Part 2 Chapter 11

Question 1

9 Jan 2024

Answer 1

In situations where related party transactions are outside the usual business activities, auditors need to evaluate the business rationale carefully. Here are the key considerations and steps:

1. Complexity of the Transaction
   
   • Overly Complex: Determine if the transaction is unusually complicated, involving multiple related parties within a consolidated group.
   • Example: A sales transaction with a commitment to repurchase, which involves multiple entities within the group.
2. Unusual Terms of Trade
   
   • Unusual Terms: Check for atypical prices, interest rates, guarantees, and repayment terms.
   • Example: Sales transactions with unusually large discounts or returns, or contracts with changed terms before expiry.
3. Lack of Apparent Business Reason
   
   • Logical Business Reason: Assess if the transaction lacks an obvious business rationale for its occurrence.
   • Example: Transactions processed in an unusual manner or involving previously unidentified related parties.
4. Management’s Discussions with Governance
   
   • Governance Discussions: Evaluate whether management has discussed the nature and accounting for the transaction with those charged with governance.
   • Example: Management’s explanation of the transaction during board meetings.
5. Emphasis on Accounting Treatment
   
   • Accounting Emphasis: Determine if management places more emphasis on a specific accounting treatment rather than the underlying economics of the transaction.
   • Example: Favoring an accounting method that benefits financial statements without regard to actual business reasons.

If management’s explanations are inconsistent with the terms of the related party transaction, the auditor must, in accordance with ISA 500, assess the reliability of these explanations and representations on other significant matters.

In cases where there is a significant risk due to fraud, auditors should:
- Inquire with Management and Governance: Ask management and those charged with governance about the nature and rationale of the transaction.
- Inspect Significant Contracts: Review contracts and agreements for any unusual terms or conditions that might indicate fraudulent activity.

Scenario: Company A enters into a complex equity transaction with Company B, involving circular arrangements where goods are sold with a commitment to repurchase.

1. Evaluate Complexity:
   
   • Auditor: “This transaction seems overly complex, involving multiple entities. Let’s break down its components.”
2. Check Unusual Terms:
   
   • Auditor: “The terms of trade here are unusual, with large discounts and repurchase commitments. We need to assess if these terms are consistent with market practices.”
3. Assess Business Rationale:
   
   • Auditor: “What is the logical business reason for this transaction? Does it serve a clear purpose?”
4. Review Management Discussions:
   
   • Auditor: “Has this transaction been discussed with the board? Are the board minutes reflecting the nature and accounting of this transaction?”
5. Verify Accounting Treatment:
   
   • Auditor: “Is management focusing too much on accounting treatment rather than the actual business impact of the transaction?”
6. Inquire and Inspect:
   
   • Auditor: “We need to inquire further with management and inspect all significant contracts to rule out any fraudulent activities.”

By following these steps, auditors ensure that significant related party transactions are thoroughly evaluated, properly disclosed, and that any potential fraud risks are mitigated.

If you need more details or have further questions, feel free to ask!Sure, I can explain these concepts in simpler terms with practical and mathematical examples.

Definition: Transactions between the entity and related parties such as owners, management, or other entities where there is significant influence or control.

Imagine Company A sells goods to Company B. Company A’s CEO is also a major shareholder in Company B. This makes Company B a related party.

1. Bank and Legal ConfirmationsProcedure: Verify bank statements and legal documents for any transactions with related parties.Example: Company A’s bank statement shows a payment to Company B. The auditor verifies the payment with the bank to ensure it’s correctly recorded.
2. Minutes of MeetingsProcedure: Review meeting minutes for discussions on related party transactions.Example: The auditor checks the minutes of a board meeting where the CEO proposed a new contract with Company B.
3. Third-Party ConfirmationsProcedure: Obtain confirmations from third parties about transactions.Example: The auditor sends a confirmation request to Company B to verify the details of the transaction with Company A.
4. Tax ReturnsProcedure: Examine the entity’s income tax returns for related party transactions.Example: The tax return shows deductions for payments made to Company B, indicating a related party transaction.
5. Regulatory InformationProcedure: Check information supplied to regulatory authorities for related party disclosures.Example: The auditor reviews regulatory filings to see if the related party transaction with Company B was disclosed.
6. Shareholder RegistersProcedure: Identify principal shareholders to find related parties.Example: The shareholder register shows that the CEO of Company A is a major shareholder in Company B.
7. Conflict of Interest StatementsProcedure: Review conflict of interest statements from management.Example: Management’s conflict of interest statement discloses the CEO’s interest in Company B.

