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Why do related-party transactions appear in financial statement notes?

When a company buys goods from a supplier, sells products to a customer, or hires a consultant, these are standard business transactions. But when the supplier is owned by the company's CEO, the customer is a director's family member, or the consultant is a board member's company, the relationship creates a conflict of interest. The company might overpay, underpay, or charge prices that wouldn't occur in an arm's-length transaction between unrelated parties.

This is why the SEC and accounting standards require related-party transactions to be disclosed in the notes to the financial statements. For investors, these disclosures are a window into governance quality and the integrity of reported numbers. A company with frequent, large, or opaque related-party transactions is signaling either weak governance or intentional self-dealing. Either way, it's a red flag.

This article walks through what constitutes a related-party transaction, how to identify them in the notes, what they reveal about governance, and why they should affect your investment thesis.

Quick definition: A related-party transaction is a transaction between a company and a party related to the company—such as a director, executive, major shareholder, family member of an insider, or another entity controlled by an insider. These must be disclosed in the footnotes if material. The disclosure must identify the related party, describe the transaction, and state the dollar amount.

Key takeaways​

  • Related parties include executives, directors, major shareholders (typically 10%+ ownership), family members of insiders, and entities controlled by these parties
  • The SEC requires disclosure of material related-party transactions to identify potential conflicts of interest and self-dealing
  • Related-party transactions are not inherently illegal, but they should occur at arm's-length prices; non-arm's-length pricing is a red flag
  • Common related-party transactions include management compensation, director fees, loans, service contracts, asset sales, and affiliate purchases
  • A company with many related-party transactions or vague disclosures is signaling weak governance or potential manipulation
  • Acquisitions from related parties are especially prone to overpayment because there is no independent verification of price
  • Related-party loans that are forgiven, extended indefinitely, or bear below-market interest rates are particularly suspicious

Under GAAP and SEC rules, related parties include:

Officers and directors. The CEO, CFO, Chief Operating Officer, and all board members are related parties. So are any officers in the company's "executive leadership" (defined differently by companies but typically C-suite and direct reports to the CEO).

Major shareholders. Anyone who owns 10% or more of the company's shares is presumed to have influence and is a related party. Some companies lower this threshold to 5% or require disclosure of any shareholder who attends board meetings or has significant dealings with the company.

Family members of insiders. Spouses, children, parents, and in-laws of officers and directors are related parties. So are any entities (companies, partnerships, trusts) that are controlled by or owned by insiders or their families.

Other entities in which an insider has influence. If a director sits on the board of another company, or owns a significant stake in a supplier, that supplier is a related party. If an officer's spouse is the CEO of a consulting firm, that consulting firm is a related party.

Pension and employee benefit trusts. If the company has a defined-benefit pension plan, the trustee and any related parties are within scope.

Significant customers or suppliers. If a customer or supplier is controlled by an insider or shareholder, it's a related party.

The key test is "influence or control." If an insider can affect the transaction's terms, pricing, or approval, it's probably a related-party transaction.

Executive compