Common methods for auditors to determine related parties include ______.

The term related-party transaction refers to a deal or arrangement made between two parties who are joined by a preexisting business relationship or common interest. Companies often seek business deals with parties with whom they are familiar or have a common interest.

Although related-party transactions are themselves legal, they may create conflicts of interest or lead to other illegal situations. Public companies must disclose these transactions.

• A related-party transaction is an arrangement between two parties that have a preexisting business relationship.
• Some, but not all, related party-transactions carry the innate potential for conflicts of interest, so regulatory agencies scrutinize them carefully.
• Unchecked, the misuse of related-party transactions could result in fraud and financial ruin for all parties involved.
• American regulatory bodies ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively.

It isn't uncommon for companies to do business with people and organizations with whom they already have relationships. This kind of business activity is called a related-party transaction. The most common types of related parties are business affiliates, shareholder groups, subsidiaries, and minority-owned companies. Related-party transactions can include sales, leases, service agreements, and loan agreements.

As mentioned above, these types of transactions are not necessarily illegal. But they can cloud the business environment by leading to conflicts of interest as they show favorable treatment for close associates of the hiring business. Consider a company that hires a major shareholder's business to renovate its offices. In some cases, related-party transactions must be approved by management consensus or a company’s board of directors. These transactions also limit competition in the marketplace.

In the United States, securities regulatory agencies help to ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively. For instance, the Securities and Exchange Commission (SEC) requires that all publicly-traded companies disclose all transactions with related parties—such as executives, associates, and family members—in their quarterly 10-Q reports and their annual 10-K reports. As such, many companies have compliance policies and procedures in place that outline how to document and implement related-party transactions.

Related-party transactions must be reported transparently to ensure that all actions are legal and ethical and do not compromise shareholder value.

The Financial Accounting Standards Board (FASB), which establishes accounting rules for public and private companies as well as nonprofits in the United States, has accounting standards for related-party transactions. Some of these standards include monitoring of payment competitiveness, payment terms, monetary transactions, and authorized expenses.

Although there are rules and standards for related-party transactions, they tend to be difficult to audit. Owners and managers are responsible for disclosing related parties and their interests, but if they withhold disclosure for personal gain, the transactions could go undetected. Transactions with related parties may be recorded among similar normal transactions, making them difficult to distinguish. Hidden transactions and undisclosed relationships could lead to improperly inflated earnings, even fraud.

Enron was a U.S.-based energy and commodities company based in Houston. In the infamous scandal of 2001, the company used related-party transactions with special-purpose entities to help conceal billions of dollars in debt from failed business ventures and investments. The related parties misled the board of directors, their audit committee, employees, as well as the public. 

These fraudulent related-party transactions led to Enron's bankruptcy, prison sentences for its executives, lost pensions and savings of employees and shareholders, and the ruin and closure of Arthur Andersen, Enron's auditor, which was found guilty of federal crimes and SEC violations.

This financial disaster led to the development of the Sarbanes-Oxley Act of 2002, which established new and expanded existing requirements for U.S. public company boards, management, and public accounting firms, including specific rules that limit conflicts of interest arising from related-party transactions.

Related parties include parent companies, subsidiaries, associate firms, joint ventures, or a company or entity that is controlled or significantly influenced or managed by a person who is a related party.

IFRS' IAS 24 covers related parties. The objective of IAS 24 is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties.

Yes. The Internal Revenue Service (IRS) examines related-party transactions for any conflicts of interest. If it finds conflicts, the IRS will not allow any tax benefits claimed from the transaction. In particular, the IRS often scrutinizes property sales between related parties and deductible payments between related parties. 

 .01        This standard establishes requirements regarding the auditor's evaluation of a company's identification of, accounting for, and disclosure of relationships and transactions between the company and its related parties.1

Objective

.02        The objective of the auditor is to obtain sufficient appropriate audit evidence to determine whether related parties and relationships and transactions with related parties have been properly identified, accounted for, and disclosed in the financial statements.2

Performing Risk Assessment Procedures to Obtain an Understanding of the Company's Relationships and Transactions with Its Related Parties

.03         The auditor should perform procedures to obtain an understanding of the company's relationships and transactions with its related parties that might reasonably be expected to affect the risks of material misstatement of the financial statements in conjunction with performing risk assessment procedures in accordance with AS 2110, Identifying and Assessing Risks of Material Misstatement. The procedures performed to obtain an understanding of the company's relationships and transactions with its related parties include:

1. Obtaining an understanding of the company's process (paragraph .04);
2. Performing inquiries (paragraphs .05-.07); and
3. Communicating with the audit engagement team and other auditors (paragraphs .08-.09).

