AU 334: Auditing Related Party Transactions

Auditing standard AU 334 has been superseded, and its principles are now integrated into modern standards that govern audit practice in the United States. For audits of private companies, the American Institute of Certified Public Accountants (AICPA) applies AU-C Section 550, “Related Parties.” Audits of public companies are governed by the Public Company Accounting Oversight Board’s (PCAOB) AS 2410, Related Parties. The core concepts of the original standard were absorbed and expanded upon to heighten auditor focus on the risks these relationships can present. While the standard numbers have changed, the responsibilities for auditors regarding these relationships remain a focus in financial statement audits.

Defining Related Parties and Transactions

In an audit, a “related party” is an individual or entity with the ability to influence a company’s management or operating policies to an extent that might prevent the company from pursuing its own separate interests. The Financial Accounting Standards Board (FASB) provides definitions in its Accounting Standards Codification (ASC) Topic 850. Examples of these relationships include a parent company and its subsidiaries, an entity and its principal owners, and the immediate family members of management. While ASC 850 applies to all entities under U.S. GAAP, public companies must also follow U.S. Securities and Exchange Commission (SEC) rules, like Regulation S-K, which can set more stringent disclosure requirements.

A “related party transaction” is any transaction between the company and one of these identified parties. These are not inherently improper, as many occur in the normal course of business. However, they require scrutiny because the existing relationship could allow for terms that differ from those in an arm’s-length transaction between independent entities. Common examples include sales of goods, transfers of real estate, lending money, and providing services or loan guarantees. The substance of these transactions is more important than their legal form, and an auditor’s work is to understand the business purpose and economic reality of these arrangements.

Auditor Procedures for Identifying Related Parties

Before examining transactions, an auditor must first perform procedures to identify all of the company’s related parties as a primary step in assessing risk. The work begins with direct inquiry of management for a complete list of all known related parties and the nature of the relationships. Auditors also make similar inquiries of those charged with governance, such as the board of directors, to corroborate management’s information.

The auditor’s efforts extend beyond inquiries and involve inspecting company records that might indicate undisclosed related parties. This includes reviewing prior-year audit files, examining stockholder listings to identify principal owners, and reading the minutes of meetings of shareholders and the board of directors. These documents often contain discussions of significant transactions that can highlight relationships with affiliated individuals or entities.

Further procedures involve reviewing a company’s public filings with the SEC, if applicable, and examining legal confirmations from the company’s attorneys. By combining these steps, the auditor develops a comprehensive understanding of the network of relationships surrounding the client.

Examining and Auditing Identified Transactions

Once an auditor has a list of related parties, the focus shifts to identifying and examining transactions with them. The auditor’s responsibility includes looking for transactions that management may not have disclosed. This is accomplished by scanning accounting records for large, unusual, or non-recurring transactions, especially those occurring near the end of a reporting period.

For each identified transaction, the auditor must obtain an understanding of its business purpose. This involves evaluating whether the transaction was necessary for ongoing operations or if its rationale seems questionable. The auditor will inspect underlying documents, such as contracts and invoices, to confirm the terms and determine if the transaction was properly authorized and recorded.

A part of this examination is assessing whether the transaction was conducted on an “arm’s-length” basis, meaning the terms are equivalent to what would be expected between unrelated parties. While financial statements cannot claim a transaction was arm’s-length unless it can be substantiated, the auditor evaluates the terms to assess risk. If a transaction appears to lack a clear business purpose or has abnormal terms, it is treated as a risk that may have been entered into to engage in fraudulent financial reporting or conceal the misappropriation of assets.

Financial Statement Disclosure and Reporting

The culmination of the auditor’s work is ensuring that the company’s financial statements include the appropriate disclosures about its related party transactions. U.S. Generally Accepted Accounting Principles (GAAP) and SEC rules for public companies mandate that financial statements disclose material related party transactions. These disclosures are presented in the footnotes to the financial statements to give users a clear understanding of the potential impact of these relationships.

The required disclosures an auditor must verify include a description of the nature of the relationship or relationships involved. The company must also provide a description of the transactions, including the dollar amounts, for each period for which an income statement is presented. Additionally, any amounts due to or from related parties as of the date of each balance sheet presented must be disclosed.

Beyond verifying the footnote disclosures, the auditor has a responsibility to communicate with those charged with governance. The auditor must report any significant findings, such as the identification of previously undisclosed related parties or significant transactions that were not properly authorized. This communication ensures that the audit committee is aware of the risks and circumstances surrounding the company’s dealings with its related parties.