Let’s say Company A sold goods worth $50,000 to Company B. The auditor needs to verify this transaction.

1. Bank Confirmation: The bank confirms that Company A received $50,000 from Company B.
2. Sales Ledger: The auditor checks Company A’s sales ledger to ensure the $50,000 sale is recorded accurately.
3. Confirmation Request: The auditor sends a confirmation request to Company B, which confirms the purchase of $50,000 goods from Company A.
4. Tax Return Check: Company A’s tax return shows a deduction of $50,000 for the sale, consistent with the transaction.

By following these procedures, auditors ensure that related party transactions are identified, verified, and disclosed properly to maintain transparency and avoid conflicts of interest.

I hope this clarifies the concept for you! If you have more specific questions or need further examples, feel free to ask.

As an auditor, if you come across information that suggests the existence of related party relationships or transactions not previously disclosed by management, here’s how you should proceed:

1. Communicate with Engagement Team
   
   • Example: You discover that Company A’s CEO is also a board member of Company B, which wasn’t disclosed. Immediately inform your audit team about this new finding.
2. Request Management to Identify All Transactions
   
   • Example: Ask management to provide a list of all transactions with Company B, the newly identified related party.
3. Inquire About Control Failures
   
   • Example: Ask management why their internal controls didn’t identify the relationship between the CEO and Company B.
4. Perform Substantive Audit Procedures
   
   • Example: Review additional documents and perform detailed testing on transactions between Company A and Company B to ensure they are properly recorded and disclosed.
5. Evaluate Implications of Non-Disclosure
   
   • Example: If you suspect that management intentionally did not disclose the relationship to manipulate financial statements, assess the risk of material misstatement due to fraud and consider its impact on your audit opinion.

Let’s say Company A made several transactions with Company B amounting to $100,000 during the audit period. These transactions were not disclosed by management.

1. Communicate with Engagement Team
   
   • Auditor: “Team, I’ve identified $100,000 worth of transactions between Company A and Company B, which were not disclosed. We need to investigate further.”
2. Request Management to Identify All Transactions
   
   • Auditor: “Management, please provide a detailed list of all transactions with Company B for our review.”
3. Inquire About Control Failures
   
   • Auditor: “Why did your internal controls fail to identify the relationship between your CEO and Company B?”
4. Perform Substantive Audit Procedures
   
   • Auditor: “Let’s verify these $100,000 worth of transactions. We will check invoices, payment records, and correspondence to ensure everything is properly documented and recorded.”
5. Evaluate Implications of Non-Disclosure
   
   • Auditor: “Given the non-disclosure, we need to assess the risk of fraud. We will consider how this impacts our overall audit strategy and potentially our audit opinion.”

By following these steps, you ensure that all related party relationships and transactions are properly identified, evaluated, and disclosed, maintaining the integrity of the financial statements. If you have more specific questions or need further clarification, feel free to ask!

When an auditor identifies significant transactions that fall outside the usual business activities of an entity, it’s essential to dig deeper and understand the rationale behind these transactions. Here’s how to approach it:

1. Inquire About the Nature of the Transactions
   
   • Business Rationale: Understand why these transactions were undertaken and their business purpose.
   • Terms and Conditions: Review the terms and conditions under which these transactions were conducted to ensure they are reasonable and arm’s length.
2. Assess Involvement of Related Parties
   
   • Inquiry: Ask management whether any related parties were involved in these transactions to identify potential conflicts of interest or undisclosed relationships.

Let’s say Company A usually sells electronic goods. However, during the audit, you identify a significant transaction where Company A sold a piece of land for $500,000. This transaction is outside its normal course of business.

