Special attention to related-party has a long history in auditing. From the auditor’s perspective, related-party transactions have two distinct, but not mutually exclusive, aspects: adequate disclosure and fraud detection. Some related-party transactions may be the direct result of the relationship. Without that relationship, the transaction might not have occurred at all or might have had substantially different terms. Thus, disclosure of the nature and amount of transactions with related parties is necessary for a proper understanding of the financial statements. Inadequate disclosure of related-party transactions may result in misleading financial statements, and so the auditor should be concerned with identifying such transactions in the audit and evaluating the adequacy of disclosure of them.
What are the audit procedures for related-party Transaction? How to Identify the existence of related-party? This post describes the procedures for related-party transactions, adapted from SAS 45 [mainly] and SFAS. Enjoy!
Example of Related-Party Transactions
Before the procedures, Let’s have a look at the following two related-party transactions:
Example: Related-Party Transactions-1
A Director of the Company is a principal in two companies that are distributors of the Company’s products. Total sales to these related companies aggregated $86,000 in 2010 and $91,000 in 2009. At August 31, 2010, these companies owed the company $35,983, of which $25,525 was owed beyond the Company’s normal credit terms.
Example: Related-Party Transactions-2
The Company occupies premises leased from two officer-shareholders for which $74,000 was paid in 2010 and $27,000 was paid in 2009. The lease agreement calls for minimum future payments of $86,000 in 2011, $94,000 in 2012, $101,000 in 2013 and $114,000 in 2014. The Company loaned $102,000 to these officer-shareholders to provide the down payment for their purchase of the property in 2008. This loan was repaid during 2009.
With these two examples, now you should get a more clear view what is related-party transactions.
Source of the Procedures
In general, auditor should be concerned, however, with the possibility that an undisclosed relationship with a party to a material transaction has been used to fabricate transactions. That is, the transactions may be fraudulent or without substance. SAS 45 clearly acknowledges the possibility that a related party relationship may be a tool for fraud by management. SAS 6 was issued primarily in response to some fraud cases in which management’s involvement in material transactions was obscured either by inadequate disclosure or outright concealment. The SAS was more disclosure-oriented than fraud-oriented, however, because fraud is the exception rather than the norm. Nevertheless, the auditor should be aware of the possibility of fraud. The SAS observed in the absence of evidence to the contrary, transactions with related parties should not be assumed to be outside the ordinary course of business.
The auditor should view related-party transactions within the framework of existing pronouncements, placing primary emphasis on the adequacy of disclosure. In addition, the auditor should be aware that the substance of a particular transaction could be significantly different from its form. When issued, SAS 6 provided guidance on disclosure of related-party transactions because accounting literature did not contain such guidance. SFAS 57 essentially transferred that guidance to the authoritative accounting literature. It was, therefore, no longer necessary or appropriate for an auditing standard to contain accounting standards. SAS 45 eliminated references to accounting considerations and disclosure requirements that were in SAS 6.
Example: Auditor’s Report Paragraph Calling Attention To The Existence Of Related Parties
If an auditor decides to call the user’s attention to related-party transactions, however, he or she may include a separate explanatory paragraph in the report. Following is a separate paragraph from an auditor’s report on the audit of the combined financial statements of the leasing and financing subsidiaries of the company:
“The leasing and financing subsidiaries engage in significant transactions with ABC Inc. as described in Note 2 of the notes to combined financial statements“.
Fundamental Procedures for Auditing Related-Party Transaction
An audit cannot be expected to provide assurance that all related-party transactions will be discovered. Nevertheless, the auditor should be aware of:
- The possibility that material related-party transactions exist that could affect the financial statements.
- Common ownership or management control relationships that are required by SFAS 57 to be disclosed even though there are no transactions. In determining the scope of work to be performed, the auditor should obtain an understanding of management responsibilities and the relationship of each of the entity’s component to the total entity. The auditor should consider controls over management activities and the business purpose served by the various components.
Note: Business structure and operating style are occasionally deliberately designed to obscure related-party transactions.
The auditor should recognize that the following transactions may indicate related parties:
- Transactions to borrow or lend at no interest or at rates significantly different from market rates.
- The sale of real estate at a price significantly different from its appraised value.
- A non-monetary exchange of property for similar property.
- Loans made with no scheduled terms for the time or method of repayment.
