed to be a fraud
risk. Under existing auditing standards, this approach would require
auditors to devote considerable audit effort to identifying and
evaluating relationships and transactions with related parties, in all
instances. However, the Board recognizes that many related party
transactions might not, in fact, represent fraud risks or other
significant risks, a view that was further informed by discussions with
the SAG.\204\ Accordingly, as such an alternative could have resulted
in potentially unnecessary audit effort, the Board determined to take a
targeted approach that would focus on the auditor obtaining sufficient
information to identify, assess, and respond to transactions that pose
increased risks of material misstatement, while, at the same time
aligning the new requirements with the risk assessment standards.
---------------------------------------------------------------------------

    \204\ See SAG Meeting Archive for the October 14-15, 2009 SAG
meeting.
---------------------------------------------------------------------------

    Consideration of Relationships and Transactions Posing Similar
Risks: The Board also considered whether to address relationships and
transactions that might fall outside the definition of a ``related
party'' but that might pose similar risks. After obtaining input from
the SAG regarding this approach,\205\ the Board decided that the
auditor should consider transactions that might pose similar risks,
such as a company's significant unusual transactions, because these
transactions not only may involve related parties previously
undisclosed to the auditor but also could pose increased risks of
material misstatement. Additionally, the Board concluded that linking
the auditor's efforts regarding related parties and significant unusual
transactions should help auditors ``connect the dots'' between these
areas.
---------------------------------------------------------------------------

    \205\ Id.
---------------------------------------------------------------------------

The Board's Approach and Choices Considered in Developing the Board's
Standard and Amendments
    The following discussion describes key policy choices considered by
the Board as it developed the standard and amendments, and as the Board
moved from its proposal to its reproposal and then to the adoption of
the standard and amendments. In developing the standard and amendments,
the Board determined to develop an audit approach that would promote
heightened scrutiny in the critical areas, but that would also provide
opportunity for efficient implementation. Key policy choices included:
    Aligning With the Risk Assessment Standards: In the Board's view,
its overall risk assessment approach promotes a cohesive audit, with
opportunities to integrate audit effort where appropriate, and
positions the auditor to identify areas in which there may be increased
risks of material misstatement in company financial statements. Such an
approach could also serve to minimize audit costs. The Board, thus,
determined that its new requirements should be explicitly aligned with
its risk assessment standards. In response to comments on its proposal,
the Board took steps in its reproposal to more closely align the

reproposed standard and amendments with its risk assessment standards.
Those who commented on this aspect of the reproposal generally agreed
that the revisions improved the alignment with the risk assessment
standards. This risk assessment focus is retained in the standard and
amendments being adopted by the Board.
    Providing Opportunity for a Scaled Approach: Similar to the risk
assessment standards, the Board determined that the standard should
reflect a scaled approach, which establishes basic required procedures
that are supplemented by more in-depth procedures that are commensurate
with the company's facts and circumstances. Such facts and
circumstances may include the size or complexity of the transaction,
the nature of the company's relationships or transactions with its
related parties, and the related risk of material misstatements in the
financial statements.
    Most commenters, including several large audit firms, agreed that
the reproposed standards and amendments provide a scaled approach,
permitting the auditor to vary the level of audit work in proportion to
the nature and number of a company's relationships and transactions
with related parties and significant unusual transactions. Some of
these commenters supported the Board's view that the level of audit
effort will vary in proportion to the number and nature of a company's
related party relationships and transactions, its significant unusual
transactions, its financial relationships and transactions with
executive officers, and the company's process to identify such matters.
Another commenter stated that an audit approach that begins with basic
procedures, and supplements them with more in-depth procedures as
needed, is a scalable approach that allows the auditor to focus on the
significant risks, regardless of the size or nature (e.g., broker or
dealer or EGC) of the issuer. A few commenters, however, objected to
the concept of basic required procedures and advocated for an approach
that would leave the determination of the procedures necessary to the
auditor's judgment.
    The Board considered commenter views and determined that requiring
the auditor to perform basic procedures in areas that could pose
increased risks of material misstatement would heighten attention by
the auditor to such areas and also provide a basis for the auditor to
identify red flags that require further attention. However, as
discussed below, the Board did revise certain aspects of its proposal
to permit additional auditor judgment in certain areas of the audit
that it determined appropriate.
    Addressing Complementary Audit Areas: The Board determined that the
standard and amendments should include linkages that would address
risks of material misstatement arising from complementary areas of the
audit. For example, the auditor's work in identifying and evaluating
significant unusual transactions could assist the auditor in
identifying related parties or relationships or transactions with
related parties previously undisclosed to the auditor by management.
This linked approach encourages the auditor to ``connect the dots''
between different aspects of the audit, which could improve audit
effectiveness, as well as provide opportunities for efficient
implementation. In its reproposal, the Board made revisions to improve
the linkages between the reproposed standard and amendments. This
approach is retained in the standard and amendments being adopted by
the Board.
    Using Existing Concepts and Procedures: The Board determined to
include some existing auditing concepts and procedures in its proposal.
This approach was intended to permit audit firms to build on existing
methodologies and training. Further, this approach could minimize the
costs of implementing the standard and amendments. In its reproposal,
the Board sought comment on such issues. Several audit firms who
commented on the reproposal indicated that they would be able to update
their methodologies and train staff to apply the standard and
amendments in a short period, suggesting that the implementation of the
standard and amendments would not be unduly burdensome.
    Additionally, commenters raised a variety of policy choices for
consideration by the Board, including the following: \206\
---------------------------------------------------------------------------