1. Inquire About the Nature of the Transactions
   
   • Auditor: “Management, can you explain the business rationale for selling the land? What are the terms and conditions of the sale?”
   • Management: “We sold the land to free up capital for a new product line. The sale was at market value with standard terms.”
2. Assess Involvement of Related Parties
   
   • Auditor: “Were any related parties involved in this transaction?”
   • Management: “No, the buyer was a third party with no connection to our company.”

Consider Company A’s financial statements:

• Regular Sales: $1,000,000 (electronic goods)
• Land Sale: $500,000 (outside normal course)

The land sale is a significant transaction. The auditor would:
1. Verify the sale agreement to ensure the terms and conditions are market-based.
2. Compare the sale price to market valuations to confirm it’s reasonable.
3. Check if the buyer has any connections to Company A’s management or shareholders.

By following these steps, the auditor ensures transparency and identifies any potential related party involvement in significant transactions outside the normal course of business.

I hope this makes the concept clear and easy to understand! If you have any more questions or need further examples, feel free to ask.

After identifying and addressing the risks associated with related party relationships and transactions, auditors need to evaluate these transactions to form an opinion according to International Standards on Auditing (ISA) 700. Here’s a simplified breakdown:

1. Appropriate Accounting and Disclosure
   
   • Evaluate: Determine if related party transactions and relationships are correctly accounted for and disclosed in accordance with the relevant financial reporting framework.
   • Example: Check if transactions with related parties are recorded at fair value and disclosed transparently in the notes to the financial statements.
2. Assess Effects on Financial Statements
   
   • Fair Presentation: Ensure that related party transactions do not prevent the financial statements from presenting a true and fair view (for fair presentation frameworks).
   • Misleading Information: Verify that related party transactions do not cause the financial statements to be misleading (for compliance frameworks).
   • Example: Assess whether the non-disclosure or incorrect disclosure of a transaction with a related party affects the overall reliability and fairness of the financial statements.
3. Understandability of Disclosures
   
   • Clear Business Rationale: Ensure that the business rationale and the effects of the transactions on the financial statements are clear and accurate.
   • Comprehensive Disclosure: Verify that key terms, conditions, and other important elements of the transactions are disclosed appropriately.
   • Example: If a company engages in a transaction with a related party, the disclosure should clearly explain why the transaction was necessary, its terms, and how it impacts the financial position of the company.

• Qualitative Materiality: Related party transactions are qualitatively material, meaning their significance is not just in their amount but also in their nature and the potential impact on the users of the financial statements.

Let’s say Company A sold goods worth $200,000 to Company B, a related party.

1. Appropriate Accounting and Disclosure
   
   • Check: Ensure the sale is recorded at fair value and the transaction is disclosed in the notes to the financial statements.
2. Assess Effects on Financial Statements
   
   • Evaluate: Determine if the sale prevents the financial statements from giving a true and fair view or causes them to be misleading. If the transaction was not at fair value or was not disclosed, it might affect the reliability of the financial statements.
3. Understandability of Disclosures
   
   • Review: Ensure the disclosure clearly states the business rationale for the sale, the terms of the transaction, and its impact on the financial position.

By following these procedures, auditors help ensure transparency and integrity in financial reporting, providing stakeholders with accurate and reliable financial information.

I hope this simplifies the concept for you! If you need further clarification or more examples, feel free to ask.

Objective: Ensure that the auditor obtains sufficient appropriate audit evidence regarding related parties by obtaining specific written representations from management.

1. Disclosure of Related Parties
   
   • Management must disclose the identity of related parties and all related party relationships and transactions they are aware of.
2. Accounting and Disclosure
   
   • Management must confirm that they have appropriately accounted for and disclosed these relationships and transactions in accordance with the applicable financial reporting framework.

1. Approved Transactions
   
   • When those charged with governance have approved specific related party transactions that materially affect the financial statements or involve management.
2. Oral Representations
   
   • When they have made specific oral representations to the auditor on details of certain related party transactions.
3. Interests in Related Parties
   
   • When they have financial or other interests in the related parties or related party transactions.

