# Understanding Related-Party Transactions: Risks and Regulations

## What Is a Related-Party Transaction?

Related-party transactions are arrangements between parties with existing business ties or common interests. While legal, these transactions can lead to potential conflicts of interest and require scrutiny to ensure they do not adversely impact shareholders or corporate profits. Public companies must disclose such dealings, emphasizing transparency in financial statements.  

### Key Takeaways

*   A related-party transaction involves a deal between parties with a preexisting business relationship, which can pose conflicts of interest.
*   Such transactions are common but require scrutiny by regulatory agencies, like the SEC, to ensure they are free from conflicts that could harm shareholders.
*   Types of related-party transactions include sales, leases, service agreements, and loans, often involving affiliates, shareholders, or subsidiaries.  
    
*   Transparency in reporting is mandatory for public companies to prevent undisclosed agreements that might lead to financial misrepresentation or fraud.  
    
*   The Enron scandal exemplifies the dangers of poorly regulated related-party transactions, underscoring the importance of accountability.

![Related-Party Transaction](https://www.investopedia.com/thmb/r1Gx7Wh3Smwx2Z9dlITTBcfYdQQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/related-partytransaction.asp-final-fd88623efae347f38d6a8e351007c452.png)

*— Investopedia / Jessica Olah*

## Common Types of Related-Party Transactions

Related parties who make transactions may be [business affiliates](https://www.investopedia.com/terms/a/affiliated-group.asp), shareholder groups, or [subsidiaries](https://www.investopedia.com/terms/s/subsidiary.asp). Related-party transactions can include

*   Sales
*   [Leases](https://www.investopedia.com/terms/l/lease.asp)
*   Service Agreements
*   Loan Agreements

These transactions are not illegal but can cloud the business environment by leading to conflicts of interest. They may show favorable treatment for close associates of the hiring business. Consider a company that contracts with a major [shareholder's](https://www.investopedia.com/terms/s/shareholder.asp) business to renovate its offices. In some cases, related-party transactions must be approved by management consensus or a company’s [board of directors](https://www.investopedia.com/terms/b/boardofdirectors.asp).

## Regulatory Framework for Related-Party Transactions

In the United States, securities regulatory agencies ensure that related-party transactions are conflict-free and do not affect shareholders' value or the corporation's profits negatively.

The SEC requires publicly traded companies to disclose all related-party transactions, including those with executives, associates, and family members, in their [10-Q](https://www.investopedia.com/terms/1/10q.asp) and [10-K](https://www.investopedia.com/terms/1/10-k.asp) reports. Many companies have policies to guide the documentation and implementation of related-party transactions.  

The FASB sets accounting standards for related-party transactions across public, private, and non-profit organizations. These standards cover monitoring payment competitiveness, terms, transactions, and authorized expenses.

> **Important**
>
> Related-party transactions must be transparently reported to ensure legality, ethics, and protection of shareholder value.

## Real-World Example: The Enron Scandal

Enron was a Houston-based U.S. energy and commodities company. In the infamous [scandal of 2001](https://www.investopedia.com/updates/enron-scandal-summary/), the company used related-party transactions with special-purpose entities to help conceal billions of dollars in debt from failed business ventures and investments. The related parties misled the board of directors, their audit committee, employees, as well as the public. 

These fraudulent transactions led to Enron's bankruptcy, executive prison sentences, lost pensions and savings, and the closure of auditor Arthur Andersen, which was found guilty of federal crimes and SEC violations.

This disaster led to the [Sarbanes-Oxley Act of 2002](https://www.investopedia.com/terms/s/sarbanesoxleyact.asp), introducing new and expanded rules for U.S. company boards, management, and accounting firms. These rules specifically limit conflicts of interest from related-party transactions.

## Are Related-Party Transactions Audited?

Although there are rules and standards for related-party transactions, they tend to be difficult to audit. Owners and managers are responsible for disclosing related parties and their interests, but if they withhold [disclosure](https://www.investopedia.com/terms/d/disclosure.asp) for personal gain, the transactions could go undetected. Transactions with related parties may be recorded among similar normal transactions, making them difficult to distinguish. Hidden transactions and undisclosed relationships could lead to improperly inflated [earnings](https://www.investopedia.com/terms/e/earnings.asp), even [fraud](https://www.investopedia.com/terms/f/fraud.asp).

## Which IFRS Regulation Covers Related Parties?

The International Financial Reporting Standards Foundation (IFRS) is a non-profit that develops global accounting and sustainability disclosure standards, known as IFRS Standards. The organization's IAS 24 covers related parties and ensures that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties.

## Does the IRS Need to Know About Related-Party Transactions?

The Internal Revenue Service (IRS) examines related-party transactions for any conflicts of interest according to Internal Revenue Code 267. If it finds conflicts, the IRS will not allow any tax benefits claimed from the transaction. In particular, the IRS often scrutinizes property sales between related parties and deductible payments between related parties. 

## Essential Insights on Related-Party Transactions

Related-party transactions involve deals between entities with preexisting business connections, posing potential conflicts of interest. Regulatory agencies like the SEC and FASB monitor these transactions to ensure transparency and fairness, requiring public companies to disclose them in financial reports. Investors and stakeholders should remain vigilant about such transactions due to risks associated with conflicts of interest and the potential impact on shareholder value.  

> **Article Sources**
>
> 1.  Deloitte. "[Related-Party Transactions](https://dart.deloitte.com/USDART/home/publications/deloitte/additional-deloitte-guidance/roadmap-initial-public-offerings/chapter-5-accounting-matters/5-3-related-party-transactions)."
>     
> 2.  U.S. Securities and Exchange Commission. "[Exchange Act Reporting and Registration](https://www.sec.gov/smallbusiness/goingpublic/exchangeactreporting)."
>     
> 3.  Financial Accounting Standards Board. "[Statement of Financial Accounting Standards No. 57 Related Party Disclosures](https://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175820908231&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=67954&blobheadervalue1=filename%3Daop_FAS57.pdf&blobcol=urldata&blobtable=MungoBlobs)."
>     
> 4.  U.S. Securities and Exchange Commission. "[SEC Statement Regarding Andersen Case Conviction](https://www.sec.gov/news/press/2002-89.htm)."
>     
> 5.  Library of Congress. "[H.R.3763 - Sarbanes-Oxley Act of 2002](https://www.congress.gov/bill/107th-congress/house-bill/3763)."
>     
> 6.  IFRS. "[IAS 24 Related Party Disclosures](https://www.ifrs.org/issued-standards/list-of-standards/ias-24-related-party-disclosures/)."
>     
> 7.  Internal Revenue Service. "[Internal Revenue Code 267](https://www.irs.gov/pub/irs-wd/0133030.pdf)."