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Deficiencies in Auditing Related-Party Transactions: Insights from AAERs

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DOI: 10.2308/ciia.2008.2.2.A10

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Current Issues in Auditing American Accounting Association
Volume 2, Issue 2
2008
Pages A10–A16

Deficiencies in Auditing Related-Party

Transactions: Insights from AAERs
Timothy J. Louwers, Elaine Henry, Brad J. Reed, and Elizabeth A. Gordon

SUMMARY: After several high-profile frauds involving related-party transactions, regulators

have raised questions as to whether current auditing standards remain appropriate. In this
study, we examine 43 SEC enforcement actions against auditors related to the examination
of related-party transactions. We conclude that the audit failures in these fraud cases were
more the result of a lack of auditor professional skepticism and due professional care than
any deficiency in current auditing standards. In other words, revised auditing standards
would likely not have prevented these auditing failures, raising questions about the need
for auditing standard revision for related-party transactions at this time. Despite this finding,
we conclude with some suggestions to improve the auditing of related-party transactions,
such as including the discussion of related-party transaction abuse during SAS No. 99
mandated fraud awareness “brainstorming” sessions. 关DOI: 10.2308/ciia.2008.2.2.A10兴

INTRODUCTION
In the wake of several recent accounting frauds involving related-party transactions 共e.g.,
Adelphia, Enron, and Tyco兲, regulators have raised questions as to whether current auditing
standards remain appropriate. For example, the Chief Auditor of the Public Company Accounting
Oversight Board 共PCAOB兲 identified related-party transactions as an upcoming project for the
PCAOB 共PCAOB 2006兲. Given that related-party transactions are quite common1 and financial
statement frauds are quite rare,2 the incidence of frauds perpetrated with related-party transac-
tions is exceedingly rare.3 Henry et al. 共2007兲 examine 83 financial statement frauds that involved
related-party transactions and conclude that, while related-party transactions provide company
management with opportunities to commit fraud, their importance in a financial statement audit
should be considered in the context of management’s motivation and rationalization. The wide
variety of contexts in which related-party transactions occur suggests that, barring the presence of

Timothy J. Louwers is a Professor at James Madison University, Elaine Henry is an Assistant Professor at the University of
Miami, Brad J. Reed is an Associate Professor at Southern Illinois University Edwardsville, and Elizabeth A. Gordon is an
Associate Professor at Temple University.

1
Gordon et al. 共2004兲 report that 80 percent of 112 companies studied in a pre-Sarbanes-Oxley period 共2000–2001兲 disclosed at
least one related-party transaction; similarly, a business press article reports that, in a post-Sarbanes-Oxley period 共2002–2003兲,
75 percent of the 400 largest U.S. companies disclosed one or more related-party transactions 共Emshwiller 2003兲.
2
Lev 共2003, 40兲 reports there were only about 100 federal class action lawsuits alleging accounting improprieties annually 共study
period 1996 to 2001兲, compared to the universe of over 15,000 companies listed on U.S. exchanges, and notes that “Overall, the
direct, case-specific evidence on the extent of earnings manipulation from fraud litigation, earnings restatements and SEC
enforcement actions suggest that such occurrences are relatively few in normal years.”
3
Other evidence 共e.g., Shapiro 1984; Bonner et al. 1998; SEC 2003兲 suggests that most frauds do not involve related-party
transactions. For example, an SEC 共2003兲 study of enforcement actions involving reporting violations during the period July 31,
1997 to July 30, 2002 found that only 23 共10 percent兲 of 227 enforcement cases involved failure to disclose related-party
transactions.

