Related-Party Transactions: Audit Identification and Procedures
Guide to auditing related-party transactions for the CPA AUD exam. Covers identification procedures, disclosure requirements, and AU-C Section 550 standards.
Why Related-Party Transactions Matter in Auditing
Related-party transactions are significant in auditing because they may not occur at arm's length terms, creating the potential for financial statements that do not faithfully represent the entity's economic transactions. Under AU-C Section 550, the auditor must perform procedures to identify, assess, and respond to the risks of material misstatement arising from the entity's failure to properly account for or disclose related-party relationships and transactions. Related parties include affiliates, principal owners, management, members of their immediate families, and other parties that can significantly influence or be influenced by the entity.
Identifying Related Parties
Risk Assessment Procedures
The auditor uses several procedures to identify related parties and related-party transactions. These include inquiring of management about the identity of related parties, the nature of relationships, and whether any transactions with related parties occurred during the period. The auditor also reviews prior-year working papers, examines shareholder and board minutes, reviews SEC filings and other regulatory filings, inspects contracts and agreements for related-party involvement, and analyzes large or unusual transactions, especially those near the end of the reporting period.
Ongoing Vigilance
The auditor remains alert throughout the audit for information that may indicate the existence of related parties or related-party transactions that management has not previously identified or disclosed. Unusual transactions, transactions at terms significantly different from market terms, transactions lacking an apparent business rationale, and transactions with entities that lack the substance to engage in the transactions on their own may indicate previously unidentified related-party relationships.
Evaluating Identified Related-Party Transactions
Understanding the Business Purpose
For each identified related-party transaction, the auditor obtains an understanding of the business purpose (or lack thereof) of the transaction. Transactions without a clear business purpose or that appear to be structured to achieve a particular accounting outcome warrant increased professional skepticism. The auditor considers whether the transaction may have been entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets.
Testing the Transactions
The auditor examines supporting documentation for related-party transactions, including contracts, invoices, shipping documents, and evidence of payment. The auditor also evaluates whether the transaction has been properly authorized by the entity's governance structure, recorded at the correct amount, and disclosed in accordance with the applicable financial reporting framework. For transactions asserted to be conducted at arm's length terms, the auditor obtains evidence to support that assertion.
Disclosure Requirements
GAAP requires specific disclosures about related-party transactions, including the nature of the relationship, a description of the transactions, the dollar amounts of the transactions, and amounts due to or from related parties. The auditor evaluates whether these disclosures are complete, accurate, and presented in accordance with the applicable financial reporting framework. Inadequate or missing related-party disclosures may constitute a material misstatement of the financial statements.
Significant Related-Party Transactions Outside the Normal Course of Business
Transactions with related parties that are outside the normal course of business are treated as significant risks under AU-C Section 550. These transactions require special audit consideration because they may present greater risks of material misstatement. The auditor inspects the underlying contracts or agreements, evaluates whether the transaction terms and amounts are consistent with the explanations of the business purpose, and obtains evidence that the transaction has been properly authorized and approved.
Previously Unidentified Related Parties
When the auditor identifies a related party or significant related-party transaction that management did not previously identify or disclose, the auditor must promptly communicate this information to the engagement team, request management to identify all transactions with the newly identified related party, inquire why controls failed to identify the relationship, perform substantive procedures on those transactions, reconsider the risk that other related parties or transactions exist that management has not identified, and evaluate the implications for the reliability of management's representations.
CPA Exam Tips
- Related-party transactions are a significant risk area. Expect questions about identification procedures and how the auditor responds to previously unidentified relationships.
- The auditor should not simply accept management's assertion that a related-party transaction was conducted at arm's length without obtaining corroborating evidence.
- Transactions with related parties that are outside the normal course of business are always significant risks requiring special audit consideration.
- Review of SEC filings, board minutes, and conflicts-of-interest questionnaires are standard procedures for identifying related parties.
- Inadequate disclosure of related-party transactions is itself a potential material misstatement.
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