A borrower I worked on some years ago presented what looked, on first read, like a comfortably positioned working capital account. Trade receivables were Rs 380 lakhs, trade creditors were Rs 290 lakhs and inventory was Rs 245 lakhs. The drawing power computed against these figures sat comfortably above the borrower’s CC outstanding of Rs 580 lakhs.
The picture changed when I started the engagement and asked the borrower’s accounts manager to identify the related-party balances in both the debtor and creditor masters. Of the Rs 380 lakhs of debtors, Rs 165 lakhs was due from three group concerns. Of the Rs 290 lakhs of creditors, Rs 140 lakhs was owed to two related entities. The same family controlled all five counterparties along with the borrower itself.
Looking only at the debtor side, the related-party balance was significant 43 percent of receivables. Looking only at the creditor side, the related-party balance was also significant 48 percent of payables. But the combined picture revealed something the single-side analysis would have missed. The borrower’s working capital cycle was substantially an internal group cycle. The bank’s working capital sanction was effectively financing the operating relationships within the family group, with the borrower as the conduit.
This article is an attempt to address the bilateral nature of related-party balances in stock audit work. Many auditors attention focuses on the receivable side because the immediate DP impact is more visible there but the creditor side carries its own distinct concerns and the combined view of both sides often reveals patterns that neither side alone discloses. Across the over 700 stock and receivables audit engagements I have now conducted, the engagements where both sides were examined together produced findings of materially different quality from those that examined only the receivable side.
Why related-party balances are fundamentally different
The starting point for any discussion of related-party balances in stock audit work is the recognition that they are economically distinct from arm’s-length balances even when they appear identical in the books. The accounting treats a Rs 50 lakhs receivable from a related party and a Rs 50 lakhs receivable from an independent customer as identical entries as both are trade receivables, both are aged from the invoice date and both flow through the same accounting workflow. The economic substance, however, can be entirely different.
| Characteristic | Arm’s length Counterparty | Related-Party Counterparty |
| Independence of decision | Customer or supplier makes commercial decisions independently | Both entities share ownership, control or significant influence |
| Payment incentive | Counterparty has independent commercial incentive to settle on terms | Settlement is a group cash management decision and not a commercial discipline |
| Pricing | Subject to market discipline | May be set within the group without market reference |
| Terms | Commercial terms negotiated between independent parties | May be relaxed, extended or modified without commercial reference |
| Enforceability | Realisable through normal commercial collection or supply withholding | Enforcement is a family or group decision |
| Visibility to bank | Counterparty is independently identifiable | May require analytical effort to identify the relationship |
| Treatment in financials | Ordinary trade transaction | Subject to AS 18 / Ind AS 24 disclosure and Companies Act Section 188 |
The implication for stock audit work is that the auditor cannot treat related-party balances within the standard ageing and margin framework that the engagement applies to arm’s-length balances. The auditor must identify them, analyse them and present them to the bank in a manner that allows the bank’s credit team to apply whatever specific policies it has for such balances.
The three concerns on the debtor side
Related-party receivables raise three distinct concerns, each of which has implications for the bank’s security position and for the drawing power computation.
The first is the recoverability concern. A receivable from an independent customer carries economic force toward settlement – the customer needs continued supply, faces commercial pressure to maintain credit standing and has independent reasons to pay. A receivable from a related party does not carry the same force. The same family controls both entities and the decision to pay or not pay is a group cash management decision rather than a commercial discipline. A receivable that has been outstanding for nine months without payment can be a normal feature of a group arrangement that may never crystallise into actual settlement.
The second is the genuineness concern. Where related-party transactions are not subject to normal commercial discipline, the question arises whether the underlying transactions correspond to actual movement of goods or rendering of services. A book entry showing Rs 50 lakhs sale to a related party may correspond to genuine inventory dispatched and received by the related party or it may correspond to an accommodation entry where no goods have moved and the entry exists for accounting or financing reasons.
The third is the diversion concern. A growing related-party debtor balance over consecutive periods may indicate that working capital sanctioned for the borrower’s own operations is flowing to the related party through the receivable mechanism. The bank’s sanction letter restricts the use of working capital to the borrower’s own business. Receivables building up against a related party while working capital outstanding remains high may indicate that the sanctioned funds are funding the group and not the borrower’s operating cycle.
The three concerns on the creditor side
Related-party payables raise concerns that are different in substance from those on the receivable side and that are often less appreciated by auditors who focus their related-party analysis on debtors alone.
The first creditor-side concern is the genuineness of the underlying procurement. Where the borrower carries large trade payables to related parties, the question is whether the goods or services represented by those payables have actually been received. An accommodation invoice raised by a related-party supplier creates a creditor balance in the borrower’s books without any corresponding receipt of goods. The borrower then claims the corresponding inventory in the stock statement (which does not exist), uses the inflated inventory figure to support a higher drawing power and the bank effectively lends against fictitious stock supported by fictitious creditor balances.
The second creditor-side concern is the substance over form of the obligation. A creditor balance owed to an independent supplier is a real obligation that will be enforced and if not paid, the supplier will withhold further supply, charge interest, sue for recovery etc. A creditor balance owed to a related party is an obligation in form but may not be one in substance. The same group controls both sides; the creditor may never seek payment; the balance may sit on the books indefinitely as a form of inter-corporate funding without ever being settled.
The third creditor-side concern is the parking arrangement risk. Where group entities supply goods or services to the borrower on extended credit, the arrangement effectively provides working capital to the borrower without showing up as a borrowing. The economic substance is closer to an inter-corporate loan than to a trade payable. The implication for the bank is that the borrower’s apparent working capital position, which depends on the proportion of operations funded by trade credit, is misleading. The “trade credit” is actually group financing that could be withdrawn or restructured at any time without commercial discipline.
| Concern Type | Debtor Side | Creditor Side |
| Concern 1 | Recoverability – payment may not be enforced | Genuineness – goods may not have been received |
| Concern 2 | Genuineness – underlying transaction may not be real | Substance – obligation may not be enforced |
| Concern 3 | Diversion – working capital may be flowing to related party | Parking arrangement – group financing disguised as trade credit |
| Primary impact on DP | Inflates eligible debtors used in DP computation | Inflates apparent paid stock and reduces creditor deduction in DP |
| Impact on bank security | Overstated realisable receivables | Overstated unencumbered inventory |
| Common reporting failure | Treated as ordinary trade debtor | Treated as ordinary trade creditor |
The combined view
The most valuable analytical procedure in related-party work is the combined examination of both sides. Several patterns become visible only when the two sides are looked at together.
The first pattern is the offsetting position. Where the same related party appears as both a debtor and a creditor on the borrower’s books, the gross balances overstate the financial exposure. A Rs 80 lakhs debtor from group company X offset by a Rs 60 lakhs creditor to the same X represents a net Rs 20 lakhs exposure rather than the Rs 80 lakhs that the debtor analysis alone would show. The two balances may be specifically intended to offset or they may have arisen independently but in either case the bank’s understanding of the position should reflect the offsetting.
The second pattern is the working capital cycle internal to the group. Where the borrower’s debtors are concentrated in group companies and the borrower’s creditors are also concentrated in group companies, the operating cycle is substantially an internal group cycle. The bank’s working capital sanction is supporting the group’s cash circulation rather than the borrower’s standalone operations. This has significant implications for credit assessment that single-side analysis would not surface.
The third pattern is the quarter-end window-dressing of both sides simultaneously. Borrowers that engage in stock statement manipulation may adjust both debtor and creditor figures at quarter-end. Debtors are pulled down through “collections” from related parties, creditors are reduced through “payments” to related parties and both balances re-emerge in the new quarter. The auditor who examines only one side may miss the pattern; the auditor who examines both sides together will see the coordinated adjustment.
The fourth pattern is the asymmetric treatment by the borrower. A common borrower behaviour is to disclose related parties on the debtor side (because the related-party transaction disclosure under AS 18 is typically more salient for receivables) while leaving the same related parties undisclosed on the creditor side. The auditor who relies only on the AS 18 list as filtered through the debtor master may not pick up creditor-side relationships that the borrower has not flagged.
Impact on Drawing Power computation
The DP computation is where the bilateral nature of related-party analysis becomes most directly material to the engagement output. The standard DP formula, inventory minus creditors plus eligible debtors times margin, treats all line items as homogeneous. When related-party balances are present, the formula produces a misleading DP unless the related-party amounts are surfaced and treated.
On the debtor side, related-party amounts may need to be excluded from the eligible debtor base depending on the sanction letter. Some banks exclude all related-party debtors regardless of ageing. Some apply enhanced ageing cut-offs or enhanced margins or value cap. The auditor’s task is to identify the related-party amounts, present the DP both including and excluding them where the sanction letter is silent, and allow the bank to apply its own policy.