Note: Obtaining an understanding of the company's relationships and transactions with its related parties includes obtaining an understanding of the nature of the relationships between the company and its related parties and of the terms and business purposes (or the lack thereof) of the transactions involving related parties.

Note: Performing the risk assessment procedures described in paragraphs .04-.09 of this standard in conjunction with the risk assessment procedures required by AS 2110 is intended to provide the auditor with a reasonable basis for identifying and assessing risks of material misstatement associated with related parties and relationships and transactions with related parties.

.04         In conjunction with obtaining an understanding of internal control over financial reporting, the auditor should obtain an understanding of the company's process for:3

1. Identifying related parties and relationships and transactions with related parties;
2. Authorizing and approving transactions with related parties; and
3. Accounting for and disclosing relationships and transactions with related parties in the financial statements.

.05         The auditor should inquire of management regarding:4

1. The names of the company's related parties during the period under audit, including changes from the prior period;
2. Background information concerning the related parties (for example, physical location, industry, size, and extent of operations);
3. The nature of any relationships, including ownership structure, between the company and its related parties;
4. The transactions entered into, modified, or terminated, with its related parties during the period under audit and the terms and business purposes (or the lack thereof) of such transactions;
5. The business purpose for entering into a transaction with a related party versus an unrelated party;
6. Any related party transactions that have not been authorized and approved in accordance with the company's established policies or procedures regarding the authorization and approval of transactions with related parties; and
7. Any related party transactions for which exceptions to the company's established policies or procedures were granted and the reasons for granting those exceptions.

.06         The auditor should inquire of others within the company regarding their knowledge of the matters in paragraph .05 of this standard. The auditor should identify others within the company5 to whom inquiries should be directed, and determine the extent of such inquires, by considering whether such individuals are likely to have knowledge regarding:

1. The company's related parties or relationships or transactions with related parties;
2. The company's controls over relationships or transactions with related parties; and
3. The existence of related parties or relationships or transactions with related parties previously undisclosed to the auditor.6

.07         The auditor should inquire of the audit committee,7 or its chair, regarding:

1. The audit committee's understanding of the company's relationships and transactions with related parties that are significant to the company; and
2. Whether any member of the audit committee has concerns regarding relationships or transactions with related parties and, if so, the substance of those concerns.

.08         The auditor should communicate to engagement team members relevant information about related parties, including the names of the related parties and the nature of the company's relationships and transactions with those related parties.8

.09         If the auditor is using the work of another auditor, the auditor should communicate to the other auditor relevant information about related parties, including the names of the company's related parties and the nature of the company's relationships and transactions with those related parties.9 The auditor also should inquire of the other auditor regarding the other auditor's knowledge of any related parties or relationships or transactions with related parties that were not included in the auditor's communications.

Identifying and Assessing Risks of Material Misstatement

.10         The auditor should identify and assess the risks of material misstatement at the financial statement level and the assertion level.10 This includes identifying and assessing the risks of material misstatement associated with related parties and relationships and transactions with related parties, including whether the company has properly identified, accounted for, and disclosed its related parties and relationships and transactions with related parties.

Note: In identifying and assessing the risks of material misstatement associated with related parties and relationships and transactions with related parties, the auditor should take into account the information obtained from performing the procedures in paragraphs .04-.09 of this standard and from performing the risk assessment procedures required by AS 2110.

.11         The auditor must design and implement audit responses that address the identified and assessed risks of material misstatement.11 This includes designing and performing audit procedures in a manner that addresses the risks of material misstatement associated with related parties and relationships and transactions with related parties.12

Note: The auditor also should look to the requirements in paragraphs .66-.67A of AS 2401, Consideration of Fraud in a Financial Statement Audit, for related party transactions that are also significant unusual transactions (for example, significant related party transactions outside the normal course of business). For such related party transactions, AS 2401.67 requires that the auditor evaluate whether the business purpose (or the lack thereof) of the transactions indicates that the transactions may have been entered into to engage in fraudulent financial reporting or conceal misappropriation of assets.

