Related-party transactions have played a significant role in accounting failures and frauds. In a study of Securities and Exchange Commission fraud allegations by the Committee of Sponsoring Organizations of the Treadway Commission, 18 percent of companies alleged to have committed fraud were accused of using related-party transactions to hide misstatements in financial reports.
“Yet the rules on accounting for these transactions have remained stagnant, and very little accounting guidance exists to assist preparers of financial statements,” says Wayne Williams, a partner at Crowe Horwath LLP.
Smart Business spoke with Williams about how related-party transactions can pose reporting problems.
What transactions are prone to errors?
Three that create the most confusion are:
1. Owner’s debt converted to equity. In these cases, there is little accounting guidance. When a business owes debt to an owner and the owner converts it into equity, the fair value of the equity often doesn’t equal the remaining balance of the debt. That means a gain or loss, or some other type of transaction, needs to be recognized for the difference. For example, if a company exchanges $50 million in debt outstanding to its owner for $80 million in equity, the business could make a credit to equity for $50 million or recognize a loss representing the fact that $80 million of equity was exchanged for only $50 million of debt.
The concept of recognizing expenses from certain transactions with related parties is widespread within U.S. generally accepted accounting principles (GAAP). However, what if the entity exchanged $50 million in debt for $40 million of equity? Unlike expenses, gains from capital-type transactions have little support within GAAP. In this scenario, the business should derecognize the carrying value of its debt, which would include elements such as a discount or premium on debt, with the offsetting credit to equity.
2. Related-party forgiveness of debt. An entity shouldn’t recognize a gain when forgiving related-party debt because assumption of debt ordinarily doesn’t result in a loss. When a business borrows from a related party, the business gets cash or other assets. To later recognize a gain from these assets provided by a related party would create an unusual result where invested funds could be treated as income, which appears to contradict existing GAAP on capital contributions when the transaction is considered as a whole. The holder of related-party debt is in effect changing the nature of its investment in the entity from debt to equity, so no gain should be recognized in net income.
3. Related-party forgiveness of other liabilities. An owner or other related party might provide goods or services to an entity and subsequently forgive the entity’s obligation to pay. For example, an owner/manager could have deferred compensation that has been accrued as an expense. If forgiven, should the business recognize a gain, or is forgiveness of the liability a capital transaction? GAAP does not prohibit either.
When deciding the appropriate accounting approach, consider how the original transaction was recognized, the nature of the relationship and the underlying economics of the transaction. In the example of deferred compensation, the arrangement had been recognized as an expense, so a gain might be appropriate. In other cases, the nature of the relationship dictates the answer — owners are more likely to engage in capital transactions because they generally benefit from the risks and rewards of ownership. Related parties are more likely to engage in transactions that would result in gain recognition when the underlying liability is forgiven.
What best practices remove risks involved with related-party transactions?
Know the related parties. Otherwise, you run the risk of failing to identify a transaction, allowing it to bypass internal controls established to evaluate and capture information about related-party transactions.
It’s also important to document related-party transactions as if they involve unrelated parties. Often, rights and responsibilities in related-party transactions are ‘understood,’ but not clearly expressed in documents.
Proceed with caution, maintain a vigilant watch for related-party transactions and you can reduce the chance of errors. ●
Insights Accounting is brought to you by Crowe Horwath LLP