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Auditing related party transactions.

An analysis of the guidance in the Professional issue Task Force's practice alert

In response to a recommendation of the Public Oversight Board (POB) of the SEC Practice Section (SECPS) of the AICPA's Division for CPA firms in the report In the Public Interest - Issues confronting the Accounting Profession, the SECPS executive committee established the Professional Issues Task Force (PITF). The PITF is charged with reviewing and examining practice issues that appear to present audit concerns for practitioners. It accumulates such information and disseminates specific guidance relating to these issues in the form of practice alerts (PA). The task force is also responsible for referring matters that may require a reconsideration of existing standards to the appropriate standard setters.

An important practice alert was issued in 1995 setting forth guidance for auditing related parties. Beginning with the Continental Vending case in the 1960s, related party transactions have been a way in which perpetrators of financial statement fraud have crafted their work at the expense of unsuspecting auditors and the public. While rented party transactions are not inherently bad, they have proven to be an easy and effective way for perpetrators to misstate the economic substance and reality of financial transactions.

The standard setters have had difficulty in providing guidance about related party transactions. Following the Continental Vending adversity, the first guidance on the presentation of related party transactions in financial statements appeared in, of all places, an SAS (SAS No. 6-July 1975) issued by the AICPA's Auditing Standards Board (ASB). It pointed out the inherent measurement difficulties with related party transactions, which by their nature may not be comparable to what would have transpired had the transactions taken place between unrelated third parties. It concluded that disclosure was the overriding principle that should govern related party transactions. Finally, in Statement of Financial Accounting Standard (SFAS) No. 57, Related Party Disclosures, the FASB issued guidance on accounting for and disclosing related party transactions, which took the same approach as the ASB. After the issuance of SFAS No. 57, SAS No. 6, with its accounting guidance, was superseded by SAS No. 45, Related Parties.

In general, the PITF issues PAs to provide auditors with information that may help them improve the efficiency and effectiveness of their audits. PA 95-3, Auditing Related Parties and Related-Party Transactions (the PA) was issued because, as indicated in the first sentence of the document, "One of the more important and yet, more difficult, aspects of the financial statement audit is the identification of related parties and transactions with related parties."

Related Party Transactions

What Is a Related-Party Transaction? Related party transactions occur when a transacting party has the ability to substantially influence or exercise control of another transacting party because of a financial, common ownership, or familial relationship with that party. It may also occur when a nontransacting party can significantly affect the policies of two other transacting parties. Related party transactions include those between -

* parent and its subsidiaries,

* subsidiaries of the same parent company,

* affiliates of the same parent company,

* joint ventures,

* a company and its principal owners, management, or their immediate families (A principal owner is one with a voting interest of more than 10%. Management includes a member of the board of directors, chief financial officer, and vice presidents), and

* a company and employee trusts established and managed by it such as a profit sharing or pension plan.

SFAS No. 57 notes that related party transactions often occur in the normal course of business and may include such activities as sales, purchases, services rendered or received, property (real and personal) transfers, lease and rentals, filings of consolidated tax returns, guarantees, granting loans or incurring debt, compensating balance requirements, and allocating common costs as the basis for billings.

A transaction between related parties may not have taken place or may have been on different terms if the entities were autonomous and pursued their own best interests. The following examples illustrate this point:

* A lease of property from the parent to subsidiary at a substantially different price than if a related party relationship had not been in existence.

* A loan at an usually low interest rate because a bank is affiliated with the borrower.

* A "shell corporation" (one with no economic substance) buys merchandise at inflated prices.

* A corporation pays consulting fees for the year ending December 31, 1996 in the amount of $250,000 to an individual who is a director and stockholder of the corporation.

SFAS No. 57 also indicates related party transactions are presumed not to be at arm's length. That is, they are not derived under conditions of competitive, free-market dealings. Because of this, GAAP requires that material related party transactions be disclosed in the financial statements.

Why Is the Detection and Disclosure of Related Party Transactions Important? The purpose of the PA is to help the independent auditor improve his or her effectiveness in identifying and preparing disclosures of related party transactions material to the issuer's financial statements. In this regard, the focus of the PA is twofold and specific: "First to focus on events that may indicate transactions with undisclosed related parties are occurring and, second, to offer suggestions on how to respond to these events." The detection and full disclosure of all related party transactions is now especially important because of the recently passed Federal legislation, The Private Securities Litigation Reform Act of 1995, which requires the independent accountant include procedures in the audit of public companies that are "...designed to identify related party transactions material to the issuer's financial statements or that otherwise require disclosure in the financial statements."

Related party disclosures also enable the reader to better understand and interpret the financial statements. For example, the management of an entity may be able to generate a significant amount of earnings by transacting business with a related party. The reader of the financial statements of such an entity would, without appropriate disclosure, have no reason to doubt these transactions were carried out at other than normal competitive circumstances. In addition, although related party transactions often occur in business operations and may represent transactions that management would not otherwise be able to enter into, they also have been the vehicle used by some to perpetrate management fraud.

Audit Considerations

The audit of related parties and related party transactions is not an easy task. The PA notes the difficulty of the process stems from the fact the independent accountant depends to some degree upon management and principal owners of the entity to identify the existence of related parties and transactions with them. In addition, an entity's internal control system may not be designed to easily uncover such items. Also, such transactions, singularly and alone, may not be material and thus be difficult to identify as requiring disclosure. For example, although a given related party transaction like a purchase may not be, in itself, material, the total of such purchases generated during the period might be. In terms of overall guidance, the PA emphasizes the fact that the number one rule for identifying related party transactions (that management has not disclosed to the independent auditor) is to "simply be alert to that possibility." It also provides some specific examples of events that may suggest to the independent auditor that undisclosed related party transactions may be occurring. These include -

* sales with a commitment to repurchase that, if known, would preclude recognition of all or part of revenue.

* sales at below market rates to an unnecessary middleman related party, who, in turn, sells to the ultimate customer at a higher price with the related party (and ultimately its principals) retaining the difference.

* interest revenue at above market rates on loans.

* loans to parties that do not possess the ability to repay.

* borrowing at below market rates of interest.

* loans advanced ostensibly for a valid business purpose and later written off as uncollectible.

* purchases of assets at prices in excess of fair market value.

* payments made for services never rendered or at inflated prices.

* services or goods purchased from a party at little or no cost to the entity.

* advances of company funds that are subsequently transferred to a debtor and used to repay what would otherwise be an uncollectible loan or receivable.

* sales without substance - e.g., funding the other party to the transaction so that the sales price is fully remitted.

Assessing the Risk of Undisclosed Related Party Transactions. The PA warns the independent auditor of the risk that related parties may be used to perpetrate fraud by noting, "In the hands of the unscrupulous, an undisclosed related party is a powerful tool." It also notes that under GAAS, (SAS No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities), the independent auditor is required to evaluate the risk that the financial statements may be materially misstated due to errors and irregularities. SAS No. 53 has just been superseded by new guidance in SAS No. 82, Consideration of Fraud in a Financial Statement Audit. At the heart of this new standard is the auditor's responsibility to assess the risk factors relating to material misstatement due to fraudulent financial reporting. These risk factors may be grouped into three categories: management characteristics, industry conditions, and operating characteristics and financial stability. In the course of making his or her assessment, the independent accountant may determine that in the current circumstances, related party transactions represent a potential source of material misstatement. The following are examples of "indicators" the PA states might lead the independent auditor to conclude this potential exists:

* The existence of unique, highly complex, material transactions very close to year-end whose substance is difficult to ascertain.

* A complex corporate structure with a propensity to withhold the identity of shareholders or owners.

* Divided responsibilities for the audits of entities that have material intercompany transactions or perhaps with one of the entities not audited at all.

* Very complex transactions during the period that provide the potential for management to easily hide the economic substance of events.

The Auditor's Response - What to Do? If any of the aforementioned indicators (or any other circumstances) cause the independent accountant to conclude there is a significant risk that the financial statements may contain material misstatements because of undisclosed related party transactions, the PA suggests the performance of several procedures. For example, increased risk requires staffing the engagement with more experienced personnel or more extensive supervision by the auditor with final responsibility for the engagement during both its planning and performance phase. In addition, the auditor may choose to expand the extent of procedures applied, apply procedures closer to or as of the balance sheet date, or modify the nature of procedures to obtain more persuasive evidence. To assure a greater degree of reliability, for example, the auditor might also attempt to secure more evidential matter from independent outside sources rather than from within the company. Also, a greater risk will also cause the auditor to increase his or her professional skepticism in conducting the audit.

Other PA Related Party Guidance. Even in the absence of the aforementioned indicators of a high risk of fraudulent financial reporting, the PA suggests the independent auditor should perform many, if not all, of the audit procedures enumerated in SAS No. 45. When determining which related party audit procedures to perform during the audit, the auditor should consider the evaluation of the company's procedures for identifying related parties and related party transactions, as well as the company's controls over management's ability to enter into related party transactions. Other relevant PA related party guidance includes the following:

* Although SAS No. 19, Client Representations (AU 333), requires that a written representation letter be obtained from management that would disclose any related party transactions that have been executed during the period, it is suggested the auditor go beyond the guidance of SAS Nos. 19 and 45 and obtain written representation from the entity's board of directors indicating whether they or any related parties engaged in transactions with the entity during the period.

* The independent auditor should be cognizant that the performance of audit procedures during the period may serve more than one audit objective. That is, when performing other audit procedures, the auditor may encounter information that may enable him or her to identify the existence of related party transactions. Thus, to maximize this discovery, it is imperative that any information uncovered be fully communicated to all members of the audit team. This includes those working at other locations as well. The PA notes that the means of accomplishing this is to prepare a list of related parties during the audit planning process that should be updated throughout the audit and circulated to all audit team members.

* When events disclose the existence of possible related party transactions, the performance of additional audit procedures should be performed with respect to the other party to determine whether such a relationship actually exists. These procedures include confirming the details of the transaction with the principals of the other party (or with the other party's permission, its auditors, to clearly ascertain the nature of any relationship with the company or its management). In more involved cases, the auditor may decide to discuss the transaction with or request evidence from specific outside parties who may be familiar with the transaction. For example, bankers or legal counsel may provide helpful assistance toward this end.

* Finally, if a previously undisclosed related party transaction is found, the audit team must consider whether the failure to disclose this information was an unintentional oversight of the entity or an intentional attempt to hide the undisclosed relationship. If it is determined there was a deliberate masking of the truth, the PA suggests the auditor reassess the overall audit scope and his or her ability to rely on management's representations in other areas as well. The auditor should withdraw from the engagement if he or she believes that, based on the facts, management cannot be relied on.

Disclosure Requirements

The requirements for related party disclosures are described in SFAS No. 57. Disclosure is required only for material related party transactions. Exceptions include compensation arrangements, expense allowances, and similar items in the normal course of business activity.

Related party disclosures generally include the following components -

* the nature and substance of the relationship;

* description of the transaction(s), whether or not dollar amounts are involved;

* dollar figures for the applicable transaction(s);

* a change in accounting for the transaction(s) from one year to the next;

* balances due from or owed to the related parties at year-end including payment terms;

* the nature of the control relationship (even if no transactions have occurred) between entities under common ownership or management control that has significantly affected the financial statement amounts and that might not have occurred if such entities were independent;

* other relevant information required to comprehend the impact of the related party transaction on the financial statements.

