State the circumstances indicative of fraud risk conditions with regard to related parties?
(a) Low importance given by management towards related party transactions
(b) Inactive participation of those charged with governance
(c) Management override of controls
(d) Lack of understanding of accounting standards with regard to related parties. The definition of a related party is complex and to some extent subjective. It may not be clear to management whether a party is related.
(e) Many accounting systems are not designed to either distinguish or summarize related party transactions. Management may therefore, have to carry out additional analysis of the accounting records to identify related tarnsactions.
(f) Directing the entity, against its interests to enter into transactions for the benefit of these parties.
(g) Collusion with related parties
(h) Entering into transactions at prices which are significantly higher or lower than normal business terms.
(i) Forming special purpose entity
(j) Fictitious transactions with related parties
(k) Sale and re purchase agreements in order to inflate the revenues.
Consider following example:
Company A, a real estate broker sold properties to Company B. an unaffiliated Company for Rs. 5 million and recognized profit of Rs. one million. However a provision of the agreement guaranteed Company B that it would suffer no loss from the operation of the properties and that it could sell the properties back to Company A. Later Company B did request that Company A take back the properties. At this point Company A formed a company, undisclosed related party, to purchase the properties from Company B. Company A knew that no profit could be recognized if it took the properties back, but by transferring the properties to undisclosed related party it concealed the fact that no income should have been recognized because the risk of loss from the properties remained with it. If the auditor fails to review adequately the agreements related to this transaction or to pursue the implications of the disposition of the properties by Company B, the auditor will be held negligent.
State audit procedures to detect undisclosed related party information?
a) Confirmations from third parties
b) Income tax return
c) Register of members t~ identify principal shareholders
d) Entity’s investments in the shares of other companies
e) Contracts in which directors and key management are interested
f) Internal auditor’s reports
g) Participation in partnership with other parties
h) Provision for services to parties at unusual terms
i) Guarantees given
It is general practice for a _parent company to guarantee the borrowings of a subsidiary company. Also sometimes a director or a shareholder guarantees the borrowings of his company by granting the bank a charge over their properties.
j) Minutes of the .shareholders and Board of Directors
(k) Transactions regulations with offshore entities with weak corporate
(l) Rendering of services at no charge
(m) Leasing without rentals
(n) Unusually large discounts
(o) Inadequate discussions among management and directors regarding contracts initiated by a related party.
(p) Unauthorized transactions with related parties
(q) High turnover of senior management or professional advisors
(r) Related party’s excessive intervention in the use of accounting
If the audit indicates significant risk factors with regard to related parties, how the auditor should respond to those risks?
(a) Confirming the transactions with intermediaries such as banks and law firms.
(b) Confirming the purpose and terms of transactions with related parties.
(c) If Possible, reading financial statements of the related parties
(d) Inquiries with related parties.
(e) Inspection of contracts with related party.
If the management ha$ made an assertion in the financial statements that the related party transactions have been carried out on arm’s length bases, how the auditor should verify such assertion?
(a) Compare the terms of the related party transactions to transactions with other unrelated parties.
(b) Using an expert to determine market value and terms of transactions
(c) Consider management’s process supporting the assertions.
Give examples of four matters that should be included in representations from management regarding related parties?
(a) Related party transactions that involve management have been approved by the Board.
(b) Confirmation of oral representations regarding related party transactions
(c) Financial interest of management in related party transactions
(d) Existence of side agreements.
State some significant matters to be communicated with those charged with governance, regarding related parties?
a) Identification by the auditor of those related parties which were not disclosed by management.
(b) Unapproved related party transactions
c) Inadequate disclosure of related parties
d) Difficulties to identify related parties.
If an entity is a related party in the ·current year, but was not a related party in last year, should sales to related party be disclosed in the comparative figures? Sales to this party were made in both the years?
Sales to related party need not be disclosed in comparatives as it does not affect last year’s results.
Explanation may be given in notes to accounts for non disclosure.
If an entity was a related party last year, but not in the current year, should sales to related party be disclosed in the comparative figures? Sales to this party were made in both the years.
Last year’s sales should be disclosed in comparatives, but current years sales need not be disclosed as the party is not related in current year.
Explanation may be given in notes to accounts for non disclosure.
Under what circumstances transaction with ·certain related parties may not be disclosed?
Disclosure of transactions between entity and certain parties arisng
simply as a result of normal role of those parties need not be made.
(a) Providers of finance
(b) Utility companies
(c) Government departments
(d) A customer, supplier, distributor or general agent with whom the entity transacts significant volume of business.
Al-Shams Limited is an unquoted public company. A large part of its business is carried out with persons / organizations who are related to the management or the shareholders?
(a) State any eight procedures which an auditor may perform for determining the existence of related parties or related party transactions.
(b) Give four examples of situations that may be indicative of dominant influence exerted by a related party.
(i) Evaluate the company’s procedures for identifying and properly accounting for related-party transactions.
(ii) Inquire of management regarding:
– The identity of the entity’s related parties, including changes from prior period;
– The nature of relationship between the entity and these related parties; and
– Whether entity entered into any transaction with these related parties during the period and, if so, the type and purpose of the transactions.
(iii) Inspect information supplied by the entity to regulatory authorities (e.g. SEep, FBR, SBP etc.)
(iv) Identify all employee benefit plans and the names of the officers and trustees thereof.
(v) Review shareholder registers to identity the entity’s principal shareholders.
(vi) Review, material investment transactions during the audit period to determine whether the nature and extent of investments during the period create related parties.
(vii) Review contracts and agreements with key management or those charged with governance.
(viii) Review significant contracts re-negotiated by the entity during the period.
(ix) Review significant contracts and agreements not in the entity’s ordinary course of business.
(x) Review of internal auditor’s report.
(xi) Review of third party confirmations obtained by the auditor.
(xii) Minutes of meetings of shareholders and of those charged with governance.
(b) Indicators of dominant influence exerted by a related party include the following:
(i) Significant transactions are referred to the related party for final approval.
(ii) There is little or no debate among management and those charged with governance regarding business proposals initiated by the related party.
(iii) Transactions involving the related party (or a close family member of the related party) are rarely independently reviewed and approved.
(iv) The related party has vetoed significant business decisions taken by management or those charged with governance.
As the auditor of a listed company with a number of related parties, what steps would you consider as part of your audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements?
The steps that I as an auditor would consider as part of the audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements are as follows:
(a) Obtaining an understanding of the controls, if any, that management has established to identify, account for, and disclose related party relationships and transactions in accordance with the applicable financial reporting framework.
(b) Inquiring of the management regarding:
- The identify of the entity’s related parties, including change from the prior period;
- The nature of relationships between the entity and these related parties and
- Whether the entity entered into any transactions with these related parties during the period and, if so, the type and purpose of the transactions.
(c) Inspecting the following documents for indications of the existence of related party relationships or transactions that management has not previously identified or disclosed:
- Bank and legal confirmations.
- Minutes of meetings of shareholders and of those charged with governance, and
- Any other records or documents as the auditor considers necessary (e.g. Form A, Form 29, Register of members etc.).
(d) Reviewing the extent and nature of business transacted with major customers, suppliers, borrowers and lenders for indications of previously undisclosed relationships.
(e) Reviewing the significant transactions outside the normal course of business, paying particular attention to the transaction recognized at or near end of the reporting period and inquire of management:
- The nature of these transactions
- Whether related parties are involved in these transactions
(f) Once related parties have been identified, the client should provide the details of transactions with such parties as auditor would ensure that these transactions are disclosed appropriately in the financial statements as per applicable financial reporting framework.
Discuss the objective to auditor as regards related party transactions?
The objective of the auditor is to obtain sufficient and appropriate audit evidence to draw reasonable conclusions that related party transactions n identified, recorded and disclosed in accordance with IFRS.
Discuss materiality considerations in relation to related parties?
Transactions are material when their disclosure might reasonably be expected to influence decisions of the users of financial statements. The materiality of related party transactions·is to be judged not only in terms of their financial significance to the entity but also in relation to the other party when that party is:
(a) Director, key manager or other individual in a position to influence, or accountable for stewardship of the reporting entity.
(b) A member of the close family of an individual mentioned in (a) above.
(c) An entity controlled by any individual mentioned in (a) or (b) above.
Both quantitative and qualitative aspects of materiality have to be considered. A transition may be of relatively small amount, but may be of significance from view point of an individual.
Discuss risks associated with related parties?
1. Related parties sometimes operate through unnecessarily complex structure, for example, special purpose entities.
2. Internal accounting and control systems are generally established
for routine transactions. The system may be inadequate to identify related parties and related party transactions.
3. Related party transactions may not be entered at fair values (ISA
4. management may not be knowledgeable of the existence of all related parties (ISA 550:6)
5. Related party transactions may be motivated for other than normal business considerations, for example, manipulation of profits or even frauds.
- Purchase of goods and services from related parties at significantly above market rates.
- Transfer of goods and services to related parties at significantly below the market rates.
- Recording dummy purchase invoices.
- Special purpose entity.
6. Tax expense and tax liability may be affected due to existence of all related party transactions.
For example, Section 108 and section 109 of the Income Tax Ordinance provide that where business is carried out between a
resident and no resident and due to close business connection between them matters are arranged in such a way so as to produce either no profit or losses other that the ordinary profits
of the resident, the Commissioner of Income Tax is empowered to determine the amount .of profit which may reasonably be accrued to the resident and -include such amount in total income of the resident.
7. Compliance may not be made of the requirements of IAS 24.
State management’s responsibilities as regards related parties?
- Management is responsible for preparation and fair presentation of financial statements.
- This responsibility includes designing, implementing and maintaining adequate internal controls, necessary to enable the preparation of financial statements that are free from material misstatements whether due to fraud or error.
- In the context of related parties, internal controls should provide for identification, recording and disclosure of related party relationships and transitions.
As the auditor of a listed company with a number of related parties, what steps would you consider as part of your audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements.?
Audit planning to ensure that all related party relationships and transactions are identified and disclosed in the financial statements include following procedures.
1. Carry out risk assessment procedures to obtain understanding the entity’s related party relationship and transactions.
(a) Discussion of related party relationships with engagement team. The discussion shall include record of previously identified related parties, risks associated with related parties, emphasis of maintaining professional skepticism, and control environment affecting related parties.
(b) Inquiry from management:
(i) What controls exist as to identifying, accounting and disclosing
related party transactions?
(ii) Control environment associated with related parties:
– Communication of code of ethics.
– Disclosure of interest that management and directors have in transactions with related parties.
– Authorization and approval procedures of transactions with related parties.
– Authorization and approval procedures for transactions outside the normal course of business.
– Regular reviews by internal auditor
– Whistle blowing policies.
(iii) The identify of related parties, including changes from the prior period.
(iv) The nature and relationship between the entity and related parties.
(v) Whether the entity entered into any transactions with related parties during the period, and if so, the type and purpose of transactions.
c) Consider deficiencies in internal controls, arising from inadequate control environment.
(d) Authorization and approval procedure.
e) Inspect documents that may provide information about undisclosed related parties:
(i) Third party confirmations
(ii) Review income tax returns
(iii) Inspect register of shareholders (Sec. 147 of Companies Ordinance, 1984)
(iv) Statement of conflicts of interest
(v) Investments made by the entity and its pension fund in other companies.
