What Are Related Parties in Accounting?
Related Parties Definition
Related parties refer to individuals or entities that are closely associated with each other due to various relationships.
These relationships may include:
Control
One party has the ability to exercise control or influence over the other.
For example, Company A owns 60% of the voting shares of Company B, giving Company A significant control over Company B.
As a result, Company A and Company B are related parties due to the control applied by Company A.
Ownership
Two or more parties have significant ownership interests in each other.
For example, Company X and Company Y each own a 40% stake in each other’s equity.
This mutual ownership defines them as related parties since both entities have significant ownership interests in one another, indicating a close financial relationship.
Common Management
Parties share common key management personnel.
For example, John Smith serves as the CEO of Company P and also holds a key management position in Company Q.
Since John Smith occupies a management role in both entities, Company P and Company Q are considered related parties due to their shared key management personnel.
Family Relationships
Parties are related through family ties.
For example, Jane Doe, the founder and CEO of Company M, has her spouse, John Doe, serving as the CFO of the same company.
Therefore, Company M and its CFO, John Doe, are related parties due to the family relationship between Jane and John Doe.
Key Personnel Relationships
Relationships between key personnel of entities.
For example, Company R and Company S both have a significant business partnership.
The CEO of Company R, Emily Jones, has a close personal relationship with the CFO of Company S, David Smith, outside of their professional roles.
Despite no formal ties between the companies, the personal relationship between key personnel establishes Company R and Company S as related parties.
Common Examples of Related Parties
To further understand the concept, let’s now look at some common real-world examples of related parties:
Parent and Subsidiary Companies
A parent company and its subsidiaries are related parties due to the parent’s control over the subsidiary.
A subsidiary company is a company that is controlled by another company (known as the parent company).
The parent company typically owns a majority of the subsidiary’s shares, giving it the power to make decisions about the subsidiary’s operations and policies.
Affiliated Companies
Companies under common ownership or management, are considered related parties.
For example, Company A owns a significant portion of Company B’s shares, making them related parties.
Key Management Personnel and Their Families
Transactions between a company and its executives, directors, or their family members are considered related party transactions.
Joint Ventures
Entities that jointly undertake business activities are related parties.
For example, if Company X and Company Y form a joint venture to develop a new product, they become related parties.
Importance of Related Parties
Related party transactions can significantly impact financial statements and should be carefully monitored and disclosed.
Here’s why they are important:
Conflict of Interest
Transactions between related parties may present conflicts of interest, potentially leading to biased decision-making or unfair advantages.
For example, a board member votes to award a lucrative contract to a business owned by their spouse, despite the availability of cheaper alternatives, resulting in personal gain at the expense of the company.
Risk Assessment
Related party transactions can pose risks such as self-dealing or manipulation of financial information.
For example, a company participates in a transaction with a related party where the pricing is significantly different from market rates, potentially indicating self-dealing or manipulation of financial figures to inflate profits.
Transparency
Disclosure of related party transactions enhances transparency and helps stakeholders understand potential influences on financial performance.
For example, in their financial statements, a company discloses that it rents office space from a company owned by one of its directors, providing stakeholders with insight into potential conflicts of interest.
Regulatory Compliance
Regulatory bodies require disclosure of related party transactions to ensure compliance with accounting standards and to prevent fraud.
Impact on Financial Statements
Related party transactions can impact financial statements in several ways:
Revenue and Expenses
Transactions between related parties may not be conducted at arm’s length, leading to potential distortions in revenue and expenses.
Assets and Liabilities
Related party transactions can affect the valuation of assets and liabilities on the balance sheet, particularly if they involve non-market terms or conditions.
Disclosure Notes
Accounting standards require disclosure of related party transactions in the notes to financial statements, providing stakeholders with insights into the nature and extent of these transactions.