Related Parties with Dominant Influence
A6. Related parties, by virtue of their ability to exert control or significant influence, may be in a position to exert dominant influence over the entity or its management. Consideration of such behavior is relevant when identifying and assessing the risks of material misstatement due to fraud, as further explained in paragraphs A29-A30. 17 SA 210, “Agreeing the Terms of Audit Engagements,” paragraph 6(a). 18 SA 700(Revised), “Forming an Opinion and Reporting on Financial Statements”, paragraph A12.
Special-Purpose Entities as Related Parties
A7. In some circumstances, a special-purpose entity19 may be a related party of the entity because the entity may in substance control it, even if the entity owns little or none of the special- purpose entity’s equity.
Risk Assessment Procedures and Related Activities
Risks of Material Misstatement Associated with Related Party
Relationships and Transactions (Ref: Para. 11)
A8. In case of certain entities, auditor’s responsibilities regarding related party relationships and transactions may be affected by the audit mandate, or by obligations on those entities arising from legislation, regulation, ministerial directives, government policy requirements, or resolutions of the legislature. Consequently, in such cases the auditor’s responsibilities may not be limited to addressing the risks of material misstatement associated with related party relationships and transactions, but may also include a broader responsibility to address the risks of non-compliance with laws and regulations governing such entities that lay down specific requirements in the conduct of business with related parties. Further, in such cases the auditor may need to have regard to any specific financial reporting requirements for related party relationships and transactions that may differ from other entities. Understanding the Entity’s Related Party Relationships and Transactions
Discussion among the Engagement Team (Ref: Para. 12)
A9. Matters that may be addressed in the discussion among the engagement team include: The nature and extent of the entity’s relationships and transactions with related parties (using, for example, the auditor’s record of identified related parties updated after each audit).
An emphasis on the importance of maintaining professional skepticism
throughout the audit regarding the potential for material misstatement associated with related party relationships and transactions. The circumstances or conditions of the entity that may indicate the existence of related party relationships or transactions that management has not identified or disclosed to the auditor (e.g., a complex organisational structure, use of special-purpose entities for off-balance sheet transactions, or an inadequate information system). The records or documents that may indicate the existence of related party relationships or transactions. 19 SA 315, paragraphs A32-A33, provides guidance regarding the nature of a special-purpose entity.
The importance that management and those charged with governance
attach to the identification, appropriate accounting for, and disclosure of related party relationships and transactions (if the applicable financial reporting framework establishes related party requirements), and the related risk of management override of relevant controls.
A10. In addition, the discussion in the context of fraud may include specific consideration of how related parties may be involved in fraud. For example:
How special-purpose entities controlled by management might be used to
facilitate earnings management. How transactions between the entity and a known business partner of a key member of management could be arranged to facilitate misappropriation of the entity’s assets.
The Identity of the Entity’s Related Parties (Ref: Para. 13(a))
A11. Where the applicable financial reporting framework establishes related party requirements, information regarding the identity of the entity’s related parties is likely to be readily available to management because the entity’s information systems will need to record, process and summarise related party relationships and transactions to enable the entity to meet the accounting and disclosure requirements of the framework. Management is therefore likely to have a comprehensive list of related parties and changes from the prior period. For recurring engagements, making the inquiries provides a basis for comparing the information supplied by management with the auditor’s record of related parties noted in previous audits.
A12. However, where the framework does not establish related party requirements, the entity may not have such information systems in place. Under such circumstances, it is possible that management may not be aware of the existence of all related parties. Nevertheless, the requirement to make the inquiries specified by paragraph 13 still applies because management may be aware of parties that meet the related party definition set out in this SA. In such a case, however, the auditor’s inquiries regarding the identity of the entity’s related parties are likely to form part of the auditor’s risk assessment procedures and related activities performed in accordance with SA 315 to obtain information regarding: The entity’s ownership and governance structures; The types of investments that the entity is making and plans to make; and The way the entity is structured and how it is financed. In the particular case of common control relationships, as management is more likely to be aware of such relationships if they have economic significance to the entity, the auditor’s inquiries are likely to be more effective if they are focused on whether parties with which the entity engages in significant transactions, or shares resources to a significant degree, are related parties.
A13. In the context of a group audit, SA 600 requires the group engagement team to provide each component auditor with a list of related parties prepared by group management and any other related parties of which the group engagement team is aware20. Where the entity is a component within a group, this information provides a useful basis for the auditor’s inquiries of management regarding the identity of the entity’s related parties.
