Despite being a normal and sometimes necessary part of operating a business, related-party transactions have developed a bad reputation because they’re sometimes used to disguise poor performance or dishonest activities. Because of this, it’s important for your external audit process to identify related parties and evaluate your interactions with them—especially when market conditions are as volatile as they are today.
How related parties are defined
When it comes to accounting, the term “related parties” is used to refer to “any party that controls or can significantly influence the management or operating policies of the company to the extent that the company may be prevented from fully pursuing its own interests.”
The following are some examples of related parties:
- Affiliates and subsidiaries
- Trusts for the benefit of employees
- Principal owners, officers, directors and managers
- Immediate family members of owners, directors or managers
- Investees accounted for by the equity method
Auditing and related parties
Auditing standards have three main areas of focus when it comes to related parties:
- Related-party transactions
- Major transactions that fall outside the company’s normal course of business or appear to be unusual due to their size, nature, or timing
- Any additional financial relationships involving the company’s owners, managers, directors, or officers
Auditors will attempt to arrive at an in-depth understanding of any related-party financial transactions or relationships and will attempt to ascertain their nature, terms, and business purpose (or, as the case may be, lack of business purpose). During the audit, auditors will gather information that may reveal undisclosed related parties, such as tax filings, information contained on a company’s website, corporate life insurance policies, contracts, and organizational charts.
Bill-and-hold arrangements, contracts for below-market goods or services, subsequent repurchase of goods sold, and uncollateralized loans are also questionable transactions which may suggest unusual or undisclosed related-party transactions to auditors.
Executive compensation
Executives have both the power and the incentive to influence financial reporting in order to meet financial targets. Because of this, auditors apply heightened scrutiny to executive compensation. The auditing standards demand an in-depth assessment of executive compensation, including stock options and performance-based bonuses.
Auditors aren’t required to make recommendations or determinations concerning the reasonableness of compensation arrangements—but they will test the completeness and accuracy of the disclosures and reporting surrounding these transactions.
Contact us for assistance
Presenting your related-party transactions and relationships openly and completely is appreciated by lenders, investors, and other stakeholders. Even if you aren’t sure that a related-party transaction needs to be disclosed or consolidated on your company’s financial statements, you can still help facilitate the audit process by being up-front with auditors about these transactions.
For more information on how related-party accounting rules might apply to your financial relationships and transactions, contact us.