Submitted: 1 March 2008

Accepted: 14 April 2008
Published: 27 August 2008
Louwers, Henry, Reed, and Gordon A11

other fraud risk factors, related-party transactions may not warrant excessive additional audit
attention. While Henry et al. 共2007兲 focus on corporate frauds involving related-party transactions,
our focus is on audit failures4 involving related-party transactions. Specifically, we examine 43
SEC Accounting and Auditing Enforcement Releases 共AAERs兲, occurring from 1983 to 2006,
which detail SEC actions against external auditors for audit failures related to the examination of
related-party transactions.
We used keyword searches of AAERs on Lexis-Nexis to first locate frauds involving related-
party transactions and then examined the AAERs for mention of the public accounting firm con-
ducting the audit. We also include 12 cases identified in Beasley et al. 共2001兲 in which the alleged
audit deficiencies included failure to recognize or disclose related-party transactions. While we
found a total of 49 audit failures, six involved audit failures not involving the examination of
related-party transactions, resulting in a final sample size of 43.
Current auditing standards for the examination of related party-transactions specify a three-
step process that involves sequentially 共1兲 identifying related parties, 共2兲 examining related-party
transactions 共e.g., ascertaining business purpose兲, and 共3兲 ensuring proper disclosure of the
transactions. Challenges exist at each stage 共AICPA 2001兲. First, related parties and transactions
warranting examination may be difficult to identify because of the wide variety of parties and types
of transactions and the fact that some transactions may not be given accounting recognition 共e.g.,
receipt of free services from a related party兲. Second, examination of related-party transactions
can be complex, especially when the transactions involve difficult-to-value assets. In both cases,
auditors must often rely on management representations for information supporting identification
and valuation of related-party transactions. A third issue relates to the sequential process of the
audit procedures; if related parties are not identified, then the related-party transactions can
neither be examined nor disclosed.
Beasley et al. 共2001兲 report that failure to recognize and/or disclose key related parties was
one of the top ten audit deficiencies in a sample of 45 SEC enforcement actions between 1987
and 1997. In this study, we focus on audit failures that involve related-party transactions. The
motivation for our analysis is first to identify at which stage—identification, examination, or
disclosure—the audit failure occurred. Second, we aim to assess whether prescribed procedures5
appear to have been appropriately applied but audit failure resulted from some apparent defi-
ciency 共or omission兲 in the standards’ specification of necessary procedures, or, alternatively,
whether audit failure resulted from an apparent deficient application of the prescribed procedures.
We examined each enforcement action to identify the stage at which the audit failure occurred
and the circumstances surrounding the failure.6 Surprisingly, while the step of identifying related-
party transactions would seem to be the most difficult step in the process, we find that relatively
few audits 共six cases兲 appear to have failed at the identification stage 共see Table 1兲. Instead, we
find that the most common 共29 cases兲 alleged audit deficiency with respect to the related-party

4
Professional standards 共SAS No. 107, AICPA 2006兲 clarify the auditor’s responsibility: “In performing the audit, the auditor is
concerned with matters that, either individually or in the aggregate, could be material to the financial statements. The auditor’s
responsibility is to plan and perform the audit to obtain reasonable assurance that material misstatements, whether caused by
errors or fraud, are detected” 共AU 312.03兲. Thus, Kadous 共2000, 327兲 defines audit failure as an auditor issuing “an unqualified
opinion on financial statements that are subsequently found to have been materially misstated.”
5
We use the term “procedures” to refer to the audit “procedures that should be considered by the auditor when he is performing
an audit of financial statements in accordance with generally accepted auditing standards to identify related-party relationships
and transactions and to satisfy himself concerning the required financial statement accounting and disclosure” 共SAS No. 45.01,
AICPA 1983兲.
6
Two members of the author team have significant audit experience and a third has internal audit experience. The classification
process was straightforward and no differences among classifications were noted.

