[Federal Register Volume 79, Number 207 (Monday, October 27, 2014)]
[Notices]
[Pages 63988-63991]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-25432]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-73396; File No. PCAOB-2014-01]
Public Company Accounting Oversight Board; Order Granting
Approval of Proposed Rules on Auditing Standard No. 18, Related
Parties, Amendments to Certain PCAOB Auditing Standards Regarding
Significant Unusual Transactions, and Other Amendments to PCAOB
Auditing Standards
October 21, 2014.
I. Introduction
On July 10, 2014, the Public Company Accounting Oversight Board
(the ``Board'' or the ``PCAOB'') filed with the Securities and Exchange
Commission (the ``Commission''), pursuant to Section 107(b) \1\ of the
Sarbanes-Oxley Act of 2002 (the ``Sarbanes-Oxley Act'') and Section
19(b) \2\ of the Securities Exchange Act of 1934 (the ``Exchange
Act''), proposed rules to adopt Auditing Standard No. 18, Related
Parties, amendments to certain PCAOB auditing standards regarding
significant unusual transactions, and other amendments to PCAOB
auditing standards, including required procedures to obtain an
understanding of a company's financial relationships and transactions
with its executive officers (collectively, the ``Proposed Rules'').\3\
The Proposed Rules were published for comment in the Federal Register
on July 24, 2014.\4\ At the time the notice was issued, the Commission
designated a longer period to act on the Proposed Rules, until October
22, 2014.\5\ The Commission received three comment letters in response
to the notice.\6\ This order approves the Proposed Rules.
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\1\ 15 U.S.C. 7217(b).
\2\ 15 U.S.C. 78s(b).
\3\ The Board originally proposed in February 2012 (``Original
Proposal'') and reproposed in May 2013 (``Reproposal'') what became
the Proposed Rules.
\4\ See Release No. 34-72643 (July 18, 2014), 79 FR 43163 (July
24, 2014).
\5\ Ibid.
\6\ See letters to the Commission from Suzanne H. Shatto, dated
July 23, 2014 (``Shatto Letter''); Tom Quaadman, Vice President,
Center for Capital Markets Competitiveness, U.S. Chamber of
Commerce, dated July 28, 2014 (``Chamber Letter''); and Deloitte &
Touche LLP, dated August 11, 2014 (``Deloitte Letter'').
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II. Description of the Proposed Rules
Related party transactions, significant unusual transactions, and a
company's financial relationships and transactions with its executive
officers are included together in the Proposed Rules because the PCAOB
believes the auditor's efforts in these areas are, in many ways,
complementary. For example, the auditor's efforts to identify and
evaluate a company's significant unusual transactions could identify
information that indicates that a related party or relationship or
transaction with a related party previously undisclosed to the auditor
might exist. Likewise, obtaining an understanding of a company's
financial relationships and transactions with its executive officers
also could identify information that indicates that a related party or
relationship or transaction with a related party previously undisclosed
to the auditor might exist.
1. Related Parties
Auditing Standard No. 18 will supersede AU section 334, Related
Parties (``AU sec. 334''), which primarily contains the existing
requirements for auditing relationships and transactions with related
parties. AU sec. 334 provides guidance and examples of procedures for
the auditor's consideration in identifying and evaluating related party
transactions. Auditing Standard No. 18 includes some auditing concepts
and procedures from AU sec. 334, but is intended to strengthen auditor
performance requirements for identifying, assessing, and responding to
the risks of material misstatement associated with a company's
relationships and transactions with its related parties by, among other
things, requiring the auditor to:
Perform specific procedures to obtain an understanding of
the company's relationships and transactions with its related parties,
including obtaining an understanding of the nature of the relationships
between the company and its related parties and of the terms and
business purposes (or the lack thereof) of transactions involving
related parties. The new procedures are required to be performed in
conjunction with the auditor's risk assessment procedures pursuant to
Auditing Standard No. 12, Identifying and Assessing Risks of Material
Misstatement.
