Related parties may not always be bad, but they certainly do raise some concern in the accounting profession. One of my favorite quotes in reference to related parties appeared in CFO Magazine when they published an article on the new auditing standard for related parties. It read, “Good friends help you move. Real friends help you move dead bodies.” Related parties have long been one of the riskier areas of the audit, and audit scandals across the years, such as Enron, were perpetrated thanks, at least in part, to related party transactions. This post will explore the background for releasing AS 18 (now codified as AS 2410), what the standard requires of auditors, and how it is different from the previous auditing requirements.
How many of you are familiar with a scenario such as this?
Hopefully, all the auditors reading this blog are avoiding the potentially disastrous mistakes made by Brian in the example above. Some of Brian’s mistakes include:
- Performing his “search” for related parties at year end. (We use the term “search” loosely here).
- His procedures were not sufficient. Sorry Brian, but generally speaking, reading last year’s documentation and inquiring with the controller doesn’t cut it!
Failing to perform your related party procedures early in the audit can leave you with little time to investigate any potential audit risks, and inquiry alone is rarely sufficient audit evidence. If this looks like something you’ve seen recently on your audit engagements, it’s time for you to meet AS 18, Related Parties, also known as AS 2410 in the updated codification.
AS 2410: Related Parties
Why the new standard? Essentially, the PCAOB felt that the current guidance was simply not sufficient or sufficiently risk-based, which could lead to inadequate auditor effort. Related parties have been a contributing factor in numerous financial reporting frauds. Additionally, the PCAOB’s inspection and enforcement activities indicate that there are continuing weaknesses in auditors’ scrutiny in these areas. (For more on audit weaknesses, don’t forget to check out our PCAOB eBook) This standard is meant to strengthen auditor performance requirements in three critical areas that have historically represented increased risks of material misstatement in company financial statements:
- Related party transactions
- Significant unusual transactions; and
- A company’s financial relationships and transactions with its executive officers
The new standard requires the auditor to perform specific procedures around each of these three areas to understand a company’s relationships and transactions with related parties. The previous guidance under AU Section 334 was less specific as it did not require many procedures, but instead just listed procedures that auditors should consider.
As you can see in the image above, all of the procedures required under AS 2410 (formerly AS 18) are either new or expanded from the previous guidance in AU 334. Specifically, the new guidance requires that auditors perform inquiries of those other than management of the company and the audit committee. The auditor is now also expressly required to communicate any related party findings to the audit committee. Many of these changes are logical and even familiar to those accustomed to performing a risk-based audit. However, these additional procedures could in turn require more diligence by management. Should the auditors uncover a related party transaction not identified by management, it could be representative of a control deficiency.
Let’s revisit our discussion question from earlier. We established that Brian did not do nearly enough, but what could he have done? Well, some of the procedures, as required by AS 2410 are:
- Performing inquiries of more than just management (i.e. others within the entity, the audit committee, etc.)
- Obtaining an understanding of the company’s processes and controls associated with related parties and significant unusual transactions
- Testing and concluding as to whether related parties and significant unusual transactions have been completely identified, accounted for, and disclosed by management
- Communicating findings to the audit committee; and
- Obtaining additional management representations about the completeness of, and access to, information about related parties
Significant Unusual Transactions
When it was originally released, AS 18 did more than just amplify the audit procedures required for related parties, it also enhanced the requirements around significant unusual transactions (SUTs). These requirements state that the auditor must understand the business purpose of the transaction (or the business purpose for lack of these transactions), evaluate the accounting and disclosure of SUTs, and consider whether these transactions were entered into for fraudulent purposes. As a result, you’ll notice that many of the new required audit procedures involve helping auditors to identify and then gather the information necessary to evaluate significant unusual transactions.
Financial Relationships and Transactions with Executive Officers
Finally, one of the last major amendments from AS 18 relates to additional procedures over financial relationships and transactions with executive officers. Specifically, the guidance requires that the auditor obtain an understanding of the company’s financial relationships and transactions with executive officers. The guidance is very clear that the purpose of this procedure is NOT to opine on the reasonableness of the compensation arrangement. Instead, it is to draw increased attention to the incentives or pressures a company may place on executives to achieve certain financial positions or operating results. Again, the goal is to draw the auditor’s attention to the risk of fraud in the audit and make audit teams aware when incentives or pressures are being placed on management.
The bottom line
Always remember, the auditor should serve as a gatekeeper in the financial reporting system. This means being alert to the possibility that related party transactions could pose increased risks of material misstatement and require an appropriate level of scrutiny in the audit. For more examples of audit procedures to be performed or information to be gathered, please check out appendix A of AS 2410. And if you’re interested in the accounting for related parties, stay tuned! Be sure to check out our post on the accounting and disclosures for related party transactions.
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
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