ISA 550, Related Parties
Comments from ACCA
June 2007
Executive Summary
ACCA welcomes the opportunity to comment on the proposed International Standard on Auditing ISA 550 (Revised and Redrafted) Related Parties (proposed ISA 550), issued for comment by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants.
We were pleased to comment on the December 2005 exposure draft of proposed ISA 550 and note that, with this re-exposure, the IAASB is not seeking repetition of comments previously made. Our comments are primarily directed, therefore, to the matters dealt with in the Explanatory Memorandum forming part of the exposure daft. We also comment on the changes proposed as a result of applying the Clarity project drafting conventions.
While we are generally supportive of the changes now proposed from the earlier exposure draft, we suggest that more needs to be done to produce a concise and clear document so as to minimise the additional costs to audits, which will fall disproportionately on smaller entities.
Specific Questions
Related party definition
Question 1: Respondents are asked for their views on whether the proposed definition of a related party is appropriate.
In our previous response, we supported the use of definitions from the applicable financial reporting framework and, for pragmatic reasons, drawing on International Accounting Standard 24 Related Party Disclosures (IAS 24) in those circumstances where the applicable financial reporting framework did not address related parties. In our response, we recommended inclusion of provisions to deal with circumstances where the financial reporting framework included only minimal related party material (such as provisions for consolidation of owned entities). We are pleased to note that the revised approach in proposed ISA 550 has addressed this point.
Accordingly, we find the proposed definition of a related party acceptable.
Arm's length assertion
Question 2: Respondents are asked for their views on whether the proposed ISA should address the auditing implications of implicit arm's length assertions that management has made for related party transactions. If respondents support the provision of specific guidance, respondents are asked for their views on an appropriate approach, bearing in mind that there would be a need to distinguish between explicit and implicit arm's length assertions.
We are pleased to note that concerns that we and others expressed have resulted in consideration by the IAASB of implicit assertions.
For identified significant related party transactions (within the normal course of business) the proposed wording in the second bullet point of paragraph 21 is acceptable. Paragraph A22 could provide explanation that the assertion may be explicit or implicit, without necessarily referring to any particular framework.
We do not believe that other related party transactions (within the normal course of business) individually merit treatment by the auditor as circumstances giving rise to significant risks. They should be dealt with in appropriate aggregations and proposed ISA 550 should make it clear that such an approach is intended.
Other Matters
In this section we comment on ‘other matters' identified for comment in the Explanatory Memorandum forming part of the exposure draft and on some matters that do not fall to be dealt with in relation to the application of the Clarity project drafting conventions.
Special Considerations in the Audit of Small Entities
The material in paragraphs A16 and A32 is helpful, but the latter paragraph relies on a particular interpretation of the words ‘authorization and approval' and our suggestion later in this response in relation to paragraph 24 is relevant.
In a smaller entity, management generally has better knowledge of transactions than in a larger entity and the converse of the statement made in paragraph A32 is actually more true. The guidance ought to refer to the need in lager entities for consistent evidence from different levels of authority in order to approach the level of evidence that can be obtained in a smaller entity.
Translations
To reduce the possibility of potential translation issues arising we continue to suggest that the Requirements section be kept as simple as possible. The ways in which this may be achieved are discussed in the Appendix to this response.
We refer to a specific issue later in this response in relation to paragraph 24.
dominant influence
The definition in paragraph 11(c) is somewhat circular and the terms ‘domination' and ‘impose their will' are close to ‘control or significant influence', wording within the definition of related party.
The definition is artificial because, clearly, corporate entities can dominate an entity. The act of excluding corporate entities from the definition may deter auditors from considering the influence of corporate entities (behind which individuals may easily hide). As a minimum, the definition should make it clear that the individuals may act through corporate entities.
We do not support the drafting device of creating artificial definitions as it introduces unnecessary confusion between common language and ISA-specific terminology. If it is necessary to restrict the auditors' attention to a subset of those who exert influence that can be done more transparently.
The changes in requirements since the December 2005 exposure draft have made the need for a definition of dominant influence much less obvious and we suggest that a common language approach can now be adopted.
Changes Made to Enhance the Clarity of Proposed ISA 550
Objectives
We consider that the objectives of the auditor are acceptable.
Requirements
The Appendix to this response provides further information on the deficiencies that we identify in the requirements of this and other proposed ISAs resulting from the Clarity project. It should be read in conjunction with each comment below as such deficiencies are particularly evident in these paragraphs.
Paragraph 12
Paragraph 12 contains no requirement and should be moved to the Application and Other Explanatory Material (A&OEM) section.
Paragraph 13
The requirement in paragraph 13 is placed on a discussion. As discussed in the Appendix to this response, under the heading Simple construction , it would be better to use a construction under which requirements are placed on ‘the auditor'.
Paragraph 14
The words ‘in accordance with the framework' are unnecessary and should be deleted.
Paragraphs 14 and 15
The condition precedent in paragraph 14 is ‘If the applicable financial reporting framework establishes related party requirements,' .
The condition precedent in paragraph 15 is ‘ If the applicable financial reporting framework establishes minimal or no related party requirements,' .
