Related Party Transactions Audit: AU-C 550 Procedures and ASC 850 Disclosure

Related party transactions are common in the entities small and mid-sized CPA firms audit. The owner leases the building to the company, a sister company supplies materials, a family member is on the payroll, or the shareholder lends money when cash is tight. None of this is wrong in itself. The audit risk is that these transactions are not identified, not on the terms they appear to be, or not disclosed.

This guide covers the audit of related party relationships and transactions under AU-C 550, Related Parties, and the disclosure requirements of ASC 850, Related Party Disclosures. It paraphrases both.

Why related parties carry audit risk

Related party transactions are not presumed to be improper. But they can carry a higher risk of material misstatement because:

• related parties may operate through complex relationships and structures that are hard to see
• information systems often do not flag related party transactions
• the transactions may not be on normal market terms, for example a loan with no interest
• they can be used to commit fraud, such as recording sales to a controlled entity that never pays

Because management may not identify all related parties, and because ownership and family relationships are rarely in the general ledger, AU-C 550 requires specific procedures throughout the audit, not a single checklist at the end.

Who is a related party under ASC 850

ASC 850 defines related parties broadly. They include:

• affiliates of the entity (entities that control, are controlled by or are under common control with it)
• entities for which investments are accounted for by the equity method, or would be absent a fair value election
• trusts for the benefit of employees, such as pension and profit-sharing trusts managed by or under the trusteeship of management
• principal owners of the entity and members of their immediate families
• management of the entity and members of their immediate families
• other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to the extent that one of them might be prevented from fully pursuing its own separate interests
• other parties that can significantly influence the management or operating policies of the transacting parties, or that have an ownership interest in one of them and can significantly influence the other

In practice, the hard part is not the definition. It is finding the parties, especially entities owned by a principal owner's relatives or by members of management.

Risk assessment procedures under AU-C 550

Team discussion

The engagement team's discussion during planning (required by AU-C 315 and AU-C 240) should include how related party relationships and transactions could give rise to material misstatement, including through fraud. A team member who knows the owner also owns a trucking company should say so.

Inquiries of management

AU-C 550 requires the auditor to inquire of management about:

• the identity of the entity's related parties, including changes from the prior period
• the nature of the relationships between the entity and those related parties
• whether the entity entered into any transactions with them during the period and, if so, the type and purpose of the transactions

The auditor also inquires of management and others about the controls management has established to identify, account for and disclose related party relationships and transactions, and to authorize and approve significant transactions with related parties and significant transactions outside the normal course of business.

Inquiry of others is useful. Consider asking those charged with governance, the controller, the purchasing manager and in-house legal counsel. They may know about arrangements management has not mentioned.

Remaining alert during the audit

AU-C 550 asks the auditor to remain alert, when inspecting records or documents, for arrangements or information that may indicate related party relationships or transactions not previously identified. Places to look:

Sharing information with the team

AU-C 550 requires the auditor to share relevant information about related parties with the engagement team. A simple practice is a related party listing in the permanent file, updated each year and circulated at planning, so that staff testing payables, revenue and payroll know which names to watch for.

Identifying and assessing risks

The auditor identifies and assesses the risks of material misstatement associated with related party relationships and transactions, and determines whether any are significant risks. AU-C 550 treats significant related party transactions outside the entity's normal course of business as giving rise to significant risks.

Fraud risk factors are relevant here. A dominant owner-manager who controls transactions with entities they also own, with no independent oversight, is a fraud risk factor under AU-C 240 and should be documented as such.

Responding to the risks

Responses should be tailored to the risks identified. Typical procedures:

• Confirm or discuss terms and amounts with the related party, or with intermediaries such as banks, lawyers or guarantors.
• Inspect the underlying agreements and evaluate the business rationale, terms and whether the accounting reflects the substance.
• Evaluate authorization and approval of significant related party transactions.
• Agree amounts to the general ledger and to the disclosure.
• Consider the financial capability of the related party, for example where a receivable from an affiliate is material and collectibility depends on the owner.
• Read the financial statements of the related party where available and relevant.

Previously unidentified related parties

If the auditor identifies related parties or significant related party transactions that management did not disclose, AU-C 550 requires the auditor to:

• communicate the information promptly to the engagement team
• request management to identify all transactions with the newly identified related parties
• inquire why the entity's controls failed to identify or disclose them
• perform appropriate substantive procedures on the newly identified relationships and significant transactions
• reconsider the risk that other unidentified related parties or transactions exist
• evaluate the implications for the audit if the nondisclosure appears intentional, which may indicate a fraud risk

Significant transactions outside the normal course of business

For significant related party transactions outside the normal course of business, the auditor inspects the underlying contracts or agreements and evaluates whether the business rationale suggests the transaction may have been entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets, whether the terms are consistent with management's explanations, and whether the transactions have been appropriately accounted for and disclosed. The auditor also obtains evidence that the transactions were appropriately authorized and approved.

