The US SEC approved Auditing Standard No. 18, Related Parties in June. The standard becomes effective for audits after December 15, 2014. Related party transactions, significant unusual transactions and financial relationships and transactions with executive officers (such as executive compensation and perks) will be under increased scrutiny, with this standard. The new auditing standard will also require auditors to identify red flags that may cause material misstatements and do additional inquiries from the boards of directors.
The US standard includes a requirement that the auditors communicate to the audit committee their evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties, as well as significant matters arising from the audit regarding the company’s relationships and transactions with related parties. This includes whether all transactions (a) were disclosed to the auditors, (b) were authorized in accordance with established policies and (c) have terms similar to those in arm’s length transactions.
CODE OF BEST PRACTICES ON RELATED PARTY TRANSACTIONS issued by the SEC in Sri Lanka puts the responsibility for RPTs on the Boards. Companies have to form a Related Party Transactions Review Committee which shall review in advance all ( with exceptions for certain transactions) proposed Related Party Transactions. It also requires the board to obtain shareholder approval by way of a Special Resolution for RPT that are not in the ordinary course of business and, in the opinion of the Related Party Transactions Review Committee, are on terms favorable to the Related Party than those generally available to the public. Therefore, any transaction that is not recommended for special resolution will be assumed to be at arms length. This however, excludes directors fees and remuneration, and employment remuneration. Which is different to the US approach on executive compensation described below.
For Executive Compensation in the US, the standard No 18 explicitly provides that the auditors’ work does not include an assessment of the appropriateness or reasonableness of executive compensation arrangements. Its designed to heighten the auditors’ attention to incentives or pressures for the company to achieve a particular financial position or operating results, recognizing the key role that a company’s executive officers may play in the company’s accounting decisions or financial reporting. In addition, auditors will need to obtain an understanding of established policies and procedures regarding the authorization and approval of executive officer expense reimbursements.
The Sri Lankan approach of putting the onus on the boards to first ensure RPTs are carried out in the normal course of business on an arms length basis seems a good start, before policing them by using auditors. However, reporting or highlighting issues to the audit committee seems a good option to reduce risk from RPTs, in listed companies. Audit committees in Sri Lanka may use some of these best practices to improve management of RPTs.