CPA Exam AUD: Auditing Related Party Transactions
Learn how auditors identify and evaluate related party transactions for the CPA AUD exam. Covers risk assessment, required procedures, and disclosure requirements.
Auditing Related Party Transactions: CPA Exam Guide
Related party transactions present unique audit risks because they may not be conducted at arm's length and may be more susceptible to manipulation. AU-C Section 550 (Related Parties) establishes the auditor's responsibilities regarding related party relationships and transactions. This topic is frequently tested on the AUD exam because it intersects with fraud risk, disclosure requirements, and professional skepticism.
What Are Related Parties?
Related parties generally include affiliates of the entity, principal owners and their immediate families, management and their immediate families, entities under common control, and other parties that can significantly influence or be influenced by the entity. Under GAAP (ASC 850), related party transactions must be disclosed in the financial statements, including the nature of the relationship, a description of the transactions, and the dollar amounts involved.
Risk Assessment for Related Party Transactions
Related party transactions are considered to have a higher risk of material misstatement for several reasons. They may occur at prices or terms that differ from arm's-length transactions. They may be motivated by financial reporting considerations rather than business substance. They provide opportunities for management to manipulate financial results. Additionally, the existence and disclosure of related party relationships and transactions may be concealed by management.
AU-C 550 requires the auditor to identify related party transactions as a significant risk when the nature or magnitude of the transactions warrants. When identified as a significant risk, the auditor must evaluate whether the underlying substance of the transaction differs from its legal form and whether the transactions have been properly accounted for and disclosed.
Required Audit Procedures
The auditor must perform specific procedures to identify and evaluate related party transactions. During risk assessment, the auditor should inquire of management about the identity of related parties, the nature of relationships, and whether transactions occurred during the period. The auditor should also inquire of the audit committee or those charged with governance about their understanding of related party relationships. In addition, the auditor should be alert for related party information throughout the audit by examining bank and legal confirmations, reading minutes of board meetings, reviewing regulatory filings, and inspecting contracts and agreements.
When related party transactions are identified, the auditor should obtain an understanding of the business purpose of the transactions, inspect supporting documentation, confirm material terms with the other parties if practicable, and determine whether the transactions have been properly authorized and approved. The auditor should also evaluate whether the financial statements achieve fair presentation regarding related party relationships and transactions, including whether the disclosures are accurate and complete.
Transactions with Previously Unidentified Related Parties
If the auditor identifies significant transactions outside the normal course of business that were not previously identified as related party transactions, the auditor should investigate the nature of the transaction and whether related parties may be involved. If the auditor identifies arrangements or information suggesting the existence of previously unidentified related party relationships or transactions, the auditor should communicate the information to the engagement team, request management to identify all transactions with the newly identified related party, inquire why the entity's controls failed to identify the relationship, perform additional substantive procedures as necessary, and reconsider the risk that other related parties or transactions may exist that were not previously identified.
Management Representations
The auditor should obtain specific written representations from management regarding related parties. These representations typically include that management has disclosed the identity of all related parties and related party transactions, that related party transactions have been appropriately authorized and approved, and that all related party relationships and transactions have been properly accounted for and disclosed in the financial statements.
Evaluating Disclosures
The auditor must evaluate whether the financial statement disclosures regarding related party transactions are adequate under the applicable financial reporting framework. Under GAAP, required disclosures include the nature of the relationship, a description of the transactions and their effects on the financial statements, the dollar amounts of transactions, and amounts due to or from related parties as of the balance sheet date. The auditor should be skeptical of assertions by management that related party transactions were conducted on terms equivalent to arm's-length transactions unless such claims can be substantiated.
Fraud Considerations
Related party transactions are closely tied to fraud risk. Fraudulent financial reporting often involves related party transactions that are not properly disclosed or that lack economic substance. The auditor should maintain heightened professional skepticism when evaluating related party transactions, particularly those involving unusual terms, transactions with previously undisclosed related parties, and transactions that lack a clear business purpose.
Exam Tips for Related Party Transactions
- Related party transactions are often identified as significant risks requiring enhanced audit procedures.
- Claims that related party transactions were at arm's length must be substantiated, not simply accepted.
- The auditor should be alert for related party information throughout the entire audit.
- Management representations about related parties are required.
- Previously unidentified related parties discovered during the audit require the auditor to reassess risk.
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