Failure to disclosure should lead to further inquiries!
Due to their nature, related parties should be part of the fraud risk assessment process and considered during an investigation, but are often overlooked!Related party relationships are frequently linked to sham transactions and could occur as follows:
- Sales activity between two parties, often related by law or industry, where insufficient consideration is given for the sales transaction.
- Seller provides total financing to transfer consideration.
- Below FMV transactions.
- Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates.
- Exchanging property for similar property in a non-monetary transaction.
- Loans with no scheduled terms for when or how the funds will be repaid.
- Loans with interest accruing differently from market rates.
- Loans to parties lacking the capacity to repay.
- Loans advanced for valid business purposes and later written off as uncollectible.
- Non-recourse loans to shareholders.
- Agreements requiring one party to pay the expenses on the other’s behalf.
- Business arrangements where the entity pays or receives payments of amounts at other than market .
- Consulting arrangements with directors, officers, or other members of management.
- Goods purchased or sent to another party at less than cost.
- Material receivables or payables from/to related parties such as officers, directors, and other employees.
Here is a research paper for some additional color.
Related-party transactions create the potential for a conflict of interest. Conflicts of interest fraud schemes include:
- Purchase schemes, which involve the over-billing of a company for goods or services by a vendor in which an employee has an undisclosed ownership or financial interest
- Sales schemes, which involve the underselling of company goods by an employee to a company in which the employee maintains a hidden interest
Some questions to ask management–
- Are periodic comparisons of vendor information with employee information, such as addresses and telephone numbers performed on a regular basis?
- Are vendors who employ former company employees under increased scrutiny?
- Does the organization have a reporting procedure for personnel to report their concerns about vendors receiving favored treatment?
- Are employees required to complete an annual disclosure document that includes business ownership, income, and investment information?
- Does the organization require vendors to sign an agreement allowing vendor audits?
- Are vendor audits conducted by someone independent of the purchase, sales, billing, and receiving departments?
- Are hospitality expenses being appropriately monitored?
Those subject to the 1934 Act
Regulation S-K requires disclosure of any transaction exceeding $120,000 “in which any related person had or will have a direct or indirect or material interest.” A related person is defined as a director or executive officer, a director nominee, a beneficial owner of more than five percent of the company’s voting stock, or an immediate family member or household member (other than a tenant or employee) of any of the aforementioned persons.
Transactions to be disclosed include, but are not limited to, any “financial transaction, arrangement or relationship (including any indebtedness or guarantee of indebtedness) or any series of similar transactions, arrangements or relationships.” The SEC released sample scenarios for such transactions, along with clarifications of terms, in Compliance and Disclosure Interpretations about Item 404 of Regulation S-K after adopting amendments to the rule in 2007.
Item 404 of Regulation S-K also requires disclosure of company policy concerning the “review, approval or ratification” of related-party transactions, including the types of transactions that are covered in the policy, the standards applied, who is responsible for applying the policy, and whether the policy is in writing.Directors should recuse themselves from any discussions or decision-making in regard to a transaction with a related party – this goes for public, private, and not-for-profit concerns.
Related party transactions need to be carefully evaluated. Corruption really cannot exist without a conflict of interest. Each and every corrupt act is driven by an underlying conflict.
Remember, just because someone discloses a related party or a conflict of interest doesn’t necessarily mean its legitimate! In fact, it could be a way of earning your trust and reducing your level of skepticism!
Jonathan T. Marks, CPA, CFE