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Louwers, Henry, Reed, and Gordon A12

TABLE 1
Analysis of Audit Failures by Auditor Size
Stage of Audit Failure Big 4 Non-Big 4 Firm
Identification of related-party transaction 0 3
Examination of related-party transaction 1 22
Disclosure of related-party transaction 4 4
Total 5 29
Sole Practitioner Total
3 6
6 29
0 8
9 43

transaction involved inadequate examination of the transaction 共e.g., ascertaining its business
purpose兲. The remainder 共eight cases兲 involved failures related to inadequate disclosure. Thus, 86
percent 共37 of the 43 cases兲 of the audit failures occurred after the related parties had been
identified.
Table 1 provides a breakdown of AAERs by audit firm size. Table 1 classifies audit firm size
into three categories: Big 4 firms,7 non-Big 4 firms, and sole practitioners. Five of the 43 共12
percent兲 cases involve a Big 4 firm, 29 共67 percent兲 cases involve a non-Big 4 firm, and 9 共21
percent兲 involve sole practitioners. There are two interesting points to be noted from Table 1. First,
of the five cases that involve Big 4 firms, four involve failure at the disclosure stage. While Big 4
firms account for only 12 percent of the total cases, Big 4 firms account for 50 percent of the
disclosure stage failures. Second, compared to Beasley et al. 共1999, 37, Table 16兲, which found
that 65 percent of the auditors in their broader sample of AAERs were non-Big 4 auditors, we find
88 percent of our sample are non-Big 4 auditors. Although these small samples do not lend
themselves to rigorous statistical analysis, audit failures in AAERs involving related-party trans-
actions appear to be more likely to involve smaller audit firms than are audit failures in AAERs in
general. The following sections document comments from SEC enforcement actions from which
we identified the point at which the auditing of related-party transactions were found to be defi-
cient.

Failures to Identify Related Parties and Related-Party Transactions

In six cases, five of which are described below, the audits appear to have failed at the point of
identification; in other words, related parties existed that the auditors failed to identify 共despite
readily available information兲.8
• International Teledata: The auditors knew shares had been issued 共the issuance was
footnoted in the financial statements兲, but they failed to sufficiently review the board
minutes and failed to make inquiries to determine to whom the shares had been is-
sued. Had they performed these basic procedures, the auditors would have discovered
that 共in addition to not being authorized by the board兲 most of the stock issued “went to
related parties in exchange for inadequate consideration.”
• Pacific Waste: Although the auditors claimed that management had represented that
there were no related-party transactions, the SEC’s action noted that there were at

7
The term “Big 4” refers collectively not only to the current Big 4 firms 共Deloitte, Ernst & Young, KPMG, and Pricewaterhouse-
Coopers兲, but also to those firms’ predecessors known as the Big 6 and Big 8 firms over the time period examined. Arthur
Andersen was also part of the Big 6/Big 8.
8
All quotes are taken from AAERs retrieved from Lexis-Nexis.

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Louwers, Henry, Reed, and Gordon A13

least five documents in the auditors’ files showing that the company’s president was
also an officer, director, and controlling shareholder of the investee-company used to
perpetrate the financial statement fraud.
• Softpoint and Pantheon: The auditor used the Softpoint’s fax machine and a fax num-
ber 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 共a兲 identified fictitious sales to three companies owned by Softpoint’s
president and chairman and 共b兲 identified the forged notes that had been purchased
with private funding from Pantheon’s top executives, respectively.
• Tri-Comp Sensors: The auditors knew loans existed, but did not think they were
related-party transactions. However, the SEC action cites various red flags that should
have indicated the transactions were with related parties, such as: “共1兲 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; 共2兲 no interest
was paid on the loan; and 共3兲 there was no written agreement or record documenting
the loan terms or purpose.”

