A related party transaction is a business deal or arrangement between two parties who are joined by a special relationship prior to the deal. A commonly seen related party transaction is a shareholder owning real estate and having a lease agreement with the corporation he owns shares in for the office space.

Besides a shareholder and the corporation, who has a special relationship resulting in related party transactions? Generally Accepted Accounting Principles (“GAAP”) guidance gives us examples of related party transactions including those between:

• - A parent entity and its subsidiaries
• - Subsidiaries of a common parents
• - An entity and trusts for the benefit of employees, such as pension and profit-sharing trusts
• - An entity and its principal owners, management, or members of their immediate families
• - Affiliates

Related party transactions as defined above are a normal feature of business and commerce. It is common for entities to operate separate parts of their activities through subsidiaries, associates or joint ventures. Common examples of related party transactions from GAAP guidance include:

• - Sales or purchase of property
• - Accounting, management, or similar services rendered
• - Lease of property or equipment
• - Borrowing relationships, including guarantees
• - Compensating bank balance relationships
• - Intra-entity billings based on allocations of common costs
• - Filing of consolidated tax returns

Even though related party transactions are customary and ordinary, these relationships can have an effect on the profit or loss and financial position of an entity. Related parties may enter into transactions that unrelated parties would not have access to, or into transactions being effected at different amounts from those that would prevail between unrelated parties. The special relationship inherent between related parties can create a conflict of interest that can result in actions that benefit the people involved as opposed to the shareholders.  For example, in the infamous Enron scandal related party transactions with “special-purpose entities” were used to help the company misreport their accounting numbers.

It is not just high-profile cases like Enron that attract lawyers and lawmen. It is not unusual to find homeowners associations or local governments enmeshed in litigation due to undisclosed related party transactions. Whether you are a business owner, investor, analyst, banker, or homeworker, you need to know if the information provided to you in a financial statement represents the true picture of the entity.

Accounting industry standards agree that a financial statement user should be able to read the financial statements of two companies in the same industry and feel comfortable that they are comparing apples to apples. Information about transactions with related parties is useful in comparing an entity’s results of operations and financial position with those of prior periods and with those of other entities. If two companies in the same industry have nearly identical balance sheets, income statements and cash flow statements, but only one set of financial statements contains disclosure of numerous related party transactions, the user can make an informed decision about the value of each company.

Based on the Federal Accounting Standards Board, a related party transaction can also occur without accounting recognition. For example, an entity may receive services from a related party without charge and not record receipt of the services. While not providing accounting or measurement guidance for such transactions this requires disclosure nonetheless.

When a related party disclosure is required, the disclosure should include a discussion of the nature of the relationship of the entities involved, a description of the transaction - including transactions to which no amounts or nominal amounts were ascribed, any information a user might need to understand the transaction, the dollar amount of the transactions during the reporting period along with any change in the method of establishing the terms from that used in the preceding period, and amounts due from or to related parties.

After reading a complete related party disclosure, a financial statement user can evaluate the significance of these transactions and make an educated decision.

Have a question about related party transactions? Contact us in Brea, 714.990.1040, or Visalia, 559.732.4135!