Introduction
Related party transactions have gained special attention in recent years for their role is significant accounting frauds. However, these types of transactions are quite common and are frequently disclosed in annual audited financial statements. While the occurrence of related party transactions is not indicative of fraudulent financial reporting, failure to recognize or disclose related party transactions was found to be one of the top 10 audit deficiencies in the United States by Beasley, Carcello and Hermanson (2001). Related party transactions can lead to materially misstated financial statements when they are not identified by auditors, inaccurately measured, or inappropriately disclosed in the notes accompanying the financial statements. A financial statement user's assessment of a company's operations may be affected by their knowledge of that company's related party transactions, relationships and outstanding balances. As a result, auditors must strive to minimize detection risk related to these types of transactions.
Due to the nature of related party relationships, they are not easily identified without enquiries of management. Thus, it can be difficult to identify and measure transactions of which management are either unaware, or are concealing for fraudulent purposes. Though current and future Canadian standards endeavour to mitigate this risk, it cannot be entirely eliminated from the financial reporting process. Instead, the existence of other factors serves to reduce these risks. Strong corporate governance policies, such as independent and financially literate directors, and a healthy level of auditor professional skepticism increase the ease of identifying, measuring and auditing related party transactions.
The remainder of this research paper is organized as follows. The next section reviews the relevant professional accounting and assurance standards on related party transactions. This review includes both current and future Canadian standards, and highlights the coming changes in reporting and auditing requirements. The third section reviews the literature surrounding director independence, with a special focus on grey directors and their possible motivations. The fourth section addresses the importance of financially literate directors and the role that their professional affiliations play in the board of directors' decision-making process. The fifth section explains the need for auditor professional skepticism when auditing related party transactions, while considering those factors which may compromise that skepticism. Finally, the concluding remarks seek to draw together the research to address the central theme of related party transactions.
Professional Standards on Related Party Transactions
Canadian accounting standards as specified by the Canadian Institute of Chartered Accountants (CICA) are currently in a period of transition from generally accepted accounting principles (GAAP) to International Financial Reporting Standards (IFRS) governed by the International Accounting Standards Board (IASB), which is mandatory for all interim and annual financial statements relating to fiscal periods beginning on or after January 1, 2011 (CICA, July 2010, Introduction to Part I, para. 1.7). As well, Canadian Assurance Standards (CAS), which are issued by the Auditing and Assurance Standards Board (AASB), are applicable to audits of financial statements and other historical financial information only, for fiscal periods ending on or after December 14, 2010 (CICA, July 2010, Preface to the CICA Handbook - Assurance, para. 20). As a result, I have reviewed both current and future Canadian accounting and assurance standards regarding related party transactions.
Current Canadian Standards
CICA Accounting Handbook Section 3840 explains that related parties exists when one party has the ability to exercise, directly or indirectly, control, joint control or significant influence over the other. Related parties also include management and immediate family members. A related party transaction is a transfer of economic resources or obligations between related parties, or the provision of services by one party to a related party, regardless of whether any consideration is exchanged (CICA, July 2010, Section 3840, para. 03). The CICA requires that related party transactions be measured at the carrying amount of the item transferred or service provided, unless the transaction has commercial substance and is either in the normal course of operations or occurs to facilitate sales to customers. If one of these exceptions is met, the transaction may be recorded at its exchange value, which is the amount of consideration paid or agreed to by the related parties. A transaction outside of the normal course of operations may also be recorded at its exchange amount if there is a substantive change in the ownership interests of the item transferred and the exchange amount is supported by independent evidence (CICA, July 2010, Section 3840, para. 29). There are also detailed disclosure requirements than an entity must make about its transactions with related parties. These disclosures include a description of the relationship between the parties, the transactions entered in to, the recognized amount of the transactions, the measurement basis (carrying or exchange value) used, amounts due to or from related parties, contractual obligations with related parties, and contingencies involving related parties (CICA, July 2010, Section 3840, para. 46).
