Related party transactions can be a means to fraudulent financial reporting. Yet, auditors often don't detect the financial statement manipulation, leading to audit failure. This article explains how to understand and find fraudulent related party transactions.
Related Party Transaction
What is a related-party transaction?
It’s a transaction between two parties that have a close association. For example, two commonly owned businesses sell services or goods to one another. In another example, a business buys property from a board member or from the owner.
Normal Related Party Transactions
Related party transactions are typical and often expected. For example, a business might rent real estate from a commonly owned entity. In such an arrangement, the rental rate can be at fair value. So if a company pays for twelve months' rent at a standard rate, everything is fine. No manipulation is occurring.
Reason for Related Party Fraud
But in some cases, companies use related party transactions to deceive financial statement readers. Why? Because the business is not performing as well as desired, or maybe the company is not in compliance with debt covenants. (Noncompliance can trigger a call for repayment, or the loan can become a current liability based on accounting standards.)
Fraudulent Increase in Net Income
Imagine this scene. It's December 15th, and management is reviewing its annual financial results. The CEO and CFO receive substantial bonuses if the company's net profit is over $10 million. At present, it looks as if the business is just short, with an expected net income of $9.7 million. They need another $300,000.
So they develop a related party transaction whereby a commonly owned company pays their business $350,000 for bogus reasons--what auditors call a transaction outside the normal course of business. Since the CEO and CFO also manage the related entity, they control the accounting for both entities.
Management performs the trick on December 27th, and soon they are toasting drinks in the back room. The bonus enables the CEO to buy his wife a new Tesla and the CFO to take a one-month trip to Europe. And it was so easy.
In considering related party transactions, know that they are more likely with smaller entities, especially when one person owns several entities. So you'll want to know if associated businesses are making payments or loans to commonly owned companies.
Related Party Audit Procedures
As you begin your audit, request a list of all related-party transactions. Also, pay attention to such activity in the company's minutes. Additionally, electronically search company receipts, payments, and journal entry descriptions using the related party names. Then investigate any abnormal transactions outside the normal course of business, especially if they involve round-dollar amounts (e.g., $350,000).
In performing your fraud inquires, ask about related party transactions and if any unusual transactions occurred during the year (or after the year-end). And make sure you interview persons responsible for initiating, approving, or recording transactions. In other words, inquire of the CEO and CFO, but also ask questions of others such as the cash receipts or the accounts payable supervisor. The CEO and CFO might hide the bogus transaction, but, hopefully, the cash receipts supervisor will not.
As you can tell in the above example, you want to be aware of incentives for fraud, such as bonuses or the need to comply with debt covenants.
Does It Make Sense?
If you see an unusual transaction, request supporting information to determine its legitimacy. I once saw a $5 million transaction at year-end, and when I asked for support, the journal entry said, "for prior services provided." You might receive some mumbo jumbo explanation for such a payment. But know this: vague reasons usually imply fraudulent activity.
So, see if the economics make sense. Would a company pay that much for the services or products received? If not, you may need to propose an audit entry to correct the misstatement.
Representation Letter
And, by the way, having the client sign a management representation letter saying the transaction is legitimate does not absolve the auditor. Either the payment is economically supportable, or it is not.
Fraudulent Decrease in Net Income
Strangely, some companies desire to deflate their earnings. For example, maybe the company has had an unusually good year and wants to defer some net income for the future. So it is possible that related party payments are made to decrease earnings, and then the company might receive the same amount in the future from the related entity. The result: expenses in the current year and revenue in the subsequent year. Again, we as auditors need to understand the goals and incentives of the company to understand how and why fraud might occur.
Related Party Disclosures
Even if related party transactions are legitimate, businesses are required to disclose them. The related party disclosure should include the reason the other entity is a related party and the amount of the transactions.
Financial Statement Fraud
The easiest way to fraudulently report financial activity--at least in my opinion--is to post deceptive journal entries. Those can be created without the use of related parties. For example, an entity might fraudulently debit receivables and credit revenue for $350,000. No revenue is earned but the entry is made anyway.
The second easiest way—explained in this article—is fraudulent related party transactions.
Either method can magically create millions in fraudulent revenue. So be on guard as you consider the possibility of transactions outside the normal course of business.
Make sure you:
- Obtain a list of related parties
- Review minutes for related party activity
- Search records electronically for related party names
- Inquire of management and others about related party activity
See AU-C 550 Related Parties for AICPA guidance.