The independent accountant should also fully analyze the entity's related party disclosures for the purpose of formulating the overall degree to which the operating results and financial position of the company have been impacted by the relationships. An evaluation should be made as to the possibility of distorted or misleading financial statements if current disclosures are deemed inadequate.

Illustrations of Related Party Disclosures Under SFAS No. 57. Some examples of typical disclosures under SFAS No. 57 follow:

* The chief executive officer also serves as the director of a major supplier. The amount of purchases from the supplier for 19X6 was $2,150,000. The amount due the supplier on December 31, 19X6 was $250,000.

* ABC Company bought crude oil amounting to $3,600,000 from XYZ Company, an affiliate, in the normal course of business.

* A major customer, DEF Company owns 30% of the company's outstanding common stock. Mr. X, a member of the board of directors, is employed by DEF Company. The sales contract is for a two year period. The selling prices and other terms of sale are mutually determined. Sales to DEF for the year ended December 31, 19X6 were $2,000,000, and the accounts receivable balance from DEF at December 31, 19X6, was $440,000.


In March 1993, the Public Oversight Board (POB) of the SEC Practice Section (SECPS) of the AICPA's Division for CPA firms issued a special report entitled, In the Public Interest - Issues Confronting the Accounting Profession. This report was the result of the POB's special examination of a wide range of controversial matters facing the accounting profession. The study was initially prompted by the representatives of a number of accounting firms who asked that the POB consider whether it could support the accounting profession's efforts to obtain relief from what the profession considered to be an excessive litigation burden. The POB's examination ultimately included not only an analysis of the litigation crisis but also an assessment of the SECPS's self-regulatory program for accounting firms, recommendations to improve the profession's self-regulatory program, recommendations for improvement of financial accounting standards and audit reports, recommendations to improve and strengthen audit performance, and other matters.

In one important issue tackled by the POB regarding improving the audit process, the board noted that although auditing standards generally define and provide guidance with respect to the nature and extent of auditor's responsibility, they should not and usually do not specify guidance on what procedures are appropriate or inappropriate in specific cases. The POB noted:

What is missing are specifics: a) examples of possible fraudulent practices linked to precisely targeted auditing guidance and rooted in an analysis of allegation's audit failure; and b) the identification of auditing practices that require reconsideration.... This guidance could be issued in a manner similar to the guidance issued in the accounting area by the Financial Accounting Standards Board's Emerging Issues Task Force. This guidance should direct attention to business, accounting, and auditing practices that pose new or special problems for auditors.

The POB wanted the profession to facilitate the resolution of emerging audit practice issues by publishing information based on issues arising in litigation, peer reviews, and firm inspections. In response to this suggestion and others comparable to it, the SECPS Executive Committee established the Professional Issues Task Force (PITF). The PITF is charged with reviewing and examining practice issues that appear to present audit concerns for practitioners. It accumulates such information and disseminates appropriate specific guidance relating to these issues in the form of Practice Alerts (PA). The task force is also responsible for referring matters that may require a reconsideration of existing standards to appropriate standard setting bodies.

The PITF consists of CPAs from diverse backgrounds and experience. For example, it includes representatives from the SECPS Executive Committee, the Quality Control Inquiry Committee, the SECPS and Private Companies Practice Section Peer Review Committees, the Auditing Standards Board, the Professional Ethics Executive Committee, and the legal or related departments of accounting firms. It is the hope of the SECPS Executive Committee that the counsel and guidance found in the Practice Alerts will be helpful to accounting professionals.

Marc H. Levine, PhD, CPA, and Joel G. Siegel, PhD, CPA, are professors at Queens College, CUNY. Adrian P. Fitzsimons, PhD, CPA, CMA, CFA, is a professor at St. John's University.
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Title Annotation:includes related article on Professional Issues Task Force
Author:Levine, Marc H.; Fitzsimons, Adrian P.; Siegel, Joel G.
Publication:The CPA Journal
Date:Mar 1, 1997
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