The notion that related-party transactions require heightened scrutiny has a long history. Transactions with related parties have historically been associated with misstatements and fraud. Several prominent frauds—Refco, Enron, Adelphia, and Tyco—serve as familiar examples. New guidance from the PCAOB in the form of AS 18 should lead to increased auditor scrutiny of the relationships and transactions, and result in improved audits.

1. T
he PCAOB’s issuance of Auditing
Standard (AS) 18, Related Parties,
in June 2014 provides an opportu-
nity to review the historical role of
related parties in auditing standards and
in practice, as well as analyze the new stan-
dard’s relation to this context. The notion
that related-party transactions require
heightened scrutiny has a long history.
Related parties, as well as the relationships
and transactions that a company has with
them, have also historically been associat-
ed with material misstatements, particu-
larly those resulting from fraud. This dis-
cussion explores those associations and
uses prominent fraud cases to illuminate
the new requirements.
Historical Association with Increased
Risk and Fraud
When the fundamental standards of
GAAS were first adopted in 1947, the
discussion included the following obser-
vation as an example of relative risk:
Arm’s length transactions with outside
parties are usually subjected to less
detailed scrutiny than intercompany
transactions or transactions with officers
and employees, where the same degree
of disinterested dealing cannot be
assumed (AICPA, “Tentative Statement
of Auditing Standards—Their General-
ly Accepted Significance and Scope,”
October 1947).
The development of the first auditing
pronouncement devoted exclusively to
related parties began as a response to the
case of Continental Vending [U.S. v.
Simon, 425 F.2d 796 (2d Cir. 1969)]. The
president of Continental Vending used an
affiliate to loot the company, but the audit-
ed financial statements failed to disclose
the transactions among Continental, the
affiliate, and the president. The use of relat-
ed-party relationships to misappropriate
corporate assets or benefits in Continental
Vending has parallels in the more current
cases of Enron, Adelphia, and Tyco (dis-
cussed later).
Before the AICPA could propose a pro-
nouncement on related parties, another
prominent case, involving U.S. Financial Inc.
(USF), attracted public attention [Securities
and Exchange Commission (SEC) Exchange
Related Parties, Then and Now
A C C O U N T I N G & A U D I T I N G
a u d i t i n g
FEBRUARY 2015 / THE CPA JOURNAL36
An Analysis and Review in Light of Auditing Standard 18
By Douglas R. Carmichael
The notion that related-party transactions
require heightened scrutiny has a long his-
tory. Transactions with related parties have
historically been associated with misstate-
ments and fraud. Several prominent
frauds—Refco, Enron, Adelphia, and
Tyco—serve as familiar examples. New
guidance from the PCAOB in the form
of AS 18 should lead to increased audi-
tor scrutiny of the relationships and
transactions, and result in improved audits.
In Brief

2. FEBRUARY 2015 / THE CPA JOURNAL 37
Act 1064, February 25, 1974]. USF report-
ed fictitious gains from primarily sham real
estate sales to undisclosed related parties.
In February 1974, the SEC issued Account-
ing Series Release (ASR) 153 on the USF
audits; it faulted the USF officers and
directors, as well as the independent auditor.
According to ASR 153, the assumption
that financial statements reflect the results of
arm’s-length bargaining between indepen-
dent parties was fundamental to financial
reporting. Moreover, it stated that transac-
tions between affiliates raised questions about
the meaningfulness of the information, as
well as its reliability and completeness. The
terms of the SEC’s settlement with the audit
firm included a requirement to “adopt, main-
tain, and comply with procedures” that the
firm agreed to develop in order to strength-
en its approach to dealing with related-
party transactions, particularly those with
management involvement in material trans-
actions.
The audit policy materials that the firm
developed to comply with the settlement in
USF were incorporated by the AICPA into
Statement on Auditing Standards (SAS) 6,
Related Party Transactions, issued in July
1975. SAS 6 contained both accounting
and auditing guidance on related parties,
including definitions and specific disclosure
requirements. After FASB extracted the
accounting requirements in Statement of
Financial Accounting Standards (SFAS) 57,
Related Party Disclosures, published in
1982, the AICPA revised its standard in 1983
to deal only with the auditing aspects, which
were codified in AU section 334, “Related
Parties.” The case of USF has similarities
to more recent cases, such as Refco and
Enron, which involve the use of related
parties to inflate income and equity.
