In recent years, external auditors have focused more attention on related party transactions. Although related party transactions are not necessarily bad, they do raise some concerns about the risk of misstatement or omission in financial reporting.
Three focal points
Issues with related parties played a prominent role in the scandals that surfaced nearly two decades ago at Enron, Tyco International, and Refco. Public outrage about these scandals led Congress to pass the Sarbanes-Oxley Act of 2002 and establish the Public Company Accounting Oversight Board (PCAOB). Similar problems have arisen in more recent financial reporting fraud cases, prompting the PCAOB to enact tougher standards on related-party transactions and financial relationships.
PCAOB Auditing Standard No. 2410 (AS 2410), Related Parties, requires auditors of public companies to enhance their efforts in financial statement matters that pose increased risk of fraud. Specifically, auditors must focus on three critical areas:
- Related-party transactions, such as those involving directors, executives, and their family members
- Significant unusual transactions that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size, or nature
- Other financial relationships with the company’s executive officers and directors
Subjecting these transactions and financial relationships to enhanced auditor scrutiny may help avert corporate failures. The PCAOB also hopes that enhanced auditor scrutiny will lead to improvements in accounting transparency and disclosures, which will help investors to more clearly gauge financial performance and fraud risks.
From start to finish
AS 2410 requires auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including their nature, terms, and business purpose (or lack thereof). Tougher related-party audit procedures must be performed in conjunction with the auditor’s risk assessment procedures, which occur in the planning phase of an audit.
In addition, auditors are expected to communicate with the audit committee throughout the audit process regarding the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its related-party relationships and transactions. They cannot wait until the end of the engagement to communicate on these matters.
During fieldwork, expect auditors to be on the hunt for undisclosed related parties and unusual transactions. Examples of information that may be gathered during the audit that could reveal undisclosed related parties include information contained on the company’s website, tax filings, corporate life insurance policies, contracts, and organizational charts.
Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans, and subsequent repurchase of goods sold — also might signal that a company is engaged in unusual or undisclosed related-party transactions.
To facilitate the audit process, management should be up-front with auditors about all related party transactions, even if they are not required to be disclosed or consolidated on the company’s financial statements.
To be honest
Private companies also engage in numerous related party transactions, and they may experience spillover effects of the tougher PCAOB auditing standard, which applies only to audits of public companies. Regardless of whether you are publicly traded or privately held, it is important to identify, evaluate, and disclose all related parties. We can help you present related party relationships and transactions, openly and completely.