    \206\ Additionally, see Appendix 4 of the reproposing release
for discussion more generally of the Board's response to significant
comments received on the Board's February 28, 2012 proposal.
---------------------------------------------------------------------------

    Expanding Auditor Judgment: In response to comments, the Board made
some changes to allow for additional auditor judgment than originally
provided for in the proposal. For example, in its proposal, any related
party relationships or transactions not previously disclosed to the
auditor would have been considered to be a significant risk and would
have required the auditor to perform specific procedures in response.
Some commenters stated that an undisclosed related party transaction
could be inconsequential in nature and, in such circumstances, treating
the transaction as a significant risk and performing all of the
procedures set forth in the proposed standard would be unnecessary.
Other commenters suggested it might be appropriate to perform some, but
not all, of the related procedures in the proposed standard. After
consideration of comments, the Board removed the proposed requirement
that the auditor always treat undisclosed related party transactions as
a significant risk. Instead, the additional procedures would only be
required in circumstances where previously undisclosed transactions
were determined by the auditor to require disclosure in the financial
statements or consideration as a significant risk. This change, which
is being retained in the standard being adopted by the Board, could
eliminate potentially unnecessary audit work.
    Clarifying the Auditor's Responsibilities to Identify a Company's
Related Parties: In response to comments, the Board made clarifications
to the proposed standard to emphasize that the auditor's efforts to
identify a company's related parties and relationships and transactions
with its related parties begins with management's work. The clarified
approach taken in the Board's reproposal recognizes that the company is
responsible, in the first instance, for the preparation of its
financial statements, including the identification of the company's
related parties, and that the auditor begins the audit with information
obtained from the company. This approach has been retained in the
standard being adopted by the Board. Additionally, in response to other
comments made regarding the reproposed standard, several other
clarifying changes have been made in this area. Those changes include
emphasizing more prominently the auditor's responsibility to perform
procedures to test the accuracy and completeness of the company's
identification of its related parties, and that in doing so, the
auditor takes into account the information gathered during the audit.
    Clarifying the Requirements Regarding a Company's Financial
Relationships and Transactions With Its Executive Officers: The Board
made two key policy choices relating to the amendments pertaining to a
company's financial relationships and transactions with its executive
officers: (i) The relationship of the amendments to the risk assessment
process; and (ii) the

appropriate scope of the population for the auditor's required
procedures.
    As discussed previously, the Board determined to supplement its
existing risk assessment requirements regarding a company's financial
relationships and transactions with its executive officers. As
proposed, the other amendments provided that the auditor should perform
procedures to obtain an understanding of a company's financial
relationships and transactions with its executive officers. While some
commenters were fully supportive of this requirement and recognized
that it did not represent a radical departure from existing standards,
other commenters expressed concern that this would require the auditor
to make an assessment regarding the appropriateness or reasonableness
of executive compensation arrangements. In its reproposal, the Board
clarified that these procedures would be performed as part of the risk
assessment process and explicitly stated that its amendment does not
require the auditor to make any determination regarding the
appropriateness or reasonableness of the company's compensation
arrangements with its executive officers. Commenters who addressed this
area of the Board's reproposal generally indicated that the revisions
were appropriate. The amendments being adopted by the Board retain the
approach taken in its reproposal.
    Additionally, the Board also considered the appropriate population
for the auditor's consideration of financial relationships and
transactions. The Board determined that the auditor's consideration of
a company's financial relationships and transactions need not extend to
the company's entire senior management population, but that a focus on
a potentially smaller group within that population--executive
officers--was appropriate. This focus is appropriate because a
company's executive officers generally are in a unique position to
determine the company's accounting and financial statement disclosures.
    In considering the appropriate population for the auditor's
consideration, the Board took note of a range of diverse comments,
including those from commenters who advocated that the auditor's
procedures should include a broader group than the company's executive
officers; others who stated that the auditor's focus on a company's
executive officers was the most appropriate group; and another who
argued for a narrower group, for example, a company's ``named executive
officers,'' (``NEOs''). Under SEC rules, NEOs generally consist of five
individuals--the principal executive officer, the principal financial
officer, and the next three most highly paid executive officers of a
company as of the end of the most recently completed fiscal year.\207\
The Board considered the use of the NEO approach, but determined that
it might focus the auditor's attention on highly paid individuals (with
high compensation due to activity unrelated to financial reporting),
rather than individuals with more direct involvement in the financial
reporting process.
---------------------------------------------------------------------------

    \207\ See Item 402(a)(3) of Regulation S-K.
---------------------------------------------------------------------------

    After considering these comments, the Board determined that a
company's executive officers is the most appropriate population for the
auditor's efforts.\208\ In the Board's view, this targeted approach
could serve to limit potentially unnecessary audit effort and related
costs.
---------------------------------------------------------------------------

    \208\ In considering the appropriate population for the
auditor's inquiry, the Board took note of a study that indicated
that the median number of ``executive officers'' for the Standard
and Poor's 500 is 8 (the mean is 8.71), and the median number of
executive officers for the Russell 2000 is 5 (the mean is 6.12). See
Broc Romanek, Study: Benchmarking the Number of ``Executive
Officers,'' The Corporate Counsel.net and LogixData (March 2, 2011).
---------------------------------------------------------------------------

