Related Party Transactions and Disclosures: CPA Audit Guide
A practical guide to auditing related party transactions for the CPA AUD exam. Covers identification, risk assessment, audit procedures, and disclosure requirements under ASC 850 and auditing standards.
Why Related Party Transactions Matter
Related party transactions are transactions between the reporting entity and a party with which it has a pre-existing relationship that could influence the terms of the transaction. These relationships include transactions between a parent company and its subsidiaries, among entities under common control, between an entity and its principal owners or key management personnel, and between an entity and its affiliates or investees. Related party transactions are significant in auditing because they may not be conducted at arm length, meaning the terms and conditions may differ from what would have been agreed upon between independent parties.
For CPA AUD candidates, related party transactions represent an important intersection of accounting standards (ASC 850 for disclosure requirements) and auditing standards (which prescribe the auditor responsibilities for identifying, evaluating, and reporting on related party transactions).
Accounting and Disclosure Requirements
ASC 850 requires disclosure of material related party transactions, including the nature of the relationship, a description of the transactions, the dollar amounts of the transactions for each period presented, and any amounts due from or to related parties at each balance sheet date. The standard also requires disclosure of the terms and manner of settlement. If the entity asserts that the transaction was on terms equivalent to those that would have prevailed in an arm length transaction, the entity must be able to substantiate that assertion.
Related party disclosures are critical because they alert financial statement users to transactions that may have been structured for reasons other than economic substance. Without adequate disclosure, users cannot properly assess the quality of earnings, the value of assets, or the completeness of liabilities.
Auditor Responsibilities
Identifying Related Parties and Transactions
The auditor must perform procedures to identify related parties and related party transactions. These procedures include inquiring of management about the identity of related parties and whether the entity entered into any transactions with those parties, reviewing SEC and other regulatory filings for information about related parties, inspecting stockholder records to identify principal owners, reviewing conflict of interest statements and other documents for relationships that management may not have disclosed, and reviewing prior audit documentation and permanent files for previously identified related parties.
The auditor should also be alert to indicators of previously unidentified related party transactions during the course of the audit. Such indicators include transactions with unusual terms, significant transactions with newly identified entities, transactions that lack apparent business purpose, and transactions processed outside the normal course of business.
Risk Assessment
Related party transactions are inherently higher-risk because the relationship between the parties may affect the economic substance and pricing of the transaction. Auditing standards, particularly for public company audits under PCAOB standards, require heightened attention to related party transactions. The PCAOB standard AS 2410 specifically requires the auditor to perform procedures to understand the business purpose of identified related party transactions and to evaluate whether the financial statements contain all required related party disclosures.
The auditor should assess whether identified related party transactions were authorized and approved in accordance with the entity policies, whether the terms of the transactions are consistent with management explanations, and whether the transactions have been properly accounted for and disclosed. For transactions that are significant to the financial statements, the auditor should obtain sufficient appropriate evidence to evaluate the business purpose and terms.
Audit Procedures for Related Party Transactions
Specific audit procedures for related party transactions include confirming the terms and amounts of transactions with the related parties, inspecting contracts and other documentation supporting the transactions, evaluating whether the business rationale for significant related party transactions suggests they may have been entered into for the purpose of engaging in fraudulent financial reporting or concealing misappropriation of assets, testing the mechanical accuracy of pricing and calculations in related party transactions, and verifying that all required disclosures have been made in the financial statements.
Fraud Considerations
Related party transactions can be used to engage in fraudulent financial reporting. For example, a company might sell assets to a related party at inflated prices to recognize fictitious gains, lease property from a related party at above-market rates to divert company resources, or engage in circular transactions with related parties to inflate revenue. The auditor must consider these fraud risks when evaluating related party transactions and should maintain heightened professional skepticism.
Common Exam Topics
CPA AUD exam questions on related party transactions often test the candidate ability to identify related parties based on the definition in accounting standards, determine the appropriate audit procedures for identified related party transactions, evaluate whether related party disclosures are complete and in accordance with ASC 850, and assess the fraud risk associated with specific related party transaction scenarios.
Key Takeaways
- Understand the definition of related parties and the types of relationships that give rise to related party status.
- Know the disclosure requirements under ASC 850, including when the entity can assert that terms were equivalent to arm length transactions.
- Be familiar with the audit procedures used to identify related parties and related party transactions.
- Understand the heightened fraud risk associated with related party transactions and how the auditor should respond.
- Practice evaluating the completeness and adequacy of related party disclosures in realistic scenarios.
Related party transactions are where auditing meets the reality of business relationships. The ability to identify, evaluate, and report on these transactions is a core competency for every auditor and a regularly tested topic on the CPA exam.
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