Inadequate Examinations of Related-Party Transactions

We classify enforcement actions against auditors as an audit failure at the examination stage
if it is stated in the enforcement action that the auditors either knew of, or it can be inferred from
the case details that the auditors should have known about, the related-party transaction. Of the
43 enforcement actions against the auditors, 29 involve auditors’ examinations of the related-party
transactions. Brief summaries and representative examples follow.
• Two examples illustrate situations in which identification of the related-party transac-
tions 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 “recast the book entries for transactions between two subsid-
iaries from ‘related-party receivables’ to ‘accounts receivables’ as part of concealing
the relationship.” 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 virtu-
ally no normal business or accounting records susceptible of audit. The company’s
books consisted primarily of a check register.”
• PNF Industries illustrates a case where the auditor performed some testing of the
related-party transaction, but the testing lacked rigor. While the auditors of PNF Indus-
tries had identified and questioned payments to a related party, they were given ficti-
tious supporting records, including fabricated board meeting minutes. The records,
however, contained numerous inconsistencies proving that they were fictitious, includ-
ing 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 felon, 关the auditors兴 should have closely scrutinized the evi-
dence supporting 关the individual’s兴 expenses. Nevertheless, 关the auditor兴 failed to re-
view the evidence obtained and therefore failed to consider whether the minutes had
been fabricated.”

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Louwers, Henry, Reed, and Gordon A14

• The cases of Great American and Itex illustrate audit inadequacies with respect to
valuing assets obtained in related-party transactions. The auditor of Great American
was cited for having inappropriately relied on management’s representations about the
values of a fictitious patent and a race horse, both acquired from officers of the com-
pany. The company reported a value of $225,000 for patents that did not exist and a
value of $1.1 million for a race horse which “had total lifetime race earnings of $1,000,
earned stud fees of less than $1,000, and been recently purchased by the persons who
contracted to sell it to Great American for only $5,000.” The Itex audit failure occurred
despite a number of red flags about both the transactions and the asset appraisals,
including the fact that “certain significant transactions occurred at or near the end of
fiscal periods, involved unusual purchases, sales, and repurchases of assets within a
short period of time, and a series of transactions involving an offshore entity whose
sole address was a post office box in Belize, Central America.”
• Illustrations of audit failures involving receivables from related parties include MCA
Financial and General Tech. For MCA Financial, had the auditors reviewed the financial
statements of the related party, they would have concluded the receivables could not
be repaid from the related party’s cash flow. Additionally, to assess whether the receiv-
ables could be repaid by liquidating the underlying collateral 共most of which had been
acquired from MCA兲, the auditors relied on “estimated fair market values provided by
management” and also on “property appraisals performed by the brother-in-law of
MCA’s CEO while employed by a company that the auditors listed as an MCA
subsidiary.”9 With respect to General Tech’s audit deficiencies, the SEC’s action noted
that all of the company’s “accounts receivables appeared on computer-generated aged
receivable listings, except for the receivables for five related parties that were simply
handwritten in at the bottom of those computer listings; despite the manner in which
those five were recorded, 关the兴 audit staff did not perform any audit work with respect to
them.”

Improper Disclosures of Related-Party Transactions

Of the 43 enforcement actions against auditors, we identify eight cases that we classify as
failures at the step of ensuring adequate disclosure. In each of the eight cases, there appears to
be little doubt about the auditor’s identification of the related-party transaction, and given the
details provided, little likelihood that the auditor failed to examine the transactions. Two represen-
tative examples follow.
• In the audit of Madera, the SEC action states the auditors were aware of consulting
agreements with officers and directors, but failed to insist that management disclose
them in the footnotes to the financial statements. The transactions were identified as
related-party transactions in the audit plan, copies of the consulting agreements were
in the audit files, and the auditors were aware that the company had issued stock to the
consultants. The most incriminating evidence, however, was the fact that the audit
manager noted in his review notes on Madera’s Form 10-K to “disclose consulting fees
as related-party transactions.”
• The SEC’s action against Adelphia’s auditors highlighted numerous disclosure defi-
ciencies. First, Adelphia was jointly and severally liable for co-borrowings with a related