A14. The auditor may also obtain some information regarding the identity of the entity’s related parties through inquiries of management during the engagement acceptance or continuance process. The Entity’s Controls over Related Party Relationships and Transactions (Ref:
A15. Others within the entity are those considered likely to have knowledge of the entity’s related party relationships and transactions, and the entity’s controls over such relationships and transactions. These may include, to the extent that they do not form part of management: Those charged with governance; Personnel in a position to initiate, process, or record transactions that are both significant and outside the entity’s normal course of business, and those who supervise or monitor such personnel; Internal auditors;
In-house legal counsel; and
The chief ethics officer or equivalent person.
A16. The audit is conducted on the premise that management and, where appropriate, those charged with governance have acknowledged and understand that they have responsibility for the preparation of the financial statements in accordance with the applicable financial reporting framework, including where relevant their fair presentation, and for such internal control as management and, where appropriate, those charged with governance, determine is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.21 Accordingly, where the 20 SA 600, ‘Using the Work of Another Auditor’. 21 SA 200, paragraph A2. framework establishes related party requirements, management, with oversight from those charged with governance, is responsible for the design, implementation and maintenance of adequate controls over related party relationships and transactions so that these are identified and appropriately accounted for and disclosed in accordance with the framework. In their oversight role, those charged with governance are responsible for monitoring how management is discharging its responsibility for such controls. Regardless of any related party requirements the framework may establish, those charged with governance may, in order to fulfill their oversight responsibilities, obtain information from management to enable them to understand the nature and business rationale of the entity’s related party relationships and transactions.
A17. In meeting the SA 315 requirement to obtain an understanding of the control environment,22 the auditor may consider features of the control environment relevant to mitigating the risks of material misstatement associated with related party relationships and transactions, such as: Internal ethical codes, appropriately communicated to the entity’s personnel and enforced, governing the circumstances in which the entity may enter into specific types of related party transactions. Policies and procedures for open and timely disclosure of the interests that management and those charged with governance have in related party transactions. The assignment of responsibilities within the entity for identifying, recording, summarising, and disclosing related party transactions.
Timely disclosure and discussion between management and those charged
with governance of significant related party transactions outside the entity’s normal course of business, including whether those charged with governance have appropriately challenged the business rationale of such transactions (for example, by seeking advice from external professional advisors). Clear guidelines for the approval of related party transactions involving actual or perceived conflicts of interest, such as approval by a subcommittee of those charged with governance comprising individuals independent of management. Periodic reviews by internal auditors, where applicable. Proactive action taken by management to resolve related party disclosure issues, such as by seeking advice from the auditor or external legal counsel. 22 SA 315, paragraph 14.
The existence of whistle-blowing policies and procedures, where
A18. Controls over related party relationships and transactions within some entities may be deficient or non-existent for a number of reasons, such as: The low importance attached by management to identifying and disclosing related party relationships and transactions. The lack of appropriate oversight by those charged with governance. An intentional disregard for such controls because related party disclosures may reveal information that management considers sensitive, for example, the existence of transactions involving family members of management.
An insufficient understanding by management of the related party
requirements of the applicable financial reporting framework.
The absence of disclosure requirements under the applicable financial
reporting framework. Where such controls are ineffective or non-existent, the auditor may be unable to obtain sufficient appropriate audit evidence about related party relationships and transactions. If this were the case, the auditor would, in accordance with SA 705(Revised)23, consider the implications for the audit, including the auditor’s report.
A19. Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively.24 The risk of management override of controls is higher if management has relationships that involve control or significant influence with parties with which the entity does business because these relationships may present management with greater incentives and opportunities to perpetrate fraud. For example, management’s financial interests in certain related parties may provide incentives for management to override controls by (a) directing the entity, against its interests, to conclude transactions for the benefit of these parties, or (b) colluding with such parties or controlling their actions. Examples of possible fraud include: Creating fictitious terms of transactions with related parties designed to misrepresent the business rationale of these transactions. Fraudulently organizing the transfer of assets from or to management or others at amounts significantly above or below market value. 23 SA 705(Revised), “Modifications to the Opinion in the Independent Auditor’s Report”. 24 SA 240, paragraphs 31 and A4. Engaging in complex transactions with related parties, such as special- purpose entities, that are structured to misrepresent the financial position or financial performance of the entity.