Evaluate whether the company has properly identified its
related parties and relationships and transactions with its related
parties. In making that evaluation, the auditor performs procedures to
test the accuracy and completeness of management's identification,
taking into account information gathered during the audit. If the
auditor identifies information that indicates that undisclosed
relationships and transactions with a related party might exist, the
auditor is required to perform procedures necessary to determine
whether undisclosed relationships or transactions with related parties
in fact exist.
Perform specific procedures if the auditor determines that
a related party or relationship or transaction with a related party
previously undisclosed to the auditor exists.
Perform specific procedures regarding each related party
transaction that is either required to be disclosed in the financial
statements or determined to be a significant risk.\7\
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\7\ Auditing Standard No. 12 defines a significant risk as a
``risk of material misstatement that requires special audit
consideration.''
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Communicate to the audit committee the auditor's
evaluation of the company's identification of, accounting for, and
disclosure of its relationships and transactions with related parties,
and other significant matters arising from the audit regarding
[[Page 63989]]
the company's relationships and transactions with related parties.
2. Significant Unusual Transactions
Existing auditing requirements regarding significant unusual
transactions are principally contained in AU section 316, Consideration
of Fraud in a Financial Statement Audit (``AU sec. 316'').\8\
Specifically, AU sec. 316 requires the auditor, if he or she becomes
aware of significant unusual transactions during the course of the
audit, to gain an understanding of the business rationale of such
transactions and consider whether that rationale suggests the
transactions may have been entered into to engage in, or conceal,
fraud. The amendments regarding significant unusual transactions are
intended to improve AU sec. 316 and other PCAOB auditing standards by,
among other things:
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\8\ See AU secs. 316.66-.67.
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Requiring the auditor to perform procedures to identify
significant unusual transactions;
Requiring the auditor to perform procedures to obtain an
understanding of, and evaluate, the business purpose (or the lack
thereof) of identified significant unusual transactions; and
Adding factors for the auditor to consider in evaluating
whether significant unusual transactions may have been entered into to
engage in fraudulent financial reporting or conceal misappropriation of
assets.
In addition to targeted enhancements to AU sec. 316, the amendments
regarding significant unusual transactions would revise Auditing
Standard No. 12 and Auditing Standard No. 13, The Auditor's Responses
to the Risks of Material Misstatement. These amendments include some
changes intended to enhance the complementary linkages between the
auditor's work relating to significant unusual transactions and related
party transactions. The amendments regarding significant unusual
transactions also include conforming changes to other PCAOB auditing
standards to provide for consistency in the use of the term
``significant unusual transactions'' throughout the Board's
standards.\9\
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\9\ The Proposed Rules describe ``significant unusual
transactions'' as ``significant transactions that are outside the
normal course of business for the company or that otherwise appear
to be unusual due to their timing, size, or nature.''
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3. Other Amendments
Additional amendments are intended to provide for improved audit
procedures in complementary areas, including requiring that the auditor
perform procedures, as part of the auditor's risk assessment, to obtain
an understanding of the company's financial relationships and
transactions with its executive officers.\10\ These new procedures are
intended to heighten the auditor's attention to incentives or pressures
for the company to achieve a particular financial position or operating
result, recognizing the key role that a company's executive officers
may play in the company's accounting decisions or in a company's
financial reporting.
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\10\ The PCAOB notes that the other amendments do not change the
existing requirement in its risk assessment standards for the
auditor to consider obtaining an understanding of compensation
arrangements with senior management as part of obtaining an
understanding of the company. Rather, the Board states that the
population for the procedures required by the other amendments is
the list of ``executive officers,'' as defined in Rule 3b-7 of the
Exchange Act or included on Schedule A of Form BD, as applicable,
while the existing requirement continues to apply to what may be a
larger population of a company's management. 17 CFR 240.3b-7 and 17
CFR 249.501.
