Auditing Related Party Transactions (AS 2410)
Transactions with related parties may not always be bad, but they certainly do raise some concern amongst CPAs. 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.” Auditing related party transactions have long been one of the riskier areas of the audit. Accounting scandals such as Enron were perpetrated, thanks at least in part, to related party transactions. This post explores the requirements for auditing related party transactions in accordance with PCAOB auditing standards.
Example: Auditing related party transactions
Here’s a scenario related to auditing related party transactions:
Debrief: Auditing related party transactions
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 2410 Related Parties!
Introducing AS 2410 Related Parties
The PCAOB issued AS 2410 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
- Financial relationships and transactions with its executive officers
The 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.
Related party transactions
AS 2410 requires that auditors perform inquiries of those other than management of the company and the audit committee. The auditor is also expressly required to communicate any related party findings to the audit committee. These required procedures require additional due 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 previous example. 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
In addition to requiring certain audit procedures over related party transactions, AS 2410 also sets out 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 these 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, the last critical area relates to financial relationships and transactions with executive officers. Specifically, the guidance with AS 2410 requires that the auditor obtain an understanding of such transactions. 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.
Closing thoughts
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.
Are you interested in the accounting for related parties? Be sure to check out this post on the accounting and disclosures for related party transactions under both U.S. GAAP and IFRS.
Still have questions regarding the requirements of related party transactions for both preparers and auditors? Check out our online course Related Parties.
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
