Related Party Transactions: Definition & Examples

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  • 0:03 Understanding…
  • 1:00 Definition of a Related Party
  • 1:59 Related-Party Disclosures
  • 3:04 Associated Risks
  • 4:49 Financial Statement Audits
  • 6:10 Lesson Summary
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Lesson Transcript
Instructor: Lori Forrest

Lori has taught college Finance, Operations and Business courses for over five years. She has a master's degree in both Accounting and Project Management.

In this lesson, we'll define related-party transactions and discuss the requirements companies must follow for financial reporting and auditing. Learn about the possible risks that these transactions may present, including misstatement of accounts and fraudulent financial reporting.

Understanding Related-Party Transactions

Maintaining tight controls over financial reporting requires oversight of many different business transactions. One such transaction involves related parties. The main consideration with a related party is, does a relationship exist prior to the business transaction that could affect the decision making or impact the financial reporting for the organization? An example would be if the vice president of marketing for a company recommended their nephew's company to perform services for their organization. Due to the relationship between the two parties, it would require that any transactions be fully disclosed. Most companies have an annual review with all employees and require them to submit a related-party transaction screening form to help self-identify these relationships for reporting and auditing purposes. While these transactions are not illegal, the reporting and disclosure requirements, if not followed, can result in significant fines and penalties, and create a red flag for investors.

Definition of a Related Party

Most companies have policies and procedures in place to document and disclose related-party transactions. Oftentimes, management approval, significant additional oversight, and internal audit may apply to these transactions, ensuring they follow all legal and ethical guidelines. There are several different definitions for related parties, but many are very common:

  • The party could be a partner, colleague, or associate of the company.
  • One of the parties has significant or common control over the other party.
  • The party is a close family member of a business owner or key management staff. A close family member is defined as spouse, children, or dependents of the individual or spouse.
  • The party is a joint venture partner.
  • The party is significantly controlled or influenced by the business owner or key management staff.
  • The party is a key management member or a parent company's key management member.
  • The party provides post-employment benefit plans for the company's employees.

Related-Party Disclosures

There are many different ways to define a related party, however, financial reporting standards have guidelines that define situations in which a related party must be disclosed. The US Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), as well as US Generally Accepted Accounting Principles (GAAP) all provide standards and guidance regarding related-party transactions. Each of the governing agencies has published disclosures which further explain the effect of related-party transactions on an organization's financial statements. The definitions of a related party are broadly similar, and industry standards require that the nature of the relationship, a description of the transaction, and the amounts involved (including outstanding balances) be disclosed for related-party transactions. None of the standards contain any measurement or recognition requirements for related-party transactions. Those responsible for financial reporting should fully understand the disclosure requirements for each reporting agency that has authority to audit their financial statements.

Associated Risks

Related-party transactions provide an opportunity for management to act in their own best interest, which can pose significant risk to the company, including financial reporting misstatement or fraud. In some cases, the related-party transaction may be legitimate and fully disclosed, but there are different factors which may cause someone to commit fraud. Auditors consider a fraud triangle model, which focuses on three components: incentive/pressure, rationalization, and opportunity. Executive officers are in a position to override or manipulate the internal control design and abuse an internal control weakness for their own gain.

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