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In response to requests for clarification received by the PCAOB as
part of its comment process, the Proposed Rules explicitly provide that
the auditor's work relating to a company's financial relationships and
transactions with its executive officers does not include an assessment
of the appropriateness or reasonableness of executive compensation
arrangements. The Commission believes the PCAOB's clarification is
responsive and appropriate since such assessments would have resulted
in a significant unintended change to the current objectives of the
audit, which are focused on risks of material misstatement of the
financial statements.
In addition to the amendments relating to financial relationships
and transactions with executive officers, the Board adopted amendments
to revise other auditing standards to conform them to the Proposed
Rules and, where appropriate, include new requirements that complement
the Proposed Rules. For example, the Board adopted amendments to AU
section 333, Management Representations (``AU sec. 333''), to require a
representation that management has made available to the auditor the
names of all related parties and relationships and transactions with
related parties. Additionally, among others, the Board adopted
amendments to AU sec. 333 to require a written representation from
management that there are no side agreements or other arrangements
(either written or oral) undisclosed to the auditor. Other new
requirements complement the requirements in the Proposed Rules through
improvements to the auditor's: (i) Communications with a predecessor
auditor; (ii) procedures during the period subsequent to the balance-
sheet date, but prior to the issuance of the financial statements; and
(iii) procedures during reviews of interim financial information.
The PCAOB has proposed application of its Proposed Rules to audits
of all issuers, including audits of emerging growth companies
(``EGCs''),\11\ as discussed in Section IV. below. The Proposed Rules
also would apply to audits of SEC-registered brokers and dealers.\12\
The Proposed Rules would be effective for audits of financial
statements for fiscal years beginning on or after December 15, 2014,
including reviews of interim financial information within these fiscal
years.
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\11\ The term ``emerging growth company'' is defined in Section
3(a)(80) of the Exchange Act. 15 U.S.C. 78c(a)(80).
\12\ On July 30, 2013, the Commission adopted amendments to Rule
17a-5 under the Exchange Act to require, among other things, that
audits of brokers' and dealers' financial statements be performed in
accordance with the standards of the PCAOB for fiscal years ending
on or after June 1, 2014. 17 CFR 240.17a-5. See Broker-Dealer
Reports, Release No. 34-70073, (July 30, 2013), 78 FR 51910 (August
21, 2013), available at http://www.sec.gov/rules/final/2013/34-70073.pdf.
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III. Comment Letters
As noted above, the Commission received three comment letters
concerning the Proposed Rules. Two commenters expressed support for the
Proposed Rules.\13\ One of these commenters also expressed a desire for
an earlier effective date.\14\ The final commenter raised concerns
regarding the substance of the PCAOB's economic analysis and
consideration of cost-benefit analysis upon EGCs.\15\
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\13\ See Shatto Letter and Deloitte Letter.
\14\ See Shatto Letter, which also raised a number of other
points with respect to brokers and dealers, but those points are
outside the scope of the PCAOB's Proposed Rules.
\15\ See Chamber Letter.
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1. Effective Date
The PCAOB describes the rationale as to the effective date, which
was established to allow for sufficient time for registered firms to
incorporate the new requirements into methodologies, guidance, audit
programs, and staff training. The Commission believes the Proposed
Rules' effective date is not unreasonable in order to provide
sufficient time for proper implementation by registered firms.
2. Economic Analysis
One commenter raised concerns regarding the substance of the
PCAOB's economic analysis and its consideration
[[Page 63990]]
of EGCs. The commenter stated that it expressed these concerns in
previous comment letters to the PCAOB, and in its opinion, those
concerns have not been considered or addressed by the PCAOB. This
commenter's principal concerns are addressed below.
In its comment letter on the Original Proposal, the
commenter stated that the proposal did not contain a cost-benefit
analysis.
The Board presented, and sought comment on, an economic analysis in
the Reproposal. Further, in response to comments on the economic
analysis provided in the Reproposal, the Board revised its analysis as
presented in its release accompanying the Proposed Rules (``Final Rule
Release'').
