On this page (4)
Why this topic matters
Related party transactions and going concern are two areas where management may have strong incentives to mislead. Auditing and Attestation (AUD) tests the procedures to identify related parties, the auditor's going concern evaluation, and how each affects the auditor's report. The accounting side is covered in Financial Accounting and Reporting (FAR).
Related parties
Why they are risky
Related party transactions may not be conducted at arm's length, can be used to hide fraud (for example, fictitious sales to an entity the owner controls), and may be complex or undisclosed. Significant related party transactions outside the normal course of business are treated as significant risks.
Risk assessment procedures
- Inquire of management about the identity of related parties, the nature of relationships, and transactions during the period, and about controls to identify, authorize, and account for them.
- Remain alert, when inspecting records, for arrangements that may indicate undisclosed related parties.
- Share related party information with the engagement team.
Where undisclosed related parties turn up
- Minutes of board and committee meetings.
- Conflict-of-interest statements from officers and directors.
- Proxy statements and regulatory filings; shareholder registers (principal owners).
- Large, unusual, or year-end transactions; loans at no or unusual interest; guarantees; sales with unusual terms.
- Bank and legal confirmations (guarantees, compensating balances); invoices from law firms.
- Prior-year audit documentation and income tax returns.
Responding
- For significant transactions outside the normal course: inspect the underlying contracts, evaluate the business rationale, and check authorization and approval.
- If previously undisclosed related parties are found: communicate to the engagement team, ask management to identify all transactions with them, reassess risk, and consider implications for fraud and management's representations.
- If management asserts that transactions were at arm's-length terms, obtain evidence supporting the assertion. An unsupported assertion that management refuses to change is a departure from the framework — qualified or adverse opinion.
- Obtain written representations that all related parties and transactions have been disclosed.
- Communicate significant related party matters to those charged with governance.
Going concern
The auditor's responsibility
The clarified auditing standards (AU-C) cover going concern in AU-C 570. Under Statement on Auditing Standards (SAS) No. 132, the auditor obtains sufficient appropriate evidence about, and concludes on, the appropriateness of management's use of the going concern basis and whether substantial doubt exists about the entity's ability to continue for a reasonable period — for US Generally Accepted Accounting Principles (GAAP), one year after the date the financial statements are issued (or available to be issued). The auditor is not responsible for predicting future events, and the absence of a going concern reference is not a guarantee.
Conditions and events that may raise doubt
| Category | Examples |
|---|---|
| Negative trends | Recurring operating losses, working capital deficiencies, negative operating cash flows, adverse key ratios |
| Financial difficulties | Default on loans, arrears in dividends, denial of trade credit, need to restructure debt, disposal of substantial assets |
| Internal matters | Work stoppages, dependence on one project, need to significantly revise operations |
| External matters | Legal proceedings or legislation that could jeopardize operations, loss of a key franchise, license, patent, customer, or supplier, uninsured catastrophe |
Procedures that may reveal them — analytical procedures, reviewing subsequent events, reading debt agreements and minutes, legal inquiries, confirming financial support arrangements — are performed during the normal audit; no special procedures are required unless conditions exist.
Evaluating management's plans
If substantial doubt is raised, evaluate management's plans (disposing of assets, borrowing or restructuring debt, reducing expenditures, increasing equity): whether it is probable they will be effectively implemented and whether they will mitigate the conditions. Obtain evidence — for example, a signed loan commitment, or, if support comes from an owner or third party, evidence of that party's intent and ability. Analyze prospective financial information and its significant assumptions. Obtain written representations about the plans.
Reporting outcomes
| Conclusion | Report |
|---|---|
| No substantial doubt | No going concern reference |
| Substantial doubt alleviated by management's plans; adequate disclosure | Unmodified opinion; no separate section required (the auditor may add an emphasis-of-matter paragraph) |
| Substantial doubt remains; adequate disclosure | Unmodified opinion with a separate section titled "Substantial Doubt About the Entity's Ability to Continue as a Going Concern"; conditional language ("if it continues") may not be used |
| Substantial doubt remains; inadequate disclosure | Qualified or adverse opinion (departure from the framework) |
| Going concern basis inappropriate (liquidation imminent) | Adverse opinion — unless the statements are prepared on the liquidation basis, which may then receive an unmodified opinion with an emphasis-of-matter paragraph |
| Management unwilling to make or extend its evaluation | Consider the implications for the report (possible scope limitation) |
If the doubt was reported last year but has been resolved this year, the going concern section is not repeated in the report on the prior-year statements when they are reissued. Significant delays in approving statements can be an additional indicator.
Communication
Communicate with those charged with governance about conditions or events identified, whether they constitute substantial doubt, management's use of the going concern basis, and the adequacy of disclosures.
How it is tested
- Identify procedures that uncover undisclosed related parties.
- Recognize conditions indicating substantial doubt.
- Choose the correct report for each going concern outcome.
- Evaluate management's plans and third-party support.
EXAM TIP: Substantial doubt with adequate disclosure never causes a modified opinion — it adds a separate going concern section to an unmodified opinion. Only inadequate disclosure (qualified or adverse) or an inappropriate basis (adverse) changes the opinion itself.