The Economic Impacts of the Standard and Amendments, Including Benefits
and Costs
    This section contains a discussion of the economic impacts
considered as the standard and amendments were developed, including
consideration of likely benefits and costs.
    At present, there is limited data and research available regarding
the economic impact of discrete changes to auditing standards.\209\ As
a result, many of the benefits and costs discussed below are difficult
to quantify reliably. The resulting benefits to investors, markets, and
others from more reliable financial reporting are complex and not
capable of reliable quantification at this time. Likewise, limited, if
any, public data exists to forecast the costs of performing additional
audit procedures in the critical areas or the spillover effect on
companies. Therefore, the economic discussion below is qualitative in
nature.
---------------------------------------------------------------------------

    \209\ The Board established a Center for Economic Analysis to,
among other things, promote and encourage academic research relating
to the role of the audit in capital formation and investor
protection. See PCAOB Announces Center for Economic Analysis,
(November 6, 2013) http://pcaobus.org/News/Releases/Pages/11062013_CenterEconomicAnalysis.aspx.
---------------------------------------------------------------------------

    The Board's consideration of the impacts of the standard and
amendments, as with all aspects of the Board's standard-setting
process, takes into account commenters' views.\210\ As part of the
standard-setting process, the Board asked commenters to provide
information, as well as empirical data, regarding both benefits and
costs, and other effects related to the reproposed standard and
amendments. In response, commenters provided views regarding whether
the standard and amendments would improve audit quality, as well as
their views regarding potential audit costs and implementation issues.
However, commenters did not provide empirical data.\211\
---------------------------------------------------------------------------

    \210\ The comment letters are available at http://pcaobus.org/Rules/Rulemaking/Pages/Docket038Comments.aspx.
    \211\ Additionally, Section C provides detail regarding the
Board's consideration of significant comments received relating to
the specific requirements of the standard and amendments.
---------------------------------------------------------------------------

    In general, commenters largely supported the Board's standard-
setting efforts, and agreed that the existing standards should be
improved in the critical areas. Commenters also generally agreed that
the standard and amendments could benefit audit quality. Some
commenters also noted the standard and amendments could result in
improvements in the auditor's: (i) Identification of material
misstatements; (ii) risk assessment for the audit; and (iii)
application of professional skepticism. In addition, benefits noted
also included improvements to audit committee communications and
company financial statement disclosures.
    Commenters who addressed potential costs provided qualitative
information that was generally consistent with the discussion of
potential costs in the reproposing release. While commenters noted that
there would be some increased costs, they did not provide data
regarding the extent of such costs. However, commenters generally
agreed that the standard and amendments were appropriate and should
apply to audits of companies of all types and sizes.
    Commenters also provided views on issues relating to scalability
and costs. For example, one commenter stated that the reproposed
standard and amendments would not require significant incremental
management or auditor resources, but the amount of resources required
could be meaningfully greater for companies with a significant number
of related party transactions or significant unusual transactions. In
general, the Board would not expect there to be significant cost
implications for audits of companies that do not have complex or
extensive: (i) Relationships or transactions with related parties; (ii)

significant unusual transactions; or (iii) financial relationships and
transactions with the company's executive officers.
    The following sections include a description of the Board's
consideration of: Benefits; Costs; Smaller Audit Firms and Smaller
Companies; and Other Economic Considerations.
Benefits
    The Board believes that the standard and amendments will benefit
investors by requiring auditors to focus appropriate auditing effort on
areas that represent increased risks and, thus, warrant heightened
scrutiny during the audit. As noted previously, to the extent that the
standard and amendments improve the likelihood that the auditor will
detect material misstatements in the financial statements, audit
quality will be improved in ways that should also improve financial
statement accounting and disclosures, which should in turn reduce the
information asymmetry between investors and company management.
    The standard and amendments take a targeted approach that is
intended to focus the auditor's attention on accounting and disclosures
relating to potentially complex and risky relationships and
transactions that historically have been associated with cases
involving fraudulent financial reporting. The magnitude and number of
such cases, which have resulted in significant losses to investors,
underscore the benefits to investors of strengthening the existing
auditing requirements in these areas. Increased focus on the critical
areas by auditors should increase the probability of auditors detecting
potential fraudulent or erroneous financial reporting \212\ and should
also deter fraudulent financial reporting because management will be
aware that auditors are likely to expend additional effort assessing
the economic substance of transactions in the critical areas.
---------------------------------------------------------------------------

    \212\ See Mark Zimbelman, The Effects of SAS No. 82 on Auditors
Planning Decisions, 35 Journal of Accounting Research, 75 passim
(1997).
---------------------------------------------------------------------------

