This is a sequel to the article published
in the BCAJ of August, 2019: ‘De-layering Related Party Transactions through
Internal Audit’ by CA Ashutosh Pednekar
This article (a sequel) gives practical
approaches to identification of Related Parties (RPs), examining the legitimacy
of Related Party Transactions (RPTs) and such other matters that internal
auditors could integrate in their audits. Conflict of interest and RPTs have
become a very important part of audits of companies. The author offers case
studies that could inform the reader about some principles, techniques and
tools to uncover the substance of transactions where RPs are involved
The way an organisation deals with its
related parties speaks volumes about the culture and integrity of the
decision-makers, i.e., the management. To an Internal Auditor, reviewing the
dealings of a company with its related parties can provide an understanding of
its culture and beliefs, its core values and transparency.
There are various pronouncements and
regulations promulgated for guiding and monitoring identification and
disclosures of RPs and RPTs. There are governance mechanisms that place an
onerous responsibility on the Audit Committee of ensuring that all RPTs are at
arm’s length pricing. Taxation laws and transfer pricing audit requirements
further reduce the possibility of arbitrariness in the commercial terms agreed
for RPTs. What, then, can the Internal Auditor’s review of RPs and RPTs
contribute that is not already covered by the various disclosure, approval and
reporting protocols?
CASE 1: WHO IS A
RELATED PARTY? SUBSTANCE OVER FORM?
Background
Ms Smart is the Internal Auditor of a large
listed company. As part of the internal audit, she came across a transaction
where the company had awarded a three-year exclusive contract to a PR agency
called Connexions under which 70% of the contract value was paid upfront and
the balance 30% was to be paid in three equal instalments – the agreement also
stated that in case of premature termination of the agreement by the company,
Connexions would not be required to refund any amount already paid to it. There
were no past commercial transactions between the company and Connexions.
An
unusual transaction
Ms Smart found this transaction unusual and
uncharacteristic of the company. The terms of the contract seemed one-sided,
favouring the PR agency. Hence, she inquired about the vendor and found that
the agency was owned by three partners, one of whom was a woman whose name
appeared somewhat familiar.
A
smart search
Ms Smart engaged with social media platforms
like LinkedIn and Facebook to find out more about the partners / owners of the
PR agency. And she found that the woman partner was none other than the fiancée
of the Managing Director’s son. She also came across news items and YouTube
videos showing the lavish engagement ceremony of the MD’s son with the woman in
question.
Is
a fiancée a related party? In matters of doubt, err on the safe side
Ms Smart felt that while the PR Agency was
not strictly an RP under any regulations, the substance of the transaction made
it an RPT. She brought this to the notice of the Audit Committee and explained
why the transaction might need approval akin to the approval required for an
RPT to ensure good governance and transparency.
Next, Ms Smart
explained that the regulations define the ambit and the intent of the law. In
case of RPTs, the intent is to prevent the abuse of minority shareholders or
other stakeholders by decisions taken by the controlling shareholders favouring
their RPs. In cases where a counter party does not strictly meet the definition
of an RP, but for all practical purposes is perceived as an RP, it is better to
treat the transaction with such a party as an RPT.
Audit
Committee verdict
The Audit
Committee agreed to take a wider view of the policy related to RPs, and advised
the management to report transactions with potential RPs to the Audit
Committee. In the present case, based on the facts presented, the Audit
Committee found the transaction to be not at arm’s length and not transparent
and, hence, advised that necessary steps be taken to revise the contract.
CASE 2: EXAMINING THE
NEED / LEGITIMACY OF AN RPT
Internal
Audit mandate for review of RPTs
Ms Sceptic, the Internal Auditor of a
company dealing in industrial products, was asked by the Audit Committee to
undertake a special review of related party transactions of a listed entity.
Internal
Audit findings
Ms Sceptic went through the policy and the
entire process of identification and approval of RPTs. She was satisfied with
the contents of the policy and the process adopted for establishing fair price
for RPTs.
But in her
detailed review of reported RPTs she came across the following two transactions
that caught her attention:
(i) Purchase of three paintings from the
spouse of one of the Independent Directors, from an exhibition held at a
well-known art gallery. The total sum paid for these paintings was Rs.
84,00,000. The value of the paintings was as per the valuation certificate and
was in line with the price of other paintings sold at the exhibition. In the
same month, the company had paid interest on late payment of GST and TDS due to
a liquidity crunch that it had been facing for some months.
