Related-Party Transactions: Definition, Risks, and Regulations

Overview

Related-party transactions are deals between entities or individuals that have a preexisting relationship or common interest—examples include transactions with subsidiaries, affiliates, major shareholders, executives, or family members. While not inherently illegal, these transactions can create conflicts of interest that harm minority shareholders, distort financial statements, or conceal liabilities if not properly disclosed and monitored.

Key takeaways

• A related-party transaction involves parties with a preexisting relationship and can present conflicts of interest.
• Public companies must disclose related-party transactions to promote transparency and protect shareholders.
• Regulators and accounting standards set disclosure and reporting rules, but auditing such transactions can be difficult if disclosures are incomplete.
• High-profile failures—most notably Enron—demonstrate the severe consequences of undisclosed or fraudulent related-party dealings.

Common types of related-party transactions

• Sales and purchases of goods or services between related entities
• Leases and property transfers
• Loans, guarantees, and other financing arrangements
• Service agreements (management fees, consulting)
• Intercompany transfers and allocations among subsidiaries

Regulatory and accounting framework

United States
* The Securities and Exchange Commission (SEC) requires public companies to disclose related-party transactions in periodic filings (e.g., Form 10-K, 10-Q) so investors can assess potential conflicts.
* The Financial Accounting Standards Board (FASB) issues accounting guidance that affects recognition, measurement, and disclosure practices for related-party transactions.

International
* IAS 24 (International Accounting Standard 24) specifies disclosures needed to reveal relationships and transactions that might affect an entity’s financial position or performance.

Tax treatment
* The Internal Revenue Code includes rules (e.g., IRC Section 267 in the U.S.) that limit tax benefits from certain related-party transactions; tax authorities scrutinize property sales and deductible payments between related parties.

Auditing challenges

• Auditors rely on management and boards to disclose related parties and relevant transactions. If management conceals relationships or structures transactions to resemble arm’s-length deals, auditors may not detect problems.
• Related-party transactions may be recorded among ordinary transactions, making them harder to identify and increasing the risk of misstated earnings or fraud.
• Robust internal controls, independent audit committees, and explicit disclosure policies help mitigate these risks.

Case study: Enron

Enron’s collapse highlighted the dangers of abusive related-party transactions. The company used special-purpose entities and related-party arrangements to hide debt and inflate profits. The resulting fraud contributed to Enron’s bankruptcy, criminal convictions, lost retirement savings for employees, and the dissolution of its auditor. That scandal prompted regulatory reforms, including the Sarbanes‑Oxley Act of 2002, which strengthened reporting, audit committee oversight, and internal control requirements.

What investors and boards should watch

• Transparency: Are related-party relationships and terms clearly disclosed in financial statements and filings?
• Approval processes: Does the company require independent board or audit committee approval for significant related-party deals?
• Terms and comparability: Are transaction terms comparable to arm’s-length market terms?
• Controls and documentation: Are policies in place to identify, record, and monitor related-party transactions consistently?
• Auditor independence and review: Does the external auditor adequately test disclosures and controls related to related parties?

Conclusion

Related-party transactions are common and can be legitimate, but they require careful governance, transparent disclosure, and independent oversight to prevent conflicts of interest and financial misrepresentation. Investors, auditors, and boards should prioritize clear policies and scrutiny to protect shareholder value.

References

• U.S. Securities and Exchange Commission — reporting rules for related-party transactions
• Financial Accounting Standards Board — related-party accounting guidance
• IAS 24 — Related Party Disclosures (IFRS)
• Internal Revenue Code Section 267 (U.S.)
• Sarbanes‑Oxley Act of 2002 (corporate governance reforms)