Related-Party Transactions: Deals That Aren't Arm's Length

Key Takeaways

• Related party transactions are deals with insiders, affiliates, or family-connected entities that lack the neutral market assumption underlying arm's-length accounting.
• Wirecard's third-party acquiring network, whose revenues represented roughly half of group profit, was later shown to be a related-counterparty structure generating revenues that did not exist.
• Investors who read only the 10-K miss Item 404 related-party disclosures, which appear in the proxy statement and cover transactions above $120,000 involving persons with a material interest.
• Growing related-party transaction volume as a percentage of revenue or operating income across consecutive years is a specific escalating risk signal even when individual transaction sizes seem small.

What It Is

Under ASC 850, related parties include affiliates, principal owners, management, members of their immediate families, and entities that can influence or be influenced by the reporting entity. The standard requires disclosure of the nature of the relationships, description of the transactions, dollar amounts involved, and balances outstanding at the reporting date.

The SEC adds a parallel requirement through Item 404 of Regulation S-K, which applies to registrants and obliges proxy-statement disclosure of any transaction exceeding $120,000 in which a related person has a direct or indirect material interest. Item 404(b) also requires disclosure of the registrant's policies and procedures for reviewing, approving, or ratifying such transactions. The two frameworks use similar but not identical definitions of "related party," so the populations disclosed under ASC 850 and under Item 404 do not always match perfectly.

The Intuition

The neutral-market assumption behind accounting is that buyers and sellers negotiate at arm's length. Related parties do not negotiate at arm's length. A controlling shareholder selling real estate to his own public company has no incentive to push price down. A subsidiary buying services from the CEO's brother-in-law has no incentive to reject a gold-plated bid.

The information value of related-party disclosure is that it lets outside investors identify transactions where the neutral assumption fails. The more material the related-party activity, the more adjustment an investor should make to reported margins, valuations, and growth rates.

How It Works

ASC 850 covers the accounting disclosure. Item 404 covers the governance disclosure. Together they require preparers to identify the counterparty relationships, describe the transactions, and quantify the amounts. Auditors are required by PCAOB AS 2410 to perform specific procedures on related-party transactions, including inquiries of management, review of minutes, and evaluation of whether the terms are consistent with arm's-length expectations.

Three patterns are worth knowing.

1. Insider-owned vendors and landlords. The public company rents office space, buys components, or pays fees to entities owned by insiders. Mark-ups on these transactions transfer value out of public-company profits into insider pockets.

2. Captive financing arrangements. A related finance company buys receivables from the operating company at favorable terms, accelerating reported cash conversion while leaving the credit exposure inside a related entity.

3. Consolidation boundary gaming. A related party holds the nominal outside equity in an SPE that would otherwise consolidate, or controls a "customer" whose purchases inflate reported revenue. The Enron Raptor and LJM structures are the archetype, but the pattern recurs in much smaller cases.

Worked Example

Hertz is a useful U.S. case on pressure-driven misstatement connected to management incentives. The SEC's 2018 administrative order (33-10601-s) found that from February 2012 through March 2014 Hertz's public filings materially misstated pre-tax income across multiple business units in an environment that placed improper emphasis on meeting internal budgets, business plans, and earnings estimates. Hertz restated 2015 financials for approximately $235 million of previously reported pre-tax income based on non-GAAP treatments and paid $16 million to settle. The SEC separately charged the former controller and the former CEO Mark Frissora for aiding and abetting the misstatements. While the primary issues were estimates and reserves rather than classic related-party fraud, the case illustrates how insider-controlled pressure distorts reporting.

Wirecard is the cross-border reference. The KPMG 2020 special-investigation report commissioned by the Wirecard supervisory board concluded that the company could not verify the existence of substantial revenues claimed from third-party acquirers operating in Dubai, the Philippines, and Singapore. An additional €1.9 billion supposedly held in trustee accounts by overseas partners proved not to exist. Related-party and related-counterparty structures were central to the scheme, with the TPA network accounting for a large share of reported revenues and profits.

Common Mistakes

1. Skipping the proxy statement. Item 404 disclosures live in the proxy, not the 10-K. Investors who read only the annual report miss the related-party transactions entirely.

2. Underweighting small dollar amounts. A $200,000 annual payment to an officer's consulting firm is trivial on an income-statement basis but often signals a governance culture where insider arrangements are normal. Culture matters for base-rate fraud risk.

3. Accepting the "comparable to arm's length" claim. Disclosures typically assert that terms were consistent with third-party arrangements. Independent verification is rare, and the claim is worth less than the disclosure itself.

4. Missing indirect relationships. A supplier owned by a company that is itself owned by an officer's spouse still meets the ASC 850 definition. Review the proxy's related-party table and the 10-K footnote together, and be alert for unconsolidated affiliates with undisclosed ownership.

5. Ignoring changes over time. A company whose related-party transaction volume grows year after year, especially as a percentage of revenue or operating income, deserves increased scrutiny regardless of the individual transaction sizes.

Frequently Asked Questions

Q: What are related party transactions in simple terms? Related party transactions are deals between a company and someone with a close personal or financial connection to it, such as a director, controlling shareholder, or their family members. Because neither side is truly independent, the pricing and terms may benefit the insider rather than the company's outside shareholders.

Q: How do related party transactions affect investment decisions? They can transfer economic value out of the public company to insiders, inflate reported revenue through captive customers, or hide liabilities through controlled affiliates. Investors who ignore them may pay a fair price for a company that is quietly draining its own profits.

Q: What is a real-world example of related party transaction abuse? Wirecard's "third-party acquirer" network in Asia, which accounted for roughly half of reported group profit, was structured through related counterparties in Dubai, Singapore, and the Philippines. KPMG's 2020 special audit could not verify the existence of these revenues, and €1.9 billion in claimed cash balances proved not to exist.

Q: How can investors use related party disclosures to protect themselves? Read both the proxy statement's Item 404 table and the ASC 850 footnote in the 10-K, then cross-reference. Any entity appearing as both a supplier and a customer deserves immediate follow-up. Compare the disclosed dollar amounts to operating income to gauge materiality.

Q: How are related party transactions different from normal affiliate transactions? All related-party transactions involve affiliates, but not all affiliate activity is problematic. The key question is whether terms are comparable to what an independent third party would accept. When management simply asserts "arm's-length terms" without independent verification, that claim carries limited weight.

Sources

1. SEC. "Item 404 of Regulation S-K: Transactions with Related Persons, Promoters and Certain Control Persons, Staff Interpretation." https://www.sec.gov/divisions/corpfin/guidance/execcomp404interp.htm
2. SEC (2018). "SEC Charges Hertz with Inaccurate Financial Reporting and Other Failures." Administrative Proceeding 33-10601-s. https://www.sec.gov/enforcement-litigation/administrative-proceedings/33-10601-s
3. Deloitte Accounting Research Tool. "5.3 Related-Party Transactions." https://dart.deloitte.com/USDART/home/publications/deloitte/additional-deloitte-guidance/roadmap-initial-public-offerings/chapter-5-accounting-matters/5-3-related-party-transactions
4. Wirecard AG. "Report Concerning the Independent Special Investigation, KPMG (April 27, 2020)." https://www.wirecard.com/uploads/Bericht_Sonderpruefung_KPMG_EN_200501_Disclaimer.pdf

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.