Audit

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Sssh – Don’t Tell the Auditors We’re Related

This month’s article considers the issue surrounding related parties in the context of audit.  Related party transactions can be quite complicated and the auditors are, to some extent, reliant on their audit client to be both co-operative and open to them when it comes to related party transactions.

This article is relevant for those students who are planning to study auditing papers in the next diet of exams. Related party transactions can be (and in real life are) technically complex but after reading this article you will be in a much better position to answer questions which deal with related party issues and, not only demonstrate to the examiner that you can ‘think outside of the box’, but will also help you stand a much better chance of scoring highly.

Further additional material for paper P7 and F8 for ACCA can be downloaded from http://www.passacca.net.  Students are advised to download paper-specific material to supplement their studies.

This article incorporates a mini case-study, and at the end of the article has a question and answer section whereby you can test your knowledge and understanding of this article.

Related parties

A key problem that seems to be prevalent when reading feedback from exam sittings is the problem of going into ‘autopilot’.  The risk with related parties is that students who are studying audit papers see the phrase ‘related parties’ and forget that it is an audit paper they are sitting and digress into FRS 8 / IAS 24, which deals with the accounting for related parties.  ISA 550 (revised and redrafted) ‘Related Parties’ deals with the auditing of related party transactions – note the differences between the two i.e. ‘accounting for related party transactions’ and ‘auditing related party transactions’ – the two standards are completely separate issues.  Whilst FRS 8 / IAS 24 may be relevant to some points in the question, it emphasises the advice repeated by tuition providers and examiners to “read the question”.

Reading the questions properly enables you to understand (a) the capacity you are acting in i.e. audit manager and (b) the position you are in relating to the audit.  You may be asked to determine audit procedures relative to related parties or you could be in a situation whereby there is non-compliance with an accounting standard, for example FRS 8 or IAS 24 (both related party standards).  It is important not to go into ‘autopilot’ - just because the phrase ‘related parties’ may feature in a question, be aware that there are several ways these types of questions can be examined.

As mentioned above, related party transactions in the context of audit are dealt with in ISA 550 (revised and redrafted) ‘Related Parties’.

So what is a related party?

It goes much beyond the fact that Uncle George might be employed by your audit client, or that one company owns another.

ISA 550 defines a related party as either:

a. A person or other entity that has significant influence or control, either directly or indirectly through one or more intermediaries, over the reporting entity; or
b. Another entity over which the reporting entity has control or significant influence, directly or indirectly through intermediaries; or
c. Another entity that is under common control with the reporting entity through having:
i. common controlling ownership;
ii. owners who are close family members; or
iii. common key management.

Problems with related parties

The problem inherent with related party transactions is that the auditor is at the mercy of the audit client (to some extent) to disclose to them transactions with related parties.  It is often the case that the auditor will request a letter of representation from the audit client to confirm that all related party transactions have been adequately disclosed in the financial statements.

So is that enough to satisfy ISA 550? The answer is most definitely not!

Responsibilities of the auditor

The purpose of the actual audit is to ensure that the financial statements of the reporting entity give a true and fair view of the state of the entity’s affairs and to enable users of the financial statements to make relevant, economic decisions.  A related party disclosure is important because it can have an impact on decisions taken by users if they are not disclosed.  Consider the following example:

Example 1

Company A is run by John Smith.  Company A buys lathes from Company B.  Company B is run by Bob Smith, the father of John Smith.  Company B supplies lathes to Company A at a substantial discount which is not offered to other customers.  What is the impact of non-disclosure of this arrangement?

If you were looking at the financial statements of Company A and considering whether to buy it, and they had not disclosed the fact that they (a) trade with the director’s fathers company and (b) purchase goods on terms which are not normal in the course of business (therefore gross profit margins being significantly higher than they would be normally), then this would obviously mislead the reader.  By omitting such disclosures would mean the financial statements fail to give a ‘true and fair’ view.  This is why related party transactions must be disclosed in order to highlight such trading and such practices.

When considering related party transactions, the auditor is required to obtain a thorough understanding of the entity and its processes as part of its planning of the audit – without this understanding the auditor will essentially be auditing a company they know nothing about.  This is covered in ISA 315 ‘Understanding the Entity and the Environment in which it Operates’.  By complying with ISA 315, the auditor will obtain a thorough understanding of the entity in order to ensure that the financial statements:

a. achieve fair presentation; and
b. are not misleading.

In order to achieve the above, the auditor needs to enquire of management regarding:

a. The identity of the entity’s related parties, including changes from the prior period;
b. The nature of the relationship between the entity and these related parties; and
c. Whether the entity entered into any transactions with these related parties and if so, the type and purpose of the transactions.