If management asserts that related party transactions were conducted on terms equivalent to those prevailing in an arm’s length transaction, the auditor must obtain sufficient appropriate audit evidence to support this assertion.

1. **Comparison with Unrelated Parties terms of the related party transaction with those of an identical or similar transaction involving unrelated parties.
2. External Expert Engagement
   
   • Engage an external expert to determine market value and confirm market terms and conditions for the transaction.
3. Comparison with Market Terms
   
   • Compare the transaction terms to known market terms for broadly similar transactions on an open market.
4. Management’s Process Evaluation
   
   • Evaluate the appropriateness of management’s process for supporting the assertion.
5. Data Verification
   
   • Verify the source of internal or external data supporting the assertion, and test the data for accuracy, completeness, and relevance.
6. Assumptions Evaluation
   
   • Evaluate the reasonableness of any significant assumptions on which the assertion is based.

Scenario: Company A asserts that a transaction with Company B, a related party, was conducted at market terms.

1. Comparison with Unrelated Parties
   
   • The auditor finds that similar transactions with unrelated parties were conducted at the same terms, supporting the arm’s length assertion.
2. External Expert Engagement
   
   • An external valuation expert confirms that the transaction terms are consistent with market conditions.
3. Comparison with Market Terms
   
   • The auditor verifies that the terms align with market terms for similar transactions.
4. Management’s Process Evaluation
   
   • The auditor evaluates management’s process for determining market terms and finds it robust and appropriate.
5. Data Verification
   
   • The auditor verifies internal records and external data, confirming their accuracy and relevance.
6. Assumptions Evaluation
   
   • The auditor assesses the assumptions used by management and finds them reasonable and well-supported.

By following these procedures, auditors can ensure that related party transactions are appropriately accounted for and disclosed, maintaining the integrity and transparency of the financial statements.

I hope this helps clarify the concept! If you have any more questions or need further examples, feel free to ask.

Objective: To ensure that related party relationships and transactions are properly identified, assessed, and disclosed in the financial statements.

1. ISA 240: The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
   
   • Description: Management may have opportunities to commit fraudulent financial reporting due to the existence of significant related party transactions not conducted in the ordinary course of business.
   • Linkage: The auditor must remain alert to the possibility of fraud through related party transactions and perform additional procedures as necessary to address the risk of material misstatement due to fraud.
2. ISA 315 (Revised 2019): Identifying and Assessing the Risks of Material Misstatement
   
   • Description: Significant transactions with related parties are considered significant risks.
   • Linkage: The auditor should assess the risk of material misstatement due to related party transactions as a significant risk and design appropriate audit procedures to address this risk.
3. ISA 705: Modifications to the Opinion in the Independent Auditor’s Report
   
   • Description:
     
     • If controls are not present or effective, the auditor may not obtain sufficient appropriate audit evidence, leading to a modification of the opinion.
     • If related party transactions are not appropriately accounted for or disclosed in accordance with IAS 24, the auditor must modify the opinion accordingly.
   • Linkage: The auditor should assess the adequacy of the entity’s controls over related party transactions and ensure they are properly accounted for and disclosed. If deficiencies are identified, the auditor may need to issue a qualified opinion or an adverse opinion based on the severity of the issue.

Scenario: During the audit of Company A, the auditor identifies significant transactions with a related party, Company B. Management has not disclosed these transactions, and the internal controls over related party transactions are ineffective.

1. ISA 240: The auditor identifies a risk of fraudulent financial reporting due to undisclosed related party transactions.
2. ISA 315: The auditor considers the transactions with Company B as a significant risk and performs additional procedures to assess the risk of material misstatement.
3. ISA 705:
   
   • The auditor finds that the internal controls over related party transactions are ineffective, resulting in insufficient appropriate audit evidence.
   • The transactions with Company B are not appropriately disclosed in the financial statements, requiring a modification of the opinion.

By linking ISA 550 with ISAs 240, 315, and 705, auditors can effectively address the risks associated with related party transactions, ensure they are properly disclosed, and modify their opinion if necessary to reflect the reliability and transparency of the financial statements.

If you need further clarification or examples, feel free to ask!