Intention is key: auditors need to be resourceful and innovative in their investigation of transactions with related parties - Back to Basics

Internal Auditor, Feb, 2003 by Frank R. Urbancic

N A POSITION PAPER PREsented to the New York Stock Exchange, Nasdaq, and the U.S. Congress in April of last year, The Institute of Internal Auditors (IIA) strongly recommended that all public companies establish and maintain an internal audit function. The IIA stressed the importance of internal auditing's risk assessment function and identified several types of risks in the position paper, including transactions with related parties.

Related-party transactions are complex and challenging to auditors because they depend largely on the intentions of the parties involved, and it is difficult to investigate those intentions when the parties are not conducting transactions at arm's length. The American Institute of Certified Public Accountants (AICPA) toolkit, "Accounting and Auditing for Related Parties and Related Party Transactions," defines a related party as an affiliate, owner, management, or any other party with which an organization deals in situations where one of the parties can influence the management or operating policies of the other.

The 49-page resource advises auditors to begin by thoroughly evaluating their organization's procedures for identifying, authorizing, and properly accounting for related-party transactions. Auditors should also be aware of transactions that may indicate related-party involvement such as:

* Borrowing or lending interest-free or at an interest rate that is substantially different from market rates.

* The sale or purchase of real estate at a price that differs greatly from its appraised value.

* Exchanges of similar property.

* Loans with no scheduled terms for repayment.

* Sales without substance, including funding the other party to the transaction so that the sales price is fully remitted.

* Free or reduced-rate goods or services.

* Loans that appear to be advanced for a valid business purpose and are later written off as uncollectible.

* Payments for services with inflated prices or services not rendered.

IDENTIFYING RELATED PARTIES

Although certain related parties may be evident -- such as parent-subsidiary or investor-investee -- others aren't readily apparent. Therefore, to identify related parties, the AICPA recommends applying audit procedures such as:

* Asking management for a list of all related parties, and inquire whether there were any transactions with these parties during a given time period.

* Reviewing correspondence and invoices from law firms that have performed work for the organization.

* Reviewing filings with the U.S. Securities and Exchange Commission and other regulatory agencies for the names of related parties and for other businesses in which officers and directors occupy directorship or management positions.

* Identifying all pensions and other trust funds established for employees and the names of their officers and trustees.

* Identifying principal stockholders.

* Reviewing material-investment transactions to determine whether the nature and extent of the investments has created related parties.

RELATED-PARTY TRANSACTIONS

Once the auditor has identified the organization's related parties, he or she will need to determine whether or not any transactions occurred between the organization and known related parties. In doing so, the auditor may discover additional, previously unidentified, related parties. The AICPA's recommended audit procedures for determining transactions with related parties include:

* Reading minutes from meetings involving the board of directors and executive or operating committees for information about material transactions, which may have been authorized or discussed during the meetings.

* Reviewing proxies and other material filed with the regulatory agencies for information about related-party transactions.

* Assessing the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders and searching for indications of previously undisclosed relationships by identifying the principals and determining whether the entity and transaction have economic substance.

* Determining whether transactions are occurring without accounting recognition, such as receiving or providing accounting, management, or other services at no charge or allowing a major stockholder to absorb corporate expenses.

* Inspecting accounting records for large, highly complex, unusual, or nonrecurring transactions or balances, and focusing particularly on transactions recognized near the end of a reporting period.

After the transactions have been identified, the guidance advises auditors to obtain a clear understanding of each related-party transaction, including its purpose, nature, and extent. In addition to making inquiries of management, auditors should:

* Examine documentation of the transaction, including invoices, executed copies of agreements, contracts, receiving reports, and shipping documents.

* Determine whether the board of directors or other appropriate officials approved the transaction.

* Confirm transaction amount and terms -- including guarantees -- with the related party.