(ii) Brokerage, amounting to Rs. 40,00,000
(being 1% of property value, this being the norm in the broking industry) on a
large property purchase transaction was credited to Amanda Services in which a
director’s daughter is a partner. Amanda Services has an impressive website
projecting the entity as a real estate broking firm. The brokerage remained
unpaid for three months after the transaction of purchase of property was
concluded.
On inquiry, Ms Sceptic found that the
brokerage could not be paid as Amanda Services did not have a GST registration.
She also found that the GST registration was applied for almost two months
after the property purchase transaction was concluded. This suggested that
Amanda Services may not be an established player in the real estate broking
business.
In both the above cases, due disclosures
were made and approvals were in place. Arm’s length pricing was also
established. However, it appeared that in the first case the need to purchase
the paintings was not established, whereas in the second case there was a
reason to doubt as to whether Amanda Services had indeed provided broking
services for the property transaction.
The
conclusion
Ms Sceptic presented her findings, with
corroborative details, to the Audit Committee, clearly pointing out that before
determining the reasonableness of pricing, it is important to establish the
legitimacy of the need and the actual delivery of services. The Audit Committee
acknowledged that the review of RPs and RPTs must include validation of the
underlying legitimacy of the RPTs.
CASE 3: PROVISION OF FREE
FACILITIES
Background
Ms Curious is the Chief Internal Auditor of
a listed company where the promoters are from a single family and hold about
40% of the equity shares. The company operates out of its corporate office in a
metro city and rents five floors of the said building.
On a day when the internal audit was going
on, Ms Curious was told that there was no place for the Internal Audit team to
sit (this is not a surprise) for a few days as certain branch managers were
visiting and they needed to be provided working space. Hence, it was suggested
that the internal audit be rescheduled and the team assigned to a branch or a
depot audit for a few days.
Chance
discovery
Ms Curious, being curious by nature and keen
to complete the internal audit on hand expeditiously, walked around the five
floors trying to find space for her team to occupy temporarily. She came across
a part of the office with a glass door
leading to an enclosed smaller office space. She found a group of about 15
people working there whom she had not interacted with before but had seen
around in the company cafeteria at lunch time. This appeared strange, as the
Internal Audit scope had covered all key areas of the company over the past few
years since she was appointed as the Chief Internal Auditor.
Research
and analysis – from doubt to a confirmed finding
On exchanging courtesies, she learned that
these people were employees of the family office of the promoters, managing
entities dealing with personal investments of the promoter family. She also
found that the family office had been occupying the space for several years.
What
next? Communicating with those charged with governance
Ms Curious ran a search to find out if any
recovery was being made towards the rent or utilities from any related party.
She also looked up the disclosures for remuneration of directors and related
party transactions to see if there was any approval / disclosure for use of corporate
office premises for the private use of the promoters, free of cost. When her
search did not yield any positive results, it became clear to her that this was
an inappropriate action by the promoters that had perhaps not been disclosed to
the Audit Committee members and, hence, never been subjected to any scrutiny or
debate.
She considered various options to bring this
issue to the notice of the management. After mulling over the options, she
sought a meeting with the Audit Committee Chairman, expressed her concern,
handed over a confidential note giving details and requested him to take it up
with the management and the other Audit Committee members.
CASE 4: ALLOWING RP TO
TERMINATE AN ONEROUS COMMITMENT
Background
Ms No Nonsense is the internal auditor of a
corporate conglomerate comprising of a flagship listed company known as XYZ
Limited (XYZ), several subsidiaries and associate entities. The listed company
held large office premises in excess of its requirements.
XYZ had leased out some of its office
premises to an associate company in which it held 49% stake and the promoter
family held 51%. The lease was given on rent and other terms that were
established to be at arm’s length. Offices in the same building were also
leased out to an unrelated party at the same time, on the same rates and terms.
Both the leases were for a period of nine years, with a lock-in period of five
years and an escalation clause increasing the rent by 8% at the end of two
years.
Two years after entering into these leases, the
real estate market nosedived and rental rates came down drastically.
Consequently, both the parties requested premature termination of the lease.
XYZ did not permit the unrelated party to terminate the lease without paying
the liquidated charges stated in the lease agreement and issued legal notices
to that effect. However, for the RP, XYZ allowed the foreclosure without
charging the dues as per the agreement. The MD approved the foreclosure
decision but requested the Audit Committee for approval, this being an RPT.
