What Is a Related-Party Transaction?
The term related-party transaction refers to a deal or arrangement made between two parties who are joined by a preexisting business relationship or common interest. Companies often seek business deals with parties with whom they are familiar or have a common interest. Although related-party transactions are themselves legal, they may create conflicts of interest or lead to other illegal situations. Public companies must disclose these transactions.
- A related-party transaction is an arrangement between two parties that have a preexisting business relationship.
- Some, but not all, related party-transactions carry the innate potential for conflicts of interest, so regulatory agencies scrutinize them carefully.
- Unchecked, the misuse of related-party transactions could result in fraud and financial ruin for all parties involved.
- American regulatory bodies ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively.
Understanding Related-Party Transactions
It isn't uncommon for companies to do business with people and organizations with whom they already have relationships. This kind of business activity is called a related-party transaction. The most common types of related parties are business affiliates, shareholder groups, subsidiaries, and minority-owned companies. Related-party transactions can include sales, leases, service agreements, and loan agreements.
As mentioned above, these types of transactions are not necessarily illegal. But they can cloud the business environment by leading to conflicts of interest as they show favorable treatment for close associates of the hiring business. Consider a company that hires a major shareholder's business to renovate its offices. In some cases, related-party transactions must be approved by management consensus or a company’s board of directors. These transactions also limit competition in the marketplace.
In the United States, securities regulatory agencies help to ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively. For instance, the Securities and Exchange Commission (SEC) requires that all publicly-traded companies disclose all transactions with related parties—such as executives, associates, and family members—in their quarterly 10-Q reports and their annual 10-K reports. As such, many companies have compliance policies and procedures in place that outline how to document and implement related-party transactions.
Related-party transactions must be reported transparently to ensure that all actions are legal and ethical and do not compromise shareholder value.
The Internal Revenue Service (IRS) also examines related-party transactions for any conflicts of interest. If it finds conflicts, then the IRS will not allow any tax benefits claimed from the transaction. In particular, the IRS scrutinizes property sales between related parties and deductible payments between related parties.
The Financial Accounting Standards Board (FASB), which establishes accounting rules for public and private companies as well as nonprofits in the United States, has accounting standards for related-party transactions. Some of these standards include monitoring of payment competitiveness, payment terms, monetary transactions, and authorized expenses.
Although there are rules and standards for related-party transactions, they tend to be difficult to audit. Owners and managers are responsible for disclosing related parties and their interests, but if they withhold disclosure for personal gain, the transactions could go undetected. Transactions with related parties may be recorded among similar normal transactions, making them difficult to distinguish. Hidden transactions and undisclosed relationships could lead to improperly inflated earnings, even fraud.
Example of Related-Party Transaction
Enron was a U.S.-based energy and commodities company based in Houston. In the infamous scandal of 2001, the company used related-party transactions with special-purpose entities to help conceal billions of dollars in debt from failed business ventures and investments. The related parties misled the board of directors, their audit committee, employees, as well as the public.
These fraudulent related-party transactions led to Enron's bankruptcy, prison sentences for its executives, lost pensions and savings of employees and shareholders, and the ruin and closure of Arthur Andersen, Enron's auditor, which was found guilty of federal crimes and SEC violations.
This financial disaster led to the development of the Sarbanes-Oxley Act of 2002, which established new and expanded existing requirements for U.S. public company boards, management, and public accounting firms, including specific rules that limit conflicts of interest arising from related-party transactions.