    Existing auditing standards addressing the critical areas largely
provide guidance and examples of procedures, rather than requiring
specific procedures. This can result in inadequate and inconsistent
application of existing standards, as well as the auditor's failure to
perform sufficient procedures in the critical areas, which warrant
heightened scrutiny. Rather than providing examples of procedures that
may not be required in every audit, the standard and amendments require
the auditor to perform specific procedures. The new specific
requirements in the standard and amendments are designed to assist the
auditor in identifying red flags that warrant heightened scrutiny. The
performance of basic required procedures should increase the
probability of the auditor uncovering events that impact investors,
such as fraud and material errors, and provide investors with increased
confidence regarding the reliability of the audited financial
statements.
    Additionally, the standard and amendments take a wholistic view of
the audit by requiring the auditor to consider the links and
relationships between a company's related party transactions and
significant unusual transactions. For example, the auditor's work in
identifying and evaluating significant unusual transactions should
assist the auditor in identifying and evaluating related parties, or
transactions with related parties previously undisclosed to the
auditor. Emphasizing the complementary nature of the auditor's efforts
regarding these areas should help the auditor to ``connect the dots''
between different aspects of the audit. The complementary approach is
intended to enhance audit efficiency as well as audit effectiveness in
that it may increase the probability of the auditor's uncovering
potential material fraud or error in a company's financial statements.
    Likewise, the standard and amendments are aligned with the Board's
risk assessment standards and, thus, should enhance the auditor's
overall risk assessment more generally by making the auditor more
effective in identifying and assessing risks of material misstatement
in the critical areas, and in designing and performing better audit
procedures to address such risks. Additionally, the standard and
amendments feature a scaled approach that requires the auditor to
supplement the basic required procedures with more in-depth procedures
in response to risks identified. Alignment with the risk assessment
standards and the use of a scaled approach promotes a cohesive audit
approach that should contribute to improved audit quality and provide
opportunities for efficient implementation.
    The auditor's heightened attention to transactions in the critical
areas also could result in the auditor obtaining more information about
the company's financial position. For example, the standards and
amendments emphasize the auditor's understanding of the business
purpose (or the lack thereof) of transactions in the critical areas. A
better understanding of the business purpose should better position the
auditor to understand and address such transactions, which often pose
difficult measurement and recognition issues, due to factors such as
transaction structure, complexity, and/or relationship to company
financial targets. Such an approach should promote audit quality by
providing the auditor with more insight into the nature of transactions
in the critical areas, which could allow the auditor to better evaluate
whether the financial statements are fairly stated.
    The auditor's increased attention to the critical areas also may
result in increased attention by companies to their accounting and
disclosures, which could result in higher quality financial reporting.
Higher quality financial reporting improves the quality of information
available to the market and reduces information asymmetry between
investors and company management. Improving the quality of financial
reporting can reduce investors' uncertainty about the information being
provided in company financial statements, foster increased public
confidence in the financial markets, and enhance capital formation and
the efficiency of capital allocation decisions. Research shows that
decreasing the level of information asymmetry reduces the cost of
capital for issuers.\213\ In addition, if management produces more
accurate disclosures, research shows that this increased quality of
disclosures to financial statement users also reduces the cost of
capital.\214\
---------------------------------------------------------------------------

    \213\ See David Easley and Maureen O'Hara, 2004. Information and
the Cost of Capital. The Journal of Finance 59 (4): 1553-1583.
    \214\ See Richard A. Lambert, Christian Leuz, and Robert E.
Verrecchia, 2012. Information Asymmetry, Information Precision, and
the Cost of Capital. Review of Finance 16 (1): 1-29.
---------------------------------------------------------------------------

    Further, new audit committee communication requirements would
promote communications regarding, and improve the auditor's
understanding of, the critical areas. For example, the auditor's
understanding of related party transactions would be informed by an
initial audit committee communication during the risk assessment that
is intended to help the auditor identify the company's significant
related party transactions, as well as to inform the auditor of any
concerns audit committee members may have regarding the company's
relationships or transactions with its related parties. Later in the
audit, the auditor is required to discuss with the audit committee the
auditor's evaluation of the company's identification of, accounting
for, and disclosure of, the company's related

party transactions, including any that were previously undisclosed to
the auditor. In addition, improving the auditor's understanding of: (i)
The business purpose (or the lack thereof) of a company's significant
unusual transactions and (ii) a company's financial relationships and
transactions with its executive officers, can enhance already existing
required audit committee communications related to significant unusual
transactions and significant risks.
    These improved communication requirements should result in both
auditors and audit committees becoming better informed and thus better
equipped to fulfill their respective roles in the company's financial
reporting. Through these communications, the auditor becomes better
informed about the company, enabling the auditor to be more effective
in identifying and addressing risks of material misstatement in the
company's financial statements. A better informed audit committee can
contribute to management oversight, which may lead management to
improve the company's financial reporting. As noted above, research has
indicated that improving the quality of financial reporting reduces
investors' uncertainty about the information being provided in
companies' financial reports and, thus, increases efficiency in capital
allocation and fosters capital formation. For example, increased level
and/or quality of financial reporting has been found to decrease the
cost of equity, decrease the cost of debt, and decrease bid-ask
spreads.\215\
---------------------------------------------------------------------------

    \215\ See Christine A. Botosan, and Marlene A. Plumlee. 2002. A
Re-examination of Disclosure Level and the Expected Cost of Equity
Capital, 40 Journal of Accounting Research 21-40, (2002), Partha
Sengupta, Corporate Disclosure Quality and the Cost of Debt., 73 The
Accounting Review 459-474, (1998), and Michael Welker, Disclosure
Policy, Information Asymmetry, and Liquidity in Equity Markets, 11
Contemporary Accounting Research 801-827 (1995), respectively.
---------------------------------------------------------------------------

