Glossary

4.4 Related party transactions

9 min read•august 19, 2024

Related party transactions are a crucial aspect of financial reporting, involving entities or individuals connected to a reporting entity. These transactions can significantly impact financial statements and pose risks of misstatement or fraud.

Understanding related party transactions is essential for assessing their substance and potential risks. Types include sales of goods or assets, services, leases, research transfers, licenses, finance arrangements, guarantees, and compensation. Proper disclosure and auditing of these transactions are vital for transparent financial reporting.

  • Related parties are entities or individuals that are connected to a reporting entity through control, joint control, significant influence, or key management positions
  • Connections between related parties can impact the terms and conditions of transactions, potentially differing from those between unrelated parties
  • Understanding related party relationships is crucial for assessing the substance and potential risks of transactions in financial reporting

Sale or purchase of goods

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  • Involves the transfer of inventory or finished products between related parties
  • Prices may be set at arm's length or could deviate from market rates, impacting profitability and tax liabilities
  • Examples include a parent company selling raw materials to its subsidiary at a discounted price or a subsidiary purchasing finished goods from its parent company at an inflated price

Sale or purchase of property and other assets

  • Relates to the transfer of tangible or intangible assets between related parties
  • Asset valuations and terms of sale may be influenced by the related party relationship
  • Examples include a company selling a building to a related party at a price above or below fair market value or a parent company transferring intellectual property rights to a subsidiary without adequate compensation

Rendering or receiving of services

  • Involves the provision of services between related parties, such as management, consulting, or technical support
  • Service fees may be set at rates that differ from those charged to unrelated parties
  • Examples include a parent company providing administrative services to its subsidiaries at inflated prices or a subsidiary offering IT support to its parent company at a discounted rate

Leases

  • Relates to the leasing of assets between related parties, such as property or equipment
  • Lease terms and conditions may be influenced by the related party relationship, potentially deviating from market rates
  • Examples include a company leasing office space from a related party at below-market rates or a subsidiary leasing equipment to its parent company at above-market rates

Transfer of research and development

  • Involves the sharing or transfer of research and development activities and results between related parties
  • The terms of the transfer, including pricing and intellectual property rights, may be influenced by the related party relationship
  • Examples include a parent company funding its subsidiary's research projects or a subsidiary transferring its research findings to its parent company without adequate compensation

License agreements

  • Relates to the granting of licenses for the use of intellectual property, such as patents, trademarks, or copyrights, between related parties
  • License fees and royalty rates may be set at levels that differ from those charged to unrelated parties
  • Examples include a parent company granting a subsidiary the right to use its trademarks at a nominal fee or a subsidiary licensing its patents to its parent company at above-market royalty rates

Finance arrangements

  • Involves the provision of loans, guarantees, or other financial support between related parties
  • Interest rates, repayment terms, and collateral requirements may be influenced by the related party relationship
  • Examples include a parent company providing an interest-free loan to its subsidiary or a subsidiary guaranteeing the debt obligations of its parent company

Provision of guarantees or collateral

  • Relates to the offering of guarantees or collateral by one related party to secure the obligations of another
  • The terms and conditions of the guarantee or collateral arrangement may be influenced by the related party relationship
  • Examples include a parent company providing a guarantee for its subsidiary's bank loan or a subsidiary pledging its assets as collateral for its parent company's debt

Settlement of liabilities

  • Involves the assumption or settlement of liabilities between related parties
  • The terms of the settlement, including the amount and timing of payments, may be influenced by the related party relationship
  • Examples include a parent company assuming the pension obligations of its subsidiary or a subsidiary settling a legal claim on behalf of its parent company

Compensation of key management personnel

  • Relates to the remuneration and benefits provided to key management personnel, such as directors and executives, who are considered related parties
  • Compensation arrangements may be influenced by the related party relationship and could potentially be above or below market rates
  • Examples include a company providing its CEO with a generous performance bonus or a subsidiary offering its key executives stock options in the parent company
  • The identity of the related party involved in the transaction must be disclosed
  • Disclosure should include the name of the related entity or individual
  • Examples include disclosing the name of the parent company, subsidiary, associate, joint venture, or key management personnel involved in the transaction

