The benefit that related-party transactions can offer is contracting efficiency. Related parties can help the businesses to overcome the disincentives or delays that often occur in negotiating contracts with third parties, perhaps with related transactions it could boost up the business operations especially those in the business of providing a variety of services. For instance, Hong Kong’s Yue Yuen Industrial (Holdings) Limited, maker of footwear and apparel for Nike and other brands contracted with Taiwan-listed Pou Chen Corporation also unlisted Golden Brands Developments Limited whom both controlled by the Tsai family. Their substantial shareholders are for raw material supplies and services ranging from leather tanning to provision of accommodations for their workers. These transactions are conducted under normal commercial terms, independently audited, and appropriately disclosed to or approved by minority shareholders; thus, they can be a superior option to the uncertainty that comes with dealing with unfamiliar third parties who may not follow the stringent workplace standards of Yue Yuen’s image-conscious clients.
Related Party Transactions (RPT) is a transactions incurred in business where the transactions is between reporting party and related party, as defined in MFRS 124 the related party consist of Investor, Key Management Personnel, Close Family Members, Joint Venture and Subsidiaries. (CFA, 2009) A related-party transaction takes place when a deal is entered into by at least two entities, where one has control over the other or where the parties come under the same control of another. The International Accounting Standards Board (IASB) defines it as a transfer of resources, services, or obligations between related parties regardless of whether a price is charged. The Financial Accounting Standards Board (FASB) defines it as a transaction between related parties even though it may not be given accounting recognition; for example, one entity may receive services from a second, related entity without charge and without recording a receipt of services. In RPT, it could be Capital Relationship, Personnel Relationship, Transaction Relationship and Status as Related Party. Second benefits of RPT, they will benefit in strategic feedback. Persons affiliated with the company may be able to provide relevant knowledge if they represent certain groups with whom the company does business. A company with a large number of suppliers, customers, and advisers may need to nominate individuals to the board who are aligned with these entities to ensure that the company has the expertise it needs to make reasoned decisions. A convenience store chain, for instance, may have a franchisee on its board of directors to make sure that it gets ready feedback on how its planned branding campaign would affect franchisees; a supplier, meanwhile, could provide insights on how logistical changes would alter the supply chain. Lastly, RPTs is very useful as the facilitation of investment. A distressed medium-sized company listed in the secondary board, for example, may find itself with limited access to bank credit lines; as such, it may resort to a loan from a wealthy officer or board member who has superior knowledge of its financial and operating prospects.
The role of transnational companies in the world economy has grown significantly in recent decades. This situation is due to globalization and partly reflects the trend of national economies integration and the technological progress. As a result of multinationals expansion, the intra-group commercial transactions have 60% significantly increased (UNCTAD, 2003). The related party transactions are very important for a company, as they have a lot of implications in various fields, such us: accounting reporting, auditing, tax compliance, strategic management, corporate governance etc. (Corlaciu & Tudor, 2011). Most RPT conducted in normal course of an entity’s business, but conceivably, some companies also act improperly or illegally through the medium of related parties. Due to this, the important of disclosure come out, because those act illegally also usually will disclose as a normal businesses transactions. The disclosure requirements of IAS 24 or MFRS 124 cannot prevent illegal actions or fraud. It sets out how related party relationships, transactions and balances should be identified and what disclosures should be made, and when. The related party transactions audit represents an important part of a financial statements audit. The detection of related parties and related party transactions as well are between the most important and difficult issues of a financial statements audit. (Corlaciu & Tudor, 2011) this part of an audit is fateful because of the following reasons, the demand under generally accepted accounting standards to present material related party transactions and particular control relationships, the possibility to distort or mislead the financial statements in the lack of appropriate disclosure, and the evidences of fraudulent financial reporting or misappropriation of assets which were encouraged, among others, by the existence of undisclosed related parties. The accounting world had been woke with several fraud cases relating to RPT that that led to a question of appropriateness and efficiency of the current standard. Enron, Adelphia, Tycoon where the international fraud history happened, not to mention, fraud related to RPT also had happened locally for instance, MISC Berhad, 1MDB the most controversial, and the closed case of auditor murdered during the investigation of billion loss of Bumiputera Finance Bank. ISA 550, the auditor has the responsibility to perform “audit procedures to identify, assess and respond to the risks of material misstatement arising from the entity’s failure to appropriately accounting for or disclose related party relationships, transactions or balances in accordance with the requirements of the financial reporting framework basis on which the reporting statements are performed” (ISA 550, par 3). The auditor has to achieve a proper understanding of an entity’s related party relationship and transactions in each auditing process, even in the cases when the applicable financial reporting framework requires minimal or no related party disclosures, as the auditor needs to be able to assess whether the financial statements are affected by those relationships and transactions (ISA 550 par 4).
