Examining Related-Party Transactions And Corporate Fraud

Examining Related- troupe Transactions And Corporate FraudRelated parties represent a connexion where one caller thunder mug exercise say-so (direct or indirect) or significant influence everyplace the operating policies of the other company. According to FRS 8 and IAS 24, a relate party let ins an entitys subsidiaries, associates, joint peril enkindles, directors and family members ofdirectors.Related-party minutes ar legitimate activities and serve practical purposes such asThey ar recognised in corporate and taxation laws.They get hold of their own standards for history treatment.Systems of checks and balances support been built around them to spend a penny sure they are conducted within these boundaries.The interest parties are not considered as relate parties in IAS 24Parties which have normal dealing with an entity. Examples include providers of finance, trade unions, government agencies and public utilities.Parties such as customers, suppliers, distributors a nd franchisors on which the entity is economically dependent.Two venturers sharing joint control over a joint venture.Two entities having a common directors or other member of key management personnel are not considered as link up parties.Related Party TransactionsRelated party proceeding (RPTs) are define in IAS 24 as any minutes make between the relate parties irrespective of whether a price is charged or not. The transactions include canalise of resources, work or obligations. In other words, RPTs are transactions between a company and its management, board members, principal owners, or members of the immediate families of any of these groups. Examples of RPTs beneath IASB include rendering or receiving of services, purchase or gross gross gross gross gross sales of goods, leases, provisions of plights or collateral, purchase or sale of property and other assets, among others.Moreover, FASB (1982) states that RPTs include transactions between a company and its affil iates. Affiliates refer to entities which control the company, they are controlled by the company or they are controlled by other entity which also controls the company. Examples of RPTs nether FASB include services received or furnished, borrowings and lendings, guarantees among others.Scenarios under related party transactionsWhen an individual purchases a stock, bond, note or mutual fund from a family member or related party entity, he becomes entitled to the related party rules and under these rules, the individuals cost rump pull up stakes actually depend on whether he ends up selling it at a gain or a loss.For example, the individuals sister owned stock of XYZ Corp which she bought for $20,000. It had declined in value to $10,000 when he bought it from her. Therefore, she isnot allowed to claim acapital loss when she sells it to him because he is a related party.Gain scenarioIf later the individual sells the stock to athird, unrelated partyfor $22,000, he forget experience a straightforward gain of $12,000 on his own acquisition cost of $10,000. However, he only have to declarea capital gain of $2,000 forincome tax purposes becausehe is allowed to use a carryover basis from his sister, since she was not able to claim the previousdisallowed loss.Loss scenarioIf the individual sells it later to athird, unrelated partyfor $8,000, he will have a true loss of $2,000 on his own acquisition cost of $10,000,and he can only declarea capitalloss of $2,000 forincome tax purposes. However, he is not allowed to use a carryover basis from his sister, even though she was not able to claim the previousdisallowed loss. The tax savings from the previous disallowed capital loss are wasted and no one claimed them.DisclosureThe objective of IAS 24 is to ensure that an entitys financial statements contain the disclosures necessary to draw attention to the possibility that its financial stick and profit or loss may have been affected by the existence of related parties a nd by transactions and outstanding balances with such parties.The IAS 28 requires the following to be disclosedRelationship between parents and subsidiaries The entity should disclose the name of its parent company or of its ultimate controlling party irrespective of whether there have been any transactions occurred between them. In the case where neither the parent company nor the ultimate controlling company produces financial statement for public use, hence the next intimately senior parent that does so moldiness also be disclosed.Management Compensation The compensation of the key management personnel must be disclosed in total and for each of the following categoriesShort-term employment benefitsPost-employment benefitsOther longer benefitsTermination benefits, andEquity Compensation benefits.Related Party Transaction If transactions have been made between the related party, then for each categories of the related party, the following should be disclosed separatelyThe amount of the transactionsThe amount of the outstanding balances including terms and conditions and guaranteesProvisions for probationary