Related party transactions seem straightforward. For privately-held companies, related party transactions are a fact of business, and they may seem totally harmless. However, recently related party transactions have caught my attention. My fellow blogger, Deepa Bhat, identified steps to reduce risks associated with related party transactions. But what about transactions that happen that seem such a normal part of business that no one thinks of them as related party transactions? And what’s the big deal anyways?
The big deal is that these transactions can lead to questions from investors or lenders. In accounting speak, a related party is an entity or an individual that can control or significantly influence a company’s policies such that the company might not act in its own best interest. A company’s business is assumed to function on an “arm’s-length” basis. When transactions happen between a company and a related party, it is possible that the close association may result in some special terms or circumstances. Related parties may include the stockholders of the company, a company with common ownership, employees of the company (specifically management) and their family members. Related party transactions may include shareholders loaning money to the company and obtaining loans or equity funds from family members. Even when members of management or shareholders get reimbursed for expenses paid personally, a related party transaction has occurred.
Transparency is essential in financial reporting, and investors and lenders don’t like surprises. That is why disclosures are so important. Beyond that, identifying who is considered a related party for the company is very important. What might seem like a transaction that would be completed on the same terms as would have been used with any third party, still needs to be identified with the terms spelled out if a related individual or company is involved. Finding out about undisclosed related party transactions leads to questions of integrity.
It’s not worth the risk. So if in doubt, identify and disclose.