Related party transactions (RPT) feature prominently in many corporate scandals around the world.
For example, the top management team of Enron used special purpose entities to manipulate profit. Cable TV company Adelphia Communications Corp guaranteed related party debts and provided extensive loans to its top executives.
RPT recently made headlines in Singapore, following an Auditor-General's Office audit of Aljunied-Hougang-Punggol East Town Council (AHPETC).
There are plenty of empirical studies that show the value-destroying impact of RPT. This explains why corporate governance laws insist on regulating them tightly.
But first, some definitions
A RELATED party transaction is a transfer of resources, services or obligations between a reporting entity and a related party.
Existing financial reporting standards (such as FRS 24) recognise that RPT is a normal feature of commerce and business. Many entities conduct their business activities through subsidiaries, joint ventures and associates, for sound business reasons. A subsidiary that sells goods to its parent at cost might not sell on those terms to another customer.
In a listed firm, the key concern in RPT is that the transactions may not be conducted in an arm's-length manner, resulting in substantial wealth loss to the shareholders.
Under FRS 24, a person is considered related to a reporting entity if he or she has control (typically for voting rights above 50 per cent) or significant influence (typically for voting rights between 20 and 50 per cent); or is a member of the key management personnel. A close family member of such a person is also considered a related party.
An entity is considered related to a reporting entity if both are in a parent company-subsidiary relationship; if it is an associate or joint venture; or if it provides key management personnel services to the reporting entity or to the parent of the reporting entity.
FRS 24 requires an entity to disclose the nature of the related party relationship, and to give information on the amount of the related party transaction, the amount of outstanding balances and commitments, and terms and conditions of the transactions. It also has to disclose bad debts, and details of guarantees given or received from related parties.
Empirical evidence on RPT
THERE is considerable evidence that RPT can be value-destroying if they are used for earnings manipulation and expropriation of wealth from shareholders.
In a study published in 2009 in the Journal of Banking and Finance, the authors (Yan-Leung Cheung , Yuehua Qi, P. Raghavendra Rau, Aris Stouraitis) found that Hong Kong firms enter deals with related parties at unfavourable prices compared to similar arm's-length deals. They pay higher prices for assets from related parties compared to similar arm's-length deals. When they sell assets to related parties, they receive a lower price.
Using a sample of listed firms in the United States, M. Ryngaert and S. Thomas (2012) find that RPT is associated with lower operating profitability, significant share price declines when RPT is first disclosed, and higher likelihood that a firm will enter into financial distress or securities deregistration.
Another study in 2002 by Kee-Hong Bae, Jun-Koo Kang and Jin-Mo Kim found that the stock price of Korean firms affiliated to industrial groups (chaebols) decreased when they bailed out other under-performing firms in the group through rescue merger.
Issues in the AHPETC case
THE Auditor-General's report dated Feb 6, 2015 highlighted several lapses in the governance of RPT in AHPETC.
The report stated that: "AHPETC did not disclose fully the RPT in its financial statements. Furthermore, it did not adequately manage the conflict of interests of related parties arising from ownership of its key officers. The related parties were two companies engaged by AHPETC to carry out managing agent services and essential maintenance and lift rescue services. They were FM Solutions and Integrated Services (FMSI) and FM Solutions and Services Pte Ltd (FMSS). The Secretary of AHPETC was the owner of FMSI. The Secretary, General Manager and Deputy General Manager of AHPETC were directors and shareholders of FMSS."
From a corporate governance perspective, one would expect that firms disclose their procedures for review, approval and ratification of RPT.
Good governance practices typically require a firm's audit committee or a group of independent directors to review and approve RPT. For example, the minutes of the meeting where the RPT was approved (and noting the views of the company's independent directors) should be properly documented. Furthermore, any related person interested in the transaction should abstain from voting.
The governance practice of some listed firms may provide a useful benchmark. In some countries, listed firms must send a circular to shareholders providing details of the transaction, including the opinion by an independent financial expert.
The Auditor-General's report also noted instances where "the Secretary and General Manager issued payment claims as owner of FMSI and director of FMSS respectively, and subsequently the same General Manager certified these payment claims and approved the payment vouchers in her capacity as an officer of AHPETC".
There were clear conflicts of interest and AHPETC has to put in place adequate mitigating controls to manage the conflicts, the report noted.
What are some possible mitigating controls? This can be independent checking and validation of work done against the invoices by non-related officers prior to payment approval, requiring non- related parties from the top management team to approve the payment, and explicitly prohibiting related parties from approving the payments. Waiver of these requirements should be on an exception basis and the reasons should be clearly documented.
Auditing related party transactions is challenging.
It may be difficult for auditors to identify all related parties and transactions warranting examination. Auditors must rely on management to provide detailed information on related parties and RPT. Thus, RPT should be assessed in the context of the company's overall governance structure, taking into account the importance of management's assertions about the existence and nature of these transactions.
The writer is an associate professor of accounting at the Nanyang Business School, Nanyang Technological University.