    Commenters largely agreed with the Board that the standard and
amendments could improve audit quality. In addition, specific benefits
suggested by commenters included: (i) Higher quality financial
statement disclosures; (ii) improving investors' confidence in audited
financial statements; (iii) improving the audit's effectiveness and
informational value; (iv) more relevant consideration of issues facing
the company; (v) increasing audit committee knowledge; and (vi)
improving the audit committees' abilities to fulfill their duties.
Additionally, another commenter stated that management may be more
attentive to written procedures and responsibilities for related party
transactions as a result of the reproposed standard. Specific comments
in each area include:
     Relationships and Transactions With Related Parties: Many
commenters stated that the reproposed standard would improve the
auditor's overall understanding of a company's relationships and
transactions with its related parties. Some commenters suggested that
obtaining such an understanding would: (i) Assist the auditor in
obtaining sufficient appropriate audit evidence and increase the
likelihood of identifying material misstatements; and (ii) enhance the
exercise of professional skepticism in the performance of the audit.
     Significant Unusual Transactions: A few commenters
suggested that requiring procedures to improve the auditor's
identification and evaluation of a company's significant unusual
transactions could improve audit quality by: (i) Increasing the
likelihood of identifying material misstatements; (ii) promoting the
exercise of professional skepticism; (iii) improving financial
statement disclosures; and (iv) improving audit committees' abilities
to fulfill their duties.
     Financial Relationships and Transactions with Executive
Officers: Commenters providing views on audit quality issues indicated
that obtaining an understanding of a company's financial relationships
and transactions with its executive officers could improve audit
quality by: (i) Improving the auditor's identification of risks of
material misstatement; (ii) resulting in more relevant audit testing;
and (iii) improving the auditor's assessment of fraud risk.
    With respect to the baseline, the Board notes that, as described
previously, some firms may perform procedures that go beyond existing
requirements. Consequently, the application of the standard and
amendments should generate greater benefits to audits of companies
whose auditors are not currently performing a comprehensive risk-based
audit or are performing only the most cursory of procedures under AU
sec. 334. Benefits also include promoting consistency in audit
practices among audit firms by establishing auditor performance
requirements.
Costs
    In general, the Board recognizes that imposing new requirements
will involve some additional audit effort and related costs, both to
audit firms and companies.
    The Board anticipates costs include direct compliance costs to
auditors that will reflect changes necessary to address the
introduction of new requirements. The Board anticipates initial and
ongoing costs for audit firms will include costs for updating and
maintaining methodologies and audit programs, implementation, and staff
training. Additionally, depending on the degree of effort currently
expended by audit firms, there may be increased costs in terms of
incremental audit effort, including increased audit partner time, and
potential costs for the time of specialists to review complex
transactions.
    The increased audit effort and resulting costs may be limited as
the standard and amendments are based on the Board's existing risk
assessment standards and retain many existing auditing concepts and
procedures that are common in practice today. For example, AU sec. 334
suggests procedures for the auditor's consideration, certain of which
have been incorporated into the standard as specific required
procedures. To the extent that audit firms have already incorporated
these procedures into their current practices, those firms should incur
lower costs in updating their methodologies. As a result, costs should
be greater where auditors are not currently performing a comprehensive
risk-based audit or are performing only the most cursory of procedures
under AU sec. 334. In general, audit firms that audit companies of all
sizes were supportive of the Board's efforts to improve audit quality
in the critical areas and did not raise concerns regarding costs or
provide data regarding the extent of such costs for the Board's
consideration.
    To the extent that there are increased costs for auditors as a
result of the application of the standard and amendments, such costs
may be passed on, in whole, or part (or not at all), to companies and
their investors in the form of higher audit fees.\216\ The Board

is aware, however, that there may be increased costs for companies
whose auditors must change their methodologies and practices to address
the new requirements. These potential costs to companies include
increased audit fees and costs for the additional time and expense of
responding to auditor inquiries.
---------------------------------------------------------------------------

    \216\ It is not clear to what extent the increased auditor
performance requirements would result in increased audit fees. The
Board is aware of public reports that have analyzed historical and
aggregate data on audit fees, and which suggest that audit fees
generally have remained stable in recent years, notwithstanding the
fact that the Board and other auditing standard-setters have issued
new standards during that period. See, e.g., Audit Analytics Audit
Fees and Non-Audit Fees: An Eleven Year Trend (July 2013). Because
amendments to, and adoption of, new Board standards typically
involve discrete parts of an audit, which is not accounted for, or
priced, on a standard-by-standard basis, it is difficult to obtain
data that isolates the costs of particular new audit standards, and
that would be comparable between firms. In its reproposal, the Board
sought data that might provide information or insight into such
costs. As noted above, commenters did not provide data regarding the
extent of such costs.
---------------------------------------------------------------------------