On the creditor side, the analytical challenge is the opposite. The standard DP formula deducts creditors from inventory to compute “paid stock”. If the related-party creditors do not represent real obligations that the borrower will pay, deducting them gives a conservative DP that understates the bank’s true security. If, conversely, the related-party creditors represent inflated balances backed by accommodation invoices for goods not actually received, the corresponding “inventory” in the books is also fictitious and the DP based on those numbers is overstated.
| Scenario | Effect on Stated DP | Auditor’s Approach |
| Related-party debtors should be excluded per sanction policy | Stated DP overstated | Present DP both ways; recommend exclusion per policy |
| Related-party creditors are genuine and will be paid | Stated DP fairly stated | Disclose RP creditor amount but no DP adjustment |
| Related-party creditors are accommodation balances with no real obligation | Stated DP understated through over-deduction | Note that DP may be understated; bank to assess |
| Related-party creditors back fictitious inventory | Stated inventory and stated DP both overstated | Investigate further; report observation as material |
| Offsetting RP debtor and creditor with same party | Gross figures inflate apparent position both ways | Show net exposure alongside gross |
| RP debtor growing while operating cash flow weakening | Possible diversion; DP based on rising debtor is unreliable | Report trend and diversion indicators |
The complexity of the bilateral DP impact is precisely why the auditor’s role is to surface the information rather than to render a verdict on the appropriate DP treatment. The bank’s credit team, with access to the borrower’s complete relationship profile and the sanction letter terms, is better positioned to make the final call. The auditor’s responsibility is to make the information visible and to quantify it accurately.
Impact on stock statement reliability
The bilateral nature of related-party balances also affects the reliability of the monthly stock statements that the borrower submits to the bank between stock audit engagements. The stock statement reports the inventory, the receivables, the creditors and computes the DP. Where related-party balances are significant on either side, the stock statement is liable to several specific failure modes that the auditor should flag in the engagement report.
The first failure mode is selective disclosure. The stock statement format typically does not require the borrower to separately identify related-party amounts. The figures submitted to the bank therefore aggregate related-party with arm’s-length balances in a way that obscures the underlying composition. The bank’s credit team, reviewing the monthly stock statement, has no way to know what proportion of the receivables or creditors are intra-group.
The second failure mode is timing manipulation. Where related-party balances can be adjusted at will through book entries (rather than through real commercial transactions), the figures shown in the stock statement on a particular reporting date may not reflect the position on any other date within the period. The auditor visiting in the middle of the month may observe quite different balances from those reported at month-end.
The third failure mode is the consortium inconsistency. Where the borrower has multiple lender relationships, the stock statements submitted to different lenders may show different related-party adjustments depending on what each lender is presumed to want to see. The auditor working for one lender may find that the borrower’s representations differ from those made to another lender for the same period.
The stock audit engagement is the bank’s principal mechanism for verifying that the position reported in the stock statements reflects the underlying reality. Where related-party balances are material, the engagement must specifically address the reliability of those balances in the stock statements and not just verify their existence on the audit date.
The identification checklist
The practical procedure for identifying related-party balances comprehensively on both sides is straightforward but disciplined. The auditor should perform every step in every engagement of significant size.
| Step | Action | Output |
| 1 | Obtain AS 18 / Ind AS 24 disclosure from latest audited financials | Authoritative starting list of related parties |
| 2 | Obtain debtor master and creditor master as on audit date | Counterparty universe |
| 3 | Cross-reference AS 18 list against both masters by exact name match | Direct matches identified |
| 4 | Analytical scan of remaining names for indicators (common address, group identifier, common director) | Additional related parties identified |
| 5 | Verify augmented list with borrower’s management; obtain confirmation or denial | Confirmed augmented list |
| 6 | Tabulate RP balances on each side with name, balance, ageing, last activity | Side-by-side schedule |
| 7 | Identify parties appearing on both sides (debtors and creditors with same name) | Offsetting positions |
| 8 | Quantify aggregate RP debtors and RP creditors as percentage of total each side | Concentration metrics |
| 9 | Compute trend across periods if previous engagement data available | Direction of movement |
| 10 | Identify any patterns of synchronised movement (quarter-end adjustments, asymmetric disclosure) | Window-dressing indicators |
| 11 | Document management representations on the substance of significant RP balances | Engagement file record |
| 12 | Present DP computation with appropriate treatment of RP balances per sanction letter | DP output |
Each step is independently small but the combined output gives the bank a complete picture of the related-party position that no single-step analysis would produce.
Reporting the bilateral position
The report format should make the bilateral position visible to the bank’s credit officer without requiring the officer to assemble the picture from multiple sections. Auditor may choose either one or more of following:
First, a dedicated section near the front of the report titled “Related-Party Balances – Combined Position” that provides the headline quantification: aggregate RP debtors, aggregate RP creditors, net RP exposure and the percentages of each side that the RP amounts represent.
