It makes sense for businesses to transact deals with organizations they have a special relationship with since contracting with someone you trust cuts the risk of the relationship turning sour. While these types of transactions are above board and legal, both parties should be alert to potential conflicts of interest which could negatively affect value for shareholders.
TL;DR (Too Long; Didn't Read)
A related party transaction is a business deal between two parties who are closely connected, such as a contract between a corporation and the wife of one of its directors.
Related Party Transactions Explained
A business enters into a related party transaction when it strikes a deal with someone who has a close association with the business. The deal could be anything from a lease or a loan to an asset transfer. And the related party could be a shareholder, affiliate, subsidiary of the company, business owner or her family members, an executive, the parent entity or a trust set up for the benefit of employees. A common scenario is when company A contracts with company B and company B is owned or controlled by person C, who is a senior executive of company A.
Why It Matters
There's nothing wrong with related party transactions and you're not breaking any law by signing them. They might even be difficult to avoid in some situations. For example, when a public company is a minority owned by the biggest supplier in its industry. The risk is that it's not an arms-length transaction and the related party gets a financial benefit from the deal. Although many related party transactions are legitimate, the potential for such transactions to be seen as a conflict of interest can be problematic.
Regulating Related Party Transactions
Regulators have put in place a number of compliance procedures to ensure that related party transactions are transparent and conflict-free. For example, public companies must disclose all related party transactions in their annual 10-K report to the Securities and Exchange Commission. In general, a company should report related party information on its financial statements to ensure that transactions are ethical and legal and do not harm shareholders in any way.
Auditing for Related Party Transactions
Since related party entities are not independent of each other, auditors must make additional disclosures in order to help shareholders understand the nature and potential effect of the transaction. While different industries have different standards, the company's auditor should report enough detail to enable shareholders to determine if the transaction is fair. You need to disclose the nature of the relationship and transaction and the dollar amounts due to or from related parties. Other required disclosures are payment terms, outstanding balances, details of guarantees given or received and any receivables from officers, affiliates or employees.