5.3 Related-Party Transactions

All related-party transactions, including those that arise as a result of the IPO process, need to be identified to ensure that they are properly disclosed as well as to identify those transactions that are modified or terminated, such as (1) shareholder agreements that provide rights of first refusal, (2) loans to directors or executive officers that may not be allowed under Sarbanes-Oxley, and (3) stock option or award plans and stock purchase plans. For example, issuers are prohibited from providing a personal loan to or for any director or executive officer (or equivalent). Accordingly, any such loans must be repaid or otherwise settled before an entity’s first public filing with the SEC.

5.3.1 Definition of a Related Party

Although both public and nonpublic entities are required to include related-party disclosures in their financial statements under U.S. GAAP, an SEC registrant’s financial statements and other disclosures in an IPO must comply with incremental SEC guidance. Therefore, when preparing for an IPO, management should be aware of the differences between the U.S. GAAP definition of “related party” and the SEC’s definition of the term to ensure that disclosures are compliant with SEC guidance.

ASC 850 defines a related party as follows:

Related parties include:

Affiliates of the entity
Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
Principal owners of the entity and members of their immediate families
Management of the entity and members of their immediate families
Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

With respect to the financial statements, the definition of related party in Regulation S-X, Rule 1-02(u), is consistent with that in U.S. GAAP. Regarding disclosures in the registration statement outside the financial statements, the SEC’s definition of a related party is similar to that in U.S. GAAP but the SEC has established its own definition of a “related person” in the instructions to Regulation S-K, Item 404(a). This definition includes:

“Any director or executive officer of the registrant.”
“Any nominee for director, when the information . . . is being presented in a proxy or information statement relating to the election of that nominee for director.”
Any beneficial owner of more than 5 percent of any class of the company’s voting securities (see Regulation S-K, Item 403(a)).
“Any immediate family member” of the people listed above (i.e., “any child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law” of such people) “and any person (other than a tenant or employee) sharing the household” of such people.

The example below highlights the need to consider what constitutes a related party under both U.S. GAAP and Regulation S-K.

Example 5-1

Under U.S. GAAP, a principal owner is considered a related party. ASC 850 defines the term “principal owners” as “[o]wners of record . . . of more than 10 percent of the voting interests of the entity.” Under the SEC definition of a related party, this amount is decreased to 5 percent of any class of voting securities. If a shareholder holds a 7 percent interest in an entity both before and after an IPO, that individual would not represent a related party for U.S. GAAP purposes but would be considered a related party under Regulation S-K, in which case additional disclosures would be required.

5.3.2 Presentation and Disclosures Associated With Related-Party Transactions

The SEC considers disclosures about related-party transactions to be an integral part of the financial statements and other disclosures in the registration statement. Management must therefore provide detailed disclosures about these transactions in registration statements.

5.3.3 Related-Party Disclosures Under U.S. GAAP

ASC 850-10-50 provides the guidance below on related-party disclosures (this guidance applies to both public and nonpublic entities).

ASC 850-10

50-1 Financial statements shall include disclosures of material related party transactions, other than compensation arrangements, expense allowances, and other similar items in the ordinary course of business. However, disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements. The disclosures shall include:

The nature of the relationship(s) involved
A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements
The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period
Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement
The information required by paragraph 740-10-50-17.[1]

50-2 Notes or accounts receivable from officers, employees, or affiliated entities must be shown separately and not included under a general heading such as notes receivable or accounts receivable.[2]

50-3 In some cases, aggregation of similar transactions by type of related party may be appropriate. Sometimes, the effect of the relationship between the parties may be so pervasive that disclosure of the relationship alone will be sufficient. If necessary to the understanding of the relationship, the name of the related party shall be disclosed.

50-4 It is not necessary to duplicate disclosures in a set of separate financial statements that is presented in the financial report of another entity (the primary reporting entity) if those separate financial statements also are consolidated or combined in a complete set of financial statements and both sets of financial statements are presented in the same financial report.

Disclosures About Arm’s-Length Bases of Transactions

50-5 Transactions involving related parties cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist. Representations about transactions with related parties, if made, shall not imply that the related party transactions were consummated on terms equivalent to those that prevail in arm’s-length transactions unless such representations can be substantiated.

Control Relationships

50-6 If the reporting entity and one or more other entities are under common ownership or management control and the existence of that control could result in operating results or financial position of the reporting entity significantly different from those that would have been obtained if the entities were autonomous, the nature of the control relationship shall be disclosed even though there are no transactions between the entities.

5.3.3.1 Related-Party Disclosures for SEC Registrants

In addition to meeting the disclosure requirements under U.S. GAAP, a registrant’s financial statements should comply with the applicable requirements of Regulation S-X. The SEC staff frequently requests additional related-party disclosures.