The auditor also needs to enquire of management, and perform other risk assessment procedures as considered necessary in order to conclude if the management has established to:

a. Identify, account for, and disclose related party relationships and transactions in accordance with the reporting framework;
b. Authorise and approve significant transactions and arrangements with related parties; and
c. Authorise and approve significant transactions and arrangements with related parties outside the normal course of business (i.e. unusual transactions and arrangements).

The auditor has a duty to approach the audit with ‘professional scepticism’ per ISA 200 ‘Overall Objective of the Independent Auditor, and the Conduct of an Audit in Accordance with ISAs’.  In other words the auditor must suspect that the financial statements may be misstated due to fraud or error at the outset, and reduce this risk to an acceptable level by virtue of audit work. 

ISA 240 “The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements” requires the auditor to evaluate fraud risk factors – this is essential where related party transactions occur.  This standard links in with ISA 550 because fraud may be more easily committed through related parties.

Inquiry is an audit procedure under ISA 500 ‘Audit Evidence’; however, the auditor should also undertake and record audit work to confirm the existence of related parties and their associated transactions.  Such procedures could be to:

• Review board minutes;
• Review the prior year audit working papers;
• Review tax returns (these will often disclose the number of associated companies for tax purposes);
• Review legal correspondence;
• Be alert for transactions that have abnormal terms of trade;
• Be alert for transactions where commercial substance differs from legal form;
• Be alert for unusual transactions that are entered into shortly before or after the accounting period;
• Review the contents of the ‘bank audit letter’; and
• Inspect general correspondence and the records held on public file at Companies House.

The above list is not exhaustive but it does give an idea of the other tests available to auditors other than merely ‘inquiry of management’ – this alone would not normally suffice, nor would simply obtaining a letter of representation.  Note the letter of representation which is addressed to the audit firm from the client which will often confirm that all related party transactions have been adequately disclosed is NOT a substitute for other audit procedures – such a letter is not, in itself, audit evidence; it is merely a disclosure to the auditor.

The auditor should devise audit tests to perform that specifically respond to risks.  Related party transactions can often be a high risk area because of their subjective nature, and the auditor therefore needs to be alert for such transactions and devise tests that specifically respond to the risks involved.  Risk is dealt with ISA 330 ‘The Auditor’s Procedures in Response to Assessed Risks’.  The ultimate aim of the audit is to reduce identified risks to an acceptable level.

If, during the course of the audit the auditor discovers transactions or arrangements that would give rise to the existence of related parties that management have not previously identified or disclosed to the auditor, then the auditor must determine whether the underlying circumstances confirm the existence of such related parties.  If such circumstances give rise to undisclosed related party transactions, the auditor must:

a. Notify the audit team;
b. Request management to identify all transactions associated with the newly identified related party (parties) for the auditor’s further evaluation;
c. Inquire as to why the entity’s internal control systems in relation to the related parties failed to enable identification or disclosure of the newly identified related party (parties).
d. Perform substantive testing on the newly identified related party transactions;
e. If the non-disclosure appears intentional by management, therefore indicative of fraud (ISA 240), then evaluate the implications on the audit itself and the audit opinion.

Illustration

You are the audit manager at Smith & Co. and are undertaking the audit of Whitaker Enterprises Limited for the year ended 30 April 2008.  Whitaker Enterprises Limited is an owner-managed business with four directors who are identified as follows:

Mr E Whitaker - Managing Director
Mrs S Heaton - Marketing Director
Mr J Whitaker - Sales Director
Mrs S Whitaker - Director (with no day to day involvement in the running of the company)

Further Information:

(a) Mrs Heaton is married to Mr Heaton who is the managing director of Shevington Shelves Limited.  Shevington Shelves Limited occupies part of the warehouse of Whitaker Enterprises Limited and pays a market rent of £15,000 per annum.  Whitaker Enterprises Limited supply goods to Shevington Shelves Limited on normal commercial terms.  The value of goods sold to Shevington Shelves Limited for the year ended 30 April 2008 amount to £7,800.  At the balance sheet date there was an amount owing to Whitaker Enterprises Limited amounting to £2,000.  Whitaker Enterprises Limited does not purchase goods from Shevington Shelves Limited.

(b) Mrs S Whitaker does not have any involvement in the day to day running of the company.  She has her own curtain and soft-furnishings business known as ‘Sue’s Interiors’.  Mrs Whitaker is a 99% shareholder in Sue’s Interiors and her husband, Mr E Whitaker owns the other 1%.  During the year Whitaker Enterprises Limited loaned Sue’s Interiors £100,000 to assist in the expansion plan.

