This Blog is written by Mr. Khizar Abbasi, Associate Audit and Assurance Services. Please read this blog and provide your valued comments.

Related Party and Role of Auditor

Related Party:

The party is an associate of the entity. Common control. The party is, directly or indirectly, either under common control with the entity or has significant or joint control over the entity.

Understanding the entity’s related parties:

Obtaining a detailed understanding of related parties is essential to adopt a risk-based approach to the audit of related party relationships and transactions and needs to involve the following procedures:

  • Discussion among the engagement team of related parties’ issues;
  • Inquiry of management about the identity of related parties, the nature of relationships and the type and purpose of related party transactions;
  • Inquiry of management and others within the entity to understand the entity’s controls on related party relationships and transactions.
  • Identification of Related Parties:

In order to identify related parties, including changes from the prior period, and to understand the nature of their relationship with the entity, as well as to establish whether transactions have been entered with these related parties during the audited period and, if so, the type and purpose of the transactions, ISA 550 requires the auditor to inquire management.

The reason for this approach is that management is normally in the best position to identify related party relationships and transactions than any other subject, notwithstanding the risk of manipulation and concealment posed by management override of controls. In particular management is likely to be aware of the relationships that have economic significance to the entity and that are more likely to carry a risk of material misstatement.

In case of recurring audits of the same entity, management inquires provide a basis for testing the consistency of the information provided by management for the current year with the auditor’s record of related parties noted in previous audits. The identity of related parties and the nature of their relationship with the entity is, in fact, normally documented in the permanent section of the audit file and updated for each year.

Significant Related Party Transaction outside Normal Course of Business:

Apart from gaining an understanding of related parties, the auditor is required, by ISA 315, to identify and assess the risks of material misstatement associated with related party relationships and transactions and to determine which of those risks are significant.

The auditor is also required, by ISA 330, to design and perform further audit procedures in response to the assessed risks of material misstatement involving related parties.

When significant related party transactions outside the normal course of the entity’s business are identified, they should be treated as significant risks. That implies that the auditor will need to perform substantive procedures that are specifically responsive to those risks.

The substantive procedures that have to be performed to obtain sufficient appropriate evidence about related party transactions outside normal business include:

  • Inspecting underlying contracts or agreements, if any;
  • Evaluating the business rationale, or rather lack of it, of the transactions to see whether they may have been initiated to engage in fraudulent financial reporting or to conceal misappropriation of assets;
  • Considering whether the terms of the transactions are consistent with management’s explanations;
  • Verifying if the transactions have been appropriately accounted for and disclosed in accordance with the applicable financial reporting requirements; and
  • Obtaining evidence that the transactions have been appropriately authorized and approved.

When evaluating if the business rationale of a related party transaction outside the entity’s normal business suggests the possibility of fraud, the auditor may consider a number of aspects such as:

  • Whether the transaction is excessively complex;
  • If it lacks an apparent logical business reason;
  • If it carries unusual terms of trade, like unusual prices, interest rates, repayment terms or guarantees;
  • Whether it involves related parties that were not previously identified by management.
  • Whether management is placing more emphasis on a particular accounting treatment rather than giving regard to the underlying economics of the transaction.

Evaluation of the accounting for and disclosure of related parties:

In forming an opinion on the overall financial statements, the auditor will need to evaluate whether:

  • Accounting and disclosure of related party relationships and transactions comply with the requirements of the applicable financial reporting framework, and
  • The effects of the related party relationships and transactions prevent the financial statements to achieve fair presentation.

The evaluation of related party disclosures in respect of the applicable financial reporting requirements may need special attention by the auditor as they may be complex and are often a source of material misstatement. The same complexity and excessive detail of the disclosures may actually obscure the substance of the related party transactions.

Related party disclosures should be evaluated considering whether the facts and circumstances of the entity have been appropriately summarized and presented so that disclosures are understandable. Disclosures may not be understandable if the business rationale and the effects of the transactions on the financial statements are unclear or if the key terms, conditions or other important elements necessary for understanding the transactions are not appropriately disclosed.

Khizar Abbasi