Issues between related parties played a prominent role in the scandals that surfaced more than a decade ago at Enron, Tyco International and Refco. Similar problems have arisen in more recent financial reporting fraud cases, prompting the Public Company Accounting Oversight Board (PCAOB) to unanimously approve a tougher audit standard on related-party transactions and financial relationships. To prevent your company from issuing financial statements with undisclosed or misleading information about these relationships, think like an auditor.
It’s all relative
Under PCAOB Auditing Standard No. 18 (AS 18), Related Parties, Amendments to Certain PCAOB Auditing Standards Regarding Significant Unusual Transactions, and Other Amendments to PCAOB Auditing Standards, related parties include the company’s directors, executives and their family members.
Ultimately, companies are responsible for the preparation of their financial statements, including the identification of these related parties. However, auditors are on the lookout for undisclosed related parties and unusual transactions.
Where to look
Certain types of questionable transactions also might signal that a company is engaged in related-party transactions. Examples include contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold.
Where can you find evidence of undisclosed related parties? Auditors are trained to consider these types of source materials:
- Proxy statements,
- 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, and
- Corporate organization charts.
Auditors also scrutinize compensation arrangements and other financial relationships with executives that may create incentives to engage in fraud to meet financial targets.
Leave no stone unturned
AS 18 requires public company auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including its nature, terms and business purpose (or lack thereof). Moreover, it requires auditors to communicate with the audit committee throughout the audit process about related-party transactions — not just at the end of the engagement.
Related parties present risks to all kinds of entities, not just public companies. Smaller companies and start-ups also tend to engage in numerous related-party transactions, such as rental and compensation arrangements. These arrangements increase the risks of fraud and legal violations, warranting increased attention for companies of all sizes.