There are many types of related party transactions that might potentially be used to misstate financial reports. The most frequent type of transactions that require regulatory action are; concessionary loans to related parties, payments to company officers for services that were either unapproved or non-existent, transfer of funds through over valued purchases of assets/investments, and sales of goods or services to related entities in which the existence of the relationship was not disclosed.
Generally, related party transactions are not necessary as a mechanism for fraud, and their presence need not indicate fraudulent financial reporting. At first sight a related party transaction is represented to be of a benevolent/benign nature. An implication is that it is important for the auditor to understand the benign nature of most related party transactions, the differentiating features between benign and fraudulent transactions, and the importance of evaluating a company’s related party transactions in light of its broader corporate governance structure.
Auditor’s response from ISA 550
The auditor’s objective is to obtain an understanding of related party relationships and transactions. This understanding should then be used to assess any resulting fraud risk indicators, and to conclude on the appropriateness of the accounting treatment and disclosures applied to related parties and transactions.
It is important to appreciate that ISA 550 recognises that related parties and transactions may give rise to a high-risk of material misstatement, and are therefore of particular significance to the auditor. Risks arise because:
# Many entities operate through a complex range of relationships and structures, increasing the complexity of related party transactions;
# Management may be unaware of the existence of all related-party relationships and transactions;
# The entity’s information systems may not identify transactions or outstanding balances with related parties, especially for transactions conducted at nil value, or outside the normal course of business;
# Related-party transactions may not be conducted under normal terms and conditions; and
# Related-party transactions may be deliberately concealed by management, and their accounting treatments often carry a high risk of deliberate manipulation.
Directors and Executive officers are in a unique position to commit financial statement fraud or asset misappropriation through their ability to manipulate accounting records and present fraudulent financial information. Therefore, by manipulating the required level of disclosures they get away from the fraudulent nature of the transaction. The auditor can always be challenged on the appropriateness of accounting/disclosure. Someone needs to focus beyond the mere disclosure!