What is Related-Party Transaction?
A related-party transaction is a business deal or arrangement between two parties who are joined by a preexisting special relationship. For example, a business transaction between a major shareholder and a corporation, such as a contract for the shareholder's company to perform renovations to the corporation's offices, would be deemed a related-party transaction.
Breaking Down Related-Party Transaction
Related-party transactions are common in business. For example, companies often seek to secure business deals with parties with whom they are familiar or have a common interest. While these types of transactions are legal, the special relationship inherent between the involved parties creates potential conflicts of interest. However, regulations exist to prevent an unfair advantage granted to related parties.
A number of regulatory procedures are in place to ensure that related-party transactions are conflict-free and do not negatively affect value for shareholders. American public companies are required to disclose all transactions with related parties, such as executives, associates, and family members, in their annual 10-K reports. As a result of this added reporting requirement, many companies have special policies and corporate compliance procedures to ensure that related-party transactions are appropriately documented and enacted.
Related parties and business services can take many different forms. Some of the most common types of related parties include business affiliates, shareholder groups, subsidiaries, and minority-owned companies. Related party transactions can include sales, leases, service agreements, and loan agreements.
In large corporate situations, public companies are often minority or majority-owned by other entities. These entities may have similar business interests due to business commonalities. In these cases, related-party transactions may naturally occur, such as vendor or supplier relationships for the mutual benefit of both companies.
Accounting and Auditing Standards
The management of policies and procedures that track related-party transactions and business deals include a number of factors. These factors are regulated by the industry’s accounting and audit standards, and, in many cases, these special transactions must be approved by management consensus or the company’s board of directors. Some specific standards and procedures set for related-party transactions include the monitoring of payment competitiveness, payment terms, monetary transactions, and authorized expenses. Overall, all related-party transactions must be transparently reported to ensure that all actions are legal and ethical and do not harm shareholder value.
Although there are rules and standards for related-party transactions, they are difficult to audit. The transactions are not always easily identifiable, and the disclosure of related parties is the responsibility of the owners and management, who may choose to withhold disclosure for personal gain. If owners or managers do not disclose related parties and their interests, the transactions can go undetected. Transactions with related-parties may be hidden among similar normal transactions, making them difficult to distinguish. Hidden transactions and undisclosed relationships could lead to improperly inflated earnings and fraud. Additionally, a company's internal control systems may not be sophisticated enough to properly track these transactions.
One example of fraudulent use of related-party transactions is the infamous Enron scandal, in which related-party transactions with "special-purpose entities" were used 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, and the public. The fraudulent related-party transactions led to the bankruptcy of Enron, 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. Misuse of related-party relationships affects more than the direct parties involved, as seen with Enron. Out of this disaster was birthed the Sarbanes-Oxley Act of 2002, which established new and expanded existing requirements for United States public company boards, management, and public accounting firms, including rules that limit conflicts of interest arising from related-party transactions.