    Additionally, other costs could include costs associated with
enhanced audit committee communications, to the extent the areas
addressed by the standard and amendments are not already discussed.
Company audit committees may require additional time and expense to
participate in new audit committee communication relating to related
party transactions and also may require expanded discussions relating
to significant unusual transactions. While companies may need
additional time or resources to conduct the new audit committee
communications, the standard and amendments build on, and work in
concert with, the approach taken in Auditing Standard No. 16. Thus, the
new requirements in this area provide additional substance for an
integrated meeting with the audit committee. This should not add
significantly to the time or resources companies spend with respect to
audit committee communications.
    The Board also considered potential unintended consequences in
conjunction with its consideration of costs. For example, the Board
considered whether, to the extent that potential costs stemming from
the standard and amendments increase audit costs related to
transactions with related parties, this could serve as a deterrent
against their use. In such cases, any cost advantage a company may have
from engaging in related party transactions during its normal course of
operations could be reduced by higher audit-related costs.
    Two commenters provided their views that the reproposed standard
and amendments could serve as a deterrent against the use of related
party transactions. One commenter suggested that requiring auditors to
obtain evidence supporting management's arm's-length assertion
regarding a related party transaction had corresponding negative
economic consequences, such as, management avoiding the use of related
party transactions. Another commenter that stated that the increased
audit effort will result in a pass through of marginally higher audit
costs to companies also noted that there could be changed behavior in
structuring transactions so that they are not related party
transactions.
    The Board considered these comments and acknowledges that, as noted
in the reproposal, potential costs stemming from the standard and
amendments could increase audit costs related to transactions with
related parties, which could conceivably serve as a deterrent against
their use. While the Board recognizes this potential, the Board notes
that companies are already required to disclose material related party
transactions in their financial statements, and auditors already should
be performing some procedures, under the existing standards, with
respect to these transactions and related disclosures. Additionally, in
considering these comments, the Board notes that the requirement in the
standard for auditors to obtain evidence supporting management's arm's-
length assertion regarding a related party transaction is consistent
with the requirement in AU sec. 334.12, as applicable financial
reporting frameworks only permit an arm's-length assertion regarding a
related party transaction to be included in the financial statements
when supported by evidence.
    In general, the Board's assessment of the impact of the adoption of
the standard and amendments relative to costs was informed by the fact
that commenters did not raise issues regarding costs that were
inconsistent with those described by the Board in its reproposal.
Additionally, while some commenters noted that there would be some
increased costs to audit firms and companies, they did not provide data
regarding the extent of such costs. A number of commenters suggested
that the costs of the standard and amendments were appropriate. For
example, one commenter stated that the benefits of the reproposed
standard and amendments would outweigh the associated costs. Another
commenter stated that the reproposed standard and amendments benefit
users without placing too high a burden on preparers or auditors.
However, a few commenters indicated that the costs associated with the
standard and amendments may be difficult to measure prior to
implementation.
    One commenter stated that the reproposed standard and amendments
would not require significant incremental management or auditor
resources, but resources required could be meaningfully greater for
companies with a significant number of related party transactions or
significant unusual transactions. Several other commenters also
indicated that smaller audit firms might be disproportionately impacted
by the Board's reproposal. However, commenters in general noted that
the standard and amendments were appropriate for, and should apply to,
audits of companies of all types and sizes, including broker-dealers
and EGCs. As noted above, the Board received comments from a wide
spectrum of commenters, including firms that audit companies of various
sizes. Further discussion of the potential impact on smaller audit
firms and smaller companies is discussed below.
Smaller Audit Firms and Smaller Companies
    The Board recognizes that the adoption of the standard and
amendments may impose disproportionally greater costs on smaller audit
firms than on larger audit firms. For example, the one-time costs to
update audit methodologies and training may represent a relatively
larger share of audit costs for smaller audit firms compared to larger
audit firms. Further, to the extent that a smaller audit firm has not
already incorporated procedures suggested by AU sec. 334 into its
current practices, such a firm would likely incur higher incremental
costs to comply with the standard and amendments.
    As described above, the costs incurred by the auditor to comply
with the standard and amendments may be passed on, in whole, or in part
(or not at all), to companies and their investors in the form of
increased audit fees. To the extent this occurs, it may particularly
affect smaller companies that rely on related party transactions as
part of their business model. This point also was asserted by some
commenters on the proposal and reproposal, many of whom also noted the
particular risks posed by related party transactions engaged in by
smaller companies. Increasing the costs of audits for smaller companies
could negatively impact their profitability.
    In considering this potential impact, the Board also has taken note
of its oversight findings, which indicate that the audits of smaller
companies are more frequently the subject of inspection findings and
enforcement actions that involve related party transactions.
Additionally, the Board notes that there is likely less information
available regarding smaller companies (e.g., they have fewer brokerage
research analysts, and less press coverage). Thus, while there is the
potential for greater cost impact on

smaller companies arising from the standard and amendments, there is
also the potential that investors in such companies would accrue
relatively larger benefits from the standard and amendments, such as a
lower cost of capital.
    As noted above, the Board believes that any additional audit costs
would likely vary based on the size and complexity of the company's
transactions in the critical areas, and would be commensurate with the
risk of material misstatement arising out of such transactions. As
noted in the reproposing release, a company that has extensive
relationships and transactions with related parties or significant
unusual transactions, or that has financial relationships and
transactions with executive officers that give rise to risks of
material misstatement, could anticipate a greater increase in audit-
related costs than a company without such relationships or
transactions.\217\ Thus, the Board would not expect there to be a
significant increase in audit fees for a company that does not have
complex or extensive: (i) Relationships or transactions with related
parties; (ii) significant unusual transactions; or (iii) financial
relationships and transactions with the company's executive officers.
In addition, to the extent that some auditors are already performing
procedures similar to those in the standard and amendments, there would
be a lesser impact. However, if the auditor identifies related parties
or relationships or transactions with related parties that were
previously undisclosed to the auditor, there would be incremental
costs, as well as benefits, associated with the auditor's response to
the increased risks of material misstatement.
---------------------------------------------------------------------------

