What’s the Risk in Related-Party Transactions?

During an external financial audit, the auditors may particularly scrutinize related-party transactions. These transactions aren’t bad, necessarily, but they do raise concerns about the risk of misstatement or omission in financial reports. Back in 2014, the Public Company Accounting Oversight Board (PCAOB) even issued an audit standard specifically addressing related-party transactions.

Scandals drew scrutiny for all

Nearly two decades ago, Issues with related parties played a prominent role in scandals at Enron, Tyco International and Refco. Public outrage led Congress to pass the Sarbanes-Oxley Act of 2002 and establish the PCAOB. Similar problems have arisen in more recent financial reporting fraud cases, prompting the PCAOB to enact tougher standards on related-party transactions and financial relationships.

PCAOB Auditing Standard No. 2410 (AS 2410), Related Parties, requires auditors of public companies to pay special attention to financial statement matters that pose increased risks of fraud. Specifically, auditors must focus on three critical areas:

  1. Related-party transactions, such as those involving directors, executives and their family members
  2. Significant unusual transactions (SUTs) that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size or nature
  3. Other financial relationships with the company’s executive officers and directors

With enhanced auditor scrutiny of these transactions and financial relationships, directors and leaders may be able to avert corporate failures. The PCAOB also hopes that increased scrutiny will lead to improvements in accounting transparency and disclosures, which will help investors to more clearly gauge financial performance and fraud risks.

Every transaction, every time

The AS 2410 standard requires auditors to obtain an in-depth understanding of every related-party financial relationship and transaction, including their nature, terms and business purpose (or lack thereof). Tougher related-party audit procedures must be performed along with the auditor’s risk assessment procedures, which occur in the planning phase of an audit.

In addition, auditors are expected to communicate with the audit committee throughout the audit regarding the company’s identification of, accounting for and disclosure of its related-party relationships and transactions. They can’t wait until the end of the engagement to communicate their evaluations of these matters.

During fieldwork, companies should expect auditors to be on the hunt for undisclosed related parties and unusual transactions. For example, they may gather information that could reveal undisclosed related parties, such as information on the company’s website, tax filings, corporate life insurance policies, contracts and organizational charts.

Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold — also might signal that a company is engaged in unusual or undisclosed related-party transactions.

To facilitate the audit, management should be up-front with auditors about all related-party transactions, even if they’re not required to be disclosed or consolidated on the company’s financial statements.

Honesty is still the best policy

Private companies also engage in numerous related-party transactions, and they may experience spillover effects of the tougher PCAOB auditing standard, although it applies only to audits of public companies. Regardless of whether you’re publicly traded or privately held, it’s important to identify, evaluate and disclose all related parties.

If you’re concerned about related-party relationships and transactions, contact us. We can help you present the necessary information openly and completely, minimizing complications and delays during your audit.

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