Most small clients have at least one related party transaction: the owner lent money to the company, the company rents a building from the owner's entity, or a management company bills a monthly fee. The accounting entries are ordinary. The disclosure is where files fall short, because the footnote needs the relationship, the amounts and the terms, and the client rarely has them in one place.
This guide works three common transactions from entry to footnote, then lists audit tests. For the identification and risk side, see /us/blog/related-party-transactions-audit.
Who is a related party?
ASC 850 applies to all reporting entities, including a subsidiary's separate financial statements. Related parties include:
- Affiliates of the entity
- Entities whose equity investments would be equity method investments
- Employee trusts, such as pension or profit-sharing trusts managed by or under the trusteeship of management
- Principal owners and their immediate families (a principal owner holds more than 10% of the voting interests)
- Management and their immediate families
- Parties that control or can significantly influence the management or policies of the entity, or are controlled or significantly influenced by it, to the extent one party might be prevented from fully pursuing its own interests
Management means persons responsible for achieving the objectives of the entity. It typically includes board members, the CEO, the COO and vice presidents in charge of principal functions, and can include people without formal titles.
What does the footnote have to say?
When financial statements include material related party transactions, disclosure covers:
- The nature of the relationship.
- A description of the transactions for each income statement period presented, including transactions with no or nominal amounts.
- The dollar amounts of the transactions for each period for which income statements are presented.
- Amounts due to or from related parties at the date of each balance sheet presented.
Similar transactions may be aggregated by type of related party where appropriate. Transactions eliminated in consolidated statements need not be disclosed in those statements. The nature of a control relationship must be disclosed even when there are no transactions between the entities.
Transactions with related parties cannot be presumed to be at arm's length. An arm's-length statement is made only when it can be substantiated. A company can say a related party loan carries terms equivalent to an unrelated lender's only if it can show that.
Example 1: shareholder loan
The owner lends the company $100,000 on July 1 at 5%, interest and principal due in a lump sum in three years.
| Account | Debit | Credit |
|---|---|---|
| Cash | 100,000 | |
| Note payable, shareholder | 100,000 |
At December 31, six months of interest is accrued: $100,000 x 5% x 6/12 = $2,500.
| Account | Debit | Credit |
|---|---|---|
| Interest expense, related party | 2,500 | |
| Accrued interest, shareholder | 2,500 |
The footnote should describe the loan terms, the interest incurred for each period, the balance and accrued interest at year end, and the settlement terms. Consider whether a modification or forgiveness of related party debt is, in substance, a capital transaction.
Example 2: lease from an entity owned by the owner
The company rents its warehouse from an entity owned by its principal shareholder for $10,000 a month. Related party leases carry the standard lease disclosures in addition to the related party disclosures.
For the audit file, the point is classification and disclosure rather than the lease accounting entry. Under an operating lease the lessee records a single lease cost, and under a finance lease the payment splits between interest and principal. A simplified entry for an operating lease:
| Account | Debit | Credit |
|---|---|---|
| Operating lease cost | 10,000 | |
| Cash | 10,000 |
The footnote states that the lessor is owned by the principal shareholder, the annual rent for each period ($120,000 in the illustration), the lease term, and any amounts payable at year end. Without the related party description, the lease disclosures alone would hide the relationship.
A sample footnote sentence for illustration: "The Company leases its warehouse from an entity owned by its principal shareholder. Rent expense was $120,000 in each of the years ended December 31, 20X2 and 20X1. No amounts were payable under this lease at year end."
Example 3: management fee
A management company owned by the owner's family bills $8,000 a month for administrative services.
| Account | Debit | Credit |
|---|---|---|
| Management fees, related party | 8,000 | |
| Accounts payable, related party | 8,000 |
The expense is disclosed with the nature of the services and the amount for each period.
How are related party items presented?
Receivables from officers, employees or affiliated entities are normally shown separately on the balance sheet and not grouped into trade receivables or other notes receivable.
A guarantor of a related party's obligations must comply with the related party disclosure requirements. See /us/standards/asc-460-guarantees-recognition-disclosure.
Audit angle
- Build the related party list. Combine management's list with the owner's other entities, officers, directors and family members known from inquiry, minutes, tax returns and prior-year files.
- Search the ledger. See also /us/blog/undisclosed-related-party-procedures-and-completeness-testing. Scan vendors, customers, loans, payroll and journal entries for names and addresses on the list, round-dollar payments and entries at period end.
- Confirm with the other side. For loans, rent and fees, obtain the agreement and a balance confirmation or statement from the related party where possible. See /us/standards/au-c-550.
- Test the amounts. Recompute interest, agree rent to the lease, and agree fees to the invoice and the contract.
- Challenge arm's-length language. Remove any statement that terms equal those of an unrelated party unless the client holds support such as a market quote.
- Test presentation. Check that receivables from officers and affiliates are not buried in trade receivables.
- Read the representation letter. Check that management states that all related party relationships and transactions are identified and disclosed.
Common misstatements: a shareholder loan netted against capital without disclosure, a related party lease footnoted only under lease disclosures, unsupported arm's-length wording, and an owner's advance shown in trade receivables.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Financial statement presentation guide, 26.2 Related party scope and relevant guidance: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_26_related_p_US/262_scope_and_releva_US.html
- PwC Viewpoint, Financial statement presentation guide, 26.3 Related party presentation: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_26_related_p_US/263_related_party_pr_US.html
- PwC Viewpoint, Financial statement presentation guide, 26.4 Related party disclosures: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_26_related_p_US/264_related_party_re_US.html
- PwC Viewpoint, Financial statement presentation guide, 26.5 Common related party transactions: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_26_related_p_US/265_common_related_p_US.html
- Deloitte DART, Roadmap: Initial public offerings, 5.3 Related-party transactions (principal owners, nature of relationship, amounts due to and from): https://dart.deloitte.com/USDART/home/publications/deloitte/additional-deloitte-guidance/roadmap-initial-public-offerings/chapter-5-accounting-matters/5-3-related-party-transactions
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error