AU 334: Related Parties

AU-C 550: Related Parties

AU EFFECTIVE DATE AND APPLICABILITY

Original Pronouncement Statement on Accounting Standards (SAS) 45.
Effective Date This statement is now effective.
Applicability Audits of financial statements in conformity with generally accepted auditing standards (GAAS).

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

AU-C 550 supersedes: AU Section 334. It also makes a substantive change. AU Section 334 is focused on auditing the amounts and disclosures pursuant to U.S. generally accepted accounting principles (GAAP), and is centered on the provisions of Financial Accounting Standards Board (FASB) Statement No. 57. AU-C 550 is framework-neutral. It encompasses financial reporting frameworks in addition to US GAAP, such as International Financial Reporting Standards. as well as special-purpose frameworks described in AU-C Section 800, Special Considerations—Audits of Financial Statements Prepared in Accordance with Special-Purpose Frameworks

AU DEFINITIONS OF TERMS

The section itself has no general definitions, but it uses terms defined in paragraph 1 and the glossary of Financial Accounting Standards (FAS) Accounting Standards Codification (ASC) 850, Related-Party Disclosures.

Affiliate. A party that, directly or indirectly though one or more intermediaries, controls, is controlled by, or is under common control with an enterprise.

Control. The possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise.

Immediate family. Family members whom a principal owner or a member of management might control or influence, or by whom they might be controlled or influenced because of the family relationship.

Management. Persons who are responsible for achieving the objectives of the enterprise and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice presidents in charge of principal business functions (such as sales, administration, or finance), and other persons who perform similar policymaking functions. Persons without formal titles also may be members of management.

Principal owners. Owners of record or known beneficial owners of more than 10% of the voting interests of the enterprise.

Related parties.

  • Affiliates of the enterprise
  • Entities for which investments are accounted for by the equity method
  • Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
  • Principal owners
  • Management
  • Members of the immediate families of principal owners and management
  • Other parties, if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the parties might be prevented from pursuing its own separate interest
  • Another party that can significantly influence the management or operating policies of the transacting parties or that has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from pursuing its own separate interests

AU-C DEFINITIONS OF TERMS

Arm’s-length transaction. A transaction conducted on such terms and conditions between a willing buyer and a willing seller who are unrelated and are acting independently of each other and pursuing their own best interests.

Related party. A party defined as a related party in GAAP.

OBJECTIVES OF AU SECTION 334

Special attention to related parties has a long history in auditing. From the auditor’s perspective, related-party transactions have two distinct, but not mutually exclusive, aspects: adequate disclosure and fraud detection.

The disclosure aspect is emphasized in FAS ASC 850. Some related-party transactions may be the direct result of the relationship. Without that relationship, the transaction might not have occurred at all or might have had substantially different terms. Thus, disclosure of the nature and amount of transactions with related parties is necessary for a proper understanding of the financial statements.

Inadequate disclosure of related-party transactions may result in misleading financial statements, so the auditor should be concerned with identifying such transactions in the audit and evaluating the adequacy of their disclosure. The auditor should also be concerned, however, with the possibility that an undisclosed relationship with a party to a material transaction has been used to fabricate transactions. That is, the transactions may be fraudulent or without substance. Section 334 clearly acknowledges the possibility that a related-party relationship may be a tool for fraud by management.

SAS 6 was issued in 1975 primarily in response to some spectacular fraud cases in which management’s involvement in material transactions was obscured either by inadequate disclosure or outright concealment. The SAS was more disclosure-oriented than fraud-oriented, however, because fraud is the exception rather than the norm. Nevertheless, the auditor should be aware of the possibility of fraud. The SAS observed:

In the absence of evidence to the contrary, transactions with related parties should not be assumed to be outside the ordinary course of business.

The auditor should view related-party transactions within the framework of existing pronouncements, placing primary emphasis on the adequacy of disclosure. In addition, the auditor should be aware that the substance of a particular transaction could be significantly different from its form.

OBJECTIVES OF AU-C SECTION 550

AU-C 550 states that:

. . . the objectives of the auditor are to

a. obtain an understanding of related-party relationships and transactions sufficient to be able to
i. recognize fraud risk factors, if any, arising from related-party relationships and transactions that are relevant to the identification and assessment of the risks of material misstatement due to fraud.
ii. conclude, based on the audit evidence obtained, whether the financial statements, insofar as they are affected by those relationships and transactions, achieve fair presentation.
b. obtain sufficient appropriate audit evidence about whether related-party relationships and transactions have been appropriately identified, accounted for, and disclosed in the financial statements.

FUNDAMENTAL REQUIREMENTS

Accounting Considerations

FAS ASC 850, Related-Party Disclosures, provides that:

1. Material related-party transactions other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business should be disclosed. (Disclosure of transactions eliminated in consolidated or combined statements is not required in those statements.)
2. The disclosures shall include:
a. The nature of the relationship(s).
b. A description of the transactions for each of the periods for which income statements are presented and such other information necessary to understand the effects of the transactions on the financial statements (including transactions to which no amounts or nominal amounts were ascribed).
c. The dollar amounts of transactions for each period for which an income statement is presented. (The effects of any change in the method of establishing the terms from the prior period should also be disclosed.)
d. Amounts due from or to related parties as of each balance sheet date presented and the terms and manner of settlement.

Audit Procedures

An audit cannot be expected to provide assurance that all related-party transactions will be discovered. Nevertheless, the auditor should be aware of:

1. The possibility that material related-party transactions exist that could affect the financial statements
2. Common ownership or management control relationships that are required by FAS ASC 850 to be disclosed even though there are no transactions

In determining the scope of work to be performed, the auditor should obtain an understanding of management responsibilities and the relationship of each of the entity’s component to the total entity. The auditor should consider controls over management activities and the business purpose served by the various components.

NOTE: Business structure and operating style are occasionally deliberately designed to obscure related-party transactions.

The auditor should recognize that the following transactions may indicate related parties:

1. Transactions to borrow or lend at no interest or at rates significantly different from market rates
2. The sale of real estate at a price significantly different from its appraised value
3. A nonmonetary exchange of property for similar property
4. Loans made with no scheduled terms for the time or method of repayment

The following are factors that the auditor should be aware of that may motivate transactions with related parties:

1. Is there a lack of sufficient working capital or credit to continue the business?
2. Does management have an urgent desire for a continued favorable earnings record to support the price of the entity’s stock?
3. Is the earnings forecast overly optimistic?
4. Does the entity depend on one or a few products, customers, or transactions for continued success?
5. Is the entity in a declining industry with many business failures?
6. Does the entity have excess capacity?
7. Is the entity involved in significant litigation, especially between stockholders and management?
8. Are there significant dangers of obsolescence because the entity is in a high-technology industry?
NOTE: These are fraud “warning signs” or risk factors. The presence of one or more factors is not proof of fraud, but the auditor should increase his or her awareness of the possibility of fraud. If the risk is high, the auditor might increase the scope of substantive tests designed to identify undisclosed relationships or use some of the expanded procedures enumerated in Section 334. (See also Section 316, Consideration of Fraud in a Financial Statement Audit.)

Basic Approach

To identify material related-party transactions the auditor should:

1. Identify related parties (through inquiry and review of relevant information to determine the identity of related parties so that material transactions with these parties known to be related can be examined).
NOTE: According to Section 334, the auditor should place emphasis on testing identified material related-party transactions.
2. Identify material transactions (consider whether there are indications of previously undisclosed relationships for material transactions).
3. Examine identified material related-party transactions.
NOTE: In Section 334, the procedures are grouped essentially in the preceding categories. In the following discussion, a different grouping is used to emphasize distinctions between specific procedures for related parties and general procedures.

Specific Procedures

Section 334 includes some procedures performed solely for the purpose of identifying related parties or related-party transactions.

1. Inquire of management:
a. Names of all related parties
b. Whether there were any transactions with these parties during the period
c. Whether the entity has procedures for identifying and properly accounting for related-party transactions; if so, evaluate these procedures
NOTE: This is covered in the management representation letter. It is helpful to give management the technical definition of related parties at the time of initial inquiry and in the letter.
2. Obtain the names of all pension and other trusts established for the benefit of employees and the names of officers and trustees of the trusts.
3. Review stockholder listings of closely held entities and identify principal stockholders.
4. Provide audit staff with the names of known related parties so that they can identify transactions with such parties.
5. For indications of undisclosed relationships, review the nature and extent of business transacted with major:
a. Customers
b. Suppliers
c. Borrowers
d. Lenders
6. Consider whether transactions are occurring but not being given accounting recognition, such as the client receiving or providing accounting, management, or other services at no charge, or a major stockholder absorbing corporate expenses.

General Procedures

The procedures in Section 334 for identifying related parties and for identifying transactions with related parties include several procedures that are usually performed in an audit. These are normal procedures performed for several purposes that may also identify related parties.

General procedure Relevance to related parties
Review prior years’ audit documentation. Identify names of known related parties.
Review minutes of meetings of board of directors and executive or operating committees. Obtain information on material transactions authorized or discussed.
Review confirmations of compensating balance arrangements. Identify whether balances are or were maintained for or by related parties.
Review invoices from law firms for regular or special services. Identify indications of related parties or related-party transactions.
Review confirmations of loans receivable and payable. Identify whether there are guarantees and the nature of relationship to guarantor.
Review material investment transactions. Determine whether investment created related party.
Review accounting records for large, unusual, or nonrecurring transactions or balances, particularly at or near end of reporting period. Consider whether transactions are with related parties.
Inquire of predecessor, principal, or other auditors of related entities (this inquiry should be made at an early stage of the audit). Obtain their knowledge of related parties or related-party transactions.