9
The auditors had specifically noted in the workpapers that this appraiser was a “Related Entity.”

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Louwers, Henry, Reed, and Gordon A15

party 共the Rigas family兲 and thus should have reported the liability. The SEC action
notes that during the audit, the company’s auditor “repeatedly proposed disclosure of
the full amount of the Co-Borrowing debt. 关The auditing firm兴 inserted more explicit
disclosure, including the amount of Rigas Co-Borrowing debt, in at least six drafts of
Adelphia’s 2000 Form 10-K. But when Adelphia’s management resisted, 关the auditing
firm兴 abandoned its attempts to make the disclosure more accurate.” A second disclo-
sure deficiency was the improper netting of related-party receivables and payables.
Adelphia netted $1.351 billion related-party receivables against $1.348 billion related-
party payables to show only $3 million net receivables on its balance sheet; the netting
practice concealed the extent of related-party transactions between the company and
the Rigas family and was characterized by the SEC as “a fraudulent device used to
conceal its liabilities.” The SEC action against the auditor states that “Adelphia was
required both by GAAP and by Commission regulations to report related-party trans-
actions with the Rigas Entities in a gross presentation.” A third disclosure deficiency
was broader. The SEC action against the auditors noted that Adelphia and the related-
party companies shared a cash management system 共CMS兲 and “the general ledger
recorded the thousands of intercompany transactions among and between Adelphia
subsidiaries and Rigas Entities. A review of bank statements would have shown that
cash receipts for both public and private entities were deposited into Adelphia’s First
Union CMS account and that disbursements on behalf of public and private entities
were paid from that same account.” However, the required disclosure of related-party
transactions was inadequate.

CONCLUSIONS
A combination of factors makes the examination of related-party transactions difficult. Unco-
operative 共or deceptive兲 clients make the task even more daunting. Numerous SEC enforcement
actions—against corporate executives, though not against their auditors—cite specific instances
in which management concealed information from its auditors. For example, in an action against
executives of Enron Broadband Services 共EBS兲 for a sham monetization transaction designed to
inflate earnings by $111 million, the SEC complaint alleges the executives “intentionally misled
Enron’s auditor 关Arthur Andersen兴 about the true character of the 关transaction兴 because they
believed that Andersen would not approve of the transaction or allow EBS to record any revenues
had Andersen known the truth.” As another example, the SEC’s complaint against Rite Aid’s top
executives states they provided their auditors with management representation letters containing
numerous false statements, including, “Related-party transactions have been properly recorded
or disclosed in the financial statements.”
Despite these challenges, our study identifies relatively few 共less than 50 in total兲 SEC en-
forcement actions against auditors for negligent identification, examination, or disclosure of
related-party transactions. With respect to the failure to identify related parties, although there
may be other unidentified contributory factors at work, it appears that the auditors may have
identified the related parties had they maintained their professional skepticism. Similarly, failure to
maintain professional skepticism appears to underlie auditors’ willingness to accept management
representations that identified related-party transactions had legitimate business purposes or that
assets acquired were properly valued. Finally, in the cases involving failures to adequately dis-
close related-party transactions, auditors appear to have acquiesced to management’s requests
to conceal 共or obfuscate the appropriate disclosure of兲 related-party transactions. Our review of

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Louwers, Henry, Reed, and Gordon A16

these actions suggests the audit failures were more the result of a lack of professional skepticism
and due professional care rather than a failure of the audit procedures themselves.
Despite the fact that our examination does not reveal particular additions or modifications that
would improve procedures as currently prescribed for use in auditing related-party transactions,
these cases do offer some insights that might contribute to improved audit practices. Primarily,
audit teams should discuss the potential for related-party transaction abuse during their fraud
awareness “brainstorming” sessions required by SAS No. 99 共AICPA 2002兲. These discussions
among audit team members could include example AAERs such as the ones described above. In
addition, the AICPA publishes a “Related-Party Transactions Toolkit” 共AICPA 2001兲 that provides
more specific guidance, checklists, confirmation templates, and other tools that may assist the
audit team. Most importantly, as illustrated by these AAERs, the importance of maintaining pro-
fessional skepticism and exercising due professional care can never be overemphasized.

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