While auditing related party transactions, an auditor is usually confronted with questions such as:
“Why should auditing related party transactions be any different from like transactions that are entered into with unrelated parties?”
“How does one ensure completeness of identification of all related party relationships and transactions with such parties?”
“How does an auditor deal with situations where the related party is the only source of supply of goods or services for an enterprise?
Related party transactions can be legitimate and value-enhancing for a corporation but they can also serve as a vehicle for illegitimate expropriation of corporate value by management or controlling shareholders. Related party transactions do not merely pose the potential harm of direct expropriation of value from minority investors, but they also reinforce negative perception of the country’s capital markets as a whole, and lead to a general discounting of equity markets.
Generally, related party transactions are not regarded as mechanisms for fraud, and their presence need not indicate fraudulent financial reporting. 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. However, at the same time, the auditor should not discount the fact that, related party relationships may present a greater opportunity for collusion, concealment or manipulation.
Enterprises establish a matrix of related party entities/ structures for tax efficiencies, compliance with regulatory requirements, ring fencing promoter interests, protecting intellectual property rights, providing common services etc. At times, related parties may be the only source of supply of goods and services. It is imperative that management designs, implements and maintains adequate controls over related party relationships and transactions so that these are identified and appropriately accounted for and disclosed in accordance with the reporting framework. In their oversight role, those charged with governance are required to monitor how management discharges its responsibility for such controls.
Standard on Auditing (SA) 550 Revised – Related Parties deals with the auditor’s responsibilities regarding related party relationships and transactions when performing an audit of financial statements.
As per the standard, the objectives of the auditor are:
a) Irrespective of whether the applicable financial reporting framework establishes related party requirements, to obtain an understanding of related party relationships and transactions sufficient to be able:
i. To recognise fraud risk factors, if any, arising from related party relationships and transactions that are relevant to the identification and assessment of the risks of material misstatement due to fraud; and
ii. To conclude whether the financial statements, insofar as they are affected by those relationships and transactions:
– Achieve a true and fair presentation (for fair presentation frameworks); or
– Are not misleading (for compliance frameworks); and
(b) In addition, where the applicable financial reporting framework establishes related party requirements, to obtain sufficient appropriate audit evidence about whether related party relationships and transactions have been appropriately identified, accounted for and disclosed in the financial statements in accordance with the framework.
Now, let us understand the application of SA 550 considering the following two case studies.
Case study I- Fraudulent financial reporting
ABC limited (‘ABC’) was engaged in the business of selling electronic items to retail, individual customers. The Company operates through retail outlets across the country and recognises revenue on sale to the retail customer on transfer of ownership of the goods. During the financial year ended 31st March 20X0, the Company entered into an arrangement with XYZ Limited (‘XYZ’) to sell goods and the Company recognised revenue on delivery of goods at the premises of XYZ. XYZ would in turn sell goods to retail customers. XYZ is an entity in which a whole time director of ABC owns 51% of the share capital. XYZ would fall within the definition of related party as per Accounting Standard 18-Related Parties (AS-18) as a key managerial personnel of ABC is able to exercise significant influence over XYZ. Sales made to XYZ constitute 15% of ABC’s total sales for the year. Initially, the auditor’s procedures were restricted to verification of documents such as delivery challans and sales invoices and ensuring that appropriate disclosures have been made as per the requirements of the AS- 18. Further, management asserted that related party transactions were conducted on terms equivalent to those prevailing in an arm’s length transaction.
The facts that were not discovered by the audit team were as follows:
• The risks of ownership were not transferred from ABC Limited to XYZ Limited on delivery of goods as XYZ was required to pay ABC only on further sale of goods and collection of money from XYZ’s end customers.
• Further, XYZ had an unlimited right to unilaterally return unsold goods back to ABC.
• The prices at which the goods were sold to XYZ were substantially higher prices than those charged to other customers.
• ABC limited also had a retail outlet in close proximity of XYZ Limited.
• The auditor should have obtained sufficient appropriate audit evidence supporting management’s representation that the transactions with XYZ were at arm’s length.
This above facts came to light when the internal auditors identified that XYZ had returned goods in the subsequent financial year and such returns constituted a significant value and volume of sales pertaining to earlier periods.
Analysis with respect to SA 550
Auditors’ Responsibilities
1 Identification and assessment of risk of material misstatement associated with related party transactions
Historically, the Company had not entered into any such transactions with any related/unrelated party as the Company’s ordinary business constituted selling of goods to individual end-customers. The Company already had an outlet in close proximity of XYZ. The sales were undertaken at prices higher than those with normal customers. Hence, this transaction should have been considered as a significant related party transaction giving rise to significant risk of fraud while performing risk assessment procedures.
2. Response to the risk of material misstatement
– The auditor should have then appropriately responded to the identified risk by performing the following procedures:
a. Inspecting the underlying contract with XYZ and evaluating –
i. The business rationale (or lack thereof) of the transaction which may suggest the same has been entered into to engage in fraudulent financial reporting.
ii. Consistency of the terms of transactions with management’s representation
b. Obtaining evidence that the transactions have been appropriately discussed and approved.
c. Where applicable, reading the financial statements of the related party or other relevant financial information, if available, for evidence of accounting of transactions in the accounting records of related party.
d. Confirming the purpose, specific terms or amounts of the transactions with the related parties. (This procedure will be less effective where the auditor judges that the Company is likely to influence the response of the related party)
3. Communication to those charged with governance:
The auditor in the above case would need to promptly communicate to those charged with governance to arrive at a common understanding of the issues involved and the expected resolution. The auditor would also need to communicate the impact on the financial statements and any resultant impact on the auditor’s report.
4. Independent Auditor’s report:
The auditor would need consider the requirement to appropriately modify the main report considering the materiality of amounts involved. Further, the auditor would also have to appropriately modify the reporting relating to paragraph 4(xxi) of the Companies (Auditor’s Report) Order, 2003 (‘CARO’) report.
We would now evaluate another case study which involves a complex structure of related party transactions.
Case Study 2
Mr. P and Mrs. P, well-known fashion designers, incorporated ABC Ltd. in April 20X0 as a 100% export oriented company to be engaged in the business of manufacturing and export of garments. The initial capital contribution was Rs. 5 crore. Given their expertise, the couple were able to attract investment from other individual shareholders of Rs. 45 crore. The shareholding pattern of ABC comprised of promoter shareholding of 51% held by Mr. P and Mrs. P whereas the balance 49% was held by other non-related shareholders. The shareholder agreement with individual shareholders mandated appointment of 3 independent directors. This appointment was made with the objective of protecting the interests of the minority shareholders.
During the year 20X1, ABC Ltd. incorporated XYZ Ltd (‘XYZ’), a subsidiary in the United States of America (US) with 60% shareholding by ABC and the balance 40% held by Mr. P and Mrs. P. ABC entered into an exclusive arrangement with XYZ by virtue of which the entire production of ABC was to be sold to XYZ. The agreement stipulated that given the commitment to buy-out the entire production, the sales consideration to be paid by XYZ to ABC for goods purchased should be just sufficient for ABC to earn a margin of 10% on cost of goods sold. This arrangement was approved by all the directors (including the 3 independent directors) in the board meeting held on 1st April 20X1. The arrangement was also approved in an extra ordinary general meeting held on 15th April
20X1 wherein only Mr. P and Mrs. P were present as shareholders.
XYZ in turn sold the goods purchased from ABC at a margin of 5% to M/s. PQR & Co., a partnership firm formed by Mr. P and Mrs. P in the US. M/s. PQR & Co. sold the goods in the retail market in the US at a margin of 40% of its cost. Against the aggregate purchases of Rs. 30 crore made by XYZ from ABC during the years 20X1-20X4, payments made by XYZ to ABC aggregated to only Rs. 10 crore. The balance payment of Rs. 20 crore could not be made by XYZ pending collection from PQR. The chief accountant at XYZ provided a confirmation to ABC for the year-end balance. PQR & Co. too provided a balance confirmation to XYZ for the amount due. The financial statements of ABC and XYZ have been audited by M/s. DEF & Associates (‘DEF’) since incorporation. Let us examine the factors which the auditors of ABC Ltd. would need to be cognizant of to comply with the requirements of SA 550
1. While assessing the risk of material misstatement, the auditors would need to assess the isk associated with related party transactions as significant risk given the existence of a related party with dominant influence–Mr. P and Mrs. P were significant shareholders in ABC and XYZ.
2. The auditors would need to understand the controls established by ABC and XYZ for identifying, accounting and disclosing related party relationships. DEF were the auditors for both ABC and XYZ. Assuming that Mr. P and Mrs. P would have disclosed their interest in the partnership firm, M/s. PQR & Co. in the notice of disclosure, DEF as auditors would need to ensure that the sales made by XYZ to PQR were disclosed as related party transactions in the financial statements of XYZ.
3. The terms of the contract between ABC and XYZ were authorised by the board as well as by the shareholders by an ordinary resolution. 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 could have been ineffective, given that ABC was subject to the dominant influence of a related party.
4. Given that the related party transaction involved a clear conflict of interest, the auditors of ABC would need to consider whether the independent directors had appropriately challenged the business rationale of the contract, for e.g., by seeking advice from external professional advisors.
5. The contract was approved by way of an ordinary resolution passed by Mr. P and Mrs. P in their capacity as shareholders. DEF would need to consider whether the contract should have been approved by members (other than Mr.P and Mrs.P) who were not interested in the contract and whether all facts were made available to these members to enable decision -making.
6. DEF would need to evaluate the business rationale of the contract from the perspective of the related parties, XYZ and PQR to better understand the economic reality of the transaction. The subsidiary XYZ was used as a conduit to transfer goods to PQR at a price far lower than the market price so as to benefit the dominant shareholders. DEF would need to evaluate whether the transactions between the related parties were at arms’ length and complied with the benchmarking norms as per local transfer pricing regulations. Another important aspect was the disparity in the margins earned by PQR on the re-sale of goods to retail customers as against the margin earned by XYZ on
sale of goods to PQR. DEF in their capacity as auditors of PQR would need to be cognizant of this aspect in their risk assessment for related party transactions.
7. In view of the non-collection of the amounts due from PQR, the ability of XYZ to settle the receivable of Rs. 20 crore was significantly impacted. The mere fact that XYZ had provided a confirmation of the balance due to ABC would not be sufficient evidence in support of the recoverability of the amount due. The auditor would need to evaluate the realisability of receivables in the books of ABC.
Concluding remarks
Considering that a large number of frauds in the corporate world involve related parties, governments and standard setting bodies have adopted stronger and proactive standards and laws to provide for guidance and monitoring of companies and auditors for accounting, disclosures and validation requirements of related party transactions.The Companies Act, 2013 has widened the scope of coverage in terms of the definition of related party and the nature of transactions covered and at the same time mandated approval of such transactions by the audit committee/board of directors/shareholders as applicable. The tax laws have also been amended to cover transactions with specified domestic related parties in addition to cross border transactions with overseas affiliates and has made it obligatory on the tax payer to substantiate that such transactions are at arms’ length. With sweeping changes in legislation, the auditor would need to exercise heightened professional skepticism in identification of related party transactions, related risk of material misstatement (including fraud risk) and design adequate procedures to ensure compliance with the financial reporting and legal framework.
