Abstract
A related party transaction often happen between parties such as individuals or firms that have control or influence on each other’s decision. When this is the case transactions may not be done at arm’s length; thereby negatively or at times positively impacting the going concern of the business. The article reviewed literature and empirical findings to support the need for liquidity and profitability that would ensure business continuity into a foreseeable future.
Keywords: Related Party Transactions (RPTs), Going Concern, Business Continuity.
In practice, many businesses have gone down (liquidated or wind-up) as a result of related party transactions, just because the right terms and conditions are either not properly documented, or documented but not applied as a result of sentiments and thought of relationship consequence of what happens if applicable terms are enforced. It is not uncommon to have business transaction with related firms, family, friends and other related parties, but doing that profitably and sustainably in manners that would at the same time ensure business going concern is what this article seeks to enlighten.
According to 2014 Middle East and North Africa (MENA) report of Organization for Economic Co-operation and Development (OECD), at the global scene, related party transactions (RPTs) frameworks and practices have been subject to growing attention following the risks connected with RPTs and the negative consequences of dishonest RPTs already witnessed in a number of markets. Therefore, this connotes that related party transaction scenario is a global phenomenon, and it is pertinent to avoid undermining its impact on business survival or threat to going concern.
Mizra, Holt and Orrel (2012), stated that related party transaction is a very sensitive subject in most part of the world. Relating this to Africa, especially in Nigeria where there is so much respect and cultural practice of adoration for individuals, related party transaction therefore often result into business done not at arm’s length. In an arm’s length transaction, both parties act in an independent manner and more importantly, they act in a way that places their own self-interest above all else (Ugazu, 2019). It therefore means that an arm’s length transaction is one in which exchange of value happens at prevailing market price, terms and condition without any of the involved party’s influence.
International Accounting Standards (IAS) 24, defines related party transaction as “a transfer of resources, services, or obligation between related parties, regardless of whether a price is charged or not”. The Standard also provide guidelines regarding proper disclosure of related party transactions in financial statements to enable users understand full picture of an entity’s position and results of business activities. This kind of disclosure could have a significant impact on the increase of investors’ confidence (Ioana, & Liliana, 2019).
Related party transactions exhibits different forms which include transactions regarding service rendering, exchange or sale of commodities, tangible or intangible transactions, within border or outside border transactions, transactions within or outside group of companies, lease transitions, import and export, joint ventures, partnership etc. Be it as it may, it is not all related party transactions that impose negative impact on business (OECD, 2014). With this, it means the intention or purpose of such transactions goes a long way to determine its possible resultant impact.
In practical terms, examples of related party transaction are: an older sibling making a car business sales to a younger sibling. Or, childhood friends rendering costly business services to each other. It can also happen in a corporate setting where companies within a group renders service or make sales to each other. To remain in business without liquidity threat to going concern, there is need to do more than break-even. To break-even therefore, requires covering relevant cost of doing business and essentially selling enough volume to justify relevant costs. This is why transactions including those done with a related party, friends, family, and associates, to mention a few may either positively or negatively affect every business.
Grzegorz et al (2021), investigated the impact of earnings management (EM) and related party transactions (RPTs) on corporate financial performance in an emerging market, Iran. The study used panel data analysis and sampled 108 Iranian manufacturing companies listed on the Tehran Stock Exchange (TSE) between 2013 and 2018. Consistent with the tunneling hypothesis or agency theory, the findings confirmed that RPTs damage corporate value of return on asset (ROA) and Tobin’s Q because managers probably consider it a mechanism to exploit enterprise resources owing to existing conflictual interests. Moreover, purchase-related party transactions lead to lower ROA, whereas sale-related party transactions and Tobin’s Q are correlated negatively. Diab, Aboud and Hamdy (2019), carried out a study to examine the impact of related party transactions on firm value of companies listed on the Egyptian stock market, using a sample of EGX 30 from 2012 to 2017. They found that there is no significant relationship between related party transactions and market value.
To remain in business into a foreseeable future, profit maximization via operational optimization seems to be key objective of firms in today’s complex and highly competitive business world; hence, the relevance of financial statements in capital markets (Grzegorz et al, 2021). In conjunction with this, literature and empirical finding abound showing that profit management
leads to the improved financial condition of companies (Nobakht and Acar 2021; Khuong et al. 2019; Abbas and Ayub 2019; Sayari and Omri 2017). In most cases, transactions with related parties are not done at arm’s length leading to the inability to cover production or service cost and even at times does not cover any of the costs (fixed or variable); thereby leading to loss making. Where this persists, the end result is gradual and automatic threat to going concern.
To mitigate the impact of related party transactions, a number of countries across the world have implemented corporate governance codes, operational procedures, approvals, laws and guidelines to guide management team and boards of companies (OECD, 2014). In Nigeria, Code of Corporate Governance (CCG) issued by Securities and Exchange Commission (SEC), Central Bank of Nigeria (CBN) and Companies and Allied Matters Act (CAMA) 2020 helps to mitigate this. Furthermore, according to Wu (2021), the tax authorities in different countries often evaluate and examine whether a RPT in importation or exportation is fair and complies with the Arm’s Length Principle (ALP) according to the basic principles of the OECD Transfer Pricing Guidelines and their own tax laws.
Conclusively, even though business or any other transaction must be done, it should follow basic principles, specified documented terms and conditions that will enable the business continue into a foreseeable future. If at all a very close relation must be transacted with, such transaction should ideally be done at arm’s length. If not possible, such transaction might be done at cost price, so that gain is not made from the relation and neither loss is incurred. If it must be done at zero cost, for the purpose of ensuring going concern or business continuity, it is recommended that the business owner deep into his personal pocket and pay the business for the transaction. Lastly, when preparing financial statements, adequate disclosures on related party transactions should be achieved in line with relevant accounting standards and regulations of the country in which the entity is based.
References
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How to Cite this Article:
Omojuyigbe, S. T. (2022). A Practical Solution to Business Continuity in a Related Party Transaction. Sunday Omojuyigbe & Co Publications, 2(22), 12-18. https://sundayomojuyigbe.com/publications/