Prominent Cases Involving
Related Parties
Several prominent cases reinforce the
historical association of related parties with
material misstatements of financial state-
ments due to fraud. All of these cases
involve public companies that failed to
account for or disclose related-party
transactions properly.
Refco. Refco provided execution and
clearing service for exchange-traded deriva-
tives and prime brokerage services in fixed-
income and foreign-exchange markets
through regulated and unregulated sub-
sidiaries. Several of Refco’s major cus-
tomers suffered massive trading losses in
a few global financial crises and were
unable to repay the funds that Refco had
advanced them for trading purposes.
Rather than write off these uncollectible
receivables, Refco’s senior management
transferred the balances via journal entries
to a receivable from Refco’s parent compa-
ny, controlled by its CEO. When this relat-
ed-party receivable became unreasonably
large, senior management arranged round-
trip loans with unrelated third parties at the
end of reporting periods in order to avoid
disclosing the full amount. Simultaneously,
Refco loaned money to a third party, which
then loaned money to the related party; in
turn, that money reduced the related-party
receivable to a negligible amount. The loans
were recorded through customer accounts at
a subsidiary, and no money actually changed
hands, except for a fee paid to the third-party
customer for engaging in the transaction. The
transfers were reversed after the end of the
reporting period, and the related-party receiv-
able returned to its original amount—approx-
imately $1 billion, at its height.
Enron. Enron was a producer, trans-
mitter, and distributor of natural gas that
expanded into natural gas trading and
financing, and then stretched that model
into electricity and other commodity mar-
kets. Enron established special-purpose
entities (SPE) under the management or
control of its CFO and used them to keep
debt and nonperforming assets off its bal-
ance sheet, as well as to recognize gains
on the sale of assets. Enron’s related-
party disclosures have been variously
described as obtuse and incomprehensible,
designed to obscure what was going on.
Similar to Refco, Enron used its related-
party relationships and transactions to
inflate earnings or avoid recognizing loss-
es. Furthermore, the CFO’s self-dealing
in managing the SPEs also effectively
involved misappropriation of corporate
assets and benefits, similar to the situations
at Adelphia and Tyco.
Adelphia. Adelphia, one of the largest
cable television providers in the country, was
controlled by the Rigas family, whose mem-
bers filled top positions in the company
and maintained control of its board of
directors through ownership of a class of
stock with disproportionate voting rights.
When Adelphia went public, not all of the
companies controlled by the Rigas family
were included, and such privately owned
entities were known as the Rigas-managed
entities. Adelphia managed a centralized trea-
sury system—known as the “cash manage-
ment system”—used for disbursements and
receipts of Adelphia, its subsidiaries, and the
Rigas-managed entities. The commingling
of funds through this centralized system and
the details of major related-party transactions
were not disclosed in Adelphia’s financial
statements. Adelphia netted related-party
receivables and payables, each category
aggregating more than $1 billion, to disclose
only a net receivable of a few million dol-
lars. Other major GAAP violations includ-
ed moving debt from Adelphia to the man-
aged entities, falsely reporting that the Rigas
family paid cash for stock purchased to retain
control, and failing to disclose the amount
of the Rigas-managed entities’ debt that
Adelphia had guaranteed.
Tyco. Similar to the charges against the
Rigas family for looting Adelphia, Tyco
senior executives were involved in self-
dealing and failed to account for and prop-
erly disclose personal benefits at the
expense of the company. Tyco was a diver-
sified manufacturing and service compa-
ny involved in fire protection and safety
systems, electronic security services,
medical products, and electrical and other
Related parties, as well
as the relationships
and transactions that a
company has with them,
have also historically been
associated with material
misstatements, particularly
those resulting from fraud.

3. FEBRUARY 2015 / THE CPA JOURNAL38
engineered products and services. Although
Tyco engaged in improper acquisition
accounting and use of reserves to enhance
and smooth earnings, a significant portion
of public and regulatory attention focused
on the self-dealing and other excesses of
its CEO and CFO.
Large amounts of senior executive com-
pensation and a large number of related-party
transactions improperly benefited the CEO
and CFO. For some of these, the audit
committee was not informed at all. When it
was informed, the fact that the CEO and
CFO were the primary beneficiaries was not
mentioned. The related-party transactions and
balances were not disclosed separately in the
financial statements.
