What Does an Auditor Do?
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How to Check for Conflict of Interest with New Auditing Clients

As an auditor, to make sure you don’t have any conflict-of-interest problems, you have to look at any third-party transactions your potential client may have been part of. If your potential client has material interests in other clients your firm represents, you have to walk away from the engagement. Usually, however, related-party transactions aren’t cause to turn down an engagement — you just need to make sure they’re properly accounted for and disclosed in the financial statements.

Most business transactions you encounter during an audit are arm’s-length transactions. A true arm’s-length transaction is when the parties are independent of each other, without some sort of special relationship, like being family members. This situation is like getting a magazine subscription: You don’t know the publishers, and they don’t know you. The price of the subscription is the same for you and the accountant in the office down the street.

However, it’s entirely possible to have a transaction between related parties that is handled as if it were at arm’s-length. For example, someone you don’t know offers you $3,000 for your used car and you sell it to your brother for the same amount. The transaction takes place between related parties but for a price that an unrelated party was willing to pay.

But when parties to any client transactions are related, the objectivity usually inherent in unrelated, third-party purchases or sales may be lost. Your job as an auditor is to make sure you adequately disclose client related-party transactions and consider any fraud that may be associated with them.

To accomplish these two objectives, you have to know what a related party is and what types of transactions can occur between related parties. Here are some examples of related parties:

  • Affiliates: Here’s an example of affiliates in action: Corporation Alpha owns all of Corporation Beta’s stock. Alpha and Beta are affiliates. Alpha directly controls Beta. 

    Now, if Corporation Beta owns all the stock in Corporation Chi, Corporation Beta and Chi are affiliates. Further, Alpha and Chi are also affiliates (albeit indirectly) because Alpha owns Chi through an intermediary — Beta.

  • Ownership interests accounted for using the equity method: Companies use the equity method if they own between 20 and 50 percent of the stock of another business.

  • Principal owners: A principal owner controls more than 10 percent of the voting stock of a company.

  • Management: This category includes members of the board of directors, officers of the corporation, or other people who have significant influence over the decisions the company makes.

  • Immediate family members of principal owners or management: A spouse, parent, child, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, and sister-in-law fall into this category.

  • Voting stockholder: This term refers to two types of stockholders. Common stockholders are the ultimate owners of a corporation and have voting privileges. For example, common stockholders of record vote to elect a corporation’s board of directors.

Now that you know who related parties are, here are some examples of accounting events that could signal a related-party transaction. Should you notice any of these types of transactions, it’s time to go back to the client to query the circumstance surrounding the events.

  • Loans made with no paperwork stipulating the loan amount, interest rate, and loan term.

  • Loans in which the interest rate is less than the market rate.

  • Sales of real estate for less than the appraised value. The related party may be using this tactic to create a recognized loss on the sale that isn’t actually realized.

  • Bargain purchases on supplies and inventory. Also, on the flip side, paying too much for goods or services. Both instances serve to artificially inflate the net income of one of the parties and decrease the net income of the other.

  • Unusual revenue transactions at or near the end of the reporting period. Look to see whether the sale has economic substance or is a fictitious sale to a related party in order to artificially inflate year-end revenue.

Businesses with common ownership often swap goods and services. Also, a company whose manufacturing facility isn’t running at 100-percent capacity may volunteer to do manufacturing work for related parties. But even if the related-party transactions are conducted at arm’s length, you still must address them.

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