Nature of the relationship

  • The nature of the relationship between the reporting entity and the related party must be disclosed
  • Disclosure should specify the type of relationship, such as , associate, joint venture, or key management personnel
  • Examples include disclosing that the transaction is between a parent company and its wholly-owned subsidiary or between the reporting entity and a joint venture in which it has a 50% interest

Description of the transactions

  • The nature and characteristics of the related party transactions must be disclosed
  • Disclosure should provide a clear understanding of the types of transactions involved, such as sales, purchases, leases, or provision of services
  • Examples include disclosing that the transaction involves the sale of goods from the parent company to its subsidiary or the provision of management services by the reporting entity to its associate

Transaction amounts

  • The monetary amounts of the related party transactions must be disclosed
  • Disclosure should include the total value of the transactions during the reporting period
  • Examples include disclosing that the total sales to a related party amounted to 10millionorthatthereportingentityreceivedmanagementfeesof10 million or that the reporting entity received management fees of 500,000 from its subsidiary

Outstanding balances and commitments

  • The outstanding balances and commitments arising from related party transactions must be disclosed
  • Disclosure should include the amounts owed to or by the related parties at the end of the reporting period and any future commitments or obligations
  • Examples include disclosing that the reporting entity has a receivable of 2millionfromitsassociateorthatithascommittedtopurchasegoodsworth2 million from its associate or that it has committed to purchase goods worth 5 million from its parent company in the next financial year

Terms and conditions

  • The key terms and conditions of the related party transactions must be disclosed
  • Disclosure should include information such as pricing policies, payment terms, interest rates, and any collateral or guarantees provided
  • Examples include disclosing that the sales to a related party are made at a 10% discount compared to market prices or that the loan provided to a subsidiary bears an interest rate of 5% per annum

Provisions for doubtful debts

  • Any provisions made for doubtful debts related to outstanding balances from related party transactions must be disclosed
  • Disclosure should include the amount of the provision and the basis for its determination
  • Examples include disclosing that a provision of $100,000 has been made for doubtful debts related to a receivable from a related party, based on an assessment of the related party's financial position and historical payment patterns

Expense recognition for bad or doubtful debts

  • Any expenses recognized in the reporting period for bad or doubtful debts related to related party transactions must be disclosed
  • Disclosure should include the amount of the expense and the circumstances leading to its recognition
  • Examples include disclosing that an expense of $50,000 has been recognized for a bad debt related to a related party transaction, due to the related party's insolvency or default on payment

Potential conflicts of interest

  • Related party transactions may give rise to potential conflicts of interest
  • Conflicts can occur when the interests of the related parties are not aligned with those of the reporting entity or its stakeholders
  • Examples include a manager favoring a related party supplier over other competitive suppliers or a director approving a transaction that benefits their personal interests at the expense of the company

Impact on financial statements

  • Related party transactions can have a significant impact on the financial statements of the reporting entity
  • Transactions that are not conducted at arm's length may distort the true financial performance and position of the entity
  • Examples include related party transactions inflating revenue or understating expenses, leading to overstated profits or concealing the true level of indebtedness

Risks of misstatement or fraud

  • Related party transactions may pose risks of misstatement or fraud in financial reporting
  • The close relationships between related parties can be exploited to manipulate transactions or engage in fraudulent activities
  • Examples include related parties colluding to create fictitious transactions, inflate asset values, or conceal liabilities, resulting in material misstatements in the financial statements
  • Auditors need to identify related parties and transactions to assess their impact on the financial statements
  • Identification involves understanding the reporting entity's relationships, reviewing contracts and agreements, and inquiring with management and those charged with governance
  • Examples of identification procedures include reviewing shareholder registers, minutes of board meetings, and declarations of interests by key management personnel

