Auditing Related Parties
Related party transactions present unique audit risks because they may not occur at arm's length and may be structured to achieve particular financial reporting outcomes. The auditor must identify related parties, evaluate whether transactions with them are properly recorded and disclosed, and consider implications for the entity's ability to continue as a going concern.
Identifying Related Parties
Related parties include entities or individuals that can significantly influence or be influenced by the reporting entity—such as parent companies, subsidiaries, affiliates, principal owners, management, and their immediate family members.
Procedures to Identify Related Parties
| Procedure | Description |
|---|---|
| Evaluate client's own procedures | Review management's process for identifying, authorizing, and disclosing related party transactions |
| Inquire of management | Ask management to identify all related parties and the nature of relationships and transactions |
| Review SEC filings | Examine proxy statements, Forms 10-K and 10-Q, and beneficial ownership filings for disclosed related parties and transactions |
| Review unusual transactions | Scrutinize transactions that appear unusual in nature, timing, or amount—these may involve undisclosed related parties |
| Review prior year documentation | Examine the predecessor auditor's workpapers and the prior year audit file for previously identified related parties |
| Inquire of predecessor auditor | Ask the predecessor auditor about known related parties and any issues encountered |
| Review conflict of interest statements | Examine questionnaires or declarations completed by management and board members |
| Examine board minutes and contracts | Review meeting minutes and significant contracts for references to related parties |
Related parties can be difficult to identify because management may not always be forthcoming. The auditor should maintain professional skepticism and be alert for indicators of undisclosed relationships, such as transactions with no apparent business purpose or at terms that differ significantly from market conditions.
Example: Identifying Related Parties at Kingfisher Industries
While auditing Kingfisher Industries, the auditor:
- Inquires of management and learns that the CEO's brother owns MSA Records, a vendor that supplies promotional materials
- Reviews SEC proxy filings and identifies that a board member has a 15% ownership interest in Illini Entertainment, a customer
- Examines the prior year audit file, which documented transactions with BIF Partners, an entity co-owned by Kingfisher's CFO
- Reviews all transactions with these parties for proper arm's-length pricing and adequate disclosure
Red Flags for Undisclosed Related Party Transactions
- Transactions with no clear business purpose
- Transactions at prices or terms significantly different from market
- Complex transactions involving special-purpose entities with no clear economic substance
- Loans to management or board members on favorable terms
- Sales to entities with common ownership or management
- Purchases from vendors with connections to management
If the auditor identifies a significant related party transaction that management failed to disclose, the auditor must evaluate:
- Whether the omission is a material misstatement
- Whether it indicates a broader control deficiency
- Whether it raises concerns about management integrity
Going Concern Considerations
When auditing any entity, the auditor must evaluate whether there is substantial doubt about the entity's ability to continue as a going concern.
Indicators of Going Concern Issues
| Category | Examples |
|---|---|
| Financial | Recurring operating losses, negative cash flows, working capital deficiency, inability to meet debt obligations |
| Operational | Loss of key management, loss of a major customer or supplier, labor difficulties, uninsured catastrophes |
| Legal/Regulatory | Pending litigation with potentially devastating outcomes, loss of a key license or patent |
| External | Economic downturns affecting the industry, loss of a principal customer (e.g., Illini Security loses its largest contract) |
Going Concern Period
The time horizon for evaluating going concern depends on the applicable reporting framework:
| Framework | Going Concern Period |
|---|---|
| FASB (U.S. GAAP for nongovernmental entities) | One year from the date the financial statements are issued (or available to be issued) |
| GASB (governmental entities) | One year from the date of the auditor's report (the going concern evaluation period under government auditing standards aligns with one year beyond the financial statement date through to the auditor's report date) |
Under FASB ASC 205-40, management is required to evaluate going concern for a period of one year after the date the financial statements are issued. The auditor evaluates management's assessment for reasonableness.
For GASB entities, the auditor's evaluation considers conditions and events known as of the auditor's report date, looking forward approximately one year from the financial statement date.
Auditor's Response to Going Concern Doubt
When the auditor concludes there is substantial doubt about going concern:
- Evaluate management's plans to mitigate the conditions (e.g., plans to sell assets, restructure debt, obtain additional financing, reduce costs)
- Assess the feasibility of management's plans
- Determine the adequacy of disclosure in the financial statements
- Include an emphasis-of-matter paragraph (or explanatory paragraph) in the auditor's report if substantial doubt remains after considering management's plans
Required Phrases in the Going Concern Paragraph
When substantial doubt about going concern exists and is not alleviated by management's plans, the auditor's report must include specific language. The following phrases are required in the going concern emphasis-of-matter/explanatory paragraph:
- "substantial doubt" – The auditor must use this exact phrase
- "going concern" – The auditor must reference the entity's ability to continue as a going concern
The paragraph is added after the opinion paragraph (for AICPA standards) and does not modify the opinion—it remains an unmodified opinion with an emphasis-of-matter paragraph.
Example: Going Concern at Illini Entertainment
Illini Entertainment has experienced three consecutive years of operating losses totaling $4.2 million, has a working capital deficit of $1.8 million, and its primary credit facility expires in six months. The auditor evaluates management's plan to raise $3 million through a new equity offering and renegotiate the credit facility.
After evaluating the feasibility of these plans (reviewing term sheets from potential investors and preliminary discussions with the bank), the auditor concludes that substantial doubt remains because the equity offering is not yet committed and the bank has not agreed to extend the facility.
The auditor includes an emphasis-of-matter paragraph in the audit report:
The accompanying financial statements have been prepared assuming that Illini Entertainment will continue as a going concern. As discussed in Note 12 to the financial statements, the Company has suffered recurring losses from operations and has a working capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management's plans regarding these matters are also described in Note 12. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Summary
| Topic | Key Points |
|---|---|
| Identifying related parties | Inquiry, SEC filings, unusual transactions, prior year files, predecessor auditor |
| Related party risks | Non-arm's-length transactions, undisclosed relationships, management integrity concerns |
| Going concern – FASB | One year from date financial statements are issued |
| Going concern – GASB | One year from auditor's report date |
| Going concern report language | Must include "substantial doubt" and "going concern" |
| Opinion type | Going concern does not change the opinion to qualified—it is an emphasis-of-matter paragraph with an unmodified opinion |