Considerations specific to smaller entities
A20. Control environment in smaller entities is likely to be different from larger entities. In particular those charged with governance may not include an outside member, and the role of governance may be undertaken directly by the owner- manager where no other owner exists. Control activities in smaller entities are likely to be less formal and smaller entities may have no documented processes for dealing with related party relationships and transactions. An owner-manager may mitigate some of the risks arising from related party transactions, or potentially increase those risks, through active involvement in all the main aspects of the transactions. For such entities, the auditor may obtain an understanding of the related party relationships and transactions, and any controls that may exist over these, through inquiry of management combined with other procedures, such as observation of management’s oversight and review activities, and inspection of available relevant documentation. Authorisation and approval of significant transactions and arrangements (Ref:
A21. Authorisation involves the granting of permission by a party or parties with the appropriate authority (whether management, those charged with governance or the entity’s shareholders) for the entity to enter into specific transactions in accordance with pre-determined criteria, whether judgmental or not. Approval involves those parties’ acceptance of the transactions the entity has entered into as having satisfied the criteria on which authorisation was granted. Examples of controls the entity may have established to authorise and approve significant transactions and arrangements with related parties or significant transactions and arrangements outside the normal course of business include:
Monitoring controls to identify such transactions and arrangements for
authorisation and approval. Approval of the terms and conditions of the transactions and arrangements by management, those charged with governance or, where applicable, shareholders.
Maintaining Alertness for Related Party Information When Reviewing
Records or Documents That the Auditor May Inspect (Ref: Para. 15)
A22. During the audit, the auditor may inspect records or documents that may provide information about related party relationships and transactions, for example: Entity income tax returns. Information supplied by the entity to regulatory authorities. Shareholder registers to identify the entity’s principal shareholders.
Statements of conflicts of interest from management and those charged
with governance. Records of the entity’s investments and those of its pension plans.
Contracts and agreements with key management or those charged with
governance. Significant contracts and agreements not in the entity’s ordinary course of business.
Specific invoices and correspondence from the entity’s professional
advisors. Life insurance policies acquired by the entity. Significant contracts re-negotiated by the entity during the period. Internal auditors’ reports. Documents associated with the entity’s filings with a securities regulator (e.g., prospectuses). Arrangements that may indicate the existence of previously unidentified or undisclosed related party relationships or transactions
A23. An arrangement involves a formal or informal agreement between the entity and one or more other parties for such purposes as: The establishment of a business relationship through appropriate vehicles or structures. The conduct of certain types of transactions under specific terms and conditions. The provision of designated services or financial support. Examples of arrangements that may indicate the existence of related party relationships or transactions that management has not previously identified or disclosed to the auditor include: Participation in unincorporated partnerships with other parties. Agreements for the provision of services to certain parties under terms and conditions that are outside the entity’s normal course of business. Guarantees and guarantor relationships. Identification of Significant Transactions outside the Normal Course of Business (Ref: Para. 16)
A24. Obtaining further information on significant transactions outside the entity’s normal course of business enables the auditor to evaluate whether fraud risk factors, if any, are present and, where the applicable financial reporting framework establishes related party requirements, to identify the risks of material misstatement.
A25. Examples of transactions outside the entity’s normal course of business may include:
Complex equity transactions, such as corporate restructurings or
acquisitions. Transactions with offshore entities in jurisdictions with weak corporate laws. The leasing of premises or the rendering of management services by the entity to another party if no consideration is exchanged. Sales transactions with unusually large discounts or returns.
Transactions with circular arrangements, for example, sales with a
commitment to repurchase. Transactions under contracts whose terms are changed before expiry. Understanding the nature of significant transactions outside the normal course of business (Ref: Para. 16(a))
A26. Inquiring into the nature of the significant transactions outside the entity’s normal course of business involves obtaining an understanding of the business rationale of the transactions, and the terms and conditions under which these have been entered into. Inquiring into whether related parties could be involved (Ref: Para. 16(b))
A27. A related party could be involved in a significant transaction outside the entity’s normal course of business not only by directly influencing the transaction through being a party to the transaction, but also by indirectly influencing it through an intermediary. Such influence may indicate the presence of a fraud risk factor. Sharing Related Party Information with the Engagement Team (Ref: Para. 17)
A28. Relevant related party information that may be shared among the engagement team members includes, for example: The identity of the entity’s related parties. The nature of the related party relationships and transactions. Significant or complex related party relationships or transactions that may require special audit consideration, in particular transactions in which management or those charged with governance are financially involved.
Identification and Assessment of the Risks of Material Misstatement
Associated with Related Party Relationships and Transactions
Fraud Risk Factors Associated with a Related Party with Dominant
Influence (Ref: Para. 19)
A29. Domination of management by a single person or small group of persons without compensating controls is a fraud risk factor.25 Indicators of dominant influence exerted by a related party include:
The related party has vetoed significant business decisions taken by
management or those charged with governance. Significant transactions are referred to the related party for final approval. There is little or no debate among management and those charged with governance regarding business proposals initiated by the related party. Transactions involving the related party (or a close family member of the related party) are rarely independently reviewed and approved. Dominant influence may also exist in some cases if the related party has played a leading role in founding the entity and continues to play a leading role in managing the entity.
