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Related party transactions are gaining attention from external auditors in recent years. They are not inherently wrong, but they do pose a risk for misstatement or omission in financial reporting.
Problems with related parties became hot button issues with the scandals nearly two decades ago concerning Enron, Tyco International, and Refco. These scandals led to Congress passing the Sarbanes-Oxley Act of 2002, and establish the Public Company Oversight Board (PCAOB). Problems have still arisen in recent years during financial reporting fraud. In turn, the PCAOB enacted more stringent standards for related-party transactions and financial relationships.
Auditors of public companies must raise their efforts in financial statement issues that pose the risk of fraud under PCAOB Auditing Standard No. 2410 (AS 2410). There are three critical areas auditors must focus on:
- Related-party transactions in matters of directors, executives, and their family members.
- Significant unusual transactions (SUT) outside the company’s regular course of business or those that appear to be unusual due to nature, size, or timing.
- Other financial relationships with the company’s executive officers and directors.
Exposing these transactions and financial relationships to enhanced auditor attention could help avoid corporate failures. The PCAOB also has the goal of enhanced auditor scrutiny leading to improvements in accounting transparency and disclosures, which will aid investors in gauging financial performance and fraud risks.
Under AS 2410 auditors are required to obtain a more in-depth understanding of every related-party financial transaction and relationship. This understanding includes the nature of the relationship, terms, and business purpose (or lack of thereof). These stricter related-party audit procedures must be performed alongside the auditor’s risk assessment procedures, occurring in the planning phase of the audit.
Auditors are also expected to communicate with the audit committee through the entire audit process regarding the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of related-party relationships and transactions. Auditors cannot wait until the finalization of engagement to communicate about related-party transaction matters.
During fieldwork, auditors will be looking for undisclosed related parties and unusual transactions. Information gathered from sources such as the company’s website, tax filings, corporate life insurance policies, contracts, and organizational charts can uncover undisclosed related parties.
Transactions that might be questionable including contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and, subsequent repurchase of goods sold, can all signal that a company might be engaged in unusual or undisclosed related-party transactions.
Management should be upfront about all related party transactions to auditors, even if these transactions are not required to be disclosed or consolidated in the company’s financial statements.
Both public and private companies engage in related party transactions. For private companies, spillover can come from tougher PCAOB standards for public companies. It is important for both types of companies to disclose their related party transactions. We can help you to present these relationships and transactions completely and openly.
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