According to AICPA (2001), the challenges of auditors face in auditing RPT are; identifying related parties, examining related-party transactions, and ensuring proper disclosure of the transactions. Few fraud cases had been categorized under difficulties of identifying related parties and related party transactions. International Teledata; where the auditors were informed regarding the shares that had been issued and the issuance also had been footnoted in the financial statement, however in the audit procedures regarding the issuance, they were unable to review any board minute meetings and failed to make inquiries to whom the issuance had been made. In their audit work, they also perform the procedures where they found the addition issuance had not been authorized and most of the issued shares “went to related parties in exchange for inadequate consideration”. Meanwhile, in the case of Pacific Waste, the auditors found there was no RPT incurred, but the SEC’s action noted there were RPT incurred. They found five documents related to the RPT which involving the president whom is also an officer, director and controlling shareholder of the investee-company which was used to perpetrate the financial statement fraud in the auditor’s file. In the case of Softpoint and Pantheon the auditor used the Softpoint’s fax machine and a fax number provided by the client for confirmations. Similarly, in the case of Pantheon, the auditor used the fax number provided by the client even though the SEC action notes the number differed from that shown in the banking directory located in the audit files. The inference is that had the auditors independently verified the fax numbers provided, they would have an identified fictitious sales to three companies owned by Softpoint’s president and chairman and identified the forged notes that had been purchased with private funding from Pantheon’s top executives, respectively. The last case which had been red flagged by SEC that indicated Tri-Comp Sensors had a RPT in term of loan. The loan was a large isolated transaction made immediately upon the closing of Sensors’ initial public offering and constituting almost a quarter of the net offering proceeds; no interest was paid on the loan; and there was no written agreement or record documenting the loan terms or purpose. The auditors knew the existence of loan but could not trace the loan made was related party transaction.
On the other hands, there are few fraud cases due to the failure of audit work in examining the related party transactions of businesses. In this case, it can be inferred as the auditors knew the existence, but no adequacy of examinations in the transactions. First case to be discussed is where identification of the related-party transactions was unavoidable, however, the auditor did not perform any audit procedures on the related-party transactions. In the case of Atratech, the top executive instructed the independent auditor to reciprocated the book entries for transactions between two subsidiaries from ‘related-party receivables’ to ‘accounts receivables’ with intention of concealing the relationship.” Meanwhile, in the case of Novaferon, the SEC noted that the company’s finances were not separable from the finances of four other entities which were under common control with Novaferon. The SEC’s action also noted the company maintained virtually with no normal business or accounting records susceptible of audit. The company’s books consisted primarily of a check register. In other cases like PNF Industries, the fraud case happened where the auditor performed testing of the related-party transaction, but the testing enable the auditors to get the accuracy and rigidity of the account. While the auditors of PNF Industries had identified and questioned payments to a related party, they were given falsified supporting records, including fabricated board meeting minutes. The records, however, contained numerous inconsistencies proving that they were fictitious, including references to information that was not known until months after the date on the records. The SEC action stated: “Because this was a material related-party transaction involving, a convicted offender, the auditors should have closely scrutinized the evidence supporting the individual’s expenses. Nevertheless, the auditor failed to review the evidence obtained and therefore failed to consider whether the minutes had been fabricated.
Lastly, the issue of proper disclosure of transactions which is challenging part faced by the auditor during the audit work.