A30. In the presence of other risk factors, the existence of a related party with dominant influence may indicate significant risks of material misstatement due to fraud. For example: An unusually high turnover of senior management or professional advisors may suggest unethical or fraudulent business practices that serve the related party’s purposes. The use of business intermediaries for significant transactions for which there appears to be no clear business justification may suggest that the related party could have an interest in such transactions through control of such intermediaries for fraudulent purposes. Evidence of the related party’s excessive participation in or preoccupation with the selection of accounting policies or the determination of significant estimates may suggest the possibility of fraudulent financial reporting. 25 SA 240, Appendix 1.
Responses to the Risks of Material Misstatement Associated with
Related Party Relationships and Transactions (Ref: Para. 20)
A31. 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.26
A32. 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:
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.
A33. 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 SA 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:
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. 26 SA 330 provides further guidance on considering the nature, timing and extent of further audit procedures. SA 240 establishes requirements and provides guidance on appropriate responses to assessed risks of material misstatement due to fraud.
A34. 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 SA 330 requirement to obtain sufficient appropriate audit evidence as to the operating effectiveness of relevant controls,27 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. Identification of Previously Unidentified or Undisclosed Related Parties or
Significant Related Party Transactions
Communicating Newly Identified Related Party Information to the Engagement
A35. 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.
Substantive Procedures Relating to Newly Identified Related Parties or
Significant Related Party Transactions (Ref: Para. 22(c))
A36. Examples of substantive audit procedures that the auditor may perform relating to newly identified related parties or significant related party transactions include: 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. 27 SA 330, paragraph 8(b).
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.
Intentional Non-Disclosure by Management (Ref: Para. 22(e))
A37. The requirements and guidance in SA 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.
Identified Significant Related Party Transactions outside the Entity’s
Normal Course of Business
Evaluating the Business Rationale of Significant Related Party Transactions (Ref: Para. 23)
A38. 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: Whether the transaction: o Is overly complex (e.g., it may involve multiple related parties within a consolidated group). o Has unusual terms of trade, such as unusual prices, interest rates, guarantees and repayment terms. o Lacks an apparent logical business reason for its occurrence. o Involves previously unidentified related parties. o 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 SA 500,28 to consider the reliability of management’s explanations and representations on other significant matters.
A39. 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. Authorization and Approval of Significant Related Party Transactions (Ref: Para. 23(b))
A40. Authorisation 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 authorisation 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. Authorisation and approval alone, however, may not be sufficient in concluding whether risks of material misstatement due to fraud are absent because authorisation 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.
Considerations specific to smaller entities
A41. A smaller entity may not have the same controls provided by different levels of authority and approval that may exist in a larger entity. Accordingly, when auditing a smaller entity, the auditor may rely to a lesser degree on authorization and approval for audit evidence regarding the validity of significant related party transactions outside the entity’s normal course of business. Instead, the auditor may consider performing other audit procedures such as inspecting relevant documents, confirming specific aspects of the transactions with relevant parties, or observing the owner-manager’s involvement with the transactions. 28 SA 500, “Audit Evidence”, paragraph 11.
Assertions That Related Party Transactions Were Conducted on Terms
Equivalent to Those Prevailing in an Arm’s Length Transaction (Ref: Para. 24)
A42. 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.
A43. Management is responsible for the substantiation of 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: 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.
A44. Evaluating management’s support for this assertion may involve one or more of the following:
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.
A45. 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.
Evaluation of the Accounting for and Disclosure of Identified Related
Party Relationships and Transactions
Materiality Considerations in Evaluating Misstatements (Ref: Para. 25)
A46. SA 450 requires the auditor to consider both the size and the nature of a misstatement, and the particular circumstances of its occurrence, when evaluating whether the misstatement is material.29 The significance of the transaction to the financial statement users may not depend solely on the recorded amount of the transaction but also on other specific relevant factors, such as the nature of the related party relationship.
Evaluation of Related Party Disclosures (Ref: Para. 25(a))
A47. Evaluating the related party disclosures in the context of the disclosure requirements of the applicable financial reporting framework means considering whether the facts and circumstances of the entity’s related party relationships and transactions have been appropriately summarized and presented so that the disclosures are understandable. Disclosures of related party transactions may not be understandable if:
