What Are Related Party Transactions, and How Should They Be Audited?

Introduction

Related Party Transactions (RPTs) are financial transactions that occur between entities that have a pre-existing relationship. These transactions are common in business operations, but they can present significant risks if not properly managed and disclosed. Auditing RPTs is crucial to ensure transparency, regulatory compliance, and the prevention of fraudulent financial reporting. This article explores the concept of RPTs, their risks, regulatory frameworks, and best practices for auditing them.

What Are Related Party Transactions?

Definition of Related Party Transactions

A related party transaction occurs when a business entity engages in financial transactions with parties that have a direct or indirect relationship with it. These related parties could include:

Parent and subsidiary companies
Entities under common control
Key management personnel and their family members
Shareholders with significant influence
Joint ventures and associates

For example, if a company sells goods to its subsidiary at a discounted rate, this would be classified as an RPT.

Types of Related Party Transactions

RPTs can take different forms, including:

Sales and Purchases – Buying or selling goods/services at preferential prices.
Loans and Advances – Borrowing or lending money between related entities.
Leases – Renting properties or equipment from a related party.
Management Fees – Charging fees for administrative or consulting services.
Guarantees and Financial Support – Providing financial guarantees for a related party’s debts.
Transfer of Intellectual Property – Licensing patents or trademarks to a related entity.

While these transactions are not inherently improper, they must be disclosed and audited to ensure fairness and transparency.

Risks Associated with Related Party Transactions

1. Conflict of Interest

RPTs may not be conducted at arm’s length, meaning they could be influenced by personal relationships rather than business considerations. This can lead to unfair advantages and unethical decision-making.

2. Financial Misstatements and Fraud

Entities might use RPTs to manipulate financial statements, inflate revenue, or hide liabilities. Fraudulent transactions can mislead investors and regulators.

3. Tax Evasion and Regulatory Violations

Some companies engage in RPTs to shift profits and reduce tax liabilities illegally. This can result in legal penalties and reputational damage.

4. Lack of Transparency

When companies fail to disclose RPTs, stakeholders may be unaware of potential risks or hidden financial obligations.

5. Insolvency and Financial Distress

If a company provides excessive financial support to a related party, it may jeopardize its own financial stability.

Regulatory Framework for Related Party Transactions

Governments and regulatory bodies have strict guidelines to monitor RPTs.

International Accounting Standards

IFRS (International Financial Reporting Standards) IAS 24 – Related Party Disclosures
- Requires entities to disclose related party relationships and transactions.
- Ensures transparency in financial reporting.
U.S. GAAP (Generally Accepted Accounting Principles) – ASC 850
- Requires disclosure of the nature, financial impact, and details of RPTs.

Singapore Accounting Standards and Regulations

In Singapore, companies must comply with:

Singapore Financial Reporting Standard (SFRS) 24 – Ensures disclosure of related party transactions.
Companies Act (Cap. 50) – Requires directors to disclose their interests in related party transactions.
Singapore Exchange (SGX) Listing Rules – Public-listed companies must obtain shareholder approval for significant RPTs.

Auditors must ensure compliance with these frameworks when reviewing financial statements.

How Should Related Party Transactions Be Audited?

The audit of RPTs involves identifying, assessing, and verifying transactions to ensure they comply with accounting standards and regulatory requirements.

1. Understanding the Entity’s Relationships

Auditors should obtain a list of related parties from management.
Review company policies on identifying and approving RPTs.
Examine board meeting minutes for discussions on RPTs.

2. Identifying Related Party Transactions

Analyze financial records for unusual transactions.
Use data analytics to identify patterns suggesting RPTs.
Confirm RPTs with third parties, such as suppliers and customers.

3. Assessing the Business Rationale of RPTs

Evaluate whether the transaction has a legitimate business purpose.
Compare pricing terms with market rates to ensure fairness.
Assess whether the transaction benefits the company or certain individuals.

4. Examining Supporting Documentation

Review contracts, invoices, and payment records for RPTs.
Check whether transactions were authorized by the board of directors.
Verify disclosures in financial statements and ensure compliance with reporting standards.

5. Testing for Fair Valuation and Disclosure

Compare transactions with similar market transactions (arms-length comparison).
Assess whether RPTs were recorded at fair value.
Ensure proper disclosure of RPTs in financial statements.

6. Interviewing Key Management and Board Members

Conduct interviews to understand management’s perspective on RPTs.
Assess whether internal controls are in place to prevent manipulation.
Investigate any conflicts of interest among key personnel.

7. Evaluating Internal Controls Over RPTs

Determine whether the company has policies to prevent abuse of RPTs.
Check for segregation of duties to avoid management override.
Assess how RPTs are approved and reported.

8. Using External Confirmations

Obtain confirmation letters from banks, suppliers, or customers to verify transactions.
Validate transactions with external auditors from related entities.

Challenges in Auditing Related Party Transactions

1. Concealment of RPTs

Some companies deliberately hide related party transactions, making detection difficult.

2. Inadequate Documentation

Lack of proper records or contracts can hinder audit procedures.

3. Resistance from Management

Management may be reluctant to disclose certain RPTs due to conflicts of interest.

4. Complexity in Valuation

Assessing the fair value of RPTs can be difficult, especially for intangible assets.

5. International Transactions

Cross-border RPTs may involve different jurisdictions and tax implications.

Best Practices for Auditing Related Party Transactions

To improve the audit process, auditors and companies should follow these best practices:

Strengthening Internal Controls
- Implement strong policies on the approval and disclosure of RPTs.
Enhancing Transparency
- Disclose all RPTs in financial statements with detailed explanations.
Conducting Independent Reviews
- Engage independent auditors to verify major RPTs.
Regular Training for Auditors
- Provide continuous training to auditors on RPT auditing techniques.
Leveraging Technology
- Use data analytics to detect hidden related party transactions.

Conclusion

Related party transactions are an integral part of business operations but require stringent controls and audits to prevent fraud, conflicts of interest, and financial misstatements. By adhering to international and local regulations, implementing strong governance practices, and conducting thorough audits, businesses can ensure transparency and accountability in their financial reporting. Properly audited RPTs not only enhance investor confidence but also help companies maintain regulatory compliance and ethical business practices.

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