In its comment letter on the Reproposal, the commenter
stated that the economic analysis was composed of a number of
assertions that were generic and speculative in nature, and were not
linked to the elements of the proposal.
In the economic analysis provided in the Final Rule Release, the
Board refined the analysis included with the Reproposal, including by
linking the elements of the analysis closer to the elements of the
Proposed Rules. Specifically, the Board's refined analysis set forth:
(1) A description of the need for the standard-setting, and how the
Proposed Rules address the need; (2) the baseline to consider the
economic impacts of the Proposed Rules; (3) the Board's approach and
consideration of alternatives; (4) the economic impacts of the Proposed
Rules including benefits, costs, effects on different categories of
audit firms and smaller companies, and responses to comments received
on the economic analysis included with the Reproposal; and (5) economic
considerations pertaining to audits of EGCs, including efficiency,
competition and capital formation. The Board also acknowledged
challenges in considering the economic impacts, such as the challenges
of quantifying the economic impact of changes to audit standards, and
explained how the Board addressed those challenges.
In its comment letter on the Reproposal, the commenter
stated that the economic analysis fails to explicitly articulate any
appropriate economic baseline against which to measure the proposed
requirements' likely economic impact.
The Board presented an economic baseline within Appendix 5 of the
Final Rule Release, which the Board used in its economic analysis as a
benchmark for comparing against the Proposed Rules. The Board's
discussion of the baseline includes both existing requirements and
current audit practices, where the latter is determined based on
information from the Board's oversight activities, including its
inspection findings. The Board's analysis of the baseline shows that
audit practices associated with the areas addressed by the Proposed
Rules are inconsistent across firms.
In its comment letter on the Reproposal, the commenter
stated that the Reproposal contains no substantive analysis of the
economic impact of the proposed requirements on EGCs, EGCs vis-
[agrave]-vis other companies, or companies generally.
The economic analysis presented in the Final Rule Release presents
the Board's economic considerations of the Proposed Rules both for
companies generally and specifically for EGCs. Broadly, the Board
believes that the areas addressed by the Proposed Rules are challenging
areas warranting additional audit effort and focus. The Board notes
that EGCs will incur some incremental costs because costs may be
disproportionately higher for smaller companies, including EGCs.\16\
However, the Board notes that EGCs may benefit more from the Proposed
Rules because, as compared to non-EGCs, related party transactions are
more common and there is a higher likelihood for control deficiencies,
which may result in a higher risk of material misstatement associated
with related party transactions.
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\16\ See Section IV below for further information regarding the
PCAOB's EGC analysis.
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The analysis includes the relevant views of those who commented on
the Reproposal on the economic effects of the Proposed Rules on EGCs.
Further, the Board notes that the Proposed Rules are designed to
mitigate cost impacts by aligning the auditor's efforts with the risk
assessment standards and providing opportunities for a scaled approach
depending on the size and complexity of the company being audited. The
Board states that this alignment with risk assessment allows auditors
to integrate audit effort where appropriate and thereby avoid
unnecessary audit effort. Finally, the Board's analysis takes into
account the view from certain commenters on the Reproposal that it may
be more costly not to apply the Proposed Rules to audits of EGCs
because it would require firms to maintain two audit methodologies. The
Commission believes that the Board's economic analysis reasonably
addresses the comment raised, and as discussed further in Section IV,
based on the analysis submitted, the Commission believes the
information in the record is sufficient for the Commission to make the
requested EGC determination in relation to the Proposed Rules.
In its comment letter on the Reproposal, the commenter
stated that the Reproposal does not adequately address potential
alternatives.
The Final Rule Release discussed the Board's consideration of
alternatives to the Proposed Rules. In response to the commenter's
suggestion that the Reproposal did not discuss why PCAOB Staff Audit
Practice Alert No. 5, Auditor Considerations Regarding Significant
Unusual Transactions (``Practice Alert''),\17\ was inadequate, the
Board stated that the Practice Alert 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 Practice Alert only
highlights circumstances for auditor consideration, it did not alter
audit requirements with respect to significant unusual transactions.