Second, a side-by-side schedule showing each related party with the receivable balance, the payable balance (where applicable), the net position and the ageing. The schedule makes the offsetting and concentration patterns visible at a glance.
Third, the DP computation section showing the DP computed under the sanction letter’s prescribed treatment (where the sanction letter addresses related-party treatment) or showing the DP both with and without the related-party amounts (where the sanction letter is silent).
Fourth, the auditor’s observations section noting any specific concerns, trends or patterns identified in the related-party position.
Fifth, the management representation section recording the borrower’s stated position on the related-party transactions and their substance.
This structure ensures that the credit officer reading the report can grasp the related-party situation within five minutes, can see the underlying detail when required, and can apply the bank’s policies to the figures without having to re-perform the analysis.
| Report Element | Purpose | Approximate Length |
| Combined position headline | Allow credit officer to grasp scale and significance | 1 paragraph + 1 small table |
| Party-by-party schedule | Provide complete underlying detail | 1 schedule, full page if needed |
| DP computation with RP treatment | Show numerical impact on bank security | 1 worksheet |
| Auditor’s observations | Identify any specific concerns or patterns | 1 to 3 paragraphs |
| Management representation | Record borrower’s position for the engagement file | 1 paragraph |
Boundaries of the auditor’s role
It is important to maintain the boundary between identification and adjudication. The stock auditor identifies related-party balances, quantifies them, presents the position with the underlying data, and makes observations on patterns visible to a professional auditor. The auditor does not conclude that specific related-party transactions are sham, that diversion has occurred or that the borrower has acted improperly. These determinations belong to the bank’s forensic process or to the appropriate regulatory or legal authorities.
The discipline of staying within the auditor’s role has practical importance for the report’s credibility and for the auditor’s professional protection. An observation that is supported by data and that withstands the borrower’s response in any subsequent natural justice proceeding is useful to the bank. A conclusion that goes beyond the data and that the borrower can challenge will not serve the bank’s purposes when it matters most.
Where the auditor’s observations on related-party balances suggest that further investigation may be warranted, the appropriate report language is that the position is of a nature that the bank may wish to subject to further detailed examination, including forensic investigation that is beyond the scope of the stock audit engagement. This places the question with the bank rather than with the auditor, while ensuring that the bank is aware of the indicators.
A final word
The borrower whose Rs 165 lakhs of related-party debtors and Rs 140 lakhs of related-party creditors I described at the start of this article did not represent a fraud case. The borrower’s management had not falsified records. The related parties were disclosed in the audited financial statements and the AS 18 list was correct. The previous stock audit had touched on the debtor side without addressing the creditor side. The previous auditor had not been negligent in any traditional sense.
What had not happened was the combined examination of both sides. The receivable analysis on its own would not have surfaced the magnitude of the group-internal working capital cycle. The creditor analysis on its own would not either. Only the bilateral view, conducted as a single integrated procedure rather than two separate procedures, revealed the picture the bank needed to see.
The cost of conducting the bilateral analysis rather than the single-sided one is modest. A few additional hours per engagement to cross-reference both masters against the AS 18 list, to tabulate the parties appearing on both sides, to compute the offsetting positions and to identify the patterns. The return on those few hours is the difference between a stock audit report that gives the bank a comfortable but incomplete picture and a stock audit report that gives the bank the information it needs to monitor the credit properly.
The professional standard for stock audit work is moving steadily in the direction of more analytical depth, more cross-referencing of internal data with external sources and more attention to the patterns that single-axis analysis would miss. Related-party transactions are one of the clearest examples of this evolution.
*******
Disclaimer: The views expressed in this article are the personal views and professional observations of the author based on experience in stock and receivables audit practice and are intended solely for academic and informational purposes. They do not constitute legal advice, regulatory guidance, banking policy interpretation, or a definitive professional opinion. References to RBI directions, ICAI pronouncements, accounting standards, and statutory provisions are based on the author’s understanding as on the date of writing and readers should refer to the latest official sources for current guidance. The illustrative examples are anonymised and do not relate to any specific borrower, bank, or audit engagement. Nothing contained herein overrides any applicable law, regulation, professional standard, or institutional policy, all of which shall prevail in case of any inconsistency. The author and Publisher (TAxGuru) accepts no responsibility or liability for any loss, action, or professional consequence arising from reliance on the contents of this article.
Author Bio
