Accounting and Audit briefs
Auditing related-party transactions
Business owners generally prefer to work with entities they know and trust. But related-party transactions can provide opportunities for individuals to act in a manner that’s inconsistent with the interests of shareholders. That’s why auditors take pains to identify and properly address related-party transactions.
What is a related party?
Accounting Standards Codification (ASC) Topic 850 defines a related-party transaction as one that takes place between:
•A parent entity and its subsidiaries,
•Subsidiaries of a common parent,
•An entity and trusts for the benefit of its employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the entity’s management,
•An entity and its principal owners and managers (or members of their immediate families), and
What’s the risk?
Related-party transactions sometimes involve contracts for goods or services that are priced at less (or more) favorable terms than those in similar arm’s length transactions between unrelated third parties. For example, a spinoff business might lease office space from its parent company at below-market rates. Or a closely held manufacturer might pay the owner’s son an above-market salary and various perks that aren’t available to unrelated employees.
How do auditors address these transactions?
Given the potential for double dealing with related parties, auditors spend significant time hunting for undisclosed related-party transactions. Examples of documents and data sources that can help uncover these transactions are:
•A list of the company’s current related parties and associated transactions,
•Minutes from board of directors’ meetings, particularly when the board discusses significant business transactions,
•Disclosures from board members and senior executives regarding their ownership of other entities, participation on additional boards and previous employment history,
•Bank statements, especially transactions involving intercompany wires, automated clearing house (ACH) transfers, and check payments, and
•Press releases announcing significant business transactions with related parties.
Audit procedures that target related-party transactions include 1) testing how related-party transactions are identified and coded in the company’s enterprise resource planning (ERP) system, 2) interviewing accounting personnel responsible for reporting related-party transactions in the company’s financial statements, and 3) analyzing presentation of related-party transactions in financial statements.
Accurate, complete reporting of these transactions requires robust internal controls. A company’s vendor approval process should provide guidelines to help accounting personnel determine whether a supplier qualifies as a related party and mark it accordingly in the ERP system. Without the right mechanisms in place, a company may inadvertently omit a disclosure about a related-party transaction.
Get it right
Undisclosed related-party transactions can raise a red flag to lenders and investors — and may even require a business to restate its financial results. Our auditors are committed to finding, disclosing and reporting these transactions in a transparent manner that complies with U.S. Generally Accepted Accounting Principles (GAAP). Contact us for help.
Don’t let collaborative arrangements cause financial reporting headaches
Businesses often enter into so-called “collaborative arrangements” when they partner with another entity on a major project. Unfortunately, the current guidance for these types of arrangements under U.S. Generally Accepted Accounting Principles (GAAP) is somewhat vague.
Here are some questions that may arise as participants report shared costs and revenue on their income statements, along with details about a recent proposal that would clarify how to report collaborative arrangements.
What is a collaborative arrangement?
Accounting Standards Codification (ASC) Topic 808, Collaborative Arrangements, provides guidance for income statement presentation, classification and disclosures related to collaborative arrangements. It lists three requirements for collaborative arrangements:
- They must involve at least two parties (or participants).
- The parties involved must all be active participants in the activity.
- All participants must be exposed to significant risks and rewards dependent on the commercial success of the activity.
Collaborative arrangements are a particularly common type of joint venture for film production and life science companies. For example, two pharmaceutical companies might agree to share research and development expenses to produce a new drug. Then, if the drug succeeds, the companies also would share the revenue from sales of the drug.
What qualifies as revenue?
Today’s guidance on collaborative agreements has led to inconsistent accounting practices. Why? Topic 808 doesn’t include guidance for determining what the appropriate unit of accounting is or when recognition criteria are met. Rather, it says to look to other areas of GAAP to account for a transaction. If there’s no formal guidance available, businesses typically apply an accounting policy or another accounting method by analogy. As a result, companies may label items as “revenue” when they belong elsewhere on the income statement.
To further complicate matters, the landmark revenue recognition standard goes into effect in 2018 for public companies and in 2019 for private ones. Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), limits application of the revenue standard to arrangements that involve a customer as one of the parties to a contract.
In April, the Financial Accounting Standards Board (FASB) proposed an update to clarify the scope of its standards for revenue and collaborative arrangements. If finalized, the proposal will help partners in a collaborative arrangement determine when a transaction should be treated as revenue. Public comments on the proposed changes are due in June.
Got more questions?
We’re atop the latest developments on reporting collaborative arrangements. Contact us with questions about the interaction of the standards for collaborative arrangements and revenue recognition. We can help you concurrently implement the latest rules and minimize the risk of restatement.