These are presumably intended to be mutually exclusive.
The condition precedent in paragraph 14 should be rewritten because ‘minimal related party requirements' (paragraph 15) are still ‘related party requirements' (paragraph 14); so paragraphs 14 and 15 are not actually mutually exclusive.
Paragraph 16
A requirement is ‘hidden' as introductory text. The paragraph should be rewritten to present a requirement to obtain an understanding.
There is no need to include the requirement that the understanding be developed in any specific way (eg ‘the auditor shall inquire of management and others within the entity and perform other procedures considered appropriate') because there is no other legitimate way this could be done.
If the requirement ‘hidden' as introductory text is intended as explanatory material it is not essential and should be removed.
Paragraph 18
The words ‘during the audit' are unnecessary.
The requirement to inquire of management whether identified significant transactions outside the normal course of business involve related parties is combined with a requirement to inquire of management to understand the nature of these transactions.
An ISA dealing with related parties is not an appropriate ISA to introduce a general requirement to inquire of management to understand the nature of identified significant transactions outside the normal course of business. We recommend deleting this requirement. If it is felt necessary to retain the requirement it should be transferred to a ‘core' ISA as it is relevant to other aspects of an audit, such as fraud.
Paragraph 19
Paragraph 19 should be made clearer by eliminating unnecessary words as follows:
- In the first sentence, the words ‘during the audit' and ‘also' are unnecessary
- In the second sentence, the words ‘In addition' are unnecessary
- In bullet point (a) the words ‘obtained as part of the auditor's procedures' are unnecessary
Paragraph 20
The requirement in paragraph 20 is, in essence, to apply ISA 240. This is unnecessary and should be deleted. In the absence of a mechanism for providing an overarching explanation of the form of and interaction between ISAs, the material in paragraph 20 is best dealt with in the Introduction section of proposed ISA 550 (and ISA 240).
Paragraph 21
The words ‘at least' are unnecessary.
Paragraph 22
Paragraph 22 is purely explanatory and should be transferred to the A&OEM section.
Paragraph 23
The words in bullet point (a) after ‘to enable them . . .' are explanatory and should be transferred to the A&OEM section.
Paragraph 24
Bullet point (b) refers to obtaining evidence that transactions have been ‘authorized and approved'. The term ‘authorization and approval' was introduced in the appendix to ISA 240. Its formal use in a requirement necessitates a proper definition as users should know precisely what is meant by combining two words that are often synonymous. This will also aid translation.
Appendix: Common Deficiencies in Requirements
This Appendix provides further information on the deficiencies that we identify in the requirements of this and other proposed ISAs issued as part of the Clarity project. Our comments are collected under three headings:
- Growth in the number of requirements
- Presentation of requirements
- Other significant issues
Growth in number of requirements
There seems to be no external economic or social justification, suddenly to increase the degree of specificity of ISAs; nevertheless, many proposed ISAs exhibit a substantial growth in the number and detail of specific requirements. We are not convinced that the implementation of the guidelines adopted for deciding on the requirements to be included in an ISA is correct.
We are concerned that the proliferation of requirements will promote a ‘tick box' mentality. Each extra requirement introduced is another box to tick, another factor that can reduce the quality of an audit, and another cost that bears disproportionately on smaller audits and deters the more widespread application of ISAs.
The cost of including a single requirement should not be underestimated. Even if that requirement is conditional and is not relevant in the circumstances, it requires consideration by every auditor on every audit and that gives rise to a considerable cost, which includes the related training and changes to audit manuals, programmes or software.
Our detailed analysis concludes that hardly any of the changes from a present-tense statement to a requirement are justified. We recommend that the proposed requirements be reconsidered on an individual basis and that each remains as a requirement only if a strong case can be made for that.
The ‘requirement' is really guidance on another requirement
Many new requirements deal with the same subject as another but in greater detail: the auditor is required both to do something and also to carry out the steps in that process. This is a simple duplication, which should be eliminated.
Such secondary requirements are best treated as explanatory material that auditors can refer to in relation to the primary requirement.
Requirements that are only relevant in rare circumstances
Extant ISAs contain some present-tense statements that provide guidance to the auditor when facing uncommon circumstances. The general Clarity project guideline for inclusion of requirements is that the requirement is expected to be applicable in virtually all engagements to which the ISA is relevant. Ordinarily, therefore, such present-tense statements should not be elevated to requirements.
We accept that certain requirements are of sufficient importance that this guideline can be disregarded. For example, although audits of public interest entities form only a small minority of audits, it is sometimes necessary to include requirements that will be relevant only to such entities. This may be done by restricting the application of the requirement by the use of a condition precedent.
We do not believe that it is appropriate, however, to make wider use of conditions as a device to justify inclusion of requirements for uncommon circumstances. Although a requirement will ensure that the auditor, when facing the specific conditions, will act in an appropriate manner, a balance has to be struck between that and the additional burden placed on every audit. Every conditional requirement requires consideration by every auditor on every audit and that gives rise to a considerable cost burden, which falls disproportionately on smaller entities.