Assessing risks of material misstatement

  • Auditors must assess the risks of material misstatement associated with related party transactions
  • Risk assessment considers factors such as the nature and complexity of the transactions, the potential for management override of controls, and the incentives or pressures that may motivate misstatement
  • Examples of high-risk transactions include those that are unusual, lack commercial substance, or are not properly authorized or approved

Obtaining sufficient appropriate audit evidence

  • Auditors need to obtain sufficient appropriate audit evidence regarding related party transactions
  • Audit procedures may include external confirmations, examination of supporting documents, and testing the effectiveness of relevant controls
  • Examples of audit evidence include invoices, contracts, bank statements, and representations from management or those charged with governance

Evaluating accounting treatment and disclosures

  • Auditors must evaluate the accounting treatment and disclosures of related party transactions in the financial statements
  • Evaluation involves assessing compliance with applicable financial reporting standards, such as Related Party Disclosures
  • Examples of evaluation procedures include reviewing the completeness and accuracy of disclosures, assessing the appropriateness of accounting policies, and considering the adequacy of explanations provided in the notes to the financial statements

Parent-subsidiary transactions

  • Transactions between a parent company and its subsidiaries are common related party transactions
  • Examples include intercompany sales, loans, management fees, and dividend payments
  • Specific transactions may involve a parent company selling raw materials to its subsidiary at a discounted price or a subsidiary providing administrative services to its parent company at an inflated rate

Associate company transactions

  • Transactions between a reporting entity and its associate companies are considered related party transactions
  • Examples include sales of goods or services, leasing arrangements, and financing transactions
  • Specific transactions may involve a company selling products to its associate at preferential terms or an associate providing consulting services to the reporting entity at above-market rates

Joint venture transactions

  • Transactions between a reporting entity and its are classified as related party transactions
  • Examples include contributions of assets, provision of services, and sharing of costs or revenues
  • Specific transactions may involve a company transferring intellectual property to a joint venture without adequate compensation or a joint venture leasing equipment to the reporting entity at below-market rates

Transactions with key management personnel

  • Transactions between a reporting entity and its key management personnel, such as directors and executives, are related party transactions
  • Examples include compensation arrangements, loans, and provision of goods or services
  • Specific transactions may involve a company granting stock options to its CEO at favorable terms or a director purchasing a company-owned property at a price below fair market value

Key Terms to Review (18)

