Related-party transactions have been routinely identified as playing a role in accounting failures and fraud in recent years. Developments ranging from the passage of the Sarbanes-Oxley Act of 2002 to enforcement actions against registered entities in emerging markets have highlighted the complexity and risks in the recognition and disclosure of related-party transactions.
Companies accused of fraud disclosed slightly more related-party transactions than companies that had not been accused of fraud in a study of public SEC fraud allegations from 1998 to 2007 performed by the Committee of Sponsoring OrganizAtions of the Treadway Commission (COSO), of which the AICPA is a member. Seventy-nine percent of fraud-accused companies disclosed a related-party transaction in the proxy statement filed during the first fraud period, compared with 71% of no-fraud companies studied during the comparable period. Eighteen percent of the companies alleged to have committed fraud in that study were accused of using related-party transactions to disguise misstatements on their financial statements.
Yet the rules on accounting for these transactions have remained stagnant, and very little accounting guidance exists to assist preparers of financial statements with reporting for them. Moreover, related-party transactions involve “substance over form” issues and might be embedded in documentation that is less clear or thorough than the documentation that ordinarily exists between unrelated parties.
In short, preparers can find the guidance difficult to apply to specific transactions. Three types of related-party transactions are especially prone to confusion and error when it comes to proper reporting.
Type 1: Owner’s Debt Converted to Equity
One interesting scenario is when an entity converts related-party debt into equity. Preparers might struggle with the issues involved in these transactions because they are not routine and the accounting guidance is slim. In many cases in which an entity has debt outstanding to an owner, and the owner enters into a transaction to convert that debt to equity, the fair value of the equity exchanged does not equal the outstanding balance of the debt. Preparers then must determine whether to recognize a gain or a loss—or some other type of transaction, such as a capital contribution—for the difference between the fair value of the equity and the carrying value of the debt.
For example, if an entity has $50 million in debt outstanding to its owner and exchanges that debt for $80 million in equity (which might happen because of the related-party nature of the relationship), the entity has the following possible alternatives:
- Recognize no gain or loss (in which case the credit to equity would be for $50 million); or
- Recognize a loss on the transaction, representing the fact that $80 million of equity was exchanged for only $50 million of debt.
In circumstances outside of troubled debt restructuring, the relevant accounting guidance (FASB ASC Section 470-50-40, Debt Modifications and Extinguishments) states that “extinguishment transactions between related entities may be in essence capital transactions.” Therefore, the preparer must determine which extinguishment transactions should be recognized as capital transactions and which should result in the recognition of a gain or loss.
Unfortunately, the guidance does not identify criteria for making such determinations, leaving the preparer to make a facts-and-circumstances decision. One important criterion that preparers may consider is the existence of factors that create an appearance that the related party might have received more favorable or unfavorable terms because of its related-party status (i.e., does the transaction suggest that the entity had a gain or a loss?).
Applying this criterion to the previous example, the entity would recognize a loss on the extinguishment of debt. In this case the creditor appears to have received a benefit from its related-party status, as theoretically it could receive equity with a value of approximately $80 million for the $50 million in debt.
The concept of recognizing expenses from certain transactions with related parties is widespread within U.S. GAAP. For example, public-company guidance requires entities to recognize compensation expense for employees paid by parent companies. Similar rules exist for share-based payments for both public and private entities (ASC Topic 718, Compensation—Stock Compensation). Accordingly, the entity should derecognize the carrying value of its debt (which would include elements not given in this example, such as a discount or premium on debt and any related debt-issuance costs) and recognize the total fair value of equity provided, with the difference recorded as a loss on extinguishment of debt.
Now the fact pattern is changed slightly. If the entity exchanges $50 million of debt for $40 million of equity, should the entity record a gain on the extinguishment of debt? In this case, the creditor does not appear to have received a benefit from its related-party status. (The creditor might have had any number of reasons for accepting a lower value of equity on conversion of that debt. For example, it might have been considering the income tax implications or the fair value of the debt at the date of the conversion, or the amount of equity it could receive might be limited by other contractual arrangements.)
The entity should not recognize a gain from an exchange transaction with its owner. Unlike expenses, gains from capital-type transactions have little support within GAAP. Thus, the entity should derecognize the carrying value of its debt (which would again include elements not given in this example, such as a discount or premium on debt and any related debt-issuance costs), with the offsetting credit to equity as described in AICPA Practice Alert 00-1, Accounting for Certain Equity Transactions.
Type 2: Related-Party Forgiveness of Debt
An owner or other related party might provide funds to the entity in the form of a loan and subsequently forgive all or a portion of the outstanding debt. Should the entity recognize a gain on the extinguishment of that debt? For example, an owner forgives an outstanding loan as a condition precedent to the company’s closing a loan agreement with a bank.
Once again, ASC Section 470-50-40 applies. That provision states that “extinguishment transactions between related entities may be in essence capital transactions.” As with Type 1 transactions, the preparer must determine whether this type of extinguishment transaction should be recognized as a capital transaction or result in the recognition of a gain.
The authors believe that an entity should not recognize a gain from the forgiveness of related-party debt. The assumption of debt ordinarily does not result in a loss. For example, an entity ordinarily receives cash or other assets when funds are borrowed from a related party. To subsequently recognize a gain from cash or other assets provided to an entity from a related party would create an unusual result in which invested funds could be treated as income—which appears to contradict existing GAAP on capital contributions when the transaction is considered as a whole. ASC Section 505-10-25, Equity, states that credits from transactions in the entity’s own stock should be excluded from the determination of net income. On a stand-alone basis, the forgiveness of related-party debt does not involve the entity’s stock. However, the forgiveness of related-party debt is inherently intertwined with the broader related-party relationship. 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. AICPA Practice Alert 00-1 applies here, too.
Type 3: Related-Party Forgiveness of Other Liabilities
In some cases, an owner or other related party might provide goods or services to an entity and subsequently forgive the entity’s obligation to pay for those goods or services. For example, an owner-manager could have a deferred compensation arrangement that has been accrued as compensation expense over several years. If that arrangement is forgiven or canceled, should the entity recognize a gain on the forgiveness of that obligation, or does the forgiveness of this liability represent a capital transaction? These types of transactions can be particularly troublesome for financial statement preparers because the types of transactions that give rise to the liability can vary, including management fees, compensation arrangements, or purchases of inventory or fixed assets.
ASC Section 470-50-40 provides guidance on the extinguishment of debt between related entities but is silent with respect to other liabilities. Therefore, GAAP would not prohibit either the recognition of a gain or recognition as a capital transaction.
When determining the appropriate accounting, a preparer should consider the following factors (among others):
The recognition of the original transaction. For example, if an owner contributed inventory to the business, and that inventory had not yet been recognized in cost of sales, gain recognition is not appropriate for the forgiveness of the related liability.
Conversely, in the example of deferred compensatioN, the deferred compensation arrangement had been recognized as expense at the time the liability was forgiven. This fact suggests that recognizing a gain may be appropriate. This example is much easier to analogize to forfeiture of stock options with only a service condition.
The nature of the relationship of the parties. Owners of the business are more likely to engage in capital transactions because they generally benefit from the risks and rewards of ownership. Related parties that are not owners, on the other hand, are more likely to engage in transactions that would result in gain recognition when the underlying liability is forgiven.
The underlying economics of the transaction. If the entity received something of clear value (e.g., commodities or services such as advertising or full-time employee service) and was not required to compensate the related party, gain recognition may be appropriate. However, when the value of the goods or services provided is less clear (e.g., when management fees are charged by an entity controlled by the owner, or inventory was ultimately expensed as obsolete), a capital transaction may be appropriate.
Regardless of the accounting recognition for such transactions, the financial statements should include clear disclosures of how these transactions were recognized. A reader should be alerted to the magnitude and location of the gain recognized or the amount credited to equity.
BEST PRACTICES FOR ACCOUNTING FOR RELATED-PARTY TRANSACTIONS
While related-party transactions almost always come with risks, financial statement preparers can take some steps to reduce the risk of noncompliance with GAAP.
Know Your Related Parties
One of the most important steps to accurately account for related-party transactions is basic: Know who the related parties are. In this instance, information truly is power. An entity that does not know the names of its related parties has a much higher risk of failing to identify the transaction. Once a transaction is “off the radar,” it can easily bypass internal controls established to evaluate and capture information about related-party transactions.
It is usually easy to identify related parties that provide debt to the entity. Other related-party vendors can be more difficult to identify, especially for entities with related parties that operate in numerous forms and with various names.
Provide Clear Documentation
Preparers should also document related-party transactions as if they were transactions with unrelated parties. Unfortunately, the rights and responsibilities of each party in related-party transactions are often “understood” but not clearly expressed in the transaction documents. This dramatically increases the risk of error, especially if the individual responsible for accounting for the transaction is removed from the underlying negotiations. There are numerous instances where key features of an agreement (such as reset or clawback provisions) are agreed to but absent from the documentation.
Ideally, documentation of related-party transactions should include:
- A description of all key features, including how those features should be calculated or applied;
- A description of the scope of the agreement (e.g., whether accrued interest is included in the forgiveness or modification of debt);
- Provisions dealing with possible future events such as a change in the control of the business or termination of employment of the counterparty;
- Facts such as the specific parties involved, effective date of the agreement, and amounts outstanding; and
- The purpose or intention of the arrangement.
High-quality documentation memorializes key points to the agreement and captures them for accounting purposes. The entity is much more likely to arrive at the right accounting answer if the fact pattern of the transaction is clear and can be shared with the accounting team.
Make Adequate Disclosures
While applying the accounting guidance for related-party transactions can require a great deal of judgment, the guidance is clear that the transactions should be disclosed in the notes to the financial statements. Once an entity has captured information on related-party transactions, the next critical step is to make the disclosures in the financial statements adequate and clear.
Disclosures should include a description of the event, its magnitude, and the specific line items in the financial statements that are affected. Entities with numerous related-party transactions should consider presenting information in a tabular format to make the notes to the financial statements easy to read. Entities with unusual and material transactions should consider separate line items on the face of the financial statements.
PROCEED WITH CAUTION
Preparers should maintain a vigilant watch for related-party transactions. Preparers also should talk with their independent financial statement auditors about material related-party transactions. It is all too easy to make mistakes on a related-party transaction that could materially misstate a company’s financial statements. Preparers who understand the risks, however, can take action to reduce the chance of errors.
The complexity and risks associated with recognition and disclosure of related-party transactions are significant. Guidance for accounting for these transactions is difficult to find, and these transactions have been associated with some accounting failures in recent years.
Particularly challenging scenarios for preparers occur when an entity converts related-party debt into equity, when related-party debt is forgiven, and when other related-party liabilities are forgiven.
Best practices for accounting for related-party transactions include knowing who the related parties are; providing clear documentation; making clear, adequate disclosures; and proceeding with caution.
Ralph M. Pucek (firstname.lastname@example.org) is a partner with Crowe Horwath LLP in the Oak Brook, Ill., office. Glenn E. Richards (email@example.com) is with Crowe Horwath LLP in the Oak Brook office.
To comment on this article or to suggest an idea for another article, contact Ken Tysiac, senior editor, at firstname.lastname@example.org or 919-402-2112.
Related-Party Audit Considerations: A Case Study Approach, Practice Aid (#APARPS12P, paperback; #APARPS12E, ebook; and #APARPSO, one-year online subscription)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.