debts related to the amount of outstanding balancesExpenses recognised during the period in respect of bad or doubtful debts due from related parties.Types of RPT that lead to corporate fraudsMany high profile companies have made an abuse use of related party transactions to pull ahead in involving in double-tongued activities. These include companies such as Enron, Adelphia, Tyco and others.Sales to ( or purchases from) related parties of goods and servicesAccording to Pesaru (2002), a related-party sales transaction represents the link between the company and the customer. In this particular transaction, it is usually difficult to identify the related parties. Thus, companies use this technique for boosting revenue. As such, the undisclosed related-party transactions may be used to fraudulently inflate earnings. Companies use fibing trick to mislead the users of financial statements. Presenting a series of sales, which are executed with an undisclosed related-party and which are peanut is an example of accountancy trick used by companies. Moreover, sales made to related party transactions can also lead to corporate frauds if the sales transactions are categorized under fake sales. Fictitious sales include round-trip sales. SEC 2003 defines round trip sales as simultaneous pre-arranged sales transactions often of the same product in order to create a false impression of justifying those fictitious sales transactions of falling under the normal ordinary course of the business. This type of transactions inflates sales figures and thus leads to overstatement of revenues.On the other hand, the purchase of goods or services from related parties is another type of RPT. This type of RPT may lead to fraud when the purchases are not disclosed or when they are considered as unauthorised transactions. Companies create fictitious purchas es of services from related party to conceal a misappropriation. For instance, in the Tyco case, it was found that the company failed to disclose a finders fee paid to an outside director in affiliation with an acquisition. Besides, one of the principal owners of PNF Industries, Inc. created fictitious records to conceal a misappropriation by claiming that he was owed consultation fees. Since the payments were considered as unauthorised, he falsified a minutes of a directors run into to authorize the fees. Non-reported purchases from a related party understate expenses and the effect of the understated figure of expenses is reflected in an overstated sales figure. On the contrary, non-reported revenues and fictitious purchases lead to understatement of income. This substantial scenario is summarised in the following diagram.First scenario EffectFICTITIOUSSALESOVERSTATEMENTOF REVENUESSMOOTHING INCOMENON-REPORTED PURCHASESSecond scenarioNON-REPORTED REVENUEFICTITIOUS PURCHASESUNDER STATEMENT OF INCOMEGenuine sales can be made to the related party in such a way that this transaction transfer wealth to the related party. This can be done if genuine sales are made below its market price to the related party. Another way of transferring wealth to the related party would be unnecessary purchases of goods and services or even purchases higher up its market price by the company. The other side of the coin will be transferring wealth from the related parties to the company. This is possible when actual sales are transacted to related party at above market prices or when purchases are made below market prices from the related party.The situation of genuine sales being transacted in a manipulating way can have two impactsFirstly, if the company is already facing a crisis in terms of low winnings for instance, then the latter can opt for transferring wealth from the related party to itself.And, if the company is transferring its wealth to the related party, this will lead to misappropriation of companys assets.Both of these impacts will lead to fraudulent financial reporting. To better understand the picture, a diagram is illustrated belowScenario of salesGENUINE SALESMade to related parties under market pricesMade to the company over market pricesLEADS TO TRANSFER OF WEALTHTo the companyTo related partiesScenario of PurchasesPURHASES MADE TORelated parties over market pricesThe company from related parties under market pricesLEADS TO TRANSFER OF WEALTHTo the companyAn example of a company which uses this to involve in fraudulent activity is Livent Inc., Humatech Inc. and Enron. Livent Inc has mischaracterised sealed receipts as revenue. In fact, the receipts were actually borrowings since there were side agreements obligating the company to repay the funds. The counterparty companies were related parties since the top executive of Livent Inc were a member of their boards. In the case of Humatech Inc, the CEO and the chief financial officer sec retly controlled the improper recognition of revenue which was actually sale to a foreign distributor. Indeed, the foreign distributor was a related party but barely no disclosure has been made of the transactions. Furthermore, Enron has made a payment to one of its employees of around $ 10 million and the chief financial officer took it as a SPE. The employee then via a payment to the CFOs family members, share a portion of its fees to the CFO.Loans to and from the related partiesThe provision of loan to and from the related parties is another major type of RPT.Lack of transparency involved in recording the following transactions outlined below of a company leads to understatement of its liabilitiesNon- recognition of borrowings by the company to the related partiesNon-disclosure of obligations incurred for the related parties in terms of guaranteeDisclosure of loan transactions to related partiesIf loans are given to the related parties by the entity are reported accordingly in t he financial records of that firm, the issue that arises is in terms of the collateral which is used as a medium to get the finance. In fact, what usually happens is that in case of related party transactions companies prevail to overstate the value of these collaterals.Manipulating interest ratesWealth are transferred to related party by either borrowing from a related party at above-market interest rates, or lending to a related party at below-market interest rates. If the related parties borrow from the company at an interest rate which is above the market interest rate, this leads to a transfer of wealth to the company. Similarly, if the company is financed out by the related parties at below-market rates or off-market, this would again leads to a transfer of wealth from the related parties to the company. According to Freidman et al. (2003), this kind of practice is referred to as propping. On the other hand, if the company lends the related parties at an interest rate which i s lower or even off the market interest rate, this will lead to a transfer of wealth from the company to the related parties.The scenario of manipulating interest rate can be easily understood through the diagram belowScenario transfer of wealth to the companyCOMPANYBorrows from the related parties at a lower market interest rateLends to related parties at a higher market interest rateLeads to transfer of wealth to the companyIf borrowings from a related party are not recognised, this will result in an understatement of liabilities. Moreover, over-estimating the collectability of loans to a related party leads to an overvaluation of assets. These situations are known as loan related misstatements and this may finally leads to frauds. Several companies adopted this technique when preparing their financial statements. For example, Adelphia understated its liabilities by $1.6 billion. It failed to report its obligation under the credit facility by claiming that its obligation was mere ly a guarantee which did not require disclosure. In addition to this, Adelphia has netted $ 1.351 billion related party receivables with against related party payables, which has enable them to hide $ 1.348 billion of related party payables. The netting has also allowed them to hide the amount of transactions between the Adelphia and the company owned by Rigas family which was Adelphias controlling shareholders and management team. Indeed, the SEC has stated that the Rigas family has lawlessly excluded over $2.3 billion in bank debt by deliberately shifting those liabilities onto the books of Adelphias off balance sheet, unconsolidated affiliates and created sham transactions backed by fictitious documents to give the false appearance that Adelphia had actually repaid debts when, in truth, it had simply shifted them to unconsolidated Rigas-controlled entities. Moreover, PrintontheNet.com did not disclose that it had guaranteed $7.3 million in related parties loans. In the case of Ty co, Mr Kozlowski, who was the precedent Chief Executive Officer of Tyco International borrowed $ 242 one thousand thousand from a Tyco program, with the intension to facilitate the executives to pay taxes on restricted-stock grants. However, instead of utilising the funds for that purpose, he spent the finances on yachts, fine art, estate jewelry and luxury apartments. In the same way, Mr Swartz, Tycos former Chief Financial Officer took a loan of $72 Million from program and made personal investment and business ventures with that money. In the Enron case, Mahonia, a special purpose entity (SPE) which was controlled by a financial institution was employed to make some of the Enrons transactions disguised a borrowing of $ 2.6 billion from the financial institution as forwards contract. Hence, as a result of the disguised loans, cash in flowed from the financial institution to Mahonia and then from Mahonia to Enron.Investment in related partiesIt is crucial to disclose investments in related parties in order to foresee frauds from occurring. Managers tend to manipulate earnings via tunneling actions in order to maintain the companys stock performance. As a result, investment decisions would be expropriated if such decisions are determined ground on the financial disclosure. If investment in the equity of a related party is not reported correctly, this will lead to an overstatement of assets and hence