Provisions, contingencies, and related parties - Identifying...

Learning Outcomes

This article addresses the identification and audit of related party relationships and transactions for the ACCA Audit and Assurance exam. You will learn how to define related parties, recognize risks of material misstatement, apply disclosure requirements of IAS 24, and perform appropriate audit procedures. By the end, you should be able to identify related party issues in scenarios, evaluate required disclosures, and set out effective audit responses.

ACCA Audit and Assurance (AA) Syllabus

For ACCA Audit and Assurance (AA), you are required to understand how to identify, assess, and audit related parties and related party transactions in financial statements. This topic is fundamental to risk assessment and evidence gathering in line with current standards.

• Explain what constitutes a related party and a related party transaction under IAS 24.
• Identify risks of material misstatement from related party relationships and transactions.
• Understand the requirements for disclosure of related parties and their transactions.
• Describe the auditor’s responsibilities in identifying, assessing, and responding to related party risks.
• Perform and explain relevant audit procedures for related party transactions, including obtaining sufficient appropriate evidence and reviewing disclosures.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the definition of a related party according to IAS 24? Name two types of relationships that may indicate related parties.
2. True or false? All transactions with related parties must be disclosed in the financial statements, regardless of materiality.
3. Which ONE of the following represents an increased audit risk with related party transactions?
   A) Routine business with a long-term supplier
   B) Significant loan made at below-market rates to a director’s family business
   C) Inventory sold at listed prices to an unrelated distributor
4. List two substantive audit procedures you would perform to ensure completeness of related party disclosures.

Introduction

Related party relationships and transactions are a risk area in financial reporting because they may not be conducted at arm’s length and can be used to conceal fraud or manipulate results. As a result, both IAS 24 and auditing standards require careful identification, assessment, and disclosure of such transactions.

Key Term: Related party
A person or entity related to the reporting entity by control, joint control, significant influence, or a close family connection with key management personnel.

Key Term: Related party transaction
A transfer of resources, services, or obligations between a reporting entity and a related party, regardless of whether a price is charged.

Importance of Related Parties in Audit

Related party relationships often present a risk of material misstatement due to the potential for transactions that are not on commercial terms, or for non-disclosure. Auditors must apply professional skepticism and ensure all relationships and transactions are fully identified and disclosed as required by IAS 24.

IDENTIFYING RELATED PARTIES

Criteria for Related Parties (IAS 24)

IAS 24 defines a related party as someone or an entity that has:

• Control or joint control over the reporting entity
• Significant influence over the entity
• Is a member of key management personnel of the entity or a parent

Related parties include (but are not limited to):

• Parent companies and subsidiaries
• Associates and joint ventures
• Key management personnel (e.g. directors)
• Close family members of directors or controlling parties
• Entities controlled, jointly controlled or significantly influenced by individuals above

It is not sufficient to consider only direct relationships – indirect connections can also create a related party link.

Relationships NOT usually related parties

Ordinary suppliers, customers, and agents are not automatically related parties unless control or significant influence exists. The same applies to entities simply because they have a director in common, unless influence or control is demonstrated.

Worked Example 1.1

Scenario: The CEO of Speedline Ltd is the majority shareholder in Tyro Holdings. During the year, Speedline makes interest-free loans to Tyro Holdings.

Question: Is Tyro Holdings a related party of Speedline Ltd, and what disclosure is required?

Answer:
Yes, Tyro Holdings is a related party since the CEO, who controls Speedline, also controls Tyro Holdings. The transactions (loans) must be disclosed per IAS 24, and the terms (interest-free) must be explained.

Indicators of Related Parties and Transactions

Auditors must be alert for:

• Transactions with no business rationale or not at market rates
• Unusual terms favourable to one party
• Complex structures or arrangements outside normal business
• Transactions near reporting period ends

Key Term: Significant influence
The power to participate in the financial and operating policy decisions of an entity, but not control over those policies.

AUDIT RISKS AND CHALLENGES

Risks Associated with Related Parties

• Completeness: Transactions or balances may be omitted to conceal their nature.
• Accuracy: Amounts may not reflect substance or may be incorrectly measured.
• Disclosure: Required information may be missing or misleading.
• Fraud risk: Related party arrangements can be used to disguise fraud or misappropriate assets.
• Overstatement or understatement of results: Transactions not at arm’s length may distort performance.

Worked Example 1.2

Scenario: Ace Ltd sells inventory to a director’s spouse at a discount much lower than standard rates. The transaction is not separately disclosed.

Question: What is the risk for the auditor, and what action should be taken?

Answer:
The risk is that the transaction, and its preferential terms, have not been properly disclosed. The auditor should investigate the completeness of related party records and require separate disclosure.

Exam Warning

Failure to identify all related parties is a frequent cause of incomplete disclosures. Auditors must actively seek evidence beyond management's representations.

DISCLOSURE REQUIREMENTS UNDER IAS 24

IAS 24 requires disclosure in the notes to the financial statements of:

• Relationships between parent and subsidiaries, regardless of any transactions.
• Key management personnel compensation (direct and indirect).
• Nature of related party relationships, descriptions of transactions, amounts, outstanding balances (including commitments), terms and conditions, and guarantees provided/received.
• Any provisions for doubtful debts or amounts written off relating to related parties.

Disclosures must be included even when no transactions occurred if relationships exist.

Materiality and Disclosure

Generally, only material related party transactions require specific disclosure, but key management compensation and parent-subsidiary relationships must always be disclosed. Non-material outstanding balances may be omitted if the information is immaterial, but the threshold is low due to sensitivity.

Key Term: Key management personnel
Those with authority and responsibility for planning, directing, and controlling the entity, including directors and officers, whether executive or otherwise.

AUDITOR RESPONSIBILITIES AND PROCEDURES

Planning and Identification Procedures

Auditors must obtain an understanding of:

• Management’s process for identifying and recording related parties and transactions.
• The control environment and whether sufficient safeguards exist to identify relationships and to ensure correct approval and disclosure.
• Lists of directors, officers, major shareholders, and their close family members.

Develop an expectation as to which related parties the entity is likely to have, based on structure, shareholding, and history.

Procedures to Obtain Audit Evidence

Audit procedures include:

• Review prior year files and minutes for changes in directors/officers and significant shareholders.
• Read board minutes for transactions or appointments indicating relationships.
• Inspect legal and regulatory documents, contracts, and agreements.
• Examine unusual or large transactions, particularly near the period end.
• Review accounting records for non-routine balances or journal entries.
• Send confirmation requests to parties believed to be related.
• Test completeness by comparing disclosed related parties and transactions to information obtained from control testing.

Key Term: Arm’s length transaction
A transaction conducted as if the parties were unrelated, so that no preference or benefit results from their relationship.

Worked Example 1.3

Scenario: Your client, Aurora Ltd, has disclosed only directors' remuneration as related party transactions. You note from minutes that a subsidiary was sold to a company run by a relative of the finance director.

Question: What should you do as auditor?

Answer:
Investigate the sale transaction, evaluate whether the purchasing entity is a related party (given the finance director's family member’s involvement), and obtain evidence of fair value. Require disclosure if IAS 24 applies.

Communicating with Management and Those Charged with Governance

• Obtain written representations affirming the completeness of related party disclosures.
• Report significant related party risks, control deficiencies, or non-disclosure to those charged with governance.

Substantive Procedures

For material related party transactions:

• Confirm existence and substance with third parties where possible.
• Inspect supporting documentation and evaluate commercial terms.
• Ensure transactions are authorized and consistent with board approvals.
• Reconcile amounts to ledgers and balance confirmations.
• Assess if disclosures in the financial statements meet IAS 24 requirements.

Revision Tip

Always corroborate management's representations regarding related parties with independent sources and documentary evidence.

Summary

Auditors must be alert to the risk of omission and misstatement in related party disclosures. Proper identification, thorough procedures, and comprehensive review are essential to ensure compliance with IAS 24 and to reduce audit risk.

Key Point Checklist

This article has covered the following key knowledge points:

• Define related parties and related party transactions per IAS 24.
• Identify who may be considered a related party in different scenarios.
• Recognize audit risks from related party relationships and transactions.
• List disclosure requirements (nature, amounts, balances, and terms).
• Describe audit procedures to identify, test, and evidence related party disclosures.
• Understand the importance of corroborating management’s disclosure through independent and substantive testing.

Key Terms and Concepts

• Related party
• Related party transaction
• Significant influence
• Key management personnel
• Arm’s length transaction