Related Party Transactions & Your Audit
What Are Related Party Transactions?
Related Party transactions occur where a business or organization interacts financially with an entity with a close relationship to themselves as defined under AASB 124. These transactions are particularly sensitive for stakeholders such as shareholders and government regulatory bodies as there is an implicit belief that the closeness of the relationship can influence decision-making and thus the financial outcome for the parties. An auditor’s role is to focus on risk and regulatory requirements in order to provide an independent level of assurance on the financial information presented by a business or organization.
When we have clients search for “Related Party Transactions & Your Audit”, they are generally interested in why their auditor is so focused on these transactions and whether or not they have a problem with the audit process. In truth, the attention to Related Party Transactions by the auditor does not necessarily show any breach of the accounting standards but rather just a heightened focus to ensure that everything has been disclosed appropriately in the financial statements, so stakeholders are aware of any transactions with a potential element of conflict.
There are also occasions during audits where we find that these transactions have been used to shift profits and effectively steal income from one group of stakeholders for the benefit of another or to conceal losses and avoid good governance. This key risk is why all audit firms will pay particular attention to Related Party Transactions and their disclosures.
Who Is Considered a Related Party?
The Australian Accounting Standards define who is considered a related party under AASB 124 including:
- The directors and key management personnel (like the CEO, COO, CFO, CTO) of an organization
- Close family members of the directors and key management personnel mentioned above
- Entities controlled or significantly influenced by directors or key management personnel
- Significant/controlling shareholders of the organization
- Parent companies, subsidiaries, and associates (in practical terms these are only generally important when they are not part of a consolidated group)
The definition under the accounting standards is intentionally broad to capture any and all relationships that could influence financial decisions.
In addition, for corporate entities the Corporations Act 2001 imposes duties on directors to act in the best interests of the company and avoid conflicts of interest. Related party transactions that breach these duties may have legal consequences and need to be examined in the case of corporate audits.
What Is a Related Party Transaction?
A transaction in this instance does not mean just the payment of fees but rather is defined much broader to include any transfer of resources, services, or obligations between related parties, regardless of whether a price is charged.
Although not an exhaustive list some examples include:
- Allowing a family member to use office space, computers or other resources whether or not it is charged for
- Loans to or from directors or their associates whether or not on commercial terms
- Directors’ fees, issuances of options or other payments made to directors, investors or other related entities
- Issue of contracts allowing first rights of refusal, supply restrictions or other intangibly non-cash benefits to related parties
- Rent charged on premises owned by a related party
- Purchases or sales of assets or provision of services between related entities
The key thing to remember is that this is about disclosure as opposed to whether something was done wrong. In circumstances whereby transactions occur at market rates and there is evidence of the same they still need to be disclosed in a separate section of the financial statements.
Why Do Auditors Focus on Related Party Transactions?
The risk of misstatement is much higher when parties are not operating at arm’s length in a normal commercial setting. On this basis auditors are legally required as part of their role and responsibilities to give this area heightened professional skepticism in audits due to the risk of:
- Conflicts of interest
- Non-arm’s length pricing
- Inadequate disclosure
- Fraud or financial manipulation
Related Party Transactions and Your Audit
1. Identification of Related Parties
Your auditor will ask the management team engaging them to formally declare all related parties to the audit team prior to the audit commencing. From there auditors will also make independent enquiries such as:
- Review company registers and ASIC records
- Examine director and shareholder information
- Review prior-year disclosures
- Analyzing press releases, marketing materials and other available information
In circumstances where management does not assist to fully identify related parties it will generally result in significant delays and increased costs for the audit process along with modified audit opinions.
2. Understanding the Transactions
After the parties are identified and agreed between auditors and management the auditor then assesses:
- Each of the transactions between the entities and what was traded and at what value
- Whether that value represents arm’s length terms of trade
- Whether the transaction is consistent with normal operations of the business or organization
- What evidence is available such as legally signed contracts and other supporting documentation
3. Testing and Evidence
All auditing involves the testing of evidence designed to:
- Confirm the terms of trade for the related party transactions against the normal terms for other customers/suppliers
- Assessing the source documents against the subsequent transaction pricing and timing to see if it matches the written evidence
- Checking governance records to ensure transactions are correct authorized and recorded and appropriate disclosures were made at a board level
- Confirming the balances outstanding and whether any risks exist
- Comparing transactions to market benchmarks
4. Disclosure Assessment
The most common issue we see with related party transactions during audits is not that theft or fraud has occurred but that they have simply not been disclosed correctly in accordance with Australian Accounting Standards, including:
- Disclosing the nature of the relationship
- Describing the transaction in detail
- Showing all the amounts involved and whether on commercial terms
- Any outstanding balances of the transactions or ongoing obligations (such as in the case of related party leases)
Director Responsibilities for Related Party Transactions
Director’s responsibilities are broad and have a critical role in the management and disclosure of related party transactions including:
- Ongoing identification and declaration of related party transactions including keeping and maintaining a related party risk register
- Ensuring that the business is formally documenting all related party transactions and that there is proper governance and auditable approval processes which exclude the conflicted party as appropriate
- Document any agreements along with written evidence of why the transactions are commercially justified and who approved them
- Working with the accountant and the audit firm to ensure that transparent disclosures are made within the financial statements
Final Thoughts: Related Party Transactions & Your Audit
There is nothing inherently wrong with related party transactions and are often an unavoidable fact for many new businesses, particularly start ups and scale ups. However, a full understanding of the disclosure rules and making sure you have proactively kept proper records including conflict registers, written approval processes and transaction records are imperative to ensure a smooth audit process along with best practice governance.
Need Help with Related Party Transactions or Your Audit?
Our team at Auditors Australia has decades of experience working with businesses and organisations on providing ongoing assurance support as part of statutory and regulatory audits. We work closely with directors and other key management personnel to ensure disclosures are accurate, compliant, and of value to stakeholders.
If you have any questions about related party transactions, or would like to discuss how we can assist, click here to get in touch with our team today!