Many businesses engage in transactions with related parties, such as the directors, executives, subsidiaries and other commonly controlled entities. Related parties might even include a business owner’s family members and friends. These transactions may be completely normal and legitimate, but they require special attention during an audit to ensure accurate and transparent financial reporting. Let’s take a closer look.
Risk assessment
Related-party arrangements increase the risks of fraud and legal violations, warranting increased attention for companies of any size. To the extent that material related-party transactions aren’t disclosed or don’t happen at arm’s length — meaning at market value — a company that engages in them could misstate its financial results and potentially mislead lenders, investors and other stakeholders.
For example, a company might artificially boost its profits by paying below-market rent to a subsidiary. Or a dishonest CFO might divert company funds by paying excessive consulting fees to a friend or relative.
Auditors perform enhanced procedures related to related-party risks as part of the risk assessment and planning phases of an audit. Auditing standards also require auditors to design their inquiries and testing procedures to address these risks.
Management’s role
Businesses must disclose related-party relationships and transactions in the footnotes of their audited financial statements. Disclosures must describe the nature of the relationships, the amounts involved and any outstanding balances.
Management is ultimately responsible for preparing the financial statements, including identifying and disclosing related parties. Implementing a conflict-of-interest policy can help reveal friends and relatives involved in the business.
Customized audit procedures
During fieldwork, external auditors must obtain sufficient appropriate audit evidence to determine whether related-party transactions have been properly identified, accounted for and disclosed. For instance, they look for undisclosed related parties — and sometimes find arrangements that management is unaware of. The search starts with targeted questions, designed to obtain an in-depth understanding of related-party financial relationships and transactions, including their nature, terms and business purpose (or lack thereof). Then the auditors perform additional procedures and conduct outside research for more insight.
Examples of information that may be gathered during an audit that could reveal undisclosed related parties include
· Disclosures contained on the company’s website,
· Confirmation responses, correspondence and invoices from the company’s attorneys,
· Tax filings,
· Life insurance policies purchased by the company,
· Contracts or other agreements,
· Corporate organization charts, and
· Public company proxy statements.
In addition, auditors scrutinize significant transactions that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size or nature. Certain types of transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans, and subsequent repurchase of goods sold — can also signal that a company is engaged in unusual or undisclosed related-party transactions.
Communication is key
As you prepare for your next audit, be sure to openly share information about related-party financial relationships and transactions with your Hood & Strong team. Discuss any new related-party arrangements and learn to properly disclose them in your year-end financial statements.