(c) Whitaker Enterprises Limited sold goods to Bury Enterprises Limited during the year amounting to £30,000.  Whitaker Enterprises Limited owned 80% of the voting rights in Bury Enterprises Limited until 30 April 2007.

Required:

We are required to:

(a) Identify the related party transactions above; and
(b) Detail what the auditors would expect to see disclosed in the financial statements for the year ended 30 April 2008.

Solution:

(a) Whitaker Enterprises Ltd rents space to Shevington Shelves Limited to Mrs Heaton’s husband.  ISA 550 states that a ‘close family member’ is classed as a related party.  Goods are also purchased from Whitaker Enterprises by Shevington Shelves and despite them being supplied on normal commercial trading terms, the fact still remains that Shevington Shelves Limited is a related party because the director is married to the director of Whitaker Enterprises Limited.

(b) The fact that Mrs Whitaker does not have any involvement in the running of Whitaker Enterprises does not preclude her from being a related party.  The question does not give shareholdings but she is married to Mr E Whitaker who is involved in the running of the company and the assets of Whitaker Enterprises Limited will contain a loan to Sue’s Interiors.  This is a related party because (a) Mrs Whitaker is a director of Whitaker Enterprises, (b) she is married to Mr Whitaker who also owns a share in Sue’s Enterprises and (c) close family members are related parties. 

(c) Whitaker Enterprises had sold its shareholding in Bury Enterprises Limited on 30 April 2007.  Therefore Bury Enterprises Limited ceased being a related party on that date, which was in the last financial year and therefore no disclosure of the transactions in the question are required.  Had Whitaker Enterprises sold its shares on (say) 30 September 2007 then it would disclose the transactions up to and including the date of sale, because Whitaker Enterprises was the controlling party up to and including the date Whitaker Enterprises relinquished its shareholding.

Disclosures

For each of the above, the auditor should expect to be disclosed in the financial statements the following:

(a) The names of the related parties and a description of the relationship between them;
(b) A description of the transactions and the amounts involved, together with any other elements of the transactions necessary for a better understanding of the financial statements i.e. if the transactions were carried out on ‘normal commercial terms’ or otherwise.
(c) The amounts due to or from the related parties at the reporting date; and
(d) Any amounts written off.

In addition, if the reporting entity is controlled by another party then there should be a disclosure of the related party relationship and the name of the ultimate controlling party.

If the reporting entity either fails, or refuses, to disclose a material related party transaction then the auditor must qualify (modify) the audit report accordingly.  Non-compliance with FRS 8/IAS 24 ‘Related Parties’ would give rise to a breach in an accounting standard and may well result in the audit report being qualified (modified) with an ‘except for’ paragraph.

Other ‘exam tips’

You should now be able to appreciate that this article, which featured one auditing standard (ISA 550) has also featured:

• ISA 200 ‘Overall Objective of the Independent Auditor, and the Conduct of an Audit in Accordance with ISAs’;
• ISA 240 ‘The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements’;
• ISA 315 ‘Understanding the Entity and the Environment in which it Operates’; and
• ISA 500 ‘Audit Evidence’

Questions in audit papers will often be discursive in nature and if you are faced with an issue that has a specific auditing standard – such as related parties, then before diving in and writing everything you know about ISA 550, think about how other auditing standards interlink with the one being examined.  This not only demonstrates your knowledge to the examiner about the specific auditing standard, but it also demonstrates to the examiner that you are aware of other standards that must be considered during the audit of a specific transaction or event.

Quick Test:

1. Company A has a 5% shareholding in Company B.  Company A governs the financial and operating policies of Company B.  Company A supplies goods to Company B.  Is this a related party transaction?

2. You are auditing Lucas and Co for the year ended 31 December 2007 and have come across a payment for £70,000 to Floyds Bank plc – this amount is material to the financial statements.  The payment is on behalf of the director to settle a personal loan.  The director refuses to disclose this in the financial statements.  What are the implications for the audit report?

3. What are the implications for non-disclosure of related party transactions?

Answers to Quick Test:

1. It is a related party transaction because even though the company does not have control from a shareholding point of view, it does have control over the financial and operating policies of Company B; therefore control is obtained as a result.

2. The loan is a ‘quasi loan’ and should be disclosed as a related party transaction.  Failure to disclose such a loan would be in breach of FRS 8 / IAS 24 and if this is the only breach then the audit report should be qualified ‘except for’.

3. Non-disclosure of related party transactions would result in the financial statements not giving a true and fair view and therefore having potential to mislead the users of them.

Steve Collings FMAAT ACCA is Audit Manager at Leavitt Walmsley Associates (http://www.lwaltd.com) and is a partner in AccountancyStudents.co.uk.  Any queries relating to this article can be directed to