    \217\ See page A4-97 of the reproposing release.
---------------------------------------------------------------------------

Other Economic Considerations
    As noted above, commenters generally supported the Board's efforts
to promote audit quality in the areas addressed by the standard and
amendments. However, a few expressed concerns. For example, one
commenter acknowledged that the Board had reproposed the standard and
amendments to obtain more information regarding economic considerations
generally, but the commenter was nonetheless critical of the Board's
economic analysis in its reproposal. This commenter stated that the
Board had failed to provide adequate specifics in its reproposal
supporting the need for the standard and stated that the reproposal did
not adequately address potential alternatives to the proposed
requirements, including any rationale for not choosing to converge with
the IAASB and ASB standards, which, in that commenter's view,
introduced unnecessary complexity and cost. This same commenter also
asked why the Board thought it necessary to adopt new requirements
after the issuance of Staff Audit Practice Alert No. 5.
    The Board considered the issues raised by this commenter and
believes that the need for the standard and amendments, and the
alternatives considered by the Board, have been fully described in the
Board's proposals and throughout this release. The standards and
amendments being adopted represent a targeted approach that
appropriately responds to areas of the audit that have historically
represented risks of material misstatement in company financial
statements. In the Board's view, the need to improve the Board's
existing standards addressing the critical areas, including alignment
with the Board's risk assessment standards, cannot be adequately
addressed through staff interpretations of existing standards. More
specific requirements are warranted to promote heightened scrutiny in
the critical areas. While the new auditor performance requirements will
involve some additional effort and related costs in some cases, to
avoid unnecessary audit efforts and costs, the Board developed the
standard to align with existing audit procedures that the auditor
already is required to perform as part of the auditor's risk assessment
and requires the auditor to perform procedures that are commensurate
with the risks of material misstatement.
    The Board also considered the comment that the Board did not set
forth a rationale for not choosing to converge the proposed auditing
requirements with the standards of the IAASB and the ASB. As a matter
of practice, the Board regularly considers the work of other standard-
setters, such as the IAASB and the ASB, for insights as it develops its
standards. In developing the standard and amendments, the Board
considered the analogous standards of the IAASB and the ASB and
incorporated a number of similar audit procedures and requirements that
the Board believed were useful and appropriate.\218\
---------------------------------------------------------------------------

    \218\ For example, paragraph 5 of the standard being adopted by
the Board contains similar requirements to paragraph 13 of ISA 550
(and paragraph 14 of AU-C 550), which require the auditor to inquire
of management regarding: The identity of the entity's related
parties, including changes from the prior period; the nature of the
relationships between the entity and these related parties; and
whether the entity entered into any transactions with these related
parties during the period and, if so, the type and purpose of the
transactions.
---------------------------------------------------------------------------

    The Board, however, has determined that the critical areas require
heightened scrutiny and, thus, the standard and amendments contain
auditing requirements that are not reflected in the analogous standards
of the IAASB and the ASB. For example, the standard and amendments
contain requirements for the auditor to focus heightened audit
attention on the business purpose (or the lack thereof) of a company's
related party transactions.\219\ Also, in view of the importance of the
audit committee's role in the oversight of the company's financial
reporting, the standard requires the auditor to make inquiries of the
audit committee (or its chair) regarding the audit committee's
understanding of the company's related parties and transactions, as
well as regarding whether any member of the audit committee has
concerns regarding such matters. Additionally, the other amendments
require the auditor to perform risk assessment procedures to obtain an
understanding of a company's financial relationships and transactions
with its executive officers.
---------------------------------------------------------------------------

    \219\ See, e.g., paragraphs 5.d., 12.a., and 19.e. of the
standard.
---------------------------------------------------------------------------

    Two commenters raised concerns regarding economic considerations of
a more general nature, suggesting that the Board develop a specific
framework for considering costs and benefits more generally. The Board
has addressed these matters separately.\220\
---------------------------------------------------------------------------

    \220\ See, e.g., PCAOB Strategic Plan: Improving the Quality of
the Audit for the Protection and Benefit of Investors 2013-2017
(November 26, 2103) at 5 and 13, and PCAOB Releases Staff Guidance
on Economic Analysis in PCAOB Standard Setting (May 15, 2014) http://pcaobus.org/News/Releases/Pages/05152014_Economic_Analysis.aspx.
---------------------------------------------------------------------------

    Finally, in its reproposal, the Board specifically asked for
comment regarding any considerations relating to efficiency,
competition and capital formation that the Board should take into
account with respect to the reproposed standard and amendments. Other
than the general comments described above, the Board did not receive
comments noting specific concerns regarding efficiency, competition and
capital formation in response to its request.
    In summary, after considering these factors and public comments,
the Board believes that its new requirements reflect a reasoned
approach that considers and is intended to limit unnecessary audit
effort and related costs.