The Board concluded, based in part on the results of its oversight
activities following the issuance of the Practice Alert, that it was
appropriate to develop standards with more specific requirements to
promote heightened scrutiny in the areas addressed by the Proposed
Rules. Further, the Board stated that the need to improve the existing
standards in these areas, including alignment with the Board's risk
assessment standards, cannot be adequately addressed through staff
interpretations of existing standards.
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\17\ See http://pcaobus.org/Standards/QandA/04-07-2010_APA_5.pdf
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In response to the commenter's statement that the Board did not
analyze why it chose not to converge the Proposed Rules with similar
standards of the International Auditing and Assurance Standards Board
(``IAASB'') and the Auditing Standards Board of the American Institute
of Certified Public Accountants (``ASB''), the Board states in its
Final Rule Release that it 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.\18\ The Board, however, determined that the areas
addressed by the Proposed Rules require heightened scrutiny, and, thus,
the Proposed Rules
[[Page 63991]]
contain auditing requirements that are not reflected in the analogous
standards of the IAASB and the ASB. Further, the Commission notes that
the Board has received similar comments in the past and has thus
previously addressed its consideration of the work of other standard-
setters generally. \19\ The Commission also addressed similar comments
in connection with its consideration of other rules proposed by the
PCAOB.\20\ As it relates to the Proposed Rules, the Commission notes
the PCAOB's efforts to consider the analogous standards of the IAASB
and the ASB. Thus, while the Commission continues to encourage the
PCAOB to consider the work of other standard-setters, there remain a
variety of reasons why the Board's standards may differ from the
standards of the IAASB and ASB, and we believe the Board has provided a
reasonable explanation for the differences here.
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\18\ For examples of similar audit procedures and requirements,
see footnote 86 on page A5-46 of the Final Rule Release.
Additionally, Appendix 6 of the Final Rule Release compares certain
significant differences between the objective and certain key
requirements of the Proposed Rules and analogous standards of the
IAASB and the ASB.
\19\ For example, in the Board's adopting release for its risk
assessment standards it stated the following:
``[B]ecause the Board's standards must be consistent with the
Board's statutory mandate, differences will continue to exist
between the Board's standards and the standards of the IAASB and
ASB, e.g., when the Board decides to retain an existing requirement
in PCAOB standards that is not included in IAASB or ASB standards.
Also, certain differences are often necessary for the Board's
standards to be consistent with relevant provisions of the federal
securities laws or other existing standards or rules of the Board.
Also, the Board's standards-setting activities are informed by and
developed to some degree, in response to observations from its
oversight activities.''
See PCAOB Release No. 2010-004, August 5, 2010, pp. A10-91--A10-
92 (internal footnotes omitted).
\20\ See Release No. 34-63606 (December 23, 2010), 75 FR 82417
(December 30, 2010) and Release No. 34-68453 (December 17, 2012), 77
FR 75689 (December 21, 2012).
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Finally, in its comment letter to the Commission, the
commenter recommended ``that the SEC return the [Proposed Rules] to the
PCAOB for a cost benefit analysis that complies with the [Jumpstart Our
Business Startups] Act and allows stakeholders to understand the costs
and benefits . . .'' Further, the commenter stated that the Proposed
Rules add to audit complexity and raise doubt that the proposed
requirements would be cost-benefit effective.
The Commission notes that the Board provided a detailed qualitative
analysis that took into account the views of commenters. As the Board
explained, there was limited research and data available regarding
economic costs and benefits of the Proposed Rules, making reliable
quantification difficult. Further, as part of the Board's process
through its issuance of the Original Proposal and the Reproposal, the
Board requested empirical data regarding costs and benefits specific to
the Proposed Rules, and commenters did not provide any. The Commission
observes that Section 103(a)(3)(C) of the Sarbanes-Oxley Act, the
relevant statutory provision added by the Jumpstart our Business
Startups (``JOBS'') Act, does not require a detailed, quantitative
cost-benefit analysis.\21\ Consistent with the responses to the
commenter's specific concerns enumerated above, the Board states that
it designed the Proposed Rules to minimize complexity by aligning the
auditor's efforts with the risk assessment standards and providing
opportunities for a scaled approach depending on the size and
complexity of the company being audited.
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\21\ See National Association of Manufacturers v. SEC, 748 F.3d
359, 369 (D.C. Cir. 2014) (stating that ``[a]n agency. . . need not
conduct a `rigorous, quantitative economic analysis' unless the
statute explicitly directs it to do so''), partially overruled on
other grounds by American Meat Institute v. U.S. Department of
Agriculture, 760 F.3d 18 (D.C. Cir. 2014) (en banc).
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IV. The PCAOB's EGC Request
Section 103(a)(3)(C) of the Sarbanes-Oxley Act provides that any
additional rules adopted by the PCAOB subsequent to April 5, 2012 do
not apply to the audits of EGCs, unless the Commission determines that
the application of such additional requirements is necessary or
appropriate in the public interest, after considering the protection of
investors and whether the action will promote efficiency, competition,
and capital formation.\22\ Having considered those factors, and as
explained further herein, the Commission finds that applying the
Proposed Rules to audits of EGCs is necessary or appropriate in the
public interest.
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\22\ Section 103(a)(3)(C) of the Sarbanes-Oxley Act, as amended
by Section 104 of the JOBS Act.
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In proposing application of the Proposed Rules to audits of all
issuers, including EGCs, the PCAOB requested that the Commission make
the determination required by Section 103(a)(3)(C). To assist the
Commission in making its determination, the PCAOB prepared and
submitted to the Commission its own EGC analysis. The PCAOB's EGC
analysis includes discussions of characteristics of self-identified
EGCs and economic considerations pertaining to audits of EGCs,
including efficiency, competition, and capital formation. In its
analysis, the Board states, among other things, that applying the
Proposed Rules to the audits of EGCs may be particularly pertinent
because of the characteristics of EGCs (e.g., potential for higher
rates of material weaknesses in internal control, use of related party
transactions, and substantial doubt about the company's ability to
continue as a going concern). In fact, the Board's oversight activities
have identified a significant number of findings regarding related
party transactions in audits of financial statements of smaller public
companies, which have characteristics that are similar to EGCs.
The PCAOB's EGC analysis was included in the Commission's public
notice soliciting comment on the Proposed Rules.\23\ Based on the
analysis submitted, we believe the information in the record is
sufficient for the Commission to make the requested EGC determination
in relation to the Proposed Rules. The Commission also takes note, in
particular, of the PCAOB's approach to the Proposed Rules, which are
intended to build upon existing requirements in the areas addressed by
them; align with the auditor's efforts in complying with the risk
assessment standards; and provide opportunities for scaling based on
the facts, circumstances, and risks of the particular company under
audit.
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\23\ One comment letter, as discussed above in Section III, was
received relating to the PCAOB's EGC analysis. See Chamber Letter.
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V. Conclusion
The Commission has carefully reviewed and considered the Proposed
Rules and the information submitted therewith by the PCAOB, including
the PCAOB's EGC analysis, and the comment letters received. In
connection with the PCAOB's filing and the Commission's review.
A. The Commission finds that the Proposed Rules are consistent with
the requirements of the Sarbanes-Oxley Act and the securities laws and
are necessary or appropriate in the public interest or for the
protection of investors; and
B. Separately, the Commission finds that the application of the
Proposed Rules to EGC audits is necessary or appropriate in the public
interest, after considering the protection of investors and whether the
action will promote efficiency, competition, and capital formation.
It is therefore ordered, pursuant to Section 107 of the Sarbanes-
Oxley Act and Section 19(b)(2) of the Exchange Act, that the Proposed
Rules (File No. PCAOB-2014-01) be and hereby are approved.
By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-25432 Filed 10-24-14; 8:45 am]
BILLING CODE 8011-01-P