Understanding Related-Party Transactions
A related-party transaction refers to a deal or arrangement made between two parties who have a preexisting business relationship or common interest. Companies often seek business deals with familiar parties, which can be both beneficial and risky.
Key Takeaways
- A related-party transaction involves parties that already have some kind of business relationship.
- These transactions are scrutinized by regulatory bodies as they may carry the potential for conflicts of interest.
- Improperly handled related-party transactions can lead to fraud and financial ruin.
- Public companies are required to disclose related-party transactions to ensure transparency and legality.
Examples of Related-Party Transactions
Companies often engage in business dealings with related parties like business affiliates, shareholder groups, subsidiaries, and minority-owned companies. These transactions can include sales, leases, service agreements, and loan agreements. For example, hiring a major shareholder’s business for office renovations.
Legal and Ethical Concerns
Although these transactions aren’t necessarily illegal, they can cloud the business environment and limit competition. In some cases, they must receive approval from a company’s management or board of directors. Additionally, U.S. securities regulatory agencies require disclosures to avoid conflicts of interest and to protect shareholders’ value.
Regulatory Oversight
In the United States, the Securities and Exchange Commission (SEC) mandates that all publicly traded companies disclose their related-party transactions in their quarterly and annual reports. This ensures transactions are transparent, legal, and ethical.
Reporting and Transparency
Companies must report related-party transactions transparently to ensure legal and ethical actions that do not compromise shareholder value. The Financial Accounting Standards Board (FASB) has set standards to guide such transactions, including monitoring payment terms and authorized expenses.
Special Challenges in Auditing
Although there are rules for related-party transactions, they can be challenging to audit. If owners and managers withhold disclosure for personal gain, these transactions might go undetected, potentially leading to fraud and improperly inflated earnings.
Example: Enron’s Downfall
One notorious example of related-party transactions leading to disaster is Enron. This U.S.-based energy company used related-party transactions with special-purpose entities to hide billions in debt, misleading their board, employees, and the public. The fraudulent activities led to bankruptcy, legal sentences, and financial ruin for involved parties. This scandal also resulted in the Sarbanes-Oxley Act of 2002, which set new regulations to prevent such conflicts of interest.
What Are Related Parties?
Related parties can include parent companies, subsidiaries, associate firms, joint ventures, or entities managed by a person who is a related party.
IFRS Regulations
IAS 24 under IFRS covers the disclosure needs for related parties to ensure that an entity’s financial position and profit/loss accounts consider related-party transactions.
IRS Scrutiny
The IRS closely examines related-party transactions for conflicts of interest and may deny any tax benefits claimed from suspicious transactions, particularly scrutinizing property sales and deductible payments between related parties.
Related Terms: conflict of interest, financial disclosure, business affiliates, subsidiaries.
References
- U.S. Securities and Exchange Commission. “Exchange Act Reporting and Registration”.
- Financial Accounting Standards Board. “Statement of Financial Accounting Standards No. 57 Related Party Disclosures”.
- U.S. Securities and Exchange Commission. “SEC Statement Regarding Andersen Case Conviction”.
- IFRS. “IAS 24 Related Party Disclosures”.
