ISA 550 RELATED PARTIES

1. The effect of related party transactions

An objective of financial statements is to provide information about an entity which is

useful to a range of users in making economic decisions. Financial statements
prepared by the directors of an entity give the results of the discharge of their
stewardship function, so it is important that RPT are adequately disclosed in order that
users may determine the extent and effect of RPT on the financial statements.

Users of accounts may reasonably assume that an entity has independent discretion
over the use of its resources and the transactions it enters into in order to achieve its
corporate objectives. The personal activities of its directors, owners or key managers
should not interfere in this process. Users may reasonably expect that its transactions
have been undertaken at "arm's length" with other parties, each side can then bargain
freely without any distortions caused by relationships between them. Such
assumptions may not be justified if there is a related party condition in existence.

There may also be situations where the parties involved may wish to conceal the
existence of such transactions for a variety of reasons which may, perhaps, be
fraudulent.

Hence, the auditor must obtain evidence that all related parties have been correctly
included in the accounts in accordance with IAS 24 Related Party Disclosures.

2. Related parties’ definition

Related parties - parties are considered to be related if one party has the ability to
control the other party or exercise significant influence over the other party in making
financial and operating decisions.

The following are examples of related parties of a reporting entity:

 its ultimate and immediate parent company, subsidiary companies and fellow subsidiary
companies;

 its associates or joint ventures;

 its directors and directors of its ultimate and intermediate parent companies;

 its employee pension fund or that of any related party entity.

There is also a PRESUMPTION that certain groups are related parties unless it can be
demonstrated that there is no influence over financial or operating policies of the
other in such a way as to inhibit the pursuit of separate interests.

These groups will include:

· the key management of the reporting entity or of its parent(s);

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 · persons holding or otherwise controlling over 20% of the voting rights in the
reporting entity;

· persons acting together to exercise control or exert influence;

· members of the close family of the above presumed related parties;

· partnerships, companies or trusts in which any presumed related party also have a
controlling interest.

Related party transaction - a transfer of resources or obligations between related

parties, regardless of whether a price is charged.

Some examples of related party transactions are:

· borrowing or lending at non commercial rates of interest;

· sale or purchase of assets at artificially high or low prices;

· management abuse of internal controls to favour another party outside the com-
pany;

· distortions of competitive tendering arrangements to favour a related party;

· supply of goods and services on favourable terms (perhaps free of any charge).

Related party transactions may be difficult to detect possibly due to:

· Reticence on the part of the directors to disclose sensitive transactions;

· Accounting systems not being designed to identify these transactions;

· Lack of controls over such transactions;

· Complexity of the definition of a related party in IAS 24.

3. Roles of the auditor in relation to related party transactions

ISA 550 emphasises the importance of maintaining professional scepticism when

planning and performing audit work on related parties, recognising always that the
risk of material undisclosed RPT may exist. The application paragraphs of ISA 550
explain that the risk of management overriding of controls with regards to related-
party relationships and transactions is potentially high when the relationships present
management with incentives and opportunities to conduct fraud.

In this regard, auditors should plan and perform the audit with the objective of obtain-
ing sufficient audit evidence regarding the adequacy of the disclosure of related party
transactions and control of the company in the accounts.

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 While directors are responsible for identifying and approving RPT, ISA 550 requires
the auditors to obtain an understanding of controls used by management to:

 identify, account for and disclose related-party relationships and transactions;

 authorise and approve significant transactions and arrangements with related
parties; and
 authorise and approve significant transactions and events outside the normal
course of business.

As is normal, these controls should be subject to tests of control to obtain audit evi-
dence in relation to RPT. If control risk is high then the required degree of audit assur-
ance will have to be obtained through substantive tests. In the case of owner managed
companies where control risk is likely to be high then substantive tests may be the
only possible choice. However, if the auditor concludes there is a low risk of
undisclosed RPT, then the planned level of substantive testing may be reduced.

It must be noted that the risk of failing to detect RPT is increased if:

· no charge is made for goods or services;

· the management or directors have taken steps to conceal the transactions;

· such concealment of an RPT may be prompted by a wish not to disclose such

"sensitive" arrangements or for reasons motivated by other than normal com-
mercial considerations e.g. fraud or window dressing the accounts. Concealment
may also involve a degree of collusion between individuals which are always very
difficult to detect;

It is therefore important that appropriately qualified staff are given the task of
detecting undisclosed RPT.

4. Materiality

IAS 24 requires the materiality of the transaction in relation to the related party, where
that party is a director or a company controlled by an individual, to be considered in
addition to that of the reporting company, i.e. is the transaction material to the director
personally.

This may prove difficult for auditors to assess where they are not in full possession of
the facts concerning the director's affairs. Auditors should therefore consider the
nature of the transactions as well as their value.

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5. Audit procedures for related party transactions

ISA 550 imposes a requirement that specific documents shall be inspected for
indications of the existence of related-party relationships or transactions that
management has not previously identified or disclosed to the auditor. The documents
referred to in the ISA are:

 bank and legal confirmations; and

 minutes of meetings of shareholders and of those charged with governance.

Although ISA 550 requires the inspection of few specific documents, it requires the
auditor to actively consider the inspection of other records or documents to identify
related-party relationships transactions. Paragraph A22 provides a comprehensive list
of suggestions, including:

 entity income tax returns;

 information supplied by the entity to regulatory authorities;
 shareholder registers to identify the entity's principal shareholders;
 statements of conflicts of interest from management and those charged with
governance;
 records of the entity's investments and those of its pension plans;
 contracts and agreements with key management or those charged with governance;
 significant contracts re-negotiated during the period.

In addition, ISA 550 requires that significant related-party transactions outside the
normal course of business be treated as a significant risk. The ISA provides examples
of such transactions, including:

 complex equity transactions,

 sales transactions with unusually large discounts or returns,
 rendering of management services with no consideration being exchanged.

If such transactions are identified, enquiries should be made into the business
rationale of the transaction, and the relevant terms and conditions. The issue here is
that the auditor should be alert to fraud-risk indicators, as well as considering whether
the transaction has been accounted for correctly, and disclosed appropriately in the
financial statements.

It is also important to consider whether significant related-party transactions outside

the normal course of business have been authorised and approved by management,
those charged with governance, or shareholders (where relevant). The absence of such
authorisation and approval without rational explanation may indicate a high risk of
material misstatement due to fraud or error.

When the auditor discovers a related-party relationship or significant transaction with

a related party that had not been disclosed by management, ISA 550 requires
additional procedures to be conducted. These include prompt communication of the
discovery with the audit engagement team, enquiry with management as to why
controls failed to identify or disclose the related party or transaction, and the

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 performance of additional substantive procedures, such as analysis of accounting
records for transactions with the newly identified related party.

The main issues for the auditor to address here are whether the non-identification of
the related party or transaction is deliberate, and whether there are other non-
identified related parties or transactions. If it appears that management has concealed
their existence, the auditor may consider whether it is necessary to re-evaluate
management's responses to auditor's enquiries. Deliberate concealment may be
viewed as a fraud risk indicator, and ISA 240 becomes relevant.

ISA 550 further requires that where the financial reporting framework establishes
related party requirements, the auditor shall obtain written representations from
management, and where appropriate, those charged with governance that:

 they have disclosed the identity of all related parties, related party relationships and
transactions that they are aware; and

 they have appropriately accounted for and disclosed such relationships and
transactions in accordance with the financial reporting framework.

6. Reporting

(a) Those charged with governance

ISA 550 provides guidance on matters relevant to related parties that the auditor
may communicate to those charged with governance, for example:

 Non-disclosure (whether intentional or not) by management to the auditor

of related parties or significant related-party transactions, which may alert
those charged with governance to significant related-party relationships and
transactions of which they may not have been previously aware;

 Disagreement with management regarding the accounting for and

disclosure of significant related party transactions in accordance with the
framework; and

 Difficulties in identifying the party that ultimately controls the entity.

(b) Shareholders

If auditors are unable to obtain sufficient appropriate evidence on related party

matters, or the disclosures are not adequate, they should consider the
implications for their report.

If auditors believe that there is more information that could have been obtained
but they have been unable to do so, this is a limitation of scope which could lead
to a qualified or disclaimed opinion.

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If disclosure is incorrect or they consider the disclosures inadequate because the
directors are unwilling to disclose information, they should consider giving a
qualified or adverse opinion on the basis of disagreement.