U.S. Auditors’ Role in Identifying Related Party Transactions When Conducting Audits of Chinese RTO Issuers


When auditing a Chinese RTO (reverse takeover) issuer, it is the U.S. auditors’ task to educate the Chinese client regarding both the meaning of the term "related parties," and the disclosure requirements under U.S. GAAP with which it must comply. The financial reporting requirements regarding related parties, as set forth by ASC 850 (codified from SFAS No. 57), are essentially disclosure obligations, not accounting rules.

Relationships, known as "guanxi," are crucial in conducting business in China. There may be Chinese clients who do not fully appreciate the breadth of the definition of related parties, or may actually consider transactions with such parties to be ordinary (i.e., at arm’s-length) and routine, and thus not worthy of disclosure.

Identification of otherwise undisclosed (or perhaps unrecognized) related parties is a somewhat challenging task, but all experienced and qualified auditors are well aware of the critical importance of this undertaking. Unless the auditors can be satisfied that all related parties have been identified, and that transactions and balances have been properly accounted for and disclosed, they would be precluded from rendering an unqualified opinion on the financial statements.

In the authors’ experiences, it is not only auditors that fail in their responsibilities in this area; even seasoned litigators, in pursuit of actions against companies and their auditors for other financial reporting infractions, commonly overlook these ubiquitous failings, which only experienced litigation-oriented accountants seem able to reliably flag. As further revelations about financial reporting missteps by Chinese RTO companies are unveiled, it is anticipated that a sizable portion of all supposed faults will pertain to this singular matter of missing required disclosures, the absence of which can make a world of difference in the how a company is seen by investors.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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