Companies’ management should consider whether to add a materiality carve-out to the related party representations now being included in management representation letters as a result of the PCAOB’s Auditing Standard No. 18 (AS 18). AS 18 established “requirements regarding the auditor’s evaluation of a company’s identification of, accounting for, and disclosure of relationships and transactions between the company and its related parties” and is effective for audits of fiscal years ended after December 14, 2015.
The sample management representation letter for auditors to consider, which is set forth in Appendix A to AU Section 333, includes the following specific representations as a result of AS 18:
- Management has made available to auditors the names of all related parties and all relationships and transactions with related parties
- There are no side agreements or other arrangements (either written or oral) that have not been disclosed to the auditors
These representations are broad given the definition in the accounting literature of the term “related party,” which is applicable to AS 18 and the related management representation letter. The definition of “related party” included in the Master Glossary of the FASB’s Accounting Standards Codification includes affiliates of an entity, principal owners of an entity and members of their immediate families, management of an entity and members of their immediate families, and other parties that can influence an entity’s management or operating policies.
“Immediate family” is defined in the Master Glossary as those “[f]amily members who might control or influence a principal owner or a member of management, or who might be controlled or influenced by a principal owner or a member of management, because of the family relationship.” The term “management” is defined as those “[p]ersons who are responsible for achieving the objectives of the entity and who have the authority to establish policies and make decisions by which those objectives are to be pursued. Management normally includes members of the board of directors, the chief executive officer, chief operating officer, vice presidents in charge of principal business functions (such as sales, administration, or finance)[,] and other persons who perform similar policy making functions. Persons without formal titles also may be members of management.” The term “principal owners” is defined as “[o]wners of record or known beneficial owners of more than 10 percent of the voting interests of the entity.”
In some cases, management may not want to make the newly required representations relating to the names, relationships, and transactions of all related parties and side agreements and other arrangements without carve-outs for immaterial transactions and arrangements. Management may have to explain to the auditors why they can accept the carve-out related to the names, relationships, and transactions of all related parties because of certain language in the auditing literature.
AU Section 333.08 states that “[m]ateriality considerations” do not apply to certain representations specifically listed in AU Section 333.06, which include the representation that relates in part to the names, relationships, and transactions with related parties but not the representation related to side agreements and other arrangements. Given that AU Section 333.08 states that “materiality considerations would not apply to those representations that are not directly related to amounts included in the financial statements” [emphasis added], however, and the absence of any change to AU Section 333.08 when the PCAOB amended AU Section 333 in connection with its adoption of AS 18, carve-outs for immaterial related party transactions should be acceptable to auditors (and have been accepted by certain auditors) when such transactions are reflected in the financial statements.
Notwithstanding the possibility of a materiality carve-out, companies should have controls in place to identify related party transactions to ensure compliance with ethical and other corporate governance standards, financial reporting requirements, and other applicable requirements. Among these controls are directors’ and officers’ questionnaires that elicit information about related party transactions, among other matters.