AS 18 and Related Amendments
The PCAOB’s response to prominent
financial reporting frauds involving relat-
ed parties, as well as to PCAOB over-
sight activities that indicated continuing
weaknesses in auditors’ scrutiny of these
areas, has focused on enhancing perfor-
mance requirements in the following
three critical areas:
n Relationships and transactions with relat-
ed parties
n Significant unusual transactions
n Financial relationships and transactions
with executive officers.
AS 18 addresses relationships and trans-
actions with related parties, and the new
requirements in the other two related areas
are implemented in amendments to sever-
al existing PCAOB standards. All of the
new requirements will be effective, subject
to SEC approval, for audits of fiscal years
beginning on or after December 15,
2014—that is, 2015 audits and interim
reviews for calendar year–end companies.
The basic requirements of AS 18 are out-
lined in the sidebar, AS 18 Requirements.
Several important requirements in AS 18
and the related amendments on significant
unusual transactions and financial relation-
ships with executive officers have no
counterpart in the AICPA or International
Auditing and Assurance Standards Board
(IAASB) requirements. The primary dif-
ferences are highlighted in another sidebar,
Significant AS 18 Requirements Not
Specifically Required by AICPA or IAASB
Standards. The following analysis focuses
on key aspects of the ways in which AS
18 and the two areas of related amendments
1. Obtain an understanding of the company’s relationships and transactions
with related parties that might reasonably be expected to affect the risks of
material misstatement.
n Obtain an understanding of the process, including the nature of
relationships and business purpose of transactions.
n Inquire of management, other knowledgeable parties within the
company, and the audit committee or its chair.
n Communicate relevant information to engagement-team members,
and, if applicable, other auditors whose work is being used.
2. Identify and assess the risks of material misstatement associated with
related parties and relationships and transactions that the company has
with them.
3. Design and implement audit responses that address the identified and
assessed risks of material misstatement.
n For each related-party transaction that is either required to be disclosed
or determined to be a significant risk, perform certain procedures,
including evaluating consistency with the explanation of business purpose.
n Perform procedures on intercompany account balances as of concurrent
dates.
4. Evaluate whether the company has properly identified its related parties and
its relationships and transactions with them.
n Test the accuracy and completeness of the company’s identification,
taking into account information gathered during the audit, which is
required to include information from reading the minutes of meetings of
stockholders, directors, and relevant committees of directors.
n If there are indications of previously undisclosed relationships or trans-
actions with related parties, determine their existence and perform specific
follow-up procedures.
5. Evaluate whether related-party relationships and transactions have
been properly accounted for and disclosed, including the substantiation of
management’s assertions, if any, of arm’s-length equivalence.
6. Communicate to the audit committee the auditor’s evaluation of the
company’s identification of, accounting for, and disclosure of relationships and
transactions with related parties.
AUDITING STANDARD (AS) 18
REQUIREMENTS

4. FEBRUARY 2015 / THE CPA JOURNAL 39
change auditing standards and practices in
the audits of public companies.
Analysis of the New Requirements
The PCAOB’s overall approach to AS
18 and the related amendments. This
includes eliminating the defensive stance
of the prior literature and developing a spe-
cific and definitive, yet scalable, standard
that would be an integral part of the audit
process.
The prior literature, in some respects,
was defensive in making statements such
as an audit “cannot be expected to provide
assurance that all related party transactions
will be discovered” (AU section 334.04).
Such statements were sometimes charac-
terized as managing user expectations. The
PCAOB has jettisoned this approach and
states more clearly: “The objective of the
auditor is to obtain sufficient appropriate
audit evidence to determine whether relat-
ed parties and relationships and transac-
tions with related parties have been prop-
erly identified, accounted for, and
disclosed in the financial statements”
(AS 18, para. 2). In other words, the
auditor’s level of assurance for this area is
no different than other aspects of an
audit of financial statements—that is,
reasonable assurance, a high level of assur-
ance, but not absolute assurance. The
PCAOB also takes a framework-neutral
approach and indicates that an auditor
should look to the requirements of the
SEC for the company under audit, with
respect to the applicable accounting prin-
ciples; for example, the applicable finan-
cial reporting framework could be U.S.
GAAP or IFRS.
AU section 334, the existing standard,
was far less specific and definitive than AS
18. Nevertheless, the PCAOB has made
the standard scalable with basic required
procedures that can be supplemented by
procedures necessary for responding to the
company’s risks of material misstatement,
based upon the specific facts and circum-
stances. An important aspect of the scala-
bility of AS 18 is that the specific proce-
dures to be applied to each related-party
transaction, or selected transactions from
an aggregate of similar transactions, are
necessary only for related-party transac-
tions that are required to be disclosed in
the financial statements or that are deter-
mined to be a significant risk.
The requirements of AS 18 and related
amendments are also integrated with the
auditor’s risk-assessment process, rather
than being a separate parallel process. In
practice, this should mean adding steps to
the existing audit plan for identifying and
assessing risks of material misstatement
and responding to them, rather than creat-
ing a separate segment of the audit plan.
Focus on business purpose. AS 18 and
related amendments place considerable
emphasis on understanding and evaluating
the nature and business purpose of a com-
pany’s relationships and transactions with its
related parties, as well as significant unusu-
al transactions. This focus on business pur-
pose is extremely important because, as indi-
cated by the kinds of prominent cases cited
above, these types of transactions could
impose increased risks of material misstate-
ment. In AS 18 and related amendments, the
references to business purpose are always
accompanied by the parenthetical phrase “or
lack thereof.” With the phrase “business pur-
pose (or lack thereof),” the PCAOB intends
to promote a questioning and skeptical
approach by auditors and stress the impor-
tance of identifying transactions that appear
to lack a business purpose.
The need for an auditor to reach an inde-
pendent conclusion on business purpose
is unequivocal. The PCAOB has elimi-
nated the notion in prior literature (AU sec-
tion 334.06) that, in the absence of evi-
dence to the contrary, transactions with
related parties should not be assumed to be
outside the ordinary course of business.
The PCAOB observes that this statement
could be misunderstood to create a pre-
sumption of validity for the business pur-
pose of related-party transactions. Experi-
ence has shown that the lack of business
purpose is a serious risk, and AS 18
emphasizes the need for professional skep-
ticism in this area.
AS 18 and related amendments require
an auditor to perform specific procedures
aimed at understanding and evaluating
business purpose. For example, the
required inquiries of management include
obtaining an explanation of the business
purpose for entering into a transaction with
a related party versus an unrelated party.
For each related-party transaction that is
either required to be disclosed or deter-
mined to be a significant risk, auditors are
required to read the underlying documen-
tation and evaluate whether the terms and
other information are consistent with expla-
nations from inquiries and other audit evi-
dence about business purpose. Auditors are
also required to perform other procedures,
as necessary, in order to address risks of
material misstatement. In the case of Enron,
for example, the auditors were aware of
the SPE-related parties, but they failed to
obtain sufficient underlying documentation
on the nature of the relationship with Enron
and the ownership structure of the SPEs or
to respond adequately to the risks of mate-
rial misstatement associated with the
related-party transactions. Depending upon
the nature of the transaction and assessed
risks, the procedures to understand busi-
ness purpose might include directly asking
the related party about the business sense
of the transaction. In other words, the audi-
tor should consider the business purpose
from the perspective of the other party to
the transaction.
An issue sometimes associated with busi-
ness purpose is whether the substance of a
related party or significant unusual transac-
tion differs materially from its form. The
PCAOB’s additional discussion material
accompanying the new requirements makes
clear that heightened scrutiny is warranted
in these circumstances, but the separate

5. FEBRUARY 2015 / THE CPA JOURNAL40
requirement in AU section 334 for the audi-
tor to evaluate whether the substance of a
related-party transaction differs materially
from its form is not included in AS 18. The
reason for this omission is not that the require-
ment has been discarded, but that the evalu-
ation of substance versus form is an integral
part of the evaluation of the presentation of
financial statements. The PCAOB observes
that AU section 411.06 requires this as part
of the auditor’s evaluation of whether the
financial statements have been presented fair-
ly in conformity with the applicable financial
reporting framework. This requirement
applies to related-party and significant unusu-
al transactions, as well as others.
The PCAOB also observes that evalu-
ating substance over form does not require
an auditor to challenge the appropriateness
of an accounting standard that is part of
the applicable financial reporting frame-
work; instead, an auditor might have to
conclude financial statements are not pre-
sented fairly if they do not include infor-
mation about matters that affect their use,
understanding, and interpretation. The
PCAOB’s discussion provides, as exam-
ples, “window-dressing” transactions to
improve the appearance of a company’s
balance sheet, such as a temporary reduc-
tion of an asset or liability or transactions
where management places more emphasis
on the need for a particular accounting
treatment than on the underlying substance
of the transaction. In the case of Refco, for
example, a very material related-party
receivable was reduced at period-end by
an undisclosed arrangement with a third
party, but before and after period-end was
not disguised. Review of the underlying
documents would have made the window
dressing apparent.