Regulation S-X prescribes the types, form, and content of the financial information that registrants must file. Many of these requirements expand on the disclosure requirements in U.S. GAAP. Under Regulation S-X, Rule 4-08(k):

Registrants must state the amounts of related-party transactions on the face of the balance sheet, statement of comprehensive income, or statement of cash flows.
When separate financial statements are presented for a registrant, certain investees, or subsidiaries, registrants must separately disclose in such statements any historical intercompany profits or losses resulting from transactions with related parties and the effects thereof.

In addition, Regulation S-X, Rule 5-02(3)(a), requires entities to state separately, on the face of the balance sheet, amounts receivable from (1) customers (trade); (2) related parties; (3) underwriters, promoters, and employees (other than related parties) that “arose in other than the ordinary course of business”; and (4) others.

Further, Regulation S-K, Item 404(a), requires registrants to disclose, in the registration statement and outside the financial statements, transactions with related parties they participated in, or will participate in, since the beginning of the registrant’s last fiscal year, for which the “amount involved exceeds $120,000, and [the related party] had or will have a direct or indirect material interest.” This disclosure should include information such as:

“The name of the related person and the basis on which the person is a related person.”
“The related person’s interest in the transaction with the registrant.”
“The approximate dollar value of the . . . transaction.”
Any additional information about the transaction “that is material to investors in light of the circumstances of the particular transaction.”

5.3.4 Identifying Related-Party Transactions

In identifying related-party transactions, registrants should consider consulting with legal counsel and reviewing the instructions to Regulation S-K, Item 404(a), to better understand the definition of a “related person” and the types of transactions a registrant needs to disclose. As part of this process, a master list of all related parties should be maintained and communicated to directors, officers, and employees so that they are aware of them. Additional information about related parties may be obtained in various ways, including an annual questionnaire distributed to directors and officers through which an entity obtains basic information about transactions between directors and officers, their family members, and the entity. Other potential sources that may help identify related parties include, but are not limited to:

Disclosures on the entity’s Web site.
Tax filings and related correspondence.
Invoices from professional advisers.
Conflicts-of-interest statements from management and others.
Shareholder registers that identify the entity’s principal shareholders.
Life insurance policies purchased by the entity.
Records of investments, pension funds, and other trusts established for the benefit of employees, including the names of the officers and trustees of such investments, pension plans, and other trusts.
Contracts or other agreements (e.g., partnership agreements) with management.
The entity’s organizational charts.
Records from a whistleblower program.
Expense reimbursement documents for executive management.

Connecting the Dots

PCAOB auditing standards require the auditor to perform certain procedures to audit related-party transactions and the related internal controls. See Section 6.7.3 for more information.

5.3.5 Focus of SEC

Types of related-party transactions that the SEC staff often comments on during the registration process include (1) sales and loans between related parties and (2) the entity’s policies and procedures for reviewing, approving, or ratifying transactions with related persons. For additional observations related to frequently issued SEC staff comments, see Deloitte’s Roadmap SEC Comment Letter Considerations, Including Industry Insights.

5.3.6 Regulation S-K, Item 404(a)(5), “Transactions With Related Persons”

Regulation S-K, Item 404(a)(5), indicates that registrants should disclose the major terms of related-party indebtedness, including the amounts involved, the largest principal amount outstanding during the period and as of the latest practicable date, principal and interest payments made during the period, and the interest rate or the interest-payable amount as of the end of the period. The SEC staff often asks registrants to expand their disclosures related to these requirements.

5.3.7 Regulation S-K, Item 404(b), “Review, Approval or Ratification of Transactions With Related Persons”

Regulation S-K, Item 404(b), requires a registrant to develop and disclose its “policies and procedures for the review, approval, or ratification of any transaction” with related persons. These policies and procedures are essential to providing information to investors regarding how related-party transactions will be addressed. Recent SEC comment letters have indicated that although the SEC may ask for additional information regarding these policies, registrants often disclose the existence, or a general summary, of such policies and procedures but exclude material features such as the types of transactions covered, the standards to be applied to the transactions, and the persons or group of persons responsible for applying the policies and procedures.

Footnotes

[1]

ASC 740-10-50-17 states, “An entity that is a member of a group that files a consolidated tax return shall disclose in its separately issued financial statements:

The aggregate amount of current and deferred tax expense for each statement of earnings presented and the amount of any tax-related balances due to or from affiliates as of the date of each statement of financial position presented
The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the group and the nature and effect of any changes in that method (and in determining related balances to or from affiliates) during the years for which the above disclosures are presented.”

[2]

As discussed above, loans to directors or executive officers may not be allowed under Sarbanes-Oxley.