Related Party Transactions

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Related Party Transaction is a transaction/ deal/ arrangement between two related parties to transfer resources, services, or obligations, irrespective of whether a price is charged. It can affect the statement of profit or loss and the financial position of an entity. Therefore, disclosing such transactions between related parties in a Financial Statement is necessary.

Related Party Transactions

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The Internal Revenue System (IRS) keeps a close eye as a part of their related party transactions disclosure. The surveillance is because the IRS wants to ensure no conflict of interest occurs. Any conflict would result in the disallowance of any tax benefit from the transactions. Also, Related parties may enter into transactions that unrelated parties may not.

Key Takeaways

  1. An agreement or arrangement between two related parties to transfer assets, obligations, or services—regardless of whether payment is involved—is referred to as a related party transaction. 
  2. It might affect a company’s financial status and profit or loss statement. The entity may benefit from such transactions if family members own a large percentage of the business. 
  3. For instance, a company that provides finished goods for the cost to a connected party may not provide them to another customer at that price. Private benefits of control are perks enjoyed alone by the party in charge and not shared proportionately among all shareholders in the company. 
  4. Management cannot oversee some linked party transactions when parties control most of the votes (more than 50%) over the board.

A Related party transaction policy is a transfer of obligations, resources, or services between related party and a reporting entity. The price is almost irrelevant in these transactions.

It should be transacted at arm’s length transactionArm's Length TransactionAn arm's length transaction is one in which two parties operate independently and the price agreed between them (also known as the transfer price) is free of any influence.read more. For better representation, an entity should disclose related party transactions between related parties and entities in the Financial Statement. Management of an Entity should follow the Accounting Standards and Policies issued by the Accounting Board/ Committee so that Frauds through such transactions can be identified and minimal frauds.

The group should prepare its consolidated financial statements after considering related party transactions as per issued accounting policies, guidelines, and standards. Consolidated financial statements as a whole can represent a better, true, and fair view of the company’s financial position since consolidated financial statements are also an integral part of an annual reportAn Annual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more, which is shared with Shareholders, Stock exchanges, Government, Stakeholders, Management, Annual General Meeting, and displayed on the group’s website.

It should be done at arm’s length between related parties to avoid fraud.

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Types

Depending on the entities involved in the hierarchy of the organization the related party transactions disclosure changes. Let us understand these different types through the discussion below.

Examples

Let us understand the concept of related party transactions policy in depth through the examples below.

Example #1

ABC Ltd. has investment and holds 26% Shareholding of CDE Ltd. And CDE ltd. Hold shares 51% of EFG ltd.

Solutions:

Company CDE ltd is an Associate Company of Company ABC ltd as it has more than 20% shareholding of Company CDE ltd. Accordingly, transactions between these companies, i.e., ABC ltd and Associate Company, i.e., CDE ltd, are to be disclosed in the Financial Statement of CompanyFinancial Statement Of CompanyFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more ABC ltd. and at the time of preparation of consolidated Financial StatementsConsolidated Financial StatementsConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries.read more.

All the related parties’ transactions among ABC ltd., CDE ltd., and EFG ltd. are to be recorded in Financial Statement because EFG ltd. is a subsidiary company of CDE ltd. and CDE ltd. is an associate company of ABC ltd.

Example #2

Company A has a 70% Shareholding of Company B. Company A sold the goods $5 Million to Company B during the Financial Year.

Solutions:

Company A is holding Company of Company B as it has more than 51% Shareholding of Company B and Transactions between Holding Company, i.e., A, and Subsidiary Company, i.e., B, to be disclosed in the Financial Statement of Company A and at the time of preparation of consolidated Financial Statement.

Above Example, Company A shall disclose the related party transaction in its financial statement and its nature.

Importance

Even though these transactions are advised to be carried out at an arm’s length, they have significant advantages from the organization and entities’ point of view. Let us understand them through the points below.

Advantages & Disadvantages

Let us understand the advantages and disadvantages of related party transaction policy through the explanation below.

Advantages

  • The entity may benefit from such transactions if family relatives hold significant ownership of the entity. For example, a company that sells the finished goods to its related party at a cost price may not sell at that price to another customer.
  • It should be disclosed separately in Financial Statements for better representation.
  • Related parties may enter into transactions that unrelated parties may not.

Disadvantages

  • An entity can have losses from such transactions if family relatives do not hold significant entity ownership.
  • Management can suppress such transactions and may gain in doing so.
  • Financial Statements should be disclosed separately for better representation; otherwise, financial statements will provide an untrue and unfair view.
  • These transactions could harm the statement of profit or loss and the financial position of an entity.

Frequently Asked Questions (FAQs)

How are transactions involving related parties handled?

Transactions between related persons and other activities of GST Schedule I will be treated as supply even if made without any consideration under Schedule I of the GST Act.

How do you recognize transactions involving related parties?

Through investigation, examination, and review processes, related parties and transactions are discovered. It is possible to find previously hidden related party relationships and transactions by identifying and analyzing large, unusual transactions and transactions involving executive authority.

Who are covered under related party transaction?

The phrase “related-party transaction” describes a deal or arrangement between two parties connected by an earlier business connection or shared interest. Companies often seek business deals with parties they are familiar with or have a common interest.

This article is a guide to What are Related Party Transactions. Here we explain its types along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

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