Related Parties
1 Introduction
Related parties can pose real difficulties for auditors because it can be very difficult to detect the relationship and related party transactions. Certainly the letter of representation sent by directors to the auditors at the end of the audit would make reference to the fact that either there were no related party transactions or that all have been disclosed.
For example, one person owns two companies and each company has different auditors. If Company A sells goods to Company B at inflated prices, Company B will make artificial losses and Company A artificial profits. Perhaps the owner intends to put Company B into liquidation to escape liabilities, but the cash has been safely transferred to Company A. It would probably be difficult for the auditors to detect what was going on.
2 What is a related party and why are they difficult for auditors?
Related parties are defined in IAS 24.
The objective of IAS 24 is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties.
A related party is a person or an entity that is related to the reporting entity:
A person or a close member of that person’s family is related to a reporting entity if that person has control, joint control, or significant influence over the entity or is a member of its key management personnel.
An entity is related to a reporting entity if, among other circumstances, it is a parent, subsidiary, fellow subsidiary, associate, or joint venture of the reporting entity, or it is controlled, jointly controlled, or significantly influenced or managed by a person who is a related party.
Note that subsidiaries, associated companies, joint venture partners and the entity’s pension scheme are related parties. You might think it is easy, for example, to identify when a company is an associate, and this would be expected when producing the group financial accounts. But if you were auditing the associate, how would you detect if it was trading with another company that was also an associate of the same parent and therefore under the influence of the parent?
Detecting ownership by family members is also very difficult: they might not all have the same family name.
Particular problems can arise if:
Transactions between the parties take place without charge. For example, simply moving inventory from one party to the other without any accounting entries will distort profits.
Related party transactions are ‘buried’ amongst normal transactions.
There are parties that the auditor is unaware of.
Complex group structures can make identifying related parties very difficult.
Management might try to conceal the relationships.
Management simply might not know that certain transactions fall within related party rules.
There is nothing illegal about a company trading with a related party: this happens all the time in groups. However, as described above, the existence of related party transaction increases the chance that transactions are not 'at arm's length' or, have been entered into to defraud other parties or to evade tax.
3 Responsibilities
It is management’s responsibility to identify and disclose related party transactions. However, of course, this does not absolve the auditors from exercising professional scepticism or from trying to obtain evidence about the existence of related party transactions.
If related party transactions are not identified by management or the auditors there is an increased risk of:
Fraud
Unfair presentation
Non-compliance with the law (eg tax legislation)
Audit procedures include
Enquire from management about related party transactions. Auditors would have to explain the concepts and give examples to help management.
Review last year’s working papers.
Review the board minutes.
Review the accounting records for unusual transactions. CAAT techniques could help here by looking at every significant transaction over the period.
Review bank certificates (one company might have given guarantees on behalf of another).
Review principal shareholders of companies with whom the client trades.
Ask the directors about their other directors and share ownership
Review correspondence with lawyers.
Review investment activities eg the purchase of shares that might indicate that significant control has been acquired.
Enquire into the names of pension trustees.
Obtain written representation from management.
4 Disclosures required in the financial statements
Relationships between parents and subsidiaries irrespective of whether there have been transactions between the parties.
Compensation to key management personnel (including short-term, post-employment and termination benefits and share-based payments).
Minimum disclosures for related party transactions include:
The amount of the transactions*
The amount of outstanding balances and their terms**
Allowances for doubtful debts relating to the outstanding balances
The expense recognised in the period in respect of irrecoverable or doubtful debts due from related parties.
* Examples of transactions with related parties include:
purchases/sales of goods, other assets or services
leases
loans and other finance arrangements
providing guarantees or collateral.
** Disclosure should state that terms are 'arm's length' only if that can be substantiated. The auditor must therefore obtain sufficient audit evidence that this assertion is true.