7533 Responses to the risks of material misstatements associated with related party relationships and transactions

Oct-2012

CAS Guidance

The nature, timing and extent of the further audit procedures that the auditor may select to respond to the assessed risks of material misstatement associated with related party relationships and transactions depend upon the nature of those risks and the circumstances of the entity (CAS 550.A31).

Depending upon the results of the auditor’s risk assessment procedures, the auditor may consider it appropriate to obtain audit evidence without testing the entity’s controls over related party relationships and transactions. In some circumstances, however, it may not be possible to obtain sufficient appropriate audit evidence from substantive audit procedures alone in relation to the risks of material misstatement associated with related party relationships and transactions. For example, where intra-group transactions between the entity and its components are numerous and a significant amount of information regarding these transactions is initiated, recorded, processed or reported electronically in an integrated system, the auditor may determine that it is not possible to design effective substantive audit procedures that by themselves would reduce the risks of material misstatement associated with these transactions to an acceptably low level. In such a case, in meeting the CAS 330 requirement to obtain sufficient appropriate audit evidence as to the operating effectiveness of controls, the auditor is required to test the entity’s controls over the completeness and accuracy of the recording of the related party relationships and transactions (CAS 550.A34).

CAS Guidance

Examples of substantive audit procedures that the auditor may perform when the auditor has assessed a significant risk that management has not appropriately accounted for or disclosed specific related party transactions in accordance with the applicable financial reporting framework (whether due to fraud or error) include (CAS 550.A32):

• Confirming or discussing specific aspects of the transactions with intermediaries such as banks, law firms, guarantors, or agents, where practicable and not prohibited by law, regulation or ethical rules;

• Confirming the purposes, specific terms or amounts of the transactions with the related parties (this audit procedure may be less effective where the auditor judges that the entity is likely to influence the related parties in their responses to the auditor);

• Where applicable, reading the financial statements or other relevant financial information, if available, of the related parties for evidence of the accounting of the transactions in the related parties’ accounting records.

If the auditor has assessed a significant risk of material misstatement due to fraud as a result of the presence of a related party with dominant influence, the auditor may, in addition to the general requirements of CAS 240, perform audit procedures such as the following to obtain an understanding of the business relationships that such a related party may have established directly or indirectly with the entity and to determine the need for further appropriate substantive audit procedures (CAS 550.A33):

• Inquiries of, and discussion with, management and those charged with governance.
• Inquiries of the related party.
• Inspection of significant contracts with the related party.
• Appropriate background research, such as through the Internet or specific external business information databases.
• Review of employee whistle-blowing reports where these are retained.

CAS Guidance

Communicating promptly any newly identified related parties to the other members of the engagement team assists them in determining whether this information affects the results of, and conclusions drawn from, risk assessment procedures already performed, including whether the risks of material misstatement need to be reassessed (CAS 550.A35).

Examples of substantive audit procedures that the auditor may perform relating to newly identified related parties or significant related party transactions include (CAS 550.A36):

• Making inquiries regarding the nature of the entity’s relationships with the newly identified related parties, including (where appropriate and not prohibited by law, regulation or ethical rules) inquiring of parties outside the entity who are presumed to have significant knowledge of the entity and its business, such as legal counsel, principal agents, major representatives, consultants, guarantors, or other close business partners.

• Conducting an analysis of accounting records for transactions with the newly identified related parties. Such an analysis may be facilitated using computer-assisted audit techniques.

• Verifying the terms and conditions of the newly identified related party transactions, and evaluating whether the transactions have been appropriately accounted for and disclosed in accordance with the applicable financial reporting framework.

The requirements and guidance in CAS 240 regarding the auditor’s responsibilities relating to fraud in an audit of financial statements are relevant where management appears to have intentionally failed to disclose related parties or significant related party transactions to the auditor. The auditor may also consider whether it is necessary to re-evaluate the reliability of management’s responses to the auditor’s inquiries and management’s representations to the auditor (CAS 550.A37).

CAS Guidance

In evaluating the business rationale of a significant related party transaction outside the entity’s normal course of business, the auditor may consider the following (CAS 550.A38):

• Whether the transaction:

  • Is overly complex (for example, it may involve multiple related parties within a consolidated group),

  • Has unusual terms of trade, such as unusual prices, interest rates, guarantees and repayment terms,

  • Lacks an apparent logical business reason for its occurrence,

  • Involves previously unidentified related parties,

  • Is processed in an unusual manner.

• Whether management has discussed the nature of, and accounting for, such a transaction with those charged with governance.

• Whether management is placing more emphasis on a particular accounting treatment rather than giving due regard to the underlying economics of the transaction.

If management’s explanations are materially inconsistent with the terms of the related party transaction, the auditor is required, in accordance with CAS 500, to consider the reliability of management’s explanations and representations on other significant matters.

The auditor may also seek to understand the business rationale of such a transaction from the related party’s perspective, as this may help the auditor to better understand the economic reality of the transaction and why it was carried out. A business rationale from the related party’s perspective that appears inconsistent with the nature of its business may represent a fraud risk factor (CAS 550.A39).

Authorization and approval by management, those charged with governance, or, where applicable, the shareholders of significant related party transactions outside the entity’s normal course of business may provide audit evidence that these have been duly considered at the appropriate levels within the entity and that their terms and conditions have been appropriately reflected in the financial statements. The existence of transactions of this nature that were not subject to such authorization and approval, in the absence of rational explanations based on discussion with management or those charged with governance, may indicate risks of material misstatement due to error or fraud. In these circumstances, the auditor may need to be alert for other transactions of a similar nature. Authorization and approval alone, however, may not be sufficient in concluding whether risks of material misstatement due to fraud are absent because authorization and approval may be ineffective if there has been collusion between the related parties or if the entity is subject to the dominant influence of a related party (CAS 550.A40).

CAS Guidance

Although audit evidence may be readily available regarding how the price of a related party transaction compares to that of a similar arm’s length transaction, there are ordinarily practical difficulties that limit the auditor’s ability to obtain audit evidence that all other aspects of the transaction are equivalent to those of the arm’s length transaction. For example, although the auditor may be able to confirm that a related party transaction has been conducted at a market price, it may be impracticable to confirm whether other terms and conditions of the transaction (such as credit terms, contingencies and specific charges) are equivalent to those that would ordinarily be agreed between independent parties. Accordingly, there may be a risk that management’s assertion that a related party transaction was conducted on terms equivalent to those prevailing in an arm’s length transaction may be materially misstated (CAS 550.A42).

The preparation of the financial statements requires management to substantiate an assertion that a related party transaction was conducted on terms equivalent to those prevailing in an arm’s length transaction. Management’s support for the assertion may include (CAS 550.A43):

• Comparing the terms of the related party transaction to those of an identical or similar transaction with one or more unrelated parties.

• Engaging an external expert to determine a market value and to confirm market terms and conditions for the transaction.

• Comparing the terms of the transaction to known market terms for broadly similar transactions on an open market.

Evaluating management’s support for this assertion may involve one or more of the following (CAS 550.A44):

• Considering the appropriateness of management’s process for supporting the assertion.

• Verifying the source of the internal or external data supporting the assertion, and testing the data to determine their accuracy, completeness and relevance.

• Evaluating the reasonableness of any significant assumptions on which the assertion is based.

Some financial reporting frameworks require the disclosure of related party transactions not conducted on terms equivalent to those prevailing in arm’s length transactions. In these circumstances, if management has not disclosed a related party transaction in the financial statements, there may be an implicit assertion that the transaction was conducted on terms equivalent to those prevailing in an arm’s length transaction (CAS 550.A45).