Question

Barry Yellen, CPA, is a sole practitioner. The largest audit client in his office is Rooster Sportswear. Rooster is a privately owned company in Chicken Heights, Idaho, with a 12-person board of directors. Barry is in the process of auditing Rooster's financial statements for the year ended December 31, 2019. He just discovered a related-party transaction that has him worried. For one thing, the relationship has existed for the past two years, but Barry did not discover it. What's just as troubling is that the client hid it from him. Rooster bought out Hen Sportswear two years ago but still operates it as a separate entity, and since then has systematically failed to disclose to the private investors related-party transactions involving the CEO of Rooster, Frank Footer. It seems that Footer is borrowing money from Hen and is deeply in debt to the CEO of that company, who is his brother-in-law. Also, Hen has hired relatives of Footer, most of whom are unqualified for their jobs, and pays them an above-market salary. This has been hidden from Barry as well. Barry was informed by an anonymous tipster that Rooster operates a secret off-balance-sheet cash account to pay for cash bonuses to senior officers, travel and entertainment expenses, an apartment rental for Footer, and cash and noncash gifts to local government officials to "grease the wheels" when permits need to be expedited in favor of Rooster. Barry doesn't know what to make of it, because he is too focused right now on the related-party transactions with Hen Sportswear. Barry is in the process of questioning Hans Burger, CPA, who is the CFO of Rooster, about these transactions. Burger explains that he had raised these issues with Footer but was instructed in no uncertain terms to leave them alone. He did just that. Burger told Barry he needed this job and wouldn't jeopardize it out of a sense of "ethics." Barry is in his office back at the firm and reflecting on how best to handle this matter.

Questions

2. What are related-party transactions? Why are related-party transactions a particularly sensitive area? What do you think Barry should do with respect to audit obligations for these transactions?

Answer 1

As per IAS 24,

A related party is a person or entity that is related to the entity that is preparing its financial statements (referred to as the 'reporting entity') [IAS 24.9].

• (a) A person or a close member of that person's family is related to a reporting entity if that person:
  • (i) has control or joint control over the reporting entity;
  • (ii) has significant influence over the reporting entity; or
  • (iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.
• (b) An entity is related to a reporting entity if any of the following conditions applies:
  • (i) The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).
  • (ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).
  • (iii) Both entities are joint ventures of the same third party.
  • (iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.
  • (v) The entity is a post-employment defined benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
  • (vi) The entity is controlled or jointly controlled by a person identified in (a).
  • (vii) A person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).
  • (viii) The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity

Significance of Related Party transactions:

Related party relationships are a normal feature of business and commerce. Such relationships may have a significant effect on the transactions of the reporting entity. For example, related parties may enter into transactions with each other that would not be entered into between unrelated parties, and such transactions may be effected at different amounts from those that would prevail between unrelated parties. Related party relationships may also affect the transactions of the reporting entity with other unrelated parties. For example, a subsidiary might terminate relations with a trading partner following the acquisition by its parent of a fellow subsidiary engaged in the same trade as the former partner.

For the above reasons, related party relationships can have an effect on the profit or loss and financial position of the reporting entity. Therefore, disclosure of related party transactions, outstanding balances and relationships is important as it may affect assessments of an entity’s operations and the entity’s risks and opportunities by users of financial statements.

In the given question, it is a clear indication of fraud from the side of Footer and his company. The same was hidden from reporting or even disclosing it with the auditors since past two years. When we see the intensity and reach of all transactions, we can see that the things have gine out of control and the company is really in a bad situation with large amounts of debts. Rooster is using the company Hen to hide all its frauds by keeping the truth that Hen was acquired by them as well.

In such a situation, as an ethical auditor, Barry need to prepare a complete report all the frauds they have committed, the incomes and expenses not disclosed and the actual position of the company at the end of the year and not the overstated false statement which they had prepared untill now. Barry must check the related party transactions and measure the arms length price of all transactions and the actual amounts involved. Finally, when delivering the final audit report, the same need to be reflected in that and the report should be qualified stating all these reasons.