Arm's-length assertions

Management sometimes wants the disclosure to say a transaction was on terms equivalent to an arm's-length transaction. ASC 850 says such representations should not be made unless they can be substantiated. AU-C 550 asks the auditor to obtain sufficient appropriate evidence about any such assertion in the financial statements.

That is often hard. If market evidence (comparable rents, quoted interest rates, independent appraisals) is not available, the better route is usually to remove the assertion from the disclosure rather than to audit it.

ASC 850 disclosure requirements

ASC 850 requires disclosure of material related party transactions, other than compensation arrangements, expense allowances and other similar items in the ordinary course of business. Disclosures include:

• the nature of the relationship
• a description of the transactions, including those to which no amounts or nominal amounts were ascribed, for each period an income statement is presented, and other information needed to understand their effects
• the dollar amounts of transactions for each period an income statement is presented, and the effects of any change in the method of establishing terms from the preceding period
• amounts due from or to related parties at each balance sheet date and, if not otherwise apparent, the terms and manner of settlement

ASC 850 also requires disclosure of the nature of a control relationship when the reporting entity and one or more other entities are under common ownership or management control and the existence of that control could result in operating results or financial position significantly different from those that would have been obtained if the entities were autonomous, even if there are no transactions between them.

Worked example: owner-leased building (illustrative figures)

The company leases its warehouse from an LLC owned by the two shareholders. Annual rent is $240,000. At year end the company owes the LLC two months of rent, $40,000. The company also guarantees the LLC's mortgage on the building.

The audit file should show:

• the LLC identified on the related party listing, with the source of identification
• the lease agreement inspected and the lease accounted for under ASC 842, including whether the arrangement is a lease with a related party under common control and how terms were evaluated
• the $240,000 expense and $40,000 payable agreed to the ledger
• the guarantee identified (bank confirmation and loan documents) and evaluated for recognition and disclosure under ASC 460
• consideration of whether the LLC is a variable interest entity and any private company accounting alternative elected
• the disclosure reviewed for the nature of the relationship, amounts, balances, the guarantee and no unsupported arm's-length language

Written representations and governance communications

Under AU-C 580, the auditor requests written representations that management has disclosed the identity of all known related parties and all related party relationships and transactions, and has appropriately accounted for and disclosed them. Under AU-C 260 and AU-C 550, significant matters arising during the audit in connection with related parties are communicated to those charged with governance unless all of them are involved in managing the entity.

Documentation

AU-C 230 and AU-C 550 expect the file to include the names of identified related parties and the nature of the relationships, the inquiries and responses, the risk assessment, the procedures performed and a conclusion on accounting and disclosure. Keep the related party listing current and cross-reference it from every area where related party transactions occur.

Common problems in related party audits

• Inquiry only. A single question to the owner, with no other procedures to identify related parties.
• No team communication. The listing exists but staff testing payables and revenue never see it.
• Unsupported arm's-length language left in the disclosure.
• Guarantees missed, especially personal and cross-guarantees with affiliates.
• Common control not disclosed when there are no transactions.
• Representation letter generic, with no reference to related parties identified.

Frequently asked questions

What does AU-C 550 require auditors to do?

AU-C 550 requires the auditor to understand the entity's related party relationships and transactions, identify and assess the risks of material misstatement they create, and obtain evidence about whether they are properly identified, accounted for and disclosed.

What must be disclosed under ASC 850?

Material related party transactions require disclosure of the nature of the relationship, a description of the transactions, their dollar amounts, and amounts due to or from related parties with settlement terms where not apparent, along with certain common control relationships.

Can the financial statements say a related party transaction was at arm's length?

Only if the representation can be substantiated. ASC 850 restricts such statements, and the auditor must obtain evidence supporting any arm's-length assertion that appears in the financial statements.

Are owner salaries related party transactions that need disclosure?

Compensation arrangements, expense allowances and similar items in the ordinary course of business are excluded from the ASC 850 disclosure requirements, though unusual arrangements and amounts owed to owners may still need disclosure.

What should I do if I find a related party management did not tell me about?

Tell the engagement team, ask management to identify all transactions with that party, ask why controls did not identify it, perform substantive procedures, reconsider the risk of other undisclosed parties and evaluate whether the nondisclosure was intentional.

Sources

• AICPA, AU-C Section 550, Related Parties
• FASB ASC 850-10, Related Party Disclosures (master glossary definition of related parties; 850-10-50)
• AICPA, AU-C Section 240, Consideration of Fraud in a Financial Statement Audit; AU-C Section 315; AU-C Section 230; AU-C Section 260; AU-C Section 580
• FASB ASC 842, Leases; ASC 460, Guarantees; ASC 810-10, Consolidation (variable interest entities)

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error