We believe you have already understood Legit’s approach to business, so today we will talk about transactions between related parties, as they are common practices in business.
“A business that earns nothing but money is a poor business,” said Henry Ford, founder of the Ford Motor Company. This expression indicates, amongst others, that a business must collaborate with other people and businesses to succeed. In the normal course of business there are many transactions between related parties, as in general, businesses are inclined to cooperate with other businesses, who know them well or have common interests.
What are related party transactions and why is it important to know more about them?
The term “related party transaction” refers to an agreement between two parties who have a previous business relationship.
Based on the International Accounting Standards, a transaction between related parties can not be considered those transactions, which are performed between:
- two entities because they simply have a director or some other key management staff member in common
- two entrepreneurs because they simply share joint control over a joint venture
- financial service providers
- trade associations
- public utility services
- government departments and agencies, based solely on the nature of normal arrangements with a unit (although they may affect a unit’s freedom of action or participate in its decision-making process)
- a customer, bidder, franchisor, distributor or general agent with whom an entity enters into transactions with a significant volume of business, simply by virtue of the resulting economic dependence.
The reasons why we need to know more about related party transactions are numerous. However, it is even more important to understand that if these transactions are not controlled, they can result in significant financial loss to the parties involved. Transactions carried out between related parties should be reported in a transparent manner to avoid conflicts of interest that may affect the partners of the companies participating in the transaction.
Transactions between related parties also carry risks, where we can mention here the risk of fraud, which can occur in the cases of related parties with dominant influence. In this case, the dominant influence exercised by the related party means that:
- the related party has vetoed decisions of considerable importance to the business
- there have been significant transactions that have received final approval from the related party
- business proposals made by the related party do not encounter objections from the persons in charge of business governance
- transactions involving the related party or close family members are independently approved and are not subject to review procedures
- the related party has had or has a leading role in establishing the entity with which it is conducting transactions.
What is the role of the Auditor in related party transactions?
Since we talked about the dominant influence above, we should mention that at the moment when the excessive participation of the related party in the selection of accounting policies becomes evident, there is room for suspicion of irregular financial reporting.
The main task of an Auditor is to record whether transactions are properly accounted for and whether they are reported in accordance with the applicable financial reporting framework. This means that in order to identify related party transactions that are intended to derive from the normal course of business, the Auditor inspects contracts or agreements between the parties and assesses whether the business logic was to include these transactions in fraudulent financial reporting or are realized to hide the misuse of assets.
If the Auditor is faced with such cases, he/she should look at the situation from the point of view of the related party, as this is the only way that will help him/her to know the economic reality of the transaction, thus understanding the reason why this transaction was performed.