The premise of presenting comparable financial statement information permeates the generally accepted accounting principles (GAAP). An investor should be able to read the financial statements of two companies in the same industry and feel comfortable that they are comparing apples to apples. If two companies in the same industry have nearly identical balance sheets, income statements and cash flow statements, but only one set of financial statements contains disclosure of numerous related-party transactions, the investor can make an informed decision about the value of each company.
Most everyone is familiar with the role that related-party transactions played in some of the high-profile financial failures that occurred in the early part of the last decade, Enron being the most recognizable. The Public Company Accounting Oversight Board (PCAOB) issued a proposed auditing standard, Related Parties, for public comment in February of this year; the comment period ended May 31, 2012. In this proposed standard, the PCAOB cites an Securities and Exchange Commission (SEC) study performed as part of the Sarbanes-Oxley Act of 2002. This study reviewed SEC enforcement actions during the five-year period leading up to 2002. The study found that approximately 10 percent of these actions included failure to disclose related-party transactions. While many who read this article are not registrants, this information is publicly available and likely is representative of issues that have taken place in the world of private businesses.
GAAP guidance indicates management should disclose information about related-party transactions in its financial statements so users can evaluate the significance of those transactions. Typically, these transactions include the following:
- Sale or purchase of property
- Accounting, management or other similar services rendered
- Lease of property or equipment
- Borrowing relationships, including guarantees
- Compensating bank balance relationships
- Allocation of common costs among entities
- Filing of consolidated tax returns
The disclosure of related-party transactions should include a discussion of the nature of the relationship of the entities involved, a description of the transaction—including transactions to which no amounts or nominal amounts were ascribed and any information a user might need to understand the transaction—the dollar amount of transactions during the reporting period along with the effects of any change in the method of establishing the terms from that used in the preceding period and amounts due from or to related parties. Additional disclosures are required for certain entities that are part of consolidated tax returns. Balances due from officers, employees or other affiliated entities should be shown separately on the face of the balance sheet and not included under a general heading, such as notes or accounts receivable. In some cases, names of the affiliated entities should be disclosed if helpful in understanding the relationship. When related-party transactions are disclosed, representations should not be made that such transactions were equivalent to an arm’s-length transaction unless such representations can be substantiated.
While the aforementioned disclosures are required, financial statement footnotes often will be the first items management will think of in terms of disclosing related-party transactions. However, clearly spelling out significant related-party items on the face of the balance sheet or income statement may be more meaningful to a user of the financial statement. For instance, interest expense on a related-party loan or management fees charged by an owner can be shown as a related-party transaction on the face of the income statement. In addition, if a related party has lent money to the company, showing the balance owed on a separate line on the balance sheet—with an indication that it is a related-party balance—will make the point more clearly than just discussing in a footnote. All of this comes back to the notion that a financial statement reader should be equipped with enough information to make an informed decision about the financial statements of one company compared to another.
For more information on disclosure of related-party transactions, contact your BKD advisor.