.12         For each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk, the auditor should:

1. Read the underlying documentation and evaluate whether the terms and other information about the transaction are consistent with explanations from inquiries and other audit evidence about the business purpose (or the lack thereof) of the transaction;
2. Determine whether the transaction has been authorized and approved in accordance with the company's established policies and procedures regarding the authorization and approval of transactions with related parties;
3. Determine whether any exceptions to the company's established policies or procedures were granted;13
4. Evaluate the financial capability of the related parties with respect to significant uncollected balances, loan commitments, supply arrangements, guarantees, and other obligations, if any;14 and
5. Perform other procedures as necessary to address the identified and assessed risks of material misstatement.

Note: The applicable financial reporting framework may allow the aggregation of similar related party transactions for disclosure purposes. If the company has aggregated related party transactions for disclosure purposes in accordance with the applicable financial reporting framework, the auditor may perform the procedures in paragraph .12 for only a selection of transactions from each aggregation of related party transactions (versus all transactions in the aggregation), commensurate with the risks of material misstatement.

.13        The auditor should perform procedures on intercompany account balances as of concurrent dates, even if fiscal years of the respective companies differ.

Note: The procedures performed should address the risks of material misstatement associated with the company's intercompany accounts.

.14         The auditor should evaluate whether the company has properly identified its related parties and relationships and transactions with related parties. Evaluating whether a company has properly identified its related parties and relationships and transactions with related parties involves more than assessing the process used by the company. This evaluation requires the auditor to perform procedures to test the accuracy and completeness of the related parties and relationships and transactions with related parties identified by the company, taking into account the information gathered during the audit.15 As part of this evaluation, the auditor should read minutes of the meetings of stockholders, directors, and committees of directors, or summaries of actions of recent meetings for which minutes have not yet been prepared.

Note: Appendix A contains examples of information and sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist.

.15         If the auditor identifies information that indicates that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist, the auditor should perform the procedures necessary to determine whether previously undisclosed relationships or transactions with related parties, in fact, exist.16 These procedures should extend beyond inquiry of management.

.16         If the auditor determines that a related party or relationship or transaction with a related party previously undisclosed to the auditor exists, the auditor should:

1. Inquire of management regarding the existence of the related party or relationship or transaction with a related party previously undisclosed to the auditor and the possible existence of other transactions with the related party previously undisclosed to the auditor;
2. Evaluate why the related party or relationship or transaction with a related party was previously undisclosed to the auditor;17
3. Promptly communicate to appropriate members of the engagement team and other auditors participating in the audit engagement relevant information about the related party or relationship or transaction with the related party;
4. Assess the need to perform additional procedures to identify other relationships or transactions with the related party previously undisclosed to the auditor;
5. Perform the procedures required by paragraph .12 of this standard for each related party transaction previously undisclosed to the auditor that is required to be disclosed in the financial statements or determined to be a significant risk; and
6. Perform the following procedures, taking into account the information gathered from performing the procedures in a. through e. above:

1. Evaluate the implications on the auditor's assessment of internal control over financial reporting, if applicable;
2. Reassess the risk of material misstatement and perform additional procedures as necessary if such reassessment results in a higher risk;18 and
3. Evaluate the implications for the audit if management's nondisclosure to the auditor of a related party or relationship or transaction with a related party indicates that fraud or an illegal act may have occurred. If the auditor becomes aware of information indicating that fraud or another illegal act has occurred or might have occurred, the auditor must determine his or her responsibilities under AS 2401.79-.82, AS 2405, Illegal Acts by Clients, and Section 10A of the Securities Exchange Act of 1934, 15 U.S.C. §78j-1.

.17         The auditor must evaluate whether related party transactions have been properly accounted for and disclosed in the financial statements. This includes evaluating whether the financial statements contain the information regarding relationships and transactions with related parties essential for a fair presentation in conformity with the applicable financial reporting framework.19

.18        If the financial statements include a statement by management that transactions with related parties were conducted on terms equivalent to those prevailing in an arm's-length transaction, the auditor should determine whether the evidence obtained supports or contradicts management's assertion. If the auditor is unable to obtain sufficient appropriate audit evidence to substantiate management's assertion, and if management does not agree to modify the disclosure, the auditor should express a qualified or adverse opinion.20

Note: Transactions with related parties might not be conducted on terms equivalent to those prevailing in arm's-length transactions (e.g., a company may receive services from a related party without cost). Except for routine transactions, it may not be possible for management to determine whether a particular transaction would have taken place, or what the terms and manner of settlement would have been, if the parties had not been related. Accordingly, it may be difficult for the auditor to obtain sufficient appropriate audit evidence to substantiate management's assertion that a transaction was consummated on terms equivalent to those that prevail in arm's-length transactions. A preface to a statement such as "management believes that" or "it is the company's belief that" does not change the auditor's responsibilities.