will mislead investors about insider activity. Several companies had inflated their assets with RPTs. For example, an investment of $2.5 million in a venture capital fund by Hollinger was not disclosed. Moreover, in the Enron case, victimisation the special purpose entities (SPEs) the managers was able to hide unfavourable performance of their investment decisions. Tonka is another example of a company which involve in fraudulent activities. The CFO of the company secretly owned a company and he misappropriate assets of Tonka by making the corporate funds to b e improperly been invested in his company.Hence, it can be seen that many companies has misused related party transaction to involve in fraudulent activities. However, the Sarbanes Oxley Act 2002 has prohibited only one type of related party transaction which was loans to related parties. Indeed, in a study by Henri et al. (2007) which examined 83 SEC enforcement actions involving in related party transaction and fraud, it was found that the most frequent type of related party transaction was loan to related party.RPT A cause for concernMany accounting frauds such as Enron, Adelphia, Tyco, Refco, Hollinger, service Aid have occurred during the past years and have shown concern towards related party transactions. This is because in one way or the other, related party transactions were involved, creating concern among regulators and other market participants about the appropriate monitoring and auditing of these transactions.However it has been pointed out that research has provided a mixed picture of the role of related party transactions in fraudulent financial reporting. For example, research has shown that related party transaction disclosures are quite common (Gordon et al. 2004a Wall Street Journal 2003). However, since fraudulent financial reporting is relatively uncommon (Lev 2003), and furthermore most frauds2 apparently do not involve related party transactions (Shapiro 1984 Bonner et al. 1988 SEC 2003), it is credible to assume that most disclosed related party transactions are not fraudulent.According to Gordon et al. (2004), RPTs play a fundamental role in a firms corporate governance environment. It is said that RPTs are an aspect of corporate governance because these transactions are complex issues between a company and its managers, directors, subsidiaries and major shareholders. RPT is considered as an issue to corporate governance because of the problems of asymmetric information between the firms manager and external capital markets. Additio nally, RPTs result in higher agency costs. This is due to the confederation of decision-making and monitoring rights.Moreover, according to Johnstone and Bedard (2004), RPTs are difficult to audit and these transactions represent a potential audit risk. When examining the financial statements of companies, auditors do not have up to(predicate) information on related party.Is it fair to blame only bad corporate governance for corporate failures?Bad corporate governance is one of the reasons which account for the corporate failures. Corporate governance issues, like those with related party transactions, crop up because of the existence of asymmetric information between shareholders and the firms managers. Existing research has shown that certain board characteristics and CEO pay-performance sensitivity are useful governance mechanisms which help to improve managerial agency problems. For example, large board size, which is observable and disclosed in proxy statements, has been foun d to be negatively correlated with firm value and interpreted as indicative of weak corporate governance (Yermack, 1996).However, this does not cease that corporate failures arise only because of bad corporate governance. There are multitude reasons behind the corporate scandal. For instance, it has been seen that a lack of standards is one of the reasons. It is believed that the erosion of accounting practices begun in the 1980s as firms tried to balance strict standards with a desire to please clients and increase consulting business. Research has shown that a lack of government regulation was one of the major causes of the huge energy trading firm Enron. This firm reported profits of hundreds of millions of dollars ($979 million in 2000, alone) before collapsing in 2001.Other examples include poor management structures, lack of independence and objectivity by auditors as well as poor business ethics. Ethics can be defined as moral philosophy. It is basically the discipline conc erned with what is morally good and bad, right and wrong. The term is also applied to any system or surmisal of moral values or principles (Ethics, Encyclopedia Britannica Online, 2000). However, when this term is applied in the business context, it is said to be the study and evaluation of decision making by businesses according to moral concepts and judgments (Business Ethics, The Columbia Encyclopedia, 2007).For instance, in the Enron case, the auditors applied reckless standards to do their audit because they were receiving significant consultation fees from the company.