Key takeaways
- A related party transaction occurs when a business deals with a person or organisation closely connected to its management or owners.
- These deals are not illegal or banned, but they carry an inherent risk of favourable pricing that bypasses open market pressures.
- Accounting standards such as IAS 24 and ASC 850 require detailed disclosure of these arrangements so stakeholders can evaluate their fairness.
- Establishing formal internal controls, such as audit committee approval and independent valuations, protects the company and its reputation.
What it means
A related party transaction refers to any business deal or transfer of resources between a reporting company and a party closely connected to it. This connection might involve directors, major shareholders, subsidiary companies, joint ventures, or close family members of key management personnel.
Because the two sides of the transaction share a personal or structural relationship, they do not operate as entirely independent entities. Consequently, the commercial terms, pricing, and conditions agreed upon may not reflect what an open and competitive market would dictate.
Accounting rules do not automatically brand these transactions as improper, illegal, or forbidden, but they recognise that the lack of true independence introduces a risk of bias or unfair enrichment. Therefore, rigorous disclosure rules exist to ensure that investors, lenders, auditors, and regulators are fully informed about these arrangements.
The core concern behind related party transactions is straightforward conflict of interest. When an individual wields influence over both the company and the counterparty, there is an incentive to structure deals in a way that benefits the individual at the expense of the corporate entity.
For example, if a chief executive leases a warehouse owned personally to their own corporate business at an inflated rent, money effectively moves from the shareholders to the executive without any formal theft occurring. The transaction follows standard legal procedures and contracts are signed, but the pricing lacks competitive discipline.
Disclosure acts as the primary mechanism that brings such hidden transfers into the light, allowing external stakeholders to judge whether the company's resources are being managed prudently. Determining who qualifies as a related party requires careful analysis because the definitions are drawn broadly and deliberately.
The category encompasses parent companies, subsidiaries, fellow subsidiaries, associated enterprises, and key management personnel along with their close family members. Furthermore, any separate entity that is controlled, jointly controlled, or significantly influenced by those individuals also falls within the net.
Many corporate disputes and audit adjustments centre not on the monetary value of a deal, but on whether a specific counterparty actually meets this definition. Entities often attempt to distance themselves from a transaction partner, making the preliminary assessment of relationship status a critical step for accountants and compliance officers.
International and domestic accounting frameworks set out clear expectations for how these deals must be handled in financial statements. Under international rules, IAS 24 governs related party disclosures, while US generally accepted accounting principles rely on ASC 850.
Both standards demand that companies disclose the nature of the relationship, the precise financial amounts involved, any outstanding balances at the reporting date, and the specific terms of the deal, including collateral and settlement methods. Crucially, the accounting standards do not mandate that related party transactions must occur at fair market value, nor do they prohibit them outright.
Instead, they rely on transparency, operating on the principle that informed readers can make their own evaluations once the facts are visible. In daily business practice, companies manage these risks by implementing strict internal control policies.
A typical control framework dictates that any transaction exceeding a specified financial threshold must be formally reviewed by the audit committee or an independent board subset. The conflicted executive or director must leave the room during discussions and abstain from voting on the matter.
Additionally, the company should secure an independent benchmark, such as a formal market valuation or competing commercial quotes, to demonstrate that the price aligns with normal market conditions. Businesses that skip these precautionary steps often discover that even though a transaction was entirely reasonable and commercially sound, it becomes almost impossible to defend once questioned by auditors, tax authorities, or disgruntled shareholders.
It is also worth noting that the most common form of related party transaction occurs within corporate groups rather than between a company and its directors. Intra-group trading, such as sales of goods or services between a parent company and its subsidiaries, represents the vast majority of related party activity.
While these transactions are eliminated during the consolidation of financial statements, they remain central to transfer pricing regulations. Tax authorities pay close attention to these internal group transfers to ensure that profits are not artificially shifted to low tax jurisdictions, meaning that internal transactions require just as much documentation and justification as deals with external related parties.
In practice
Real-world examples
Example 1
A manufacturer buys 60% of its packaging from a supplier owned by the finance director's brother. Procurement runs a competitive tender to confirm the pricing is in line with alternatives, and the audit committee approves the arrangement with the finance director recused from the vote.
Example 2
A founder lends her own company $2,000,000 at 4% interest to bridge a cash shortfall while a funding round completes. The loan is disclosed in the accounts with its rate, term and outstanding balance, because a director's loan is a related party transaction even when the terms favour the company.
Example 3
A group's UK subsidiary charges its Irish subsidiary $8,000,000 a year for management services. Both tax authorities scrutinise the charge under transfer pricing rules, and the group has to show the fee reflects the actual cost and value of the services provided.
Worked example
Related Party Lease Valuation and Excess Calculation
| Metric | Actual Term | Market Benchmark | Variance / Excess |
|---|---|---|---|
| Property Size | 10,000 sq ft | 10,000 sq ft | - |
| Annual Rent Paid | $500,000 | $350,000 | $150,000 |
| Cost per Square Foot | $50 | $35 | $15 |
| Impact on Pre-Tax Profit ($2,000,000 base) | 25.0% of profit | 17.5% of profit | 7.5% siphoned |
Think of it
Related party transaction is a deal between connected parties-insiders transacting.
Formula
Calculation
Excess over arm's length terms = amount actually paid - amount an independent party would charge
A company rents its 12,000 square foot head office from a building owned by its chief executive and pays $480,000 a year. That works out at $480,000 / 12,000 = $40 per square foot.
Two independent agents confirm the local market rate for comparable space is $30 per square foot, which would cost 12,000 x $30 = $360,000. The excess is $480,000 - $360,000 = $120,000 a year. Against pre-tax profit of $1,500,000, that excess is $120,000 / $1,500,000 = 8% of profit quietly transferred to the chief executive, which is exactly the kind of figure the disclosure note is designed to make visible.Case study
Seen in the real world
This is a fictional and illustrative example. Tanglewood Components, an invented family-controlled parts manufacturer preparing for a trade sale, had for years bought its raw castings from a foundry owned by the founder's two sons, with no written contract and no benchmarking.
During due diligence the buyer's advisers found that the foundry charged roughly 15% above quotes from three independent suppliers, which had reduced reported operating profit by about $600,000 a year. The buyer did not allege wrongdoing, but it repriced the deal, arguing that the true cost base was uncertain and that the supply arrangement would end at completion.
In this illustrative account, Tanglewood eventually closed the sale at a valuation roughly $4,000,000 below the initial offer. Its finance director's later verdict was blunt: the transaction had been defensible all along, but nobody had gathered the evidence at the time it happened.
Watch out
Common mistakes
- Believing that related party transactions are prohibited, when the rules require disclosure and governance rather than a ban.
- Defining related parties too narrowly and missing close family members or entities under a director's influence.
- Approving a related party deal without an independent benchmark, leaving the company unable to demonstrate the price was reasonable when questioned later.
Questions
People also ask
Do these transactions have to be at market rates?
Accounting standards do not require it, though company law, listing rules and tax authorities frequently apply pressure in that direction.
Are transactions between a parent and its subsidiary disclosed in the group accounts?
They are eliminated on consolidation, but they must still be disclosed in the separate accounts of each individual company.
What should a manager do if they spot an undisclosed related party arrangement?
Raise it with the finance team or audit committee promptly, since the reputational damage comes from concealment far more often than from the deal itself.