Economic Considerations Pertaining to Audits of EGCs, Including
Efficiency, Competition, and Capital Formation
    The PCAOB has been monitoring implementation of the JOBS Act in
order to understand the characteristics of EGCs \221\ and inform the
Board's considerations regarding whether it should recommend that the
SEC apply the standard and amendments to audits of EGCs. To assist the
SEC, the Board is providing the following information regarding EGCs
that it has compiled from public sources.\222\
---------------------------------------------------------------------------

    \221\ Pursuant to the JOBS Act, an EGC is defined in Section
3(a)(80) of the Exchange Act. In general terms, an issuer qualifies
as an EGC if it has total annual gross revenue of less than $1
billion during its most recently completed fiscal year (and its
first sale of common equity securities pursuant to an effective
Securities Act of 1933 (the ``Securities Act'') registration
statement did not occur on or before December 8, 2011). See JOBS Act
Section 101(a), (b), and (d). Once an issuer is an EGC, the entity
retains its EGC status until the earliest of: (i) The first year
after it has total annual gross revenue of $1 billion or more (as
indexed for inflation every five years by the SEC); (ii) the end of
the fiscal year after the fifth anniversary of its first sale of
common equity securities under an effective Securities Act
registration statement; (iii) the date on which the company issues
more than $1 billion in non-convertible debt during the prior three
year period; or (iv) the date on which it is deemed to be a ``large
accelerated filer'' under the Exchange Act (generally, an entity
that has been public for at least one year and has an equity float
of at least $700 million).
    \222\ To obtain data regarding EGCs, the PCAOB's Office of
Research and Analysis has reviewed registration statements and
Exchange Act reports filed with the SEC with filing dates between
April 5, 2012, and November 20, 2013, for disclosures by entities
related to their EGC status. Only those entities that have
voluntarily disclosed their EGC status have been identified. The
PCAOB has not validated these entities' self-identification as EGCs.
The information presented also does not include data for entities
that have filed confidential registration statements and have not
subsequently made a public filing.
---------------------------------------------------------------------------

Characteristics of Self-Identified EGCs
    As of November 20, 2013, based on the PCAOB's research, 1,227 SEC
registrants had identified themselves as EGCs in SEC filings. These
companies operate in diverse industries. The five most common Standard
Industrial Classification (``SIC'') codes applicable to these companies
are codes for: (i) Blank check companies; (ii) pharmaceutical
preparations; (iii) real estate investment trusts; (iv) prepackaged
software services; and (v) computer processing/data preparations
services.
    The five SIC codes with the highest total assets as a percentage of
the total assets of the population of EGCs are codes for: (i) Federally
chartered savings institutions; (ii) real estate investment trusts;
(iii) national commercial banks; (iv) state commercial banks; and (v)
crude petroleum or natural gas. Total assets of EGCs in these five SIC
codes represent approximately 35% of the total assets of the population
of EGCs. EGCs in three of these five SIC codes (federally chartered
savings institutions, national commercial banks, and state commercial
banks) represent financial institutions and the total assets for these
three SIC codes represent approximately 22% of the total assets of the
population of EGCs.
    Approximately 19% of the EGCs identified themselves in registration
statements and were not previously reporting under the Exchange Act as
of November 20, 2013. Approximately 64% of the companies that have
identified themselves as EGCs began reporting under the Exchange Act in
2012 or later. The remaining 17% of these companies have been reporting
under the Exchange Act since 2011 or earlier. Accordingly, a majority
of the companies that have identified themselves as EGCs began
reporting information under the securities laws since 2012.
    Approximately 63% of the companies that have identified themselves
as EGCs and filed an Exchange Act filing with information on smaller
reporting company status indicated that they were smaller reporting
companies.\223\
---------------------------------------------------------------------------

    \223\ The SEC adopted its current smaller reporting company
rules in Smaller Reporting Company Regulatory Relief and
Simplification, Securities Act Release No. 33-8876 (December 19,
2007). Generally, companies qualify to be smaller reporting
companies (``SRCs'') and, therefore, have scaled disclosure
requirements if they have less than $75 million in public equity
float. Companies without a calculable public equity float will
qualify if their revenues were below $50 million in the previous
year. Scaled disclosure requirements generally reduce the compliance
burden of SRCs compared to other issuers. Notably, the only area in
which SRC requirements may be more extensive than requirements for
other issuers is with respect to the disclosure of related party
transactions. The SEC justified this difference in treatment based
on the importance of disclosing related party transactions,
particularly for issuers with lower materiality thresholds.
---------------------------------------------------------------------------

    Approximately 32% of the companies that have identified themselves
as EGCs provided a management report on internal control over financial
reporting. Of those companies that provided a report, approximately 46%
stated in the report that the company's internal control over financial
reporting was not effective.\224\
---------------------------------------------------------------------------

    \224\ For purposes of comparison, the PCAOB compared the data
compiled with respect to the population of companies that identified
themselves as EGCs with companies listed in the Russell 3000 Index
in order to compare the EGC population with the broader issuer
population. The Russell 3000 was chosen for comparative purposes
because it is intended to measure the performance of the largest
3,000 U.S. companies representing approximately 98% of the
investable U.S. equity market (as marketed on the Russell Web site).
To contrast, approximately 95% of the companies in the Russell 3000
Index provided a management report on internal control over
financial reporting. Of those companies that provided a management
report, approximately 4% stated in the report that the company's
internal control over financial reporting was not effective.
---------------------------------------------------------------------------

    Audited financial statements were available for nearly all of the
companies that identified themselves as EGCs.\225\ For those companies
for which audited financial statements were available and based on
information included in the most recent audited financial statements
filed as of November 20, 2013:
---------------------------------------------------------------------------

    \225\ Audited financial statements were available for 1,216 of
the 1,227 self-identified EGCs. Audited financial statements were
not available for some EGCs that had filed registration statements
that had not been declared effective by the SEC.