The following are factors that the auditor should be aware of that may motivate transactions with related parties:
- Is there a lack of sufficient working capital or credit to continue the business?
- Does management have an urgent desire for a continued favorable earnings record to support the price of the entity’s stock?
- Is the earnings forecast overly optimistic?
- Does the entity depend on one or a few products, customers, or transactions for continued success?
- Is the entity in a declining industry with many business failures?
- Does the entity have excess capacity?
- Is the entity involved in significant litigation, especially between stockholders and management?
- Are there significant dangers of obsolescence because the entity is in a high technology industry?\
Note: These are fraud “warning signs” or risk factors. The presence of one or more factors is not proof of fraud, but the auditor should increase his or her awareness of the possibility of fraud. If the risk is high, the auditor might increase the scope of substantive tests designed to identify undisclosed relationships or use some of the expanded procedures enumerated in SAS 45.
To identify material related-party transactions the auditor should:
- Identify related parties (through inquiry and review of relevant information to determine the identity of related parties so that material transactions with these parties known to be related can be examined). [Note: According to SAS 45, the auditor should place emphasis on testing identified material related-party transactions].
- Identify material transactions (consider whether there are indications of previously undisclosed relationships for material transactions).
- Examine identified material related-party transactions.
Note: In SAS 45, the procedures are grouped essentially in the preceding categories. In the following discussion, a different grouping is used to emphasize distinctions between specific procedures for related parties and general procedures.
SAS 45 includes some procedures performed solely for the purpose of identifying related parties or related-party transactions:
. Inquire of management
- Names of all related parties.
- Whether there were any transactions with these parties during the period.
- Whether the entity has procedures for identifying and properly accounting for related-party transactions. If so, evaluate these procedures.
[Note: This is covered in the management representation letter. It is helpful to give management the technical definition of related parties at the time of initial inquiry and in the letter].
. Obtain the names of all pension and other trusts established for the benefit of employees and the names of officers and trustees of the trusts.
. Review stockholder listings of closely held entities and identify principal stockholders.
. Provide audit staff with the names of known related parties so that they can identify transactions with such parties.
. For indications of undisclosed relationships, review the nature and extent of business transacted with major:
- Borrowers; and or
. Consider whether transactions are occurring but not being given accounting recognition, such as the client receiving or providing accounting, management, or other services at no charge, or a major stockholder absorbing corporate expenses.
The procedures in SAS 45 for identifying related parties and for identifying transactions with related parties include several procedures that are usually performed in an audit. These are normal procedures performed for several purposes that may also identify related parties.
General procedure and Its Relevance to Related Parties
- Review prior years’ audit documentation. Relevance to related parties: Identify names of known related parties.
- Review minutes of meetings of board of directors and executive or operating committees. Relevance to related parties: Obtain information on material transactions authorized or discussed.
- Review confirmations of compensating balance arrangements. Relevance to related parties: Identify whether balances are or were maintained for or by related parties.
- Review invoices from law firms for regular or special services. Relevance to related parties: Identify indications of related parties or related party transactions.
- Review confirmations of loans receivable and payable. Relevance to related parties: Identify whether there are guarantees and the nature of relationship to guarantor.
- Review material investment transactions. Relevance to related parties: Determine whether investment created related party.
- Review accounting records for large, unusual, or nonrecurring transactions or balances, particularly at or near end of reporting period. Relevance to related parties: Consider whether transactions are with related parties.
- Inquire of predecessor, principal, or other auditors of related entities (this inquiry should be made at an early stage of the audit). Relevance to related parties: Obtain their knowledge of related parties or related-party transactions.
Procedures for Public Companies
Some procedures in SAS 45 are relevant only for public companies:
- Review filings with the SEC and other regulatory agencies for the names of related parties and for other businesses in which officers and directors occupy directorships or other management positions.
- Review proxy and other material filed with the SEC and comparable data filed with other regulatory agencies for information on material transactions with related parties.
- Review “conflict-of-interest” statements obtained by the entity from its management.
Procedures for Identified Transactions
After a related-party transaction is identified, the auditor should apply substantive tests to that transaction. Inquiry of management is not sufficient. According to AU 334.09, procedures that should be considered are:
- Obtaining an understanding of the transaction’s business purpose [NOTE: Until the auditor understands the business sense of the transaction, he or she cannot complete the audit].
- Examining invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.
