PCAOB Staff Audit Practice Alert

PCAOB

Staff Audit Practice Alert No.5 is titled "Auditor Considerations Regarding Significant Unusual Transactions." The alert reminds auditors that when determining the fitness of a set of financial statements they must consider significant unusual transactions and the disclosure thereof. If significant unusual transactions are not well-disclosed, the auditor has the duty to withhold his or her approval until the situation is rectified, typically by adequately disclosing the transactions in question.

In order to do this, the auditor must be sufficiently familiar with the company's business as to understand the business rationale for such transactions. If that rationale does not exist, this may suggest "that the transactions may have been entered into to engage in fraudulent financial reporting." If the auditor does not have sufficient knowledge of the company's business to make such a determination, the auditor should seek out such an individual to assist with the determination. Doing so would remove the possibility that an auditor could be fooled into signing off on fraudulent statements simply because he or she did not understand the complexity of the transactions that went into the statements.

The purpose of the alert issued by the PCAOB was to compile the different rules regarding significant unusual transactions, which appear in different sections of the accounting standards. The standard also categorizes existing requirements for unusual transactions into five different categories. What the alert does not do is introduce new standards for auditors; it merely serves as a means to bring the existing standards together in a single document.

At the heart of the issue is the amount of knowledge that an auditor has about the company's business. The auditor needs to either have sufficient knowledge about the client's business or find somebody that does have this knowledge to act as an advisor. Once this has happened, the auditor is in a position to assess the risk of material misstatement in the financial statements. The auditor should consider, for example, management's selection and application of accounting principles in assessing the risk of fraud. Some red flags identified in the alert are when the transaction is overly complex; whether or not management has discussed the accounting of such transactions; if management is placing undue emphasis on accounting treatment of a transaction; if transactions involve third parties, including special purpose entities; and if the transactions do not have sufficient substance.

The alert prescribes a course of action for situations when an auditor believes that there is a significant risk of material misstatement. The auditor must identify his or her findings in an engagement completion document; document actions taken to address significant unusual transactions and must state the basis for the conclusions reached.