CICA Assurance Handbook Section 6010 discusses the audit of related party transactions in the context of complying with generally accepted auditing standards. Management is responsible for making a reasonable effort to identify all related parties, adopting appropriate policies and procedures to identify related parties and ensuring that identified transactions are measured and disclosed in the entity's financial statements in accordance with GAAP (CICA, July 2010, Section 6010, para. 03). The CICA notes that related party transactions are difficult to identify and measure for several reasons, including the extensive range of possible relationships, lack of consideration exchanged, the transaction may not be in the normal course of operations and transactions may be manipulated and/or concealed by management (CICA, July 2010, Section 6010, para. 04). An understanding of the entity's relationship with related parties is usually obtained through a combination of prior experience with the entity and audit procedures performed during field work. As a result, even when inherent risk is assessed as low, an auditor is required to make enquiries of management to confirm that all related party transactions have been measured and disclosed per GAAP and be alert for unidentified related parties and transactions with those parties while performing other audit procedures (CICA, July 2010, Section 6010, para. 15). As well, the CICA details certain circumstances that may indicate the existence of undisclosed related parties or related party transactions. Because enquiry of management is a key source of evidence for this type of transaction, it is critical that the auditor obtain a written representation from management regarding its disclosure and measure of related party transactions. Finally, the CICA requires that an auditor inform the audit committee of any previously unidentified related party transactions outside of the normal course of operations involving significant judgments by management (CICA, July 2010, Section 6010, para. 29).
International Financial Reporting Standards
IASB International Accounting Standard (IAS) 24 is the equivalent standard to CICA Accounting Handbook Section 3840 and has similar definitions of a related party and a related party transaction. However, IASB does not exclude certain management compensation arrangements in the normal course of operations, nor does it discuss the measurement of related party transactions. The IASB's disclosure requirements are much more extensive than those of the CICA and include additional disclosures regarding the nature of control relationships, key management personnel compensation, guarantees given or received and provisions for doubtful debts and the related expenses (IASB, July 2010, IAS 24).
Canadian Auditing Standards
The AASB has also issued CAS 550 relating to the audit of related party transactions, equivalent to CICA Assurance Handbook Section 6010. CAS 550 details additional requirements for auditors regarding risk assessment procedures, responses to previously unidentified related party transactions, and procedures for transactions outside of the normal course of operations in addition to those requirements outlined by the CICA. As a component of the risk assessment process, the engagement team is required to discuss the susceptibility of the financial statements to material misstatement as a result of fraud or error through related party transactions (AASB, July 2010, CAS 550, para. 12). Auditors are also required to inspect bank and legal confirmations, minutes of shareholder meetings and meetings of those charged with governance, and any other necessary documents for indications of unidentified related parties and/or transactions (AASB, July 2010, CAS 550, para. 15). Additional procedures for unidentified related party transactions include communication of relevant information to the engagement team, request management to identify all transactions for the new related party, inquire as to why management's controls over related party transactions failed, reconsider risk assessment of unidentified related parties and consider implications for the engagement if the non-disclosure by management appears to be intentional (AASB, July 2010, CAS 550, para. 22). Finally, the AASB requires that auditors perform specific procedures on significant identified related party transactions outside of the normal course of operations. These procedures involve inspecting the underlying contracts or agreements, evaluating the business rationale (or lack thereof) of the transactions to determine if they were entered into for fraudulent purposes, assessing whether the terms of the transaction are consistent with management's explanations, and ensuring that the transactions have been appropriately accounted for, disclosed, authorized and approved (AASB, July 2010, CAS 550, para. 23).
From a review of the relevant professional standards, it is evident the Canadian accounting and assurance requirements are in a period of great transition. Both IFRS and CAS will result in increased disclosures by an entity regarding its related parties and transactions with those parties. CAS details many procedures not currently required by the CICA that attempt to reduce detection risk related to this type of transaction. As well, CAS focuses on establishing the business rationale for those transactions outside of the normal course of operations, as these are more likely to be used to conceal fraudulent activities or the misappropriation of assets. However, these standards are not able to entirely mitigate the risk that management may be unaware of the existence of all related party relationships and transactions, or that a related party transaction is concealed by management for fraudulent purposes.
