Related Party Transaction
A related party transaction is a transaction between a company and a person or entity that has a close relationship with the company — such as a major shareholder, executive officer, director, or entity in which such persons have a financial interest — that may not have been negotiated on fully arm's-length terms and therefore requires specific disclosure under U.S. GAAP and SEC regulations.
Related party transactions are governed under U.S. GAAP by ASC 850 (Related Party Disclosures), which requires companies to disclose the nature of the relationship, a description of the transaction, the dollar amount, and the amounts due to or from related parties as of each balance sheet date. The SEC's Regulation S-K also requires proxy statement disclosure of related party transactions exceeding $120,000 in which any executive officer, director, nominee for director, or five-percent shareholder has a direct or indirect material interest.
The accounting and disclosure concern with related party transactions is that they may be structured to benefit the related party rather than the company, and because both parties to the transaction share a common interest, normal market discipline — the arm's-length bargaining that typically ensures transactions are fairly priced — may be absent or diminished. A company that leases its headquarters from a building owned by the CEO, for example, may pay above-market rents without the scrutiny that a third-party landlord transaction would receive.
Common categories of related party transactions include real estate leases or purchases involving properties owned by executives or directors, loans to or from officers or directors (generally prohibited for public companies under SOX Section 402 but disclosed when they existed historically), consulting agreements with entities controlled by former executives, sales to or purchases from entities in which significant shareholders hold interests, and intercompany transactions between a parent and its subsidiaries or between affiliates in a consolidated group.
The audit implications of related party transactions are addressed in PCAOB AS 2410 (Related Parties), which requires auditors to perform specific procedures to identify related party relationships and transactions, evaluate whether they are properly accounted for and disclosed, understand the business purpose and economic substance of material transactions, and communicate findings to the audit committee. The standard heightened auditor obligations in this area after the PCAOB identified related party failures as a recurring inspection finding.
For investors, related party disclosures are a high-priority area of proxy statement and annual report analysis. Transactions that do not appear to be at arm's length, involve undisclosed beneficial relationships, lack documented approval by independent directors, or are vague in their description warrant additional scrutiny. Academic research consistently identifies concentrated related party transactions as a leading indicator of corporate governance weakness and, in extreme cases, of financial fraud.