The Related Party That Wasn't Disclosed
You are the manager on the audit of Harrowgate Services Ltd, a private company with £9m turnover. During planning you note that the managing director's spouse owns 100% of a supplier, Pinnacle Facilities Ltd, which received £780k of payments in the year (8.7% of turnover). The MD has not declared this in the related party disclosure note, which states 'the company has no related party transactions requiring disclosure'. When challenged, the MD says the transactions were at arm's length and 'commercially confidential'. You also discover that the finance director approved all Pinnacle invoices personally and that the purchase ledger clerk was told not to query them. The partner wants to issue an unmodified report because the amounts are 'not material to the profit'.
1. Evaluate whether the related party matter is material and whether an unmodified opinion is appropriate.
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Materiality is not solely a profit test. Related party disclosures are qualitative: users rely on them to assess whether the company has been run in the shareholders' interests and whether transactions are on arm's length terms. £780k is 8.7% of turnover and a significant cash outflow, so it is material by size as well as by nature.
The financial statements are therefore misstated because the disclosure note is factually wrong. The MD's claim of arm's length terms is unsubstantiated, and the instruction not to query invoices is a red flag for management override. The auditor cannot accept 'commercially confidential' as a reason to omit a required disclosure.
An unmodified opinion is not appropriate. The options are a qualified opinion on the grounds of material misstatement (if the effect is material but not pervasive) or an adverse opinion (if pervasive). Given a single disclosure note, qualification is likely the proportionate response, but the partner must consider whether the omission, combined with the override indicators, is pervasive. The matter should also be reported to those charged with governance and considered under the firm's money laundering and fraud procedures.
2. What audit procedures should you perform to obtain evidence about the related party transactions and the suspected override?
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Procedures should address existence, completeness, terms and authorisation:
- Obtain written representations and a related party questionnaire from all directors, updated for changes during the year.
- Review the statutory registers and Companies House filings for shareholdings and directorships.
- Inspect the purchase ledger for Pinnacle: invoices, contracts, price lists and evidence of competitive tender.
- Compare Pinnacle's prices with those of alternative suppliers for similar goods to test the arm's length assertion.
- Review board minutes and email correspondence for approval of the relationship.
- Test the authorisation trail: the FD approved all invoices, which breaches segregation of duties; inspect whether any independent review occurred.
- Interview the purchase ledger clerk about the instruction not to query invoices and document the response.
- Review journal entries around the Pinnacle account for unusual postings.
- Consider whether the relationship affects the auditor's independence or creates a fraud risk requiring escalation to the partner and, if appropriate, to the relevant authority.
Findings should be documented, discussed with those charged with governance, and reflected in the audit report and management letter.