 Hello and welcome to the session. This is Professor Farhad in which we will discuss the auditing of related party transactions. But first we have to understand what are related party transaction. Now, we do learn about related party transaction and for when we discuss disclosure, we have to disclose certain information about related party transactions. And this is another example why you should take FAR before you take audit because you have to know certain things in FAR that you are going to be auditing in audit. And this is what we'll do today. But first I will discuss what are related party transaction. Then we will discuss the auditing responsibilities. What do we need to do as auditors when it comes to related party transaction? So when do related party transaction occur? Usually they occur when companies conduct business transaction in which one party, one company can significantly influence the policies and the decision of the other companies. Simply put, you are buying or selling, you are conducting some sort of a transaction where one party have the power to twist the hand to influence the other party. Now, this happens on a daily basis. A lot of companies are interrelated. Basically, one company owns 40, 50, 60% of another company, maybe one company, the CEO is on the board of directors of another company, so on and so forth. So that's normal. But we have to be aware of those, know what they are, know what is the significance of it and what do we need to do as auditors. So simply put, we use the term arm length transaction. When we buy and sell, we assume it's an arm length transaction. Simply put, the parties are not related. In other words, the transaction is based on fair value. It means what you're paying me is a fair price, what I'm selling you is a fair value for that price. And this is an important concept with what tax, which is also you will cover in tax. So notice related party transaction is covered in FAR, covered in tax, which is in regulation and covered in audit. So notice it's a very important topic in the real world. If the transaction is not arm length transaction, if the transaction is not based on fair value, you already violated the historical cost principle. If you're buying something and you're not buying it for its true cost, that's it. You record it at some cost that's not reflecting the historical cost principle. So competitive market for a related party transaction don't exist. Okay. So again, they violate the historical cost. Some examples of related party transaction is borrowing and lending at below interest rate, at below interest rate, ongoing interest rate. So I want to borrow money. I will borrow money from you. Usually I should pay 10%. You will charge me 6%. Well, that's not an arm length transaction. I want to buy something from you. Well, we appraise it and it's a different appraisal than the real value. And a case in point for different appraisal is a company called Enron, used to exist not anymore. What Enron used to do, Enron used to buy investments. So they will buy an investment. And some of these investments were not good investments. And what they would do, so they buy an investment for 3 million, now they are stuck with this investment and the value of this investment really dropped. But that investment is not publicly traded. So it's maybe they bought a private company. So how would they show that they did not really made a bad investment? They will create a shell company, another company called Special Purpose Entity, not the company is called Special Purpose Entity. The company's legal structure is SPE Special Purpose Entity. Then what they would do, they will sell this investment to this company for 5 million. And they would say, wow, that investment, now we made a profit of 2 million. Now you might be asking, okay, how did this SPE got the 5 million? That's another story. The SPE will go to the bank, let's assume Bank of America, which they did go to Bank of America, and they will borrow money for 5 million. Well, hold on a second. If this SPE is a new company, how would they borrow money for 5 million? Well, Enron would guarantee the loan of this, for this SPE. Enron would say, don't worry, lend them the money. We are guaranteeing the loan. And the bank would say, oh, okay, Enron is a large company, you have enough assets, you have a good credit, we can lend you the money. But what they would do, after Enron lend the money, Enron, what they would do, they will disconnect from this company. So it would appear as this company is independent, therefore, they don't have to show that this company is part of Enron. And this is how they sold the investment, made the profit of 2 million and added 5 million of cash, which is supposed to be debt. Again, I'm just giving you fictitious numbers. It's much more complicated. I talk about this in my advanced accounting, but that's the point of related party transaction. That's the risk. Sometime it could be manifested in exchange of non-monetary assets, you're exchanging 2 assets, a truck for another truck, and it's not really related, the transaction is not arm length. It could be transaction with shell corporation, corporation that exists only on papers or exists on papers or they are offshore. It means offshore means it doesn't mean offshore. It means not in the places where there's a tax haven, where you might be able to book the transaction and no one knows who are the true owners of the company. And this is what we are risking with related party transaction. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So what are the auditor responsibilities when it comes to related party transaction? Here's what we have to do. We have to identify any related party transaction, assess the risk involved and respond to that risk, just basically what we do with everything. Identify if there's any risk, assess it and design procedures to fight to overcome that risk. Determine if fraud risk factor exists in this transaction. Now, bear in mind related party transaction occur on a regular basis because a lot of companies are interrelated. For example, somewhat if you're manufacturing a product, you want to have a good relationship with your supplier. You might invest in your supplier to guarantee that flow of goods, flow of supply. So related party transaction always exists. You won't see if there's any fraud risk factors involved. Then you design procedures to respond to those risks. Now, the first thing you want to know is how to identify related party transactions and the answer is very simple. How do I identify them? I ask, simply you ask the company and literally there's a list of procedures and any auditing program. There's a bunch of questions, a list of