(vi) Register of contracts in which directors are interested (Section 219 of the Companies Ordinance, 1984)
(vii) Internal auditor’s reports
(viii) Contracts not in the entity’s ordinary course of business.
(f) Review arrangements for indication of undisclosed related parties:
(i) Business relationship through appropriate vehicle
For example, Mr.·B is a director in A Limited. Mr. B is also a partner in a firm, B Enterprises. The partners of B Enterprises from a private limited company, C Ltd. A limited sells goods to C Limited. Such goods are sold by C Ltd.to outsiders.
Cost of goods sold by A Ltd to C Ltd was Rs. 8 million and fair value was Rs. 10 million. The goods were sold by A Ltd to C Ltd at Rs. 8 million. C Limited then sold such goods to outsiders for Rs. 10 million.
(ii) Agreements for provision of services under terms and conditions that are outside the entity’s normal course of business.
(iii) Guarantees and guarantor relationships.
(g) Identify significant transactions outside normal course of business:
(i) Transactions with offshore entities with minimum corporate regulations
(ii) Leasing of premises or management services with no charge
(iii) Unusually large discounts
(iv) Sale and re purchase transactions.
2. Identify and assess risk of material misstatement
Significant risks associated with related parties arise from:
(a) Transactions not in the ordinary course of entity’s business.
(b) Existence of.a director with dominant.influence:
(i) Decisions made by the dominant related party prevail over the decisions of all other directors.
(ii) ·No transactions can take place without approval of related party,
(iii) No questions are raised for any.business proposals made by related party,
(iv) Unusually high turnover of staff particularly’ in the finance department.
(v) Use of business intermediaries
(vi) .Excessive participation of related -party it}.the selection an application of’accounting policies.
Discuss audit procedures in response to risk of material misstatements regarding related parties?
Audit procedures in response to risk of material misstatement regard related parties are as follows:
(a) If the auditor has assessed a high risk of undisclosed related parties, following substantive procedures are appropriate (Refer to ISA 550:20, A32):
– Confirm specific aspects of transactions with intermediaries such as banks
– Confirm the purpose of related party transaction with the related parties.
– Read financial statements of related party to verify substance of transactions.
(b) If the auditor has assessed high risk of material misstatement due to dominant related party, following procedures should be carried out. (refer to ISA 550:20, A33):
(i) Inquiry with management and board of directors (ISA 550: A33)
(ii) Inquiry from related party
(iii) Inspection of significant contracts
(iv) Interest research
(v) Whistle bellowing reports.
(c) If the auditor identifies related parties, not previously disclosed by the management the auditor should (Refer to ISA 550:22, a35-a37):
(i) Communicate the information to other team members .
(ii) Request management to identify all transactions with the newly identified related party.
(iii) Inquire causes for non-disclosure.
(iv) Perform suitable substantive procedures:
– Inquire into relationship of related parties with the entity.
– Verify that the transactions have been correctly recorded in accordance with IFRS.
(v) Reconsider that there may be other un disclosed related a parties.
(vi) If the auditor discovers significant related party transactions outside the normal course of business, the auditor should:
– consider whether. the transaction is complex, involving several related parties, unusual terms, prices, lack of logical business rationale processed in unusual manner.
– Whether board of directors in aware of such transactions.
– Consider business rationale from the perspective of related party.
(d) If the auditor identified significant related party transactions outside normal course of business, the auditor should: (Refer to ISA 550:23, A38-A41):
(i) Inspect contracts with related party to consider business rationale
(ii) Verify approval of board of directors
(iii) Consider terms of contract
(iv) Obtain understanding of the business rationale of transactions.
List some significant matters to be communicated to those charged with governance as required by ISA 550, related parties?
(a) Identification of related parties not disclosed by management.
(b) Disagreement with management on adequacy of disclosures.
(c) Non-compliance with laws and regulations relating to transactions with related parties
(d) Related party transactions entered by management but no approved by those charged with governance. (Refer to ISA 550:A50).