.19         The auditor should communicate to the audit committee the auditor's evaluation of the company's identification of, accounting for, and disclosure of its relationships and transactions with related parties.21 The auditor also should communicate other significant matters arising from the audit regarding the company's relationships and transactions with related parties including, but not limited to:

1. The identification of related parties or relationships or transactions with related parties that were previously undisclosed to the auditor;
2. The identification of significant related party transactions that have not been authorized or approved in accordance with the company's established policies or procedures;
3. The identification of significant related party transactions for which exceptions to the company's established policies or procedures were granted;
4. The inclusion of a statement in the financial statements that a transaction with a related party was conducted on terms equivalent to those prevailing in an arm's-length transaction and the evidence obtained by the auditor to support or contradict such an assertion; and
5. The identification of significant related party transactions that appear to the auditor to lack a business purpose.

Appendix A - Examples of Information and Sources of Information That May Be Gathered During the Audit That Could Indicate That Related Parties or Relationships or Transactions with Related Parties Previously Undisclosed to the Auditor Might Exist

.A1         This Appendix contains examples of information and sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. Specifically, paragraph .A2 of this Appendix contains examples of information that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist. Similarly, paragraph .A3 contains examples of sources that could contain such information. The examples contained in this Appendix are not intended to represent a comprehensive listing.

.A2         The following are examples of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist:

• Buying or selling goods or services at prices that differ significantly from prevailing market prices;
• Sales transactions with unusual terms, including unusual rights of return or extended payment terms generally not offered;
• "Bill and hold" type transactions;
• Borrowing or lending on an interest-free basis or with no fixed repayment terms;
• Occupying premises or receiving other assets or rendering or receiving management services when no consideration is exchanged;
• Engaging in a nonmonetary transaction that lacks commercial substance;
• Sales without economic substance (e.g., funding the other party to the transaction to facilitate collection of the sales price, or entering into a transaction shortly prior to period end and unwinding that transaction shortly after period end);
• Loans to parties that, at the time of the loan transaction, do not have the ability to repay and possess insufficient or no collateral;
• Loans made without prior consideration of the ability of the party to repay;
• A subsequent repurchase of goods that indicates that at the time of sale an implicit obligation to repurchase may have existed that would have precluded revenue recognition or sales treatment;
• Advancing company funds that are used directly or indirectly to pay what would otherwise be an uncollectible loan or receivable;
• Sales at below market rates to an intermediary whose involvement serves no apparent business purpose and who, in turn, sells to the ultimate customer at a higher price, with the intermediary (and ultimately its principals) retaining the difference;
• Guarantees and guarantor relationships outside the normal course of business; or
• Transactions between two or more entities in which each party provides and receives the same or similar amounts of consideration (e.g., round-trip transactions).

.A3         The following are examples of sources of information that may be gathered during the audit that could indicate that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist:

• Periodic and current reports, proxy statements, and other relevant company filings with the SEC and other regulatory agencies;
• Disclosures contained on the company's website;
• Confirmation responses and responses to inquiries of the company's lawyers;
• Tax filings and related correspondence;
• Invoices and correspondence received from the company's professional advisors, for example, attorneys and consulting firms;
• Relevant internal auditors' reports;
• Conflicts-of-interest statements from management and others;
• Shareholder registers that identify the company's principal shareholders;
• Life insurance policies purchased by the company;
• Records of the company's investments, pension plans, and other trusts established for the benefit of employees, including the names of the officers and trustees of such investments, pension plans, and other trusts;
• Contracts or other agreements (including, for example, partnership agreements and side agreements or other arrangements) with management;
• Contracts and other agreements representing significant unusual transactions;
• Significant contracts renegotiated by the company during the period under audit;
• Records from a management, audit committee, or board of directors' whistleblower program;
• Expense reimbursement documentation for executive officers; or
• The company's organizational charts.