Related Party Transactions Part 1

Question 1

10 jan 2025

Answer 1

Definition: A transaction conducted on such terms and conditions as between a willing buyer and a willing seller who are unrelated and are acting independently of each other and pursuing their own best interests.

Example: If Company A sells goods to Company B, and neither company has any control or significant influence over the other, and both are acting in their own self-interest without any pressure or influence, this would be an arm’s length transaction.

Definition: A party that is either:
- (i) A related party as defined in the applicable financial reporting framework; or
- (ii) Where the applicable financial reporting framework establishes minimal or no related party requirements:

a) A person or other entity that has control or significant influence, directly or indirectly through one or more intermediaries, over the reporting entity;

b) Another entity over which the reporting entity has control or significant influence, directly or indirectly through one or more intermediaries; or

c) Another entity that is under common control with the reporting entity through having:

i. Common controlling ownership;

ii. Owners who are close family members; or

iii. Common key management.

Example:

• a) If Company A’s CEO owns a majority stake in Company B, then Company B is a related party to Company A due to the CEO’s control over both entities.
• b) If Company A controls Company B by owning more than 50% of its voting shares, Company B is a related party.
• c) If Company A and Company B are both controlled by the same group of shareholders or management, they are related parties.

These definitions ensure clarity and transparency in identifying and reporting related party transactions, which are crucial for accurate financial reporting and auditing. If you need further explanations or more examples, just let me know!

Goal: Identify fraud risk factors arising from related party relationships and transactions, relevant to the identification and assessment of risks of material misstatement due to fraud.

Steps for Auditors:
1. Inquire with Management:
- Identify the entity’s related parties, including any changes from the prior period.
- Understand the nature of the relationships between the entity and its related parties.
- Determine whether the entity entered into any transactions with these related parties during the period, including the type and purpose of these transactions.

2. Evaluate Internal Controls:
   
   • Assess the controls established by management to identify, account for, and disclose related party relationships and transactions in accordance with the applicable financial reporting framework (AFRF).
   • Verify the processes for authorizing and approving significant transactions and arrangements with related parties.
   • Ensure that significant transactions and arrangements outside the normal course of business are properly authorized and approved.

Important Note: If controls are not present or ineffective, the auditor may not be able to obtain sufficient appropriate audit evidence, which may lead to a modification of the audit opinion in accordance with ISA 705.

Goal: Ensure that related party relationships and transactions are appropriately identified, accounted for, and disclosed in the financial statements in accordance with the relevant framework (e.g., IAS 24).

Steps for Auditors:
1. Evaluate Accounting and Disclosure:
- Verify that related party relationships and transactions have been properly identified, accounted for, and disclosed in the financial statements.
- Ensure the financial statements achieve fair presentation and are not misleading.

2. Specific Procedures:
   
   • Compare terms of related party transactions to those of similar transactions with unrelated parties.
   • Engage external experts to determine market value and confirm market terms.
   • Evaluate the reasonableness of management’s process and assumptions for supporting the assertion that transactions were conducted at arm’s length.

Scenario: Company A’s CEO also owns Company B. During the audit, you identify transactions between Company A and Company B that were not disclosed.

1. Understanding Relationships and Transactions:
   
   • Inquire with Management:
     
     • Auditor: “Can you provide a list of all related parties, including any changes from last year?”
     • Management: “The CEO owns Company B.”
     • Auditor: “Have there been any transactions with Company B this year?”
     • Management: “Yes, we purchased services worth $100,000.”
2. Evaluate Internal Controls:
   
   • Assess Controls:
     
     • Auditor: “What controls are in place to identify and disclose related party transactions?”
     • Management: “We have a policy for disclosing related party transactions in our financial statements.”
     • Auditor: “How are significant transactions with related parties authorized and approved?”
3. Obtaining Audit Evidence:
   
   • Verify Accounting and Disclosure:
     
     • Auditor: “Let’s check the financial statements and ensure the $100,000 transaction with Company B is disclosed appropriately.”
     • Procedures:
       
       • Compare the terms of the transaction with market terms for similar services.
       • Engage an external expert to confirm that the transaction was conducted at market value.

By following these steps, auditors can ensure related party transactions are properly identified, evaluated, and disclosed, maintaining the integrity of the financial statements.

If you need more details or have further questions, feel free to ask!

Once auditors understand the related party relationships and transactions, they must discuss and share this information with the engagement team. Key points to cover include:

1. Nature and Extent of Relationships and Transactions
   
   • Discuss the specifics of the entity’s relationships and transactions with related parties.
2. Emphasis on Professional Skepticism
   
   • Highlight the importance of maintaining professional skepticism throughout the audit.
3. Unidentified or Undisclosed Relationships
   
   • Consider circumstances or conditions that may indicate the existence of undisclosed related party relationships or transactions.
4. Records Indicating Related Party Relationships
   
   • Review records or documents that may suggest related party relationships or transactions.

Discussions about fraud should include how related parties might be used to facilitate fraudulent activities, such as earnings management or misappropriation of assets. Special attention should be given to:

• Special Purpose Entities: Used to manipulate financial results.
• Unusual Transactions: Significant or non-routine transactions that might be designed to mislead.

The first objective is to understand related party relationships and transactions by:
- Inquiring with management.
- Considering internal controls.
- Identifying and assessing the risk of material misstatement as per ISA 315 (Revised 2019) and ISA 240.

After performing the initial procedures, auditors may encounter certain risks or situations. Here’s how to respond:

Response and Procedures:
1. Confirm with Intermediaries:
- Discuss specific aspects of the transactions with banks, law firms, guarantors, or agents.
2. Confirm with Related Parties:
- Verify the purposes, specific terms, and amounts of the transactions with the related parties.
3. Review Financial Statements:
- Where applicable, read the financial statements or other relevant financial information of the related parties for evidence of proper accounting.

Examples:
- Complex equity transactions.
- Leasing premises or rendering management services without consideration.
- Sales transactions with unusually large discounts or returns.

Response and Procedures:
1. Inspect Contracts or Agreements:
- Evaluate the business rationale and terms of the transactions.
- Ensure the transactions are consistent with management’s explanations and appropriately accounted for and disclosed.

2. Obtain Audit Evidence:
   
   • Verify that the transactions have been properly authorized and approved.

Scenario: Company A has entered into a complex equity transaction with a related party, Company B.

1. Inspect Contracts:
   
   • Auditor: “Let’s review the contract for this equity transaction.”
   • Evaluate the business rationale to ensure it doesn’t suggest fraudulent reporting or asset misappropriation.
2. Confirm Terms:
   
   • Auditor: “Are the terms of this transaction consistent with what management has explained to us?”
3. Verify Authorization:
   
   • Ensure that the transaction was authorized and approved according to the entity’s procedures.

By following these procedures, auditors can ensure that related party transactions are properly identified, evaluated, and disclosed, maintaining the integrity of the financial statements.

If you need more details or have further questions, feel free to ask!