We recommend, therefore, that any such proposed elevation be supported by an assessment of the frequency with which the condition for its use is met and the additional benefit (if any) to the quality of the audit that arises through inclusion as a requirement. We would not ordinarily expect such assessments to show that the benefit of elevation outweighed its cost.
Presentation of Requirements
We do not find the Requirements sections of proposed ISAs easy to understand. As well as the proliferation of requirements, many of which are overlapping, as discussed above under the heading Growth in number of requirements, t here are two main reasons for this:
- explanatory material is interspersed with the requirements, and
- the requirements are not constructed in a simple fashion.
Explanatory material
We do not support splitting the supplementary material providing explanation and guidance between the Application and Other Explanatory Material (A&OEM) section and the Requirements section. Such an approach forces users to carry out a detailed analysis of the text of the Requirements section to identify the ‘essential explanatory material' and discover which parts of the text are actual requirements. Rather than improving clarity, explanatory material adds unnecessary length and detracts from the reader's understanding. Instead, we strongly suggest that the ‘essential explanatory material' and the ‘supplementary material providing further explanation and guidance' both be presented only in the A&OEM section (or its appendices).
Simple construction
We do not find the requirements easy to understand because they are not always drafted in a simple fashion. As a result, auditors who need to know when a requirement applies, and when it does not, have to be very diligent and analytic readers.
In our February 2006 response to the redrafting proposals ‘Improving the Clarity of IAASB Standards' we proposed the adoption of a structure that clearly showed:
- any conditions precedent
- on whom a requirement was placed
- the action required, and
- the object of that action.
The Appendix to that response included an example of an appropriate tabular layout to achieve that result. As ISAs have now been issued without such a method of presentation, we see no point in continuing to argue against the use of prose to convey the requirements. We believe that more should be done, however, to address the difficulties of presenting requirements in prose so that there is less doubt about the meaning of the various ‘shall' statements.
Conditions precedent
Requirements with multiple conditions precedent are particularly difficult to understand when written in prose. The complexity of the material also makes translation difficult. Where possible, we recommend keeping conditions precedent close to the requirement so that the auditor does not have to refer back to earlier material.
Some apparent conditions precedent are intended to place the requirement at a particular stage of the audit or identify it as relevant in particular circumstances. We recommend avoiding such constructions by positioning words after the ‘shall' statement unless they are clearly an explicit condition precedent.
On whom the requirement is placed
Sometimes, instead of the auditor being required to do something, the requirement is placed on a document or earlier action. A typical construction being ' The auditor's evaluation shall cover the same period as that used by management . . . ‘. Such indirect requirements are less clear than ones written to apply directly to the auditor.
Other significant issues
Basic principles and essential procedures
The bold type in extant ISAs identifies basic principles and essential procedures. These are substantially different in nature, but the Clarity project has combined the two as ‘requirements'. We do not agree with this approach, which leads to confusion, as auditors may attempt to treat a principle as an action. The corresponding and perhaps greater danger is that auditors who correctly interpret some of the ‘shall' statements as principles will treat as principles some that are intended as active requirements.
We recommend separating the principles with which the auditor is required to comply from the required procedures and other actions. This could be achieved by separating requirements into two sub-sections but it could also be achieved through explanation in the A&OEM section for each requirement that is a basic principle. Such explanation could also refer to the fact that it is unnecessary for the auditor to document separately compliance with matters for which compliance is self-evident within the audit file.
Limitation or clarification of the auditor's responsibility
Statements apparently limiting or clarifying the auditor's responsibility are present in several ISAs. These should be considered individually to determine the best way to present them when redrafting an ISA. As a general rule we do not favour introducing such statements into the Requirements section as they are neither requirements nor form conditions precedent and, if included there as explanatory material, they detract from the clarity of the requirements.
Statements that are sufficiently important should be included in the Introduction section where that is necessary to elaborate on the scope or context of the particular ISA. Other statements should be included in the A&OEM section.
Timing of requirements
We have commented above, under the heading Conditions precedent that wording intended to place a requirement at a particular stage of the audit could be interpreted as a condition precedent and restrict its application.
The preferred timing of a requirement is a matter that should be considered on a consistent basis for all ISAs. If sufficiently important, the timing of a requirement should itself be a requirement; if timing is not critical, the preferred timing should be indicated by guidance material or left unstated. It should be remembered that many of the requirements depend on others and that the introduction of explicit mention of timing (or similar rephrasing of a requirement) should not be undertaken lightly.
Communication of audit matters with those charged with governance
Several ISAs include requirements to communicate with those charged with governance. Proposed ISA 260 Communication of Audit Matters with Those Charged with Governance contains wording to take account of the circumstance when all of those charged with governance are involved in managing the entity.
An appropriate method of recognising such circumstances is needed for the Clarity project. Consistent with our view on the exclusion of explanatory material from the Requirements section, we suggest that a cross-reference be made in the A&OEM section to the related material in ISA 260.
For example, in our April 2007 response to proposed ISA 230 Audit Documentation we explained the difficulty of using the words 'in exceptional circumstances' in paragraph 10 of that proposed ISA.