Procedures: Public Companies

Some procedures in Section 334 are relevant only for public companies:

1. Review filings with the SEC and other regulatory agencies for the names of related parties and for other businesses in which officers and directors occupy directorships or other management positions.
2. Review proxy and other material filed with the SEC and comparable data filed with other regulatory agencies for information on material transactions with related parties.
3. Review “conflict-of-interest” statements obtained by the entity from its management.

Procedures for Identified Transactions

After a related-party transaction is identified, the auditor should apply substantive tests to that transaction. Inquiry of management is not sufficient. According to AU 334.09, procedures that should be considered are:

1. Obtaining an understanding of the transaction’s business purpose.
NOTE: Until the auditor understands the business sense of the transaction, he or she cannot complete the audit.
2. Examining invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.
3. Determining whether the transaction has been approved by the board of directors or other appropriate officials.
4. Testing for reasonableness the compilation of amounts to be disclosed or considered for disclosure.
5. Inspecting or confirming and obtaining satisfaction that collateral is transferable and appropriately valued.
6. For intercompany account balances:
a. Arranging for examination at concurrent dates, even if fiscal years differ
b. Arranging for examination of specified, important, and representative related-party transactions by auditors for each of the parties with an exchange of relevant information
NOTE: A principal auditor–other auditor relationship may exist, and the component not audited by the principal auditor may have conducted related-party transactions that are complex or unusual. In these circumstances, the principal auditor should request access to the other auditor’s audit documentation concerning this matter.

Expanded Procedures

If the auditor concludes that it is necessary to fully understand a related-party transaction, he or she should consider the following procedures that might otherwise be unnecessary:

1. Confirm the amount and terms of the transaction, including guarantees and other significant data, with the other party.
2. Inspect evidence in the other party’s possession.
3. Confirm or discuss significant information with intermediaries (banks, guarantors, agents, or attorneys).
4. If there is reason to believe that material transactions with unfamiliar customers, suppliers, or others may lack substance, refer to financial publications, trade journals, credit agencies, and other information sources.
5. Obtain information on the financial capability of the other party for material uncollected balances, guarantees, or other obligations.

Equivalence Representations

No representations need be made in the financial statements that related-party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions. If representations are made that state or imply that, FAS 57 requires that the entity be able to substantiate them. Thus, the auditor should consider whether there is sufficient support for such a representation, if made, and appropriately qualify his or her opinion if there is not such support.

NOTE: Lack of substantiation of representations made on equivalence of material related-party transactions should result in a qualified or adverse opinion because of a departure from GAAP.

AU INTERPRETATIONS

Exchange of Information Between the Principal and Other Auditor on Related Parties (April 1979)

The principal auditor and the other auditor should, at an early stage in the audit, obtain from each other the names of known related parties.

Examination of Identified Related-Party Transactions with a Component (April 1979)

Audit procedures may have to be applied to a component audited by another auditor. When unusual or complex related-party transactions exist, the principal auditor may need access to the relevant portions of the other auditor’s workpapers. Access ordinarily should be provided.

The Nature and Extent of Auditing Procedures for Examining Related-Party Transactions (May 1986)

The higher the auditor’s assessment of risk regarding related-party transactions, the more extensive or effective the audit tests should be. To understand the business purpose or to obtain sufficient evidence about the transaction, the auditor may:

1. Refer to audited or unaudited financial statements of the related party
2. Apply procedures at the related party
3. Audit the financial statements of the related party

The auditor should consider obtaining representations from senior management and its board of directors about whether they or other related parties engaged in any transactions with the entity during the period.

Management’s and Auditor’s Responsibilities for Related-Party Disclosures Prefaced by Terminology Such as “Management Believes That” (May 2000; June 2009)

As discussed above under “Equivalence Representations,” if management makes an assertion in financial statements about equivalency that is prefaced by “management believes that” or “it is the company’s belief that,” the auditor’s responsibility is not changed. That is, the auditor must obtain evidence relating to the equivalency assertion, and management must still substantiate the asserted equivalence. If the auditor believes that the representation is unsubstantiated, depending on the materiality of the related-party transaction, the auditor should express either a qualified or adverse opinion because of a GAAP departure.

TECHNIQUES FOR APPLICATION

Preliminary Evaluation of Risk

A preliminary evaluation concerning the likelihood of related-party transactions is usually made during the planning of the audit when the risk assessment questionnaire is completed (see Section 311, Planning and Supervision). This evaluation includes:

1. Obtaining an understanding of the structure of the entity and management responsibilities.
2. Considering the business purpose of the various components of the entity.
3. Considering the control consciousness within the entity and controls over management activities.

Purpose of Auditing Procedures Designed Specifically for Related-Party Transactions

The purpose of auditing procedures designed specifically for related-party transactions is to determine the existence of related parties and to identify significant related-party transactions, including those not recognized in the accounting records.

If the auditor identifies significant related-party transactions, he or she should examine these transactions and evaluate the adequacy of their disclosure.

The auditor also is concerned with the adequacy of disclosure of economic dependence (see below).

Determining the Existence of Related Parties

The existence of some related parties, such as parent–subsidiary, investor–investee, and affiliates, is obvious. To determine the existence of other related parties, specific audit procedures are necessary. These procedures were described in “Fundamental Requirements” and are listed in the related-party checklist in the “AU Illustrations” section.

Identifying Related-Party Transactions

Related-party transactions and similar transactions that require disclosure may be classified as follows:

1. Those recognized in the accounting records
2. No-charge transactions
3. Those that create economic dependence

Related-Party Transactions Recognized in the Accounting Records

To identify these transactions, specific audit procedures are necessary. These procedures were described in “Fundamental Requirements” and are listed in the related-party checklist in “AU Illustrations.”

No-Charge Transactions

Sometimes a related party provides services that are not given accounting recognition. Examples of these services are the following:

1. Accounting and managerial
2. Credit and collection
3. Professional

To identify no-charge transactions, the auditor should compare expenses with sales and

1. Investigate deviations from industry standards
2. Investigate deviations from prior year

These are essentially analytical procedures (see Section 329, Analytical Procedures).

Transactions That Create Economic Dependence

FAS ASC 850 does not address the issue of economic dependence. Related parties do not exist solely because one party is economically dependent on another. If one party exercises significant influence over the other, however, a related-party situation does exist and should be disclosed. In situations where economic dependence does not create related parties, disclosure may still be necessary to keep the financial statements from being misleading.

Examining Related-Party Transactions

When the auditor identifies related-party transactions, he or she should analyze them to determine the following:

1. The purpose of the transactions
2. The nature of the transactions
3. The extent of the transactions
4. The effect of the transactions on the financial statements

To determine the preceding, the auditor applies normal auditing procedures and also may have to apply extended auditing procedures.

Management Representation Letter

Much of the information about related parties is obtained through inquiry of management. The responses to these inquiries should be formalized in the management representation letter (see Section 333, Management Representations).

If no related-party transactions occurred, a statement to that effect should appear in the management representation letter. If related-party transactions occurred, the following should be noted:

1. Identification of the related parties
2. Identification of the transactions
3. The nature of the transactions
4. The amount of the transactions

The auditor should also consider obtaining written representations from the client’s senior management and its board of directors about whether they or other related parties engaged in any transactions with the entity.

AU ILLUSTRATIONS

This section contains the following illustrations:

1. Paragraph in auditor’s report calling attention to the existence of related parties
2. Notes to financial statements disclosing the existence of related parties
3. Related-party checklist
Illustration 1. Auditor’s Report Paragraph Calling Attention to the Existence of Related Parties
This section does not require the auditor to note the existence of related-party transactions in the report. If the auditor decides to call the user’s attention to related-party transactions, however, he or she may include a separate explanatory paragraph in the report. Following is a separate paragraph from an auditor’s report on the audit of the combined financial statements of the leasing and financing subsidiaries of Pullman Incorporated:
The leasing and financing subsidiaries engage in significant transactions with Pullman Incorporated as described in Note 2 of the notes to combined financial statements.
Illustration 2. Disclosure in Notes to Financial Statements
Following are illustrations of the disclosure of related-party transactions in the notes to financial statements:
Related-Party Transactions
A Director of the Company is a principal in two companies that are distributors of the Company’s products. Total sales to these related companies aggregated $86,000 in 20X2 and $91,000 in 20X1. At August 31, 20X2, these companies owed the company $35,983, of which $25,525 was owed beyond the Company’s normal credit terms.
Related-Party Transactions
The Company occupies premises leased from two officer-shareholders for which $74,000 was paid in 20X2 and $27,000 was paid in 20X1. The lease agreement calls for minimum future payments of $86,000 in 20X3, $94,000 in 20X4, $101,000 in 20X5 and $114,000 in 20X6. The Company loaned $102,000 to these officer-shareholders to provide the down payment for their purchase of the property in 20X0. This loan was repaid during 20X1.
Illustration 3. Related-Party Checklist

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