Are Related Party Transactions Red Flags?

Abstract

This study investigates whether or not related party transactions serve as "red flags" that warn of potential financial misstatement. We hand-collect related party transactions for S&P 1500 firms in 2001, 2004, and 2007 and find a positive correlation between these transactions and future restatements, suggesting restatements are more likely when a firm engages in related party transactions. The association is concentrated among transactions that appear to reflect "tone at the top" rather than arguably more necessary business transactions. We also find RPT firms pay lower audit fees. However, "tone RPT" firms that subsequently restate pay higher audit fees, providing evidence that auditors recognize the individual restatement risks of these firms. Our results suggest that tone-based RPTs serve as signals of higher risk of material misstatement. Faut-il voir des signaux d'alarme dans les op erations entre apparent es ? R ESUM E Les auteurs se demandent si les op erations entre apparent es servent ou non de « signaux d'alarme » annonc ßant des anomalies financi eres potentielles. Ils rel event manuellement les op erations entre apparent es des soci et es composant l'indice S&P 1500 en 2001, 2004 et 2007 et observent une corr elation positive entre ces op erations et les retraitements ult erieurs, ce qui semble indiquer que les retraitements sont plus probables lorsque les soci et es concluent des op erations entre apparent es. Le lien se manifeste davantage parmi les op erations qui semblent refl eter le « ton donn e par la direction » plutôt que parmi les op erations commerciales pouvantêtre qualifi ees de plus n ecessaires. Les auteurs constatent egalement que les soci et es qui concluent des op erations entre apparent es paient moins d'honoraires d'audit. Toutefois, les soci et es dont la direction donne le ton aux op erations entre apparent es et qui proc edent subs equemment a un retraitement paient des honoraires d'audit plus elev es, ce qui permet de conclure que les auditeurs reconnaissent les risques de retraitement que pr esentent individuellement ces soci et es. Les r esultats de l' etude semblent indiquer que les op erations entre apparent es refl etant le ton donn e par la direction signalent un risque plus elev e d'anomalies significatives.

Discussion of “Are Related Party Transactions Red Flags?”

“…The Kohlbeck and Mayhew () study finds that simple RP_TONE s are red flags for poor accounting quality associated with lower audit fees. The authors develop a model to explain these observations, suggesting that RP_TONE is associated with poor “tone at the top” and that this leads the management to negotiate for lower‐quality audits to minimize monitoring costs.…”

“…In their paper, Kohlbeck and Mayhew () (hereafter KM), analyze hand‐collected data for listed U.S. S&P 1500 firms for 2001, 2004 and 2007 to demonstrate that certain types of related party transactions (RPTs) are associated with a higher likelihood of financial restatement and, surprisingly, with a lower audit fee . The authors present two main findings.…”

“… Abstract Kohlbeck and Mayhew () create a new data set featuring two types of related party transactions. They use empirical‐archival methods to investigate the effect of such transactions on the likelihood of restatements and on audit fees.…”

Disclosure on Related Party Transactions: Evidence from Italian Listed Companies

“…Some examples of this abuse could lead to a reduction in shareholder wealth (tunneling transactions), yielding a virtual increase in the resources of the corporation or finally towards producing misleading statements (earnings management). Furthermore, some studies (Gordon et al, 2004;Kohlbeck & Mayhew, 2005) conclude that weak CG leads to a larger number of RPTs. Several studies have confirmed the use of earnings management by large numbers of listed companies in order to achieve particular levels of return on equity (ROE) (Chen & Yuan, 2004;Liu & Lu, 2007).…”

“…Although the theories are opposed, Kohlbeck and Mayhew (2005) suggest that the potential benefit or detriment depends on the parties involved in the transaction or the type of RPTs conducted.…”