“Good friends help you move. Real friends help you move dead bodies.” Perhaps this ubiquitous (and anonymous) quote sheds some light on auditing standard setters’ recent emphasis on updating guidance regarding related-party transactions. Of course, by “real friends” I refer to a company’s related parties – and who better and more trustworthy to help conceal some of its dirty secrets?
In light of major corporate accounting scandals of the past two decades (think Enron, Tyco, or more recently, Olympus), which were perpetrated with the assistance of related-party transactions, auditing standard-setters have focused their attention on the heightened risk of fraudulent financial reporting that accompanies related-party transactions. But even if transactions and arrangements with related parties are not for nefarious purposes, standard-setters have recognized that activity with related parties increases the risk of error that financial statements are not presented fairly and will require an auditor’s careful inspection.
In July 2014, the Public Company Accounting Oversight Board issued proposed a new standard on related parties that builds upon many of the required audit procedures issued in recent years by the Auditing Standards Board of the American Institute of CPAs and the International Auditing and Assurance Standards Board. Among several reasons for the new guidance, the PCAOB’s proposal notes that in the course of the PCAOB’s disciplinary actions, a number of deficiencies were identified around related-party auditing procedures, particularly in audits conducted by smaller domestic-audit firms.
This past October, the Securities and Exchange Commission approved the new PCAOB auditing standard and other amendments in the areas of related-party transactions, significant unusual transactions, and financial relationships and transactions with executive officers, which are now effective for registered companies with fiscal years beginning on or after December 14, 2014.
The Impact on Small and Midsized Businesses
For many small and midsize businesses, the emphasis on the documentation of related-party transactions can be counterintuitive. That’s because business owners are generally less concerned about the agreements and terms set with a related party (unless, of course, your friends and family happen to be the Corleones). All too often, small and midsized businesses rely on incomplete documents as corroborating evidence of related-party transactions (e.g., seed funding and interest-free loans from family members) and ignore the corporate formalities that would normally exist when dealing with a separate and independent third party.
Such carelessness may result from the use of related-party transactions as a financial expedient. For instance, they might serve as a quick access to cash or be used because the related party is within arm’s length and there is an inherent business relationship. While the newly released PCAOB standard directly affects those registered companies under the PCAOB’s purview, it’s important to note that privately owned companies or partnerships, which typically include small or midsized businesses, will also need to pay close attention to related-party documentation because the scrutiny around related parties relates to more than just auditing standards. Many predictable or unpredictable corporate events can give rise to increased scrutiny of related-party transactions, such as prospective public offerings, applications for financing, minority share disputes, and mergers and acquisitions.
Given the risk of fraudulent financial reporting associated with related-party transactions and the potential use of the transactions to conceal embezzlement, money laundering, or other illegal activities, the subject of related parties also continues to be a focal point of regulators and government prosecutors seeking to bring civil or criminal legal actions.
The New Auditing Standards
While the existing PCAOB standard of AU Sec. 334, Related Parties, provides auditors with guidance and examples of related-party procedures, the standard states that the procedures outlined aren’t required in all audits and “related party transactions should not be assumed to be outside the ordinary course of business.” The updated standard supersedes the existing standard and requires procedures that expand upon many of the auditing procedures included in the ASB’s standard. The required procedures include obtaining an understanding of the company’s process of identifying related parties, performing inquiries of management and others within the company regarding the identification of related parties and purpose of the transactions, and testing the related-party transactions by reading underlying documentation.
Key Areas for Consideration
In anticipation of the increased focus on related parties as part of the new auditing requirements, small and midsize businesses should consider the following key areas when drafting, applying, and implementing policies and procedures for related-party relationships and transactions:
- Transactional documentation. Although related-party transactions are performed using a variety of methods, companies should strive to keep each transaction separate and complete with fully executed documentation. Companies should also avoid unnecessarily commingling funds among related parties or introducing other complex arrangements that will further muddy the transaction and lend itself to heightened scrutiny by auditors, regulators, and possibly government prosecutors.
The recent guidance stresses the need for an auditor to understand the business purpose of the transaction. In many related-party transactions, the substance and form are incongruent and may require a different accounting treatment and disclosure than would be given to a similar transaction with an independent third party. Companies should consider including the business purpose within the transaction documents themselves as evidence of the reason for the related-party arrangement, thereby reducing misunderstanding with auditors.
- “Arm’s-length” documentation. A company often will assess a related-party transaction as having been performed “at arms-length,” without fully considering how it came to this conclusion. If a company decides to include this disclosure in its financial statements, management must ensure that such a claim can be substantiated. For example, the company should strongly consider the use of external specialists to evaluate the market rate of the related-party transaction or reference other similar transactions with third parties and incorporate the results of such procedures in their related-party documentation.
- Disclosures. The identification of related parties should be reassessed on a regular basis to ensure that the related-party disclosures in the notes to the company’s financials are complete and accurate. Along with disclosures of specific transactions with related companies that are reflected in year-end balances on the company’s balance sheet, careful consideration should be made to identify related-party transactions that occur between financial reporting periods that may require disclosure.
- Board of directors/stockholders’ approval. The updated standards include the requirement for auditors to read the stockholders’ or board meeting minutes in their evaluation of whether the company properly identified relationships with related parties. In addition to cross-referencing the company’s financial statement disclosures to the board meeting minutes, companies should ensure that relationships and arrangements with related parties are discussed and agreed to early on to support the respective relationship and/or arrangement.
Small and midsized businesses should use the recent guidance for related parties from the auditing standard-setters as a catalyst to reassess their businesses’ readiness for the increased level of review of relationships and transactions with related parties. Gaining comfort around related-party transactions will help businesses avoid unwanted misunderstandings with auditors, disagreements among shareholders, and interest by regulators and government prosecutors.
While it’s unreasonable to assume that the new standards will cause businesses to limit their transactions with related parties, the standard should convince companies to increase the level of transparency around these transactions and perhaps make it a little more difficult for friends to help each other hide their misdeeds.
Howard Berkowitz is a Managing Consultant at Berkeley Research Group.
Illustration by jardc87