The
Internal Auditor – Putting things in perspective
Ms No Nonsense, the Internal Auditor, was
required to review the RPTs on a quarterly basis and report to the Audit
Committee on the same. In the present case, she apprised the Audit Committee
that the RPT transaction (of waiver of escalation clause and permitting a
foreclosure of the lease without any penalties) was not in the interest of XYZ
and the treatment given to the RP was significantly favourable compared to an
exactly similar transaction undertaken with an unrelated counter party. In her
opinion, this RPT was a case of favouring the RP against the interest of XYZ
Limited.
Constraints
of the Audit Committee
When the Audit Committee is asked to approve
RPTs, at times the information given is incomplete and misleading. Comparable
transactions with unrelated parties are not always presented to the AC. Thus
approvals given by it may be based on incomplete facts. Besides, the attention
given at the time of entering into an RPT is much more compared to the
attention given to terminations, rollovers or extensions. Having an objective
review prior to giving approval may help the Audit Committee to grant approval
based on full facts and details.
LESSONS FROM THE CASE
STUDIES
The case studies presented above contain
several important lessons, both for the Internal Auditors and the Audit
Committee. A summary of these lessons is presented hereunder:
(a) Going
beyond the confines of definitions: In identifying an RP and an RPT,
one needs to go beyond the confines of the regulatory definitions and apply the
‘substance over form’ principle by looking at the spirit of the regulations.
(b) Unmasking: Special attention may be paid to unravel:
(1) Arrangements for providing free usage of
assets, facilities and resources to RPs;
(2) Unusual, uncharacteristic arrangements
that do not reflect usual contractual acumen, as RPTs may be masked therein;
(3) Terminations and modifications of
approved RP transactions / contracts on terms favourable to the RP.
(c) Questioning
purpose and legitimacy: Review of RPTs needs to go beyond the
disclosures and reporting protocols and must extend to questioning the
legitimacy and the purpose of entering into such transactions.
(d) Going beyond the obvious: Internal Auditors may periodically consider special audits like an
asset usage review, people deployment review, etc., to identify potential
redundancies and misuse, including violation of regulations pertaining to RPs.
(e) Engaging
with the AC: The Audit Committee must create opportunities for direct,
periodic interactions between the auditors and the Audit Committee members in
the normal course. Internal Auditors need to maintain a line of communication
open with the Audit Committee members, to be able to escalate issues directly
relating to governance matters. Reporting on issues related to RPs and RPTs is
sensitive and requires tactful communication.
SHOULD INTERNAL AUDIT
SCOPE INCLUDE REVIEW OF RPTS?
The cases discussed above are very simple
and straightforward. As organisations become larger and the complexity, volume
and value of RPTs increase, it becomes difficult for the Audit Committee to
ensure that:
(I) All RPs and RPTs have been duly
identified;
(II) Adequate
processes and technology-based initiatives have been employed for
identification of all RPs and RPTs;
(III) Dealings not resulting in financial
transactions are also reported to the Audit Committee;
(IV) The facts and details required for a
fair assessment of the necessity for RPTs and the arm’s length pricing thereof
have been presented to them;
(V) Entities that are not strictly RPs but
are likely to be perceived as such are also subjected to similar scrutiny as
RPTs; and
(VI) The tendency of the executive
management to circumvent due scrutiny of RPTs is identified and escalated in a
timely manner.
With onerous responsibilities cast on the
Audit Committee with respect to related party dealings and disclosures, it has
become imperative for the Audit Committee to put the RP-related processes and
transactions through the objective scrutiny of specialist professionals.
Internal Auditors, with their curiosity, scepticism, smartness and
no-nonsense approach, are well suited to give due assurance to the Audit
Committee and, where required, give early alerts with respect to cases of
abuse, inappropriateness, misuse or fraudulent conduct.
By extending the Internal Audit scope to
RPTs, the Internal Auditors are empowered to gain necessary access to such transactions
and through this, gain relevant insights into the culture and ethics of the
Management. Such insights make the overall Internal Audit more meaningful and
conversations with the Audit Committee more relevant.
To conclude, Internal Audit of processes
pertaining to Related Parties and Transactions is not just a compliance review
– it is an audit of integrity and culture, of the tone at the top, of
convergence between stated values and demonstrated actions. When looked at in
this light, this audit assumes great importance: it calls for great maturity,
sensitivity and experience from the Internal Auditors.
If
you have integrity, nothing else matters. If you don’t have integrity, nothing
else matters.
– Alan K. Simpson
