May 7, 2013 / 6:02 PM / 5 years ago

Audit watchdog wants more insider business deal scrutiny

(Reuters) - Corporate auditors would be required to look more closely at insider business deals, like those used in many Chinese company frauds, under a rule the audit regulator proposed on Tuesday.

The Public Company Accounting Oversight Board’s rule takes aim at so-called “related party transactions,” or deals between a company and corporate insiders. These kinds of transactions have played a role in many accounting frauds.

Over the past two years, investors have suffered massive losses after U.S.-listed companies based in China funneled company assets to insiders in improper business deals.

In February, China-based petrochemical company Keyuan Petrochemicals Inc agreed to pay $1 million to settle securities fraud charges involving related-party transactions.

Greater auditor scrutiny “can help to avert the corporate failures and job losses we read about all too often once it’s too late,” PCAOB Chairman James Doty said at a PCAOB meeting.

The board is seeking comments from the public on the proposed rule through July 8. It could take effect as early as next year, a PCAOB staff member said at the meeting.

Auditors are allowed too much latitude in how they deal with related-party transactions under current rules, PCAOB Chief Auditor Martin Baumann said at the Washington meeting.

Baumann cited a long history of frauds committed through unusual transactions. Former energy trader Enron Corp, for example, set up joint ventures that drained company funds and were not well-understood by investors, he said.

Enron’s devastating collapse in 2001 helped spur Congress to create the PCAOB and toughen regulation of corporate auditors.

In addition to related-party transactions, the new PCAOB rule would require auditors to take a closer look at executives’ pay to see if it creates incentives to manage earnings.

Auditors would not assess if executives’ pay is reasonable, but would review it to see if it puts pressure on executives to meet financial targets, board member Jay Hanson said.

Many executives’ bonuses are tied to earnings targets, a structure meant to align their interests with shareholders. But pressure to meet targets for bonus pay has often been a motive for accounting fraud, according to academic studies.

Tuesday’s proposal was a revision of an audit standard first proposed in February 2012. The rule was tweaked to clarify some requirements but follows the same basic approach, Hanson said.

Auditors would have to review related-party transactions, determine if they pose a significant risk and discuss them with the audit committee, he said. They would also have to look at significant unusual transactions to be sure they were not used for fraudulent purposes, he said.

Reporting by Dena Aubin; Editing by Kevin Drawbaugh and David Gregorio

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