As we enter into another audit busy season, I have started my standard exercise of compiling a list of frequently encountered audit and accounting issues that require research, additional analysis and often times detailed disclosures and even material adjustments to my client’s financials. An oft-recurring theme is the existence of related party transactions and how such transactions are recorded and disclosed.
Below are a few frequently asked questions on this subject that merit our attention:
Who are related parties?
Parties are considered related when there exists a relationship either through ownership, contractual right, personal or family relationship, which allows one entity to control or influence another. Some common examples are common control entities (parent companies, subsidiaries, and affiliates), owners of the Company, members of management, family members, companies owned by the same individuals or entities, etc.
Why do we care to track activities with related parties?
The underlying presumption for transactions reflected in financial statements is that the terms were at an arm’s length or at an equal footing. However, when a transaction with a related party occurs, such a representation is misleading as the transaction might not even have occurred, but for the special relationship between the entities. Therefore it becomes necessary to make necessary disclosures of related party transactions to not mislead the users of the statements. Adequate disclosures help users evaluate the entity’s results of operations, after adjusting for related party transactions.
What are some typical related party transactions that need special disclosures or accounting treatment?
Some common transactions with related parties include sales, purchases of goods and services, management fees, notes receivable, notes payable, guarantees, interest-free loans, etc. Special disclosures include but are not limited to the nature of the relationship, description of the transaction, dollar amounts involved in the transactions, amounts due from or payable to related parties on the balance sheet date, guarantees of debt made on behalf of related entities that could impact amounts payable by the reporting entity, etc. Special accounting treatment may include imputing interest on a note where there is no stated interest rate or the stated rate does not reflect market rates.
What could be the impact of omitting to record or properly disclose related party transactions?
Besides the obvious impact of not revealing all relevant facts to users who rely on these financials, there are other consequences of incorrectly recording or omitting related party transactions. In the case of purchase and sale of goods or services between related entities across geographies, taxing authorities are interested in knowing that the transfer price between the related parties includes an adequate profit margin. The absence of adequate documentation or support for transfer pricing could result in additional taxes or penalties. Another possible fallout of the failure to record related party transactions is the impact on loan covenants when such transactions are later discovered and adjusted from net income or ratio calculations, causing the reporting entity to violate its covenants.
Hopefully, the above concepts help gain an understanding of the importance of reporting for related party transactions to avoid future heartburn.