Evaluating the company’s identifica-
tion. One of the most significant require-
ments of AS 18—a clear break from the
defensive stance in prior literature—is the
duty imposed on the auditor to evaluate
whether the company has properly identi-
fied its related parties and the relationships
and transactions that it has with them.
The PCAOB notes that auditors must
remain sensitive throughout the audit to the
possibility that management might not have
informed the auditor of all related parties
and relationships and transactions; thus,
auditors should perform procedures to test
the accuracy and completeness of the com-
pany’s identification.
Determining whether previously undis-
closed related parties or the relationships
and transactions with them exist has to
extend beyond inquiries of management.
An auditor starts with the names of relat-
ed parties and transactions provided by
management, but AS 18 makes clear that
inquiries of management are a complement
to the performance of testing of accuracy
and completeness, not a substitute for them.
The related amendments require written
representations of management to state
explicitly that the company has provided
the names of all related parties and rela-
tionships and transactions with them; how-
ever, the PCAOB emphasizes that, for pur-
poses of identifying related parties and
the relationships and transactions with
them, an auditor may not solely rely on
management’s representations or a com-
bination of representations and an assess-
ment of the adequacy of the company’s
process and related controls.
The procedures required by AS 18
include reading the minutes of meetings of
stockholders, directors, and committees of
directors (or summaries of actions at recent
meetings for which there are no minutes)
and taking into account information
obtained from the audit work on signifi-
cant unusual transactions and financial rela-
tionships, as well as transactions with exec-
utive officers. Appendix A to AS 18
provides auditors with examples of infor-
mation and sources of information that may
n Test the accuracy and completeness of the related parties and the relation-
ships and transactions with them identified by the company, taking into account
information gathered during the audit.
n Perform procedures to identify whether the company has entered into any
significant and unusual transactions; if so, identify the nature, terms, and
business purpose (or the lack thereof) of those transactions and whether such
transactions involve related parties.
n Perform procedures to obtain an understanding of the company’s financial rela-
tionships and transactions with its executive officers and identify and assess the
risks of material misstatement associated with those relationships and transactions.
n Inquire of the predecessor auditor regarding the nature of the company’s relation-
ships and transactions with related parties and significant and unusual transactions.
n Obtain written representations from management for both annual and interim
financial statements that there are no side agreements or other arrangements
(written or oral) undisclosed to the auditor, and, if applicable, that transactions
with related parties were conducted on terms equivalent to those prevailing in an
arm’s-length transaction.
n Make inquiries with respect to subsequent events as to whether there have
been any changes in the company’s related parties, any significant new related-
party transactions, or any significant unusual transactions.
Note: Requirements taken from AS 18 and the related amendments.
IAASB = International Auditing and Assurance Standards Board
SIGNIFICANT AS 18 REQUIREMENTS NOT
SPECIFICALLY REQUIRED BY AICPA OR
IAASB STANDARDS

6. FEBRUARY 2015 / THE CPA JOURNAL 41
be gathered during the audit to potentially
identify previously undisclosed related par-
ties or the relationships and transactions a
company has with them.
Appendix A is neither a comprehen-
sive listing of information and sources of
information for testing accuracy and com-
pleteness nor a listing of matters for which
the auditor is required to perform proce-
dures in every audit. The PCAOB, how-
ever, observes that other auditing standards
may impose requirements to perform pro-
cedures regarding the examples in
Appendix A, such as inspecting confir-
mation responses and responses to the
inquiries of a company’s lawyers, per-
forming analytical procedures, and testing
journal entries.
If an auditor’s procedures identify infor-
mation that indicates previously undisclosed
related parties, relationships or transactions,
she must apply procedures to resolve the
issue and follow up, if applicable, by obtain-
ing additional information on the identified
related parties and relationships or transac-
tions. The auditor is also required by
AS 18 to assess the effect of the new infor-
mation on all aspects of the audit. Each
previously undisclosed matter does not have
to be treated as a significant risk, but the
auditor does need to obtain sufficient infor-
mation to determine whether the undisclosed
matter represents a significant risk.
