What is Related Party Transactions?
The term “related party transactions” refers to various arrangements or deals that take place between two associated parties with the intent to transfer services, resources, or obligations. In some cases, these transactions are carried out at a specially agreed price, which then has an influence on the financial statements of the entity. As such, these transactions have serious financial implications and so are required to be disclosed in the financial statements.
In a normal business set-up, companies usually carry out business operations and strike deals with parties with whom they share some common interest. These type of arrangements are considered to be legal. However, at times these transactions can result in inpotential conflict of interest. As such, most of the transactions require the approval of the company’s board of directors or senior management.
Examples of Related Party Transactions
Following are the examples are given below:
Let us take the following example to understand how reporting of related party transactions happens. Let us assume that ASD Inc. owns 60% shares of SDF Inc. During FY2019, SDF Inc. sold goods worth $15 Million to ASD Inc.
Since ASD Inc. holds more than 51% shareholding in SDF Inc., ASD Inc. is the holding company of SDF Inc. Therefore, the purchase transaction between ASD Inc. and SDF Inc. needs to be disclosed in the financial statement of ASD Inc. and the consolidated financial statement. In the disclosure, the nature of the transactions also has to be captured.
Let us take another example to understand the concept of related party transactions. ZXC Inc. recently invested in GHJ Inc. and currently owns 26% of its shares. On the other hand, GHJ Inc. holds 51% shares in BNM Inc.
Since ZXC Inc. holds more than 20% in GHJ Inc., GHJ Inc. is the associate company of ZXC Inc. and any transactions between them have to be disclosed in the ZXC Inc.’s financial statement and in the consolidated financial statement. In fact, all the transactions among ZXC Inc., GHJ Inc., and BNM Inc. have to be recorded in the financial statements asBNM Inc. is GHJ Inc.’s subsidiary, which is again the associate company ofZXC Inc.
How are Related Party Transactions Regulated?
The regulations can be categorized into the following three heads:
- Governing agencies
- Accounting standards
1. Governing Agencies
As per Securities and Exchange Commission (SEC), all the publicly traded companies are required to disclose their transactions, which may include transactions with associates, executives or family members, in both quarterly (Form 10-Q) and annual (Form 10-K)reporting. Consequently, most of the companies maintain documented records for all related party transactions.
On the other hand, the Internal Revenue Service (IRS) evaluates the transactions for any instances of “conflict of interest”. In case the IRS is able to detect any such issue, then all the tax benefits associated with the transaction are rejected. The IRS majorly focus on transactions that involve the sale of property and deductible payments between related parties.
2. Accounting Standards
The Financial Accounting Standards Board (FASB) is responsible for establishing accounting rules for all companies as well as non-profit organizations in the US. The FASB has put in place certain accounting standards for related party transactions, such as monitoring terms of payment along with its competitiveness, monetary transactions, etc.
It is important to disclose all material information pertaining to related party transactions, which include the nature of the relationship as well as transaction, the monetary value of the transaction, and method of allocation of current and deferred tax expense among the related parties. In case of common ownership, disclose the nature of the relationship between the controlling entity and controlled entity. The disclosures are done with the intent to ensure that there is scope for any conflict of interest.
Consequences of Related Party Transactions
Some of the major consequences are as follows:
- A company can incur heavy losses as a result of related party transactions that are not carried out at favorable arrangements.
- At times management personnel hide facts pertaining to such transactions in order to gain illicit benefits.
- Financial statements end up presenting a false and unfair picture of the company in the absence of properly disclosed related part transactions.
Threshold Limits of Related Party Transactions
The threshold limit for related party transaction varies across nations and some of them have been captured below:
- Italy: Transactions such as the issue of securities, asset acquisition, and revenue transactions are considered to be material if the transaction is equivalent to 5% of the lower of market capitalization or assets or a lower threshold established by the company.
- Canada: A related party transaction, which may include the issue of securities, asset acquisition, and revenue transactions, is considered to be material if it exceeds 25% of market capitalization. However, there are exceptions to it.
- Singapore: Asset acquisitions and revenue transactions between related parties are considered to be material if it is more than 5% of the group’s latest audited net tangible assets.
- US: Issue of securities considered to be material if it exceeds 1% of securities outstanding or a lower threshold as per the review of an appropriate group within the company.
- China: Transactions such as asset acquisition and revenue transactions are considered to be material if the transaction is equivalent to 5% of the company’s latest audited net asset value and ¥30 million in absolute terms.
So, it can be inferred that it is very important that companies disclose all the material information pertaining to related party transactions to ensure that there is no scope for fraud. A transaction carried out at arm’s length price is what is recommended and prescribed by the accounting standards and policies under various governing bodies.
This is a guide to Related Party Transactions. Here we also discuss what is related party transactions along with how it is regulated and the major consequences. You may also have a look at the following articles to learn more –