What it means
When a business enters into an agreement with someone close to it, such as a company owner, a major shareholder, a director, or a close family member, it is conducting a related party transaction. In standard business dealings, two independent parties negotiate fiercely to get the best possible price.
However, when a business buys services from a CEO's spouse or rents an office building owned by a board member, that natural tension disappears. There is a risk that the deal might not happen on normal market terms, potentially short-changing the business and its other owners.
Regulators and accountants care deeply about these transactions because they create potential conflicts of interest. Without proper oversight, insiders could funnel company money into their own pockets by overpaying for goods or services, or by shifting profits away from minority shareholders.
To prevent this, accounting standards require companies to disclose all significant related party deals in their financial statements. This ensures transparency, allowing investors and lenders to see if transactions were carried out at fair market value.
In daily practice, identifying these transactions requires companies to maintain a clear register of interests, capturing details of directors, key managers, and their connected businesses. Before any contract is signed, the interested party must usually declare their connection and step aside from any voting process.
Auditors will then test these transactions specifically to verify that the prices charged match what an independent third party would pay in the open market. Imagine you are selling your used car.
If you sell it to a stranger, you will haggle to get the highest price. If you sell it to your teenager for $5, that is a related party deal, and other family members might rightfully question if the price was fair.
In practice
Real-world examples
Example 1
TechStart Ltd rents its main office building from a property company fully owned by the CEO's brother. The company pays $50,000 a year in rent, which must be disclosed in its financial statements. To show the rent is fair, the finance director obtains a written valuation from an independent surveyor, who confirms that nearby offices of the same size cost about $48,000 to $52,000.
Example 2
A local catering SME awards its annual office supplies contract worth $12,000 to the operations manager's spouse without checking prices from other suppliers. When the owner later asks for competing quotes, two suppliers come in at about $9,500. The company has overpaid by roughly $2,500 and must now decide how to handle the relationship.
Example 3
A manufacturing firm with international operations buys raw materials from a parent company overseas at a fixed rate, requiring careful review for fair market pricing. Tax authorities and minority shareholders both look closely at such prices. The finance team keeps benchmark quotes on file each year to demonstrate that the rate is comparable to what an unconnected supplier would charge.
Think of it
Imagine you are selling your used car. If you sell it to a stranger, you will haggle to get the highest price. If you sell it to your teenager for five pounds, that is a related party deal, and other family members might rightfully question if the price was fair.
Formula
Calculation
Variance Percentage = ((Related Party Price - Fair Market Price) / Fair Market Price) x 100
Example: if a director charges their company $12,000 for IT services that independent providers offer for $10,000, the variance is ((12,000 - 10,000) / 10,000) x 100 = 20% above market rate, highlighting a potential overpayment of $2,000.
The test also works in the other direction. If a director's company sells equipment to the business for $8,000 when the fair market price is $10,000, the variance is ((8,000 - 10,000) / 10,000) x 100 = -20%. A price well below market can also need explaining, for example because it may hide a favour that will be repaid elsewhere.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightRetail plc, a growing fashion chain, needed a new logistics system. The board approved a $250,000 contract with SwiftLogistics, a software firm owned entirely by the son of BrightRetail's finance director. The finance director did not vote on the contract, but the company failed to obtain competing quotes from other providers. During the annual audit, the external auditors flagged the deal as an undisclosed related party risk, noting that similar software packages were readily available on the market for $180,000.
As a result, BrightRetail had to issue a revised note in its financial statements detailing the $70,000 premium paid to the director's family. That premium was almost 39% above the market price of $180,000. The board faced sharp criticism from institutional investors for poor governance and lack of competitive bidding, forcing them to adopt a stricter procurement policy for all future vendor relationships involving staff and family members. The new policy requires at least three quotes for any contract over $25,000 and a written declaration of interests from everyone involved in the decision.
Watch out
Common mistakes
- Assuming that transactions with family members do not need to be declared if the amounts involved are small.
- Failing to keep an up to date register of interests for directors, senior managers, and their close relatives.
- Forgetting to document how the company determined that a related party price matched fair market rates.
Questions
People also ask
Are all related party transactions illegal?
No, they are completely legal and common in business. They simply require full disclosure and proof that terms are fair.
Who counts as a related party?
This includes parent companies, subsidiaries, major shareholders, directors, key managers, and close family members of these individuals.
Why must companies report these transactions?
Reporting protects investors and lenders by ensuring insiders are not unfairly benefiting at the expense of the wider business.