The Role of Related Party Transactions in Fraudulent Financial Reporting

Abstract

Motivated by mixed findings in the auditing literature about the importance of related party transactions as red flags indicating potential fraud, this study examines 83 SEC enforcement actions involving both fraud and related party transactions. In addition to comparing the characteristics of firms in this sample with firms examined in other fraud studies, we describe generally how each type of related party transaction might potentially be used to misstate financial reports and then document the types of related party transactions actually occurring in these fraud cases. Overall, the most frequent type of transactions in the enforcement actions were loans to related parties, payments to company officers for services that were either unapproved or non-existent, and sales of goods or services to related entities in which the existence of the relationship was not disclosed. Misappropriation of the company's assets are most often related to transactions where the cash flow is outward, while instances of misstatement of financial reports are more often related to transactions where the cash flow is expected to be inward. Generally, related party transactions are not necessary as mechanisms for fraud, and their presence need not indicate fraudulent financial reporting. An implication is that it is important for the auditing profession to understand the benign nature of most related party transactions, the differentiating features between benign and fraudulent transactions, and the importance of evaluating a company's related party transactions in light of its broader corporate governance structure.