Arm's length principle: The arm's length principle is a guideline in international taxation and transfer pricing that requires transactions between related parties to be conducted as if they were unrelated parties, ensuring that the prices charged are consistent with those that would be agreed upon in a competitive market. This principle is vital for maintaining fairness in taxation and preventing profit shifting among multinational companies.
ASC 850: ASC 850 is the Accounting Standards Codification topic that addresses related party transactions, providing guidelines on how to disclose transactions and relationships between entities and their related parties. This standard aims to enhance the transparency and understanding of these transactions in financial reporting, ensuring that users of financial statements are aware of potential conflicts of interest and the economic substance behind these relationships.
Cost method: The cost method is an accounting approach used for recognizing the value of investments in subsidiaries and associated companies, reflecting the initial purchase price without considering any changes in fair value thereafter. This method is particularly relevant in scenarios involving related party transactions, where the pricing and terms may differ from those in open market transactions, impacting how these investments are reported on financial statements.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of financial reform legislation enacted in 2010 in response to the 2008 financial crisis. Its primary aim is to increase transparency in the financial system, protect consumers, and prevent future economic collapses by regulating financial institutions and enhancing oversight of financial markets.
Earnings Management: Earnings management refers to the intentional manipulation of financial statements to present a desired picture of a company's financial performance. This practice can involve the timing of revenue recognition, expenses, and other accounting entries to smooth out earnings over time, often creating a more favorable impression for investors and stakeholders. While it can be legal and considered part of standard accounting practices, excessive or deceptive earnings management can lead to ethical issues and financial misrepresentation.
Fair Value Measurement: Fair value measurement is the process of estimating the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This concept plays a crucial role in financial reporting, affecting how assets and liabilities are valued on financial statements and guiding various accounting practices across different jurisdictions.
Financial Accounting Standards Board (FASB): The Financial Accounting Standards Board (FASB) is an independent organization responsible for establishing and improving financial accounting and reporting standards in the United States. FASB plays a critical role in ensuring transparency, consistency, and comparability in financial statements, which is essential for investors and stakeholders to make informed decisions.
Financial statement fraud: Financial statement fraud involves the intentional misrepresentation or omission of financial information with the aim to deceive users of those statements. This form of fraud can lead to significant consequences, including legal penalties and damage to reputations. It often occurs in the context of overstating revenues, understating liabilities, or manipulating expenses to present a more favorable financial position than what truly exists.
IAS 24: IAS 24, also known as 'Related Party Disclosures,' is an International Accounting Standard that requires entities to disclose information about transactions with related parties. This standard ensures transparency in financial reporting by requiring organizations to reveal the nature and extent of related party relationships, transactions, and outstanding balances, which can significantly impact the financial position and performance of the entity.
International Accounting Standards Board (IASB): The International Accounting Standards Board (IASB) is an independent organization responsible for developing and maintaining international financial reporting standards (IFRS) to ensure transparency, accountability, and efficiency in financial markets globally. The IASB plays a vital role in fostering consistency in accounting practices across different countries, which helps businesses and investors make informed decisions.
Joint Ventures: A joint venture is a business arrangement where two or more parties come together to undertake a specific project or business activity, sharing resources, risks, and profits. This collaborative approach allows companies to leverage each other’s strengths and market knowledge, while also creating a separate legal entity for the venture that can operate independently. Joint ventures can be particularly beneficial in international markets, where local expertise is crucial for success.
Materiality: Materiality is a concept in accounting and financial reporting that refers to the significance of information that could influence the decision-making of users of financial statements. This principle helps determine what information should be disclosed and how it should be presented, ensuring that stakeholders receive all relevant information for informed judgments.
Non-controlling interest: Non-controlling interest refers to the equity ownership in a subsidiary not attributable to the parent company, representing the portion of equity held by other shareholders. This concept is essential for accurately presenting the financial position and performance of a consolidated group, reflecting the rights of minority shareholders and ensuring transparency in financial reporting.
Parent-subsidiary: A parent-subsidiary relationship occurs when one company (the parent) holds a controlling interest in another company (the subsidiary), typically owning more than 50% of its voting stock. This structure allows the parent company to exert significant influence over the subsidiary's operations, financial reporting, and strategic decisions, leading to consolidated financial statements that reflect the performance of both entities.
Related party disclosure notes: Related party disclosure notes are a set of notes in financial statements that provide detailed information about transactions and relationships with related parties, such as subsidiaries, associates, joint ventures, and key management personnel. These disclosures are crucial for ensuring transparency and helping users of financial statements understand the potential impact of these transactions on the financial position and performance of an entity.
Sarbanes-Oxley Act: The Sarbanes-Oxley Act is a federal law enacted in 2002 to protect investors from fraudulent financial reporting by corporations. It establishes stricter requirements for financial disclosures, corporate governance, and the responsibilities of boards of directors, thereby enhancing accountability and transparency in financial practices.
Transaction details: Transaction details refer to the specific information about a financial transaction, including the parties involved, the nature of the transaction, amounts exchanged, and the terms of agreement. These details are critical for accurately recording and reporting related party transactions, ensuring compliance with relevant accounting standards and regulations.
Transparency: Transparency refers to the clarity and openness with which organizations communicate their financial and operational information, allowing stakeholders to understand and evaluate their activities and decisions. This concept is essential in fostering trust, accountability, and informed decision-making among investors, regulators, and the public.
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