Director Independence
Various academic research papers have demonstrated that the greater the proportion of independent directors on a company's board, the lower the probability of financial statement fraud (Beasley, 1996). These members increase the effectiveness of the board's monitoring function, thus reducing the probability of management engaging in financial statement fraud. Further research has indicated that while the presence of related party transactions is not indicative of fraud, when fraud does exist, it is one of the top reasons cited for audit failure (Gordon, Henry, Louwers & Reed, 2007). As such, it stands to reason that the presence of independent directors will lower the probability of fraud through the use of related party transactions.
Grey Directors
The occurrence of related party transactions may impair the independence of formerly independent directors, rendering them grey (neither inside nor outside directors). Carcello and Neal (2000) found that there was no difference between inside and grey directors in regards to the relationship between proportion of the audit committee and the receipt of going-concern reports. There is a significant negative relationship between the percentage of inside or grey directors and the receipt of a going-concern report. While a going-concern report is not relevant to a discussion of related party transactions, Carcello and Neal demonstrate the similar lack of effectiveness for both inside and grey directors. Beasley's research regarding board composition and financial statement fraud found that there was no difference in board effectiveness of detecting fraud whether directors were fully independent or grey (Beasley, 1996). These findings completely contradict those of Carcello and Neal and call the presumed ineffectiveness of grey directors into question.
It is also important to consider the motivation of grey directors when assessing their effectiveness as members of the board. Certain types of grey directors, such as significant stock or debt holders, may have an economic incentive to closely monitor the company as compared with completely independent directors. Jensen (1993) found that encouraging outside directors to hold substantial equity interests would provide sufficient incentive for better monitoring. As well, Jensen believes that active investors are important as they generally have an unbiased view of management and policies due to their financial interest and independence. Active investors are defined as "individuals or institutions that simultaneously hold large debt and/or equity positions in a company and actively participate in its strategic direction" (Jensen, 1993, p. 867). Without the incentive of maximizing the value of their investment, independent directors may not monitor the company as closely, which could increase the probability of fraud through the use of related party transactions.
However, non-management principal owners (a particular type of grey director) may have conflicting interests that impair their ability to act as effective monitors of the company. Such shareholder may use company resources to create unfair allocations between the principal owner and other investors or employees. As Shleifer and Vishny (1997) describe, this power arises when the shareholder's control right exceeds their cash flow right through share classes with superior voting rights. Principal owners may also use their control to exploit business relationships with other company's under their control. This would be considered a related party transaction and may be difficult to identify if management is not aware of the relationship.
Using the incidence of financial statement fraud as a proxy for unreported related party transactions, it is evident that independent directors on the board result in fewer reported frauds and greater identification of related party transactions. However, the occurrence of a related party transaction with a board member impairs their independence and renders them grey. Current research is inconclusive as to whether or not a grey director is more or less effective than an independent director. I believe that any director with a minority interest in the firm (less than 50 percent of the voting rights) has enough economic motivation to become a more effective monitor of the company. This will result in higher quality reporting from the company and reduce the risk of related party transactions not being disclosed and audited.
Financially Literate Directors
Securities commissions have certain policies in place that require the presence of financially literate audit committee members. Canadian National Instrument 52-110 - Audit Committees requires that each and every audit committee member be financially literate. A director is considered to be financially literate if "he or she has the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues that are reasonably comparable to the breadth and complexity of the issues that can reasonably be expected to be raised by the issuer's financial statements" (source - NI 52-110). Individual American stock exchanges have their own requirements regarding financial literacy, in addition to Securities and Exchange Commission (SEC) requirements. The SEC's Final Rules require companies to disclose whether or not they have at least one audit committee financial expert serving on their audit committee. The Final Rules further define an audit committee financial expert as a director with all of the following attributes: 1) an understanding of GAAP and financial statements; 2) the ability to assess the principles in connection with accounting for estimates, accruals and reserves; 3) experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity comparable to that of the company; 4) an understanding of internal controls and procedures for financial reporting; and 5) an understanding of audit committee functions (source). As members of the audit committee must also be part of the board of directors, requiring a greater number of financially literate audit committee members will likely increase the presence of such members on the board.
Should a board only have one financially literate director, his or her understanding of complex accounting issues may not be adequate to provide effective oversight of the financial reporting process. Rezaee, Olibe and Mimmier (2003) believe that the audit committee should obtain independent advice on the company's complex business activities, including appropriate accounting treatments, and inform the board of directors. Furthermore, the board of directors should ensure that complex transactions are adequately communicated to investors.
Professional Affiliations
The professional obligations of financially literate board members may have an impact on the underlying company's accounting policies. Carpenter and Feroz (2001) found that the participation of key accounting bureaucrats in professional accounting organizations led to the early adoption of GAAP by certain governments. The pressure to adopt that came from these bureaucrats with decision-making power was due in part to their professional obligations as accountants. Carpenter and Feroz also present a contradicting view as to why professional accountants may not support the adoption of GAAP. They may choose not to maximize their professional self-interest, but instead focus on their interests at the inter-organizational level.
Chalmers and Godfrey (2004) continue research in this direction by focusing on the incentives for voluntary derivative financial instrument disclosures in Australia. At the time of Chalmers and Godfrey's research, Australia had not yet converted to IFRS and its equivalent GAAP did not contain explicit standards regarding the disclosure and presentation of financial instruments. They found that professionals affiliated with the Australian Society of Corporate Treasurers (ASCT), a professional body for financial and treasury professionals, had higher levels of voluntary derivative financial instrument disclosures when compared with non-affiliated professionals. This increased level of disclosure was likely due to the fact that ASCT members were expected to exercise their influence and ensure that company disclosures conformed to ASCT best practices. By ensuring that their company's voluntary disclosures were made, ASCT professionals attempted to preserve or enhance their own professional reputations.
The aforementioned findings are further developed by Arshad, Darus and Othman (2009) who hypothesized that there is a significant positive relationship between the percentage of board members with professional affiliations and the extent of related party disclosures. Board members' motivation to fulfill their professional obligations and enhance their own reputations causes them to pressure senior management to increase related party disclosures. Arshad et al. found that the influence of affiliated professionals on related party disclosures was stronger when more comprehensive disclosures were required, thus supporting the argument of reputation maintenance.
Through an examination of varying securities commission requirements in North America, it is apparent that the importance of financially literate directors and audit committee members has become more prevalent in recent years. A review of recent research has demonstrated that directors with professional business affiliations are motivated to fulfill their governing body's standards and maintain their standing in the respective profession. As a result, these board members are able to pressure management into increased disclosure of related party transactions, a requirement under both IFRS and GAAP, making such transactions easier to measure and audit.
Auditor Professional Skepticism
CAS 200 - Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Canadian Auditing Standards requires that the auditor plan and perform an audit with professional skepticism, as circumstances may exists that result in the material misstatement of the financial statements. It further explains that professional skepticism includes being alert to contradicting audit evidence and conditions that may indicate possible fraud, among others behaviours. Maintaining this skepticism throughout the audit is necessary to reduce the risks of overlooking atypical circumstances, over simplifying conclusions based on audit observations, and employing inappropriate assumptions in determining audit procedures and evaluation the results of those procedures. Nelson (2009) defines professional skepticism as "indicated by auditor judgments and decisions that reflect a heightened assessment of the risk that an assertion is incorrect, conditional on the information available to the auditor" need proper citation. Using this definition, an auditor with high professional skepticism needs relatively more persuasive evidence before concluding on an assertion.
Recent Accounting Scandals
Beasley et al. (2001) examined public companies engaged in financial statement fraud or the misappropriation of assets and found that auditors did not maintain an attitude of professional skepticism in 60% of SEC enforcement cases. Of these types of enforcement cases, one particularly significant fraud was perpetrated using related party transactions - Enron Corporation.
While the fraud committed by Enron was wide-spread, one important element was its use of special purpose entities (SPEs). At the time, U.S. GAAP required that a SPE have at least one independent equity investor contributing at least three percent of the fair value of assets. The investor had to assume the risks of the transaction and be an outsider. If these requirements are not met, the SPE is consolidated with the parent's financial statements. Enron used SPEs to move debt off the balance sheet and create operating cash flow, while non-executive employees served as "independent" equity investors. The Arthur Andersen LLP audit partner on the engagement agreed to allow these transactions as long as the board of directors waived its conflict-of-interest requirements (source). As a result of building fraudulent activities, Enron was forced to restate its earnings by $1.2 billion from 1997 to 2000, and finally declared bankruptcy in late 2001. Arthur Andersen was convicted of obstruction of justice in 2002 for shredding documents related to its Enron engagement, although this decision was later reversed in 2005 (source).
Factors Affecting Auditor Skepticism
An auditor's professional skepticism can be influenced by many factors, either psychological or situational. A study by Russo, Meloy and Wilks (2000) found that professionals distort information during the decision making process to support whichever alternative they favour. This results in the professional overweighting evidence that supports their favoured alternative. Similarly, Kadous, Kennedy and Peecher (2003) note that auditor assessment of the quality of a client's accounting depends on the auditor's commitment to directional goals. A directional goal exists when an individual is motivated to arrive at a certain conclusion, resulting in narrowed thinking to support that judgment. An auditor's directional goal is generally to accept client-preferred accounting methods by exploiting ambiguous standards. Hence, the higher the directional commitment, the more likely it is that an auditor will accept the client's method as the most appropriate accounting treatment, regardless of its aggressiveness or the availability of a higher quality method. Specifically, Kadous et al. found that the magnitude an auditor's commitment to directional goals will affect their selection of the most appropriate accounting method. Finally, Earley (2002) found evidence that when an auditor's initial expectation of no errors or significant differences is supported by initial evidence, they tend not to investigate any further. By not completing further work, the auditor may be overlooking a potential problem, resulting in an undetected misstatement.
An auditor's commitment to directional goals has several effects on the work performed by that auditor. When an individual is committed to a directional goal, they search for and overweight evidence supporting the desired conclusion. As well, they are more skeptical of information that is not consistent with their preference (Kadous et al., 2003). Wright and Wright (1997) note that an auditor may waive current period misstatements that are detrimental to a client's position in order to maintain a relationship with that client. This indicates that the auditor's directional goal may be to continue its professional relationship with that particular client. Furthermore, there was a significant positive correlation between client size (a proxy for audit fees) and the likelihood of a waived adjustment (Wright & Wright, 1997). An additional study examined the proportion of adjustments forced by an auditor when holding materiality constant. It was found that auditors were less likely to waive misstatements for smaller clients, based on annual net sales (Nelson, Elliott & Tarpley, 2002). These findings further support the relationship between client size and the likelihood of auditor's waiving misstatements.
The level of auditor experience may also contribute to the strength of professional skepticism maintained throughout an engagement. Shaub and Lawrence (2002) established that experienced auditors maintain the lowest level of professional skepticism, while auditors with the least experience were the most aggressive skeptics. In addition, Kaplan, Moeckel and Williams (1992) note that non-error events are considered more likely causes for unexpected variations when performing analytical procedures when such procedures are completed by more experienced auditors. Koonce, Walker and Wright (1993) draw on these findings to conclude that experienced auditors may rely too heavily on a non-error event as a cause of variation, rather than maintaining an appropriate level of skepticism. On the contrary, the increased client and industry experience of these auditors likely better allows them to understand the greater probability of non-error events as compared to true financial statement errors.
A healthy level of professional skepticism is a critical requisite for auditors in the current economic environment. A lack of skepticism combined with the use of related party transactions played a significant role in the downfall of both Enron and Arthur Andersen. Numerous studies have demonstrated that an auditor is more likely to support low quality accounting methods, waive material misstatements, and not complete sufficient audit work as a result of strong directional goals. These types of goals result in auditors supporting client-preferred accounting methods and may result in detected and undetected errors in the financial statements. However, an important part of the audit process is ensuring the continued working relationship between the audit firm and the client. As a result, it may be quite difficult to determine at what point directional goals are a detriment to professional skepticism.
If auditors are able to find a balance between their directional goals and the requirement to maintain a healthy level of professional skepticism, related party transactions would be easier to identify, measure and audit. Auditors would seek out evidence to support a particular transaction, without overweighting the evidence that supports management's statements. As well, sufficient audit evidence would be collected to corroborate management assertions. High quality accounting methods would be applied in a fashion that best benefits financial statement users. Material misstatements would be addressed in an appropriate manner, regardless of client size and the related audit fees earned by the audit firm. Finally, experienced auditors would ensure that unexpected variations are truly non-errors and not financial statement errors by substantiating these discrepancies. If a healthy level of skepticism is maintained, the likelihood of related party transactions not being disclosed or accurately measured is greatly reduced.
Conclusion
Difficulties in identifying, measuring and auditing related party transactions have come to the forefront of accounting discussion in recent years. Although these transactions occur on a frequent basis, misstatements due to error or fraud may occur when management is either unaware of related parties or concealing certain transactions from auditors. Full disclosure of these transactions is important to financial statement users, as they affect users' assessment of a company's operations. Unfortunately, related party transactions are not easily identified without the assistance of management, who may have incentives to not disclose particular transactions. While Canadian accounting and assurance standards are moving towards increased related party disclosures and greater auditor focus on such transactions, this does not entirely eliminate the likelihood that material related party transactions will not be identified. As such, this research paper outlines three important factors that act to minimize detection risk for related party relationships and transactions.
Given that a greater number of independent directors on a company's audit committee lowers the probability of financial statement fraud, and related party transactions are a common reason for audit failure, it is likely true that independent directors will reduce the risk of related party transactions not being identified by management. However, transactions with formerly independent directors render them grey- neither inside nor independent directors. There are conflicting studies regarding the effectiveness of grey directors of a company, with evidence as to whether they should still be considered independent from management. The economic incentives of grey directors with share of debt holdings with the company may cause them to highly effective monitors, as they will seek to maximize their investment. This is again contrasted by non-management principal owners whose conflict of interests may result in poor monitoring. As a result, it appears that only truly independent directors, or grey directors with minority interests in the company may serve as effective monitors and lower the risk of fraud through related party transactions.
North American securities commissions have varying requirements regarding financially literate directors, but all require at least one financially literate member on the board of directors and audit committee. Given the stringent qualifications to be considered financially literate, it is likely that those directors will have professional affiliations to finance, treasury or accounting organizations. Several studies have found that a professional's affiliations influence their pressure on management engage in higher quality reporting. As well, professionals seek in maintain or enhance their professional reputations by ensuring that the company has comprehensive disclosures in accordance with standards or best practices. This has the potential to increase board of director pressure on management to identify and disclose all significant related party transactions.
Finally, a healthy level of auditor professional skepticism will result in higher quality accounting methods and reduce the likelihood of unidentified related party transactions. A lack of professional skepticism, combined with the use of related party transactions, lead to the downfall of both Enron and Arthur Andersen. An auditor's skepticism is affected by several factors, including commitment to directional goals, size of the client and level of audit experience. When commitment to a directional goal is too strong, the auditor is not able to conduct an unbiased review of accounting methods or conclude on an assertion. As well, it has been shown that auditors will waive a greater proportion of uncorrected misstatement for larger clients in an attempt to maintain that relationship. Experienced auditors may also overlook potential misstatements, instead attributing variations to non-error causes. It appears that auditors with an appropriate amount of professional skepticism, combined with moderate commitment to directional goals, will best be able to identify, measure and audit related party transactions. While the risk of material unidentified, inaccurately measured or inappropriately disclosed related party transactions cannot be completely eradicated, strong corporate governance policies and a healthy level of auditor professional skepticism will serve to reduce this risk to an acceptable level.