- Determining whether the transaction has been approved by the board of directors or other appropriate officials.
- Testing for reasonableness the compilation of amounts to be disclosed or considered for disclosure.
- Inspecting or confirming and obtaining satisfaction that collateral is transferable and appropriately valued.
- For inter-company account balances (a) Arranging for examination at concurrent dates, even if fiscal years differ (b) Arranging for examination of specified, important, and representative related party transactions by auditors for each of the parties with an exchange of relevant information.
Note: A principal auditor-other auditor relationship may exist and the component not audited by the principal auditor may have conducted related-party transactions that are complex or unusual. In these circumstances, the principal auditor should request access to the other auditor’s audit documentation concerning this matter.
If the auditor concludes that it is necessary to fully understand a related-party transaction, he or she should consider the following procedures that might otherwise be unnecessary:
- Confirming the amount and terms of the transaction, including guarantees and other significant data, with the other party.
- Inspecting evidence in the other party’s possession.
- Confirming or discussing significant information with intermediaries (banks, guarantors, agents, or attorneys).
- If there is reason to believe that material transactions with unfamiliar customers, suppliers, or others may lack substance, refer to financial publications, trade journals, credit agencies, and other information sources.
- Obtaining information on the financial capability of the other party for material uncollected balances, guarantees, or other obligations.
No representations need be made in the financial statements that related-party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions. If representations are made that state or imply that, SFAS 57 requires that the entity be able to substantiate them. Thus, the auditor should consider whether there is sufficient support for such a representation, if made, and appropriately qualify his or her opinion if there is not such support. Note: Lack of substantiation of representations made on equivalence of material related-party transactions should result in a qualified or adverse opinion because of a departure from GAAP.
Techniques For Application
Preliminary Evaluation Of Risk – A preliminary evaluation concerning the likelihood of related-party transactions is usually made during the planning of the audit when the risk assessment questionnaire is completed. This evaluation includes:
- Obtaining an understanding of the structure of the entity and management responsibilities.
- Considering the business purpose of the various components of the entity.
- Considering the control consciousness within the entity and controls over management activities.
Purpose Of Auditing Procedures Designed Specifically For Related Parties Transactions – The purpose of auditing procedures designed specifically for related-party transactions is to determine the existence of related parties and to identify significant related-party transactions, including those not recognized in the accounting records. If the auditor identifies significant related-party transactions, he or she should examine these transactions and evaluate the adequacy of their disclosure. The auditor also is concerned with the adequacy of disclosure of economic dependence.
Determining The Existence Of Related Parties – The existence of some related parties, such as parent-subsidiary, investor-investee and affiliates, is obvious. To determine the existence of other related parties, specific audit procedures are necessary.
Identifying Related-Party Transactions – Related-party transactions and similar transactions that require disclosure may be classified as follows:
- Those recognized in the accounting records.
- No-charge transactions.
- Those that create economic dependence.
No-Charge Transactions – Sometimes a related party provides services that are not given accounting recognition. Examples of these services are the following:
- Accounting and managerial.
- Credit and collection.
To identify no-charge transactions, the auditor should compare expenses with sales; and..:
- Investigate deviations from industry standards.
- Investigate deviations from prior year.
These are essentially analytical procedures
Transactions That Create Economic Dependence – SFAS 57 does not address the issue of economic dependence. Related parties do not exist solely because one party is economically dependent on another. If one party exercises significant influence over the other, however, a related-party situation does exist and should be disclosed. In situations where economic dependence does not create related parties, disclosure may still be necessary to keep the financial statements from being misleading.
Examining Related-Party Transactions – When the auditor identifies related-party transactions, he or she should analyze them to determine the following:
- The purpose of the transactions.
- The nature of the transactions.
- The extent of the transactions.
- The effect of the transactions on the financial statements.
To determine the preceding, the auditor applies normal auditing procedures and also may have to apply extended auditing procedures.
Management Representation Letter – Much of the information about related parties is obtained through inquiry of management. The responses to these inquiries should be formalized in the management representation letter. If no related-party transactions occurred, a statement to that effect should appear in the management representation letter. If related-party transactions occurred, the following should be noted:
- Identification of the related parties.
- Identification of the transactions.
- The nature of the transactions.
- The amount of the transactions.
The auditor should also consider obtaining written representations from the client’s senior management and its board of directors about whether they or other related parties engaged in any transactions with the entity.