questionnaires and those are standards in any audit program. You just simply ask them, do you have any related party transaction? If the answer is yes, OK, give us the names, give us their background information in which industry they operate. You'll ask the questions in more than one way, but one of them is there any related party transaction? For example, if it's an important figure, is the spouse of your CEO or CFO work for another competitor or work for a supplier? List of questions basically to cover your basis to generate answers from the company because that's your first source. And management should know if there's any related party transaction because they are the company themselves, they are involved in the process. Well, if it's a publicly traded company, you would breed their SEC filing, look for names and try to connect those names to other companies, maybe. Obviously, you want to read the prior year audit documentation. See what did we find in the prior year? If you were not that company, look at what the other company did. Review any public record available, any news, do a search. If you suspect anything, do a Google search, start with the Google search and you have no idea how powerful Google is sometimes in connecting people. Sometimes through LinkedIn, you can connect people that you don't know that they are connected somehow. And I know this is funny, but it is true for private companies review articles of incorporation. They might have the names of the people who incorporated the company and any private information listing. Sometimes they are privately listed on some on some exchange, see if they can get any information. Obviously, you want to review the board of directors minute. Those are in charge with governance, usually large transaction, important transaction goes through them. So review, see if there's any transaction that's going to raise red flag or it might indicate a related party transaction. Review any large, complex and usual transaction, especially at the end of the period. Because this is where the company get desperate to meet their numbers, to meet their earnings per share, to meet the Wall Street estimate. So they will try to book transactions at the end of the period. Also loan agreement might give you some additional information. Let's assume there's somebody guaranteeing their loan. There's a co-guarantor. Who's that co-guarantor, right? Well, if that co-guarantor is just doing doing them a favor. Why are they related somehow? Tell me how you identify your related party. If the interest rate is favorable, why is the why are they given them lower than the market ongoing interest rate giving the risk? Again, it might trigger some red flags that might be following. So what are the procedures now you identified and what do you need to do? Well, the first thing you have to ask yourself. Well, the first thing is, is this a valid purposeful business transaction? If the answer is yes, well, a lot of risk factors are removed because they undertake this transaction for business purpose. Because the risk is they're undertaking this transaction to create paperwork. Paperwork means paper gain or paper loss. If it's a valid business transaction, you should breathe. They said, that's great. No, there's a valid business transaction. It doesn't mean you are done. You have to review the documents, the closing paper. Are we using fair value measurement? Are they exchanging those transactions based on fair value or is it favorable terms? If it's favorable terms, we need to know why and how important, how big, how material those favorable terms is. What's the transaction authorized? How about if the person in charge of the company, top officers or a CEO or a CFO, their transaction, they are conducting transaction with their spouses or relatives or boyfriend or girlfriend. Well, we need to know about this. Was it authorized? They may, well, if it's, if they don't want you to know about it, it may not be authorized. If they don't want the company to know about it, was it authorized? That tells you something. What else do you need to do as part of your audit procedures? Communicate with those, with those charged with governance, basically the board of directors. Any significant related party transaction. Again, there's going to be a lot, you want to communicate the significant ones, especially fraud or you suspect any, you know, conspiracy or fraud ongoing. And of course, you want to document the process. What do you document? Well, you document the names, the nature of the relationship, the transaction information. And this is needed for disclosure purposes. And I will show you a disclosure on the next slide for a real company, how you would disclose related party transaction. And related party transactions are so important, they might affect your opinion. If related party transactions are not substantiated, simply put, they don't make any sense. They're inflating the figures. Well, guess what? I'm not comfortable issuing an unqualified opinion, especially if there's a large portion of your sales or revenue or large portion of your assets. Under those circumstances, you might qualify, depending on how big it is or give an adverse opinion, because of that, if the issue is so severe. Again, related, not again, related party transaction is a gap issue, not gas. So there's some problem with your accounting. Your historical principles are incorrect. Your revenue is incorrect. We have problem with valuation with figures, not what gas, not what evidence gas, GAAS issue. Now, this is an actual disclosure from a related party transaction. And this is basically from Tesla. And hopefully we know who the CEO of Tesla, Elon Musk in November 2018. Our CEO purchased from us 284,000 shares, 575 in private placement at a per share price equal to the last closing price of our stock prior to the execution of the purpose of an agreement for an aggregate amount of 20 million. So just telling you that the CEO purchased stocks of the company. This is a related party transaction. In May, the CEO purchased again, almost half a million shares for 25 million. In February, our CEO and a member of board of directors purchased from us. Again, more shares from the company. Again, they discussed those related party transaction. What should you do now? This, this concept is important. Go to Farhat lectures and answer MCQs. I have MCQs that are CPA and previously released AI CPA questions. Answer those questions. Make sure you understand this concept. Again, this concept is covered in FAR, audit and reg. It's covered in the real world as well, related party transaction. Be on the lookout for those as a future CPA. Good luck, study hard and of course, stay safe.