In the case of Refco, the auditors relied
on management’s identification of related-
party transactions and did not follow up on
indications of large, unexpected transactions
with related parties during the period. In
the case of Tyco, the auditors failed to fol-
low up when they learned that information
on related parties provided by management
was false. In the high-risk environment of
Adelphia, the auditors also failed to exercise
due care and appropriate professional skep-
ticism; as a result, they remained unaware
of the debt reclassifications made via post-
closing journal entries, and they failed to
obtain an adequate understanding of the
details of intercompany transactions by
which the Rigas family’s stock purchases
were effected. The auditors were, however,
fully aware of the improper netting of those
transactions and nondisclosure of the amount
of the guarantee, and they acquiesced to these
material departures from GAAP.
Significant unusual transactions. The
conforming amendments to AS 18 adopt
a uniform definition of significant unusu-
al transactions, require specific proce-
dures to identify them, and emphasize their
relationship to AS 18’s requirements.
The amendments make conforming
changes to adopt a uniform description
throughout the PCAOB’s standards of sig-
nificant unusual transactions. That defini-
tion is “significant transactions that are out-
side the normal course of business for the
company or that otherwise appear unusu-
al due to their timing, size, or nature.”
The analysis of whether a transaction is
significant and unusual has to be based
upon the specific facts and circumstances
of a company and its environment.
Timing and frequency are only elements
to be considered. For example, such
transactions do not need to occur infre-
quently. In addition, whether a transaction
is outside the normal course of business
is not determinative; a transaction can be
in the normal course of business and still
be a significant unusual transaction. In the
case of Refco, for example, the round-trip
loans used to disguise a related-party
receivable were within the normal course
of business because Refco routinely made
loans to customers. The round-trip loans,
however, were unusual in size (several
orders of magnitude larger than loans to
similar customers) and nature (not made to
finance a customer’s trading and not col-
lateralized). The auditors failed to inspect
underlying documents for the related-party
accounts at the subsidiary, as well as for
the loans to the third parties involved in
the round-trip loans.
A major difference from the prior liter-
ature is that auditors are required to per-
form procedures as part of the risk-assess-
ment process to identify significant unusual
transactions and not just evaluate those
transactions of which the auditor becomes
aware. Although the procedures to identi-
fy significant unusual transactions include
inquiry of management, the PCAOB
makes clear that whether a transaction is
a significant unusual transaction is the
responsibility of the auditor. Information
provided by management cannot be the
sole consideration in this determination.
Necessary procedures include inquiries of
others, understanding related controls,
and most importantly “taking into
account other information obtained dur-
ing the audit.” In other words, the auditor
cannot audit with blinders on and fail to
consider the implications of evidence
examined for another purpose for the iden-
tification and evaluation of significant
unusual transactions.
For example, in the case of Adelphia,
the auditors examined large journal
entries, but failed to identify and evalu-
ate three major transfers of debt via jour-
nal entry from Adelphia to Rigas-man-
aged entities. Furthermore, the lead
partner was aware of direct placements of
stock on behalf of Rigas family mem-
bers but failed to examine the details of
those significant unusual intercompany
transactions and learn that the co-bor-
rowers who drew down funds to pay for
the stock were not the entities that bought
the securities. As a result, the stock should
have been treated as a stock subscrip-
tion, rather than a sale.
Under the amendments, an auditor is
required to take into account other infor-
mation obtained by performing procedures,
such as reading the minutes of directors’
meetings, testing journal entries, reading
SEC filings, inspecting confirmation
responses and responses to inquiries of the
company’s lawyers, and performing ana-
lytical procedures. The amendments note
that the audit steps to identify and evalu-
ate significant unusual transactions can
inform the evaluation of whether the
company has properly identified related
In the case of Tyco, the
auditors failed to follow up
when they learned that
information on related
parties provided by
management was false.

7. FEBRUARY 2015 / THE CPA JOURNAL42
parties. In other words, when identifying
and evaluating significant unusual transac-
tions, the auditor might identify related par-
ties or relationships or transactions with
them that were previously undisclosed. For
example, as previously mentioned, if
Refco’s auditors had treated the round-
trip loans as the significant unusual trans-
actions they were, the auditors could have
detected the undisclosed transactions with
related parties.
Executive officers. The amendments
related to AS 18 require auditors to per-
form specific procedures in order to obtain
an understanding of a company’s financial
relationships and transactions with its exec-
utive officers. The PCAOB requires that
these procedures include, at a minimum,
1) reading employment and compensation
contracts and 2) reading proxy statements
and other relevant regulatory filings. The
PCAOB also requires that auditors con-
sider 1) making inquiries about the struc-
turing of executive-officer compensation to
the chair of the compensation committee
and compensation consultants, and 2) per-
forming procedures to obtain an under-
standing of policies and procedures for
authorizing and approving executive-offi-
cer expense reimbursements.
The PCAOB makes clear that the purpose
of these procedures is to further the auditor’s
risk assessment, not to require that auditors
assess the appropriateness of the compen-
sation of executive officers. Relevant aspects
of the risk assessment might include whether
the company’s controls are adequate enough
to address the risk that management com-
pensation incentives might result in overly
aggressive or fraudulent accounting. Of
particular relevance to AS 18 is that the
understanding of the company’s financial
relationships and transactions with executive
officers could identify information
that indicates the existence of previously
undisclosed related-party relationships or
transactions.
In the case of Tyco, management bonus-
es were not properly accounted for as oper-
ating expenses. In addition, transactions with
the CEO and CFO were not appropriately
authorized or disclosed. Even though the
auditors were aware of these and other sig-
nificant related-party relationships and trans-
actions, the auditors never reassessed the
level of audit risk with regard to executive
compensation or related-party transactions,
nor did they inform the audit committee of
the ways in which the CEO and CFO ben-
efited improperly. Even when the auditors
learned that the audit team was given false
information on related-party transactions, no
additional audit steps were performed.
Intercompany accounts. AS 18 requires
an auditor to perform procedures on inter-
company account balances as of concur-
rent dates (even if the fiscal years of the
respective companies differ). SAS 6 con-
tained a statement that its guidance did not
apply to transactions eliminated in con-
solidation. This changed when the standard
was amended and there was no limitation
on applicability to intercompany transac-
tions and balances. In practice, however,
the procedures applied to intercompany
transactions often continued to be a per-
functory check that, numerically, the bal-
ances eliminated in consolidation. AS 18
makes a significant and necessary change
in this area. In the cases of Refco and Adel-
phia, a lack of scrutiny of intercompany
accounts and transactions contributed to the
auditors’ failure to adequately understand
the related parties and relationships and
transactions with them, as well as the fail-
ure to properly account for or disclose
them.
Continued Improvement
Analyzing AS 18 and related amendments
and comparing them to major instances of
financial-statement fraud involving related
parties indicates that the PCAOB has con-
siderably strengthened the auditor-perfor-
mance requirements in areas that have his-
torically resulted in audit failures. (See the
sidebar, Additional Resources, for further
reading on this subject.)
New guidance is not a panacea, how-
ever. Past audit failures seem to have pri-
marily resulted from serious lapses in the
exercise of due professional care and pro-
fessional skepticism. The new performance
requirements should considerably enhance
the ability of auditors to be more effective
in determining that related parties—and the
relationships and transactions that a com-
pany has with them—are properly identi-
fied, accounted for, and disclosed. q
Douglas R. Carmichael, PhD, CPA, CFE,
CFF, is the Eli and Claire Mason Pro-
fessor of Accountancy at Baruch College,
New York, N.Y. He was the first chief audi-
tor of the PCAOB. He is also a member
of The CPA Journal Editorial Board.
n Elizabeth A. Gordon, Elaine Henry, Timothy J. Louwers, and Brad J. Reed,
“Auditing Related Party Transactions: A Literature Overview and Research Syn-
thesis,” Accounting Horizons, March 2007, vol. 21, no. 1, pp. 81–102.
n Joshua R. Hochberg, “Final Report of Examiner,” Jul. 11, 2007. [Refco]
n Timothy J. Louwers, Elaine Henry, Brad J. Reed, and Elizabeth A. Gordon,
“Deficiencies in Auditing Related Party Transactions: Insights from AAERs,” Cur-
rent Issues in Auditing, August 2008, vol. 2, no. 2, A10–A16.
n William C. Powers, Raymond S. Troubh, and Herbert S. Winokur, “Report of
Investigation by the Special Investigative Committee of the Board of Directors of
Enron Corporation,” Feb. 1, 2002. [Enron]
n SEC, In the Matter of Richard P. Scalzo, CPA, Accounting and Auditing
Enforcement Release (AAER) 1839, August 13, 2003 [Tyco].
n SEC, In the Matter of Gregory M. Dearlove, CPA, AAER 2779, Jan. 31, 2008
[Adelphia].
ADDITIONAL RESOURCES