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    Auditing Related Party Transactions: A Literature Overview...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 13.0 Governance 
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    Title:
    Auditing Related Party Transactions: A Literature Overview and Research Synthesis.
    Practical Implications:

    In this paper, the authors link academic research and other pertinent literature to issues raised in the PCAOB briefing paper on auditing related party transactions. Overall, the authors believe that the findings in academic research and the significance of related party transactions in recent prominent fraud cases are consistent with the PCAOB’s reconsideration of auditing of related party transactions.

    Citation:

    Gordon, E. A., E. Henry, T. J. Louwers, and B. J. Reed. 2007. Auditing Related Party Transactions: A Literature Overview and Research Synthesis. Accounting Horizons 21 (1): 81-102.

    Keywords:
    related party transactions, arm’s length transactions, corporate governance, financial disclosure
    Purpose of the Study:

    Related party transactions are difficult to audit for a number of reasons.  

    • Related parties and transactions warranting examination may be difficult to identify.
    • Auditors must rely on management to provide detailed information on related parties and related party transactions.
    • Despite the increased internal control requirements imposed by the Sarbanes-Oxley Act of 2002, internal controls have difficulty tracking related party transactions. This difficulty arises because of the wide variety of parties and types of transactions and because some transactions may not be given accounting recognition, e.g., receipt of free services from a related party.

    The authors examine research relevant to auditing related party transactions to contribute to the PCAOB project on this topic and to provide other policy makers, auditors, and academics with an overview of relevant literature. Specifically, they report on the challenges associated with the identification, examination, and disclosure of related party transactions. Additionally, they address issues and research evidence related to nondisclosure and reliance on management assertions, risk assessment, materiality, fraud detection, the effect of related party transactions on corporate governance, and international auditing issues.

    Design/Method/ Approach:

    To prepare PCAOB Standing Advisory Group (SAG) members for discussion of these issues, the PCAOB staff prepared a briefing paper posing 13 broad questions for consideration by the SAG. The authors contribute to the PCAOB project by reviewing pertinent literature and providing appropriate insights from academic research relevant to auditing related party transactions. They highlight instances where existing research addresses the questions raised in the briefing paper. 

    Findings:

    The primary conclusions from the literature review are:

    • The definition of related parties varies across regulatory bodies.
    • Related party transaction disclosures are present in the Securities and Exchange Commission (SEC) filings of most publicly held companies.
    • While listed as a fraud risk factor in authoritative literature, related party transactions do not appear to be more common in companies committing fraud than in companies in which no fraud has been detected. Accordingly, but in opposition to authoritative guidance, survey research indicates that the presence of related party transactions alone does not appear to significantly increase external auditors’ client risk assessments.
    • Although related party transactions in isolation may not be a significant indicator of fraud, when fraud does exist, the presence of related party transactions is one of the top reasons cited for audit failures. The willingness of auditors to tolerate greater misstatement in footnotes may help partially explain this apparent contradiction.
    • Related party transactions should be assessed in the context of the company’s overall governance structure, particularly given the importance of managements’ assertions about the existence and nature of these transactions.
    • Related party transactions often impact the corporate governance of the company by creating gray directors, i.e., directors who are neither insiders nor totally independent of the company. Whether gray directors differentially impact a board’s monitoring effectiveness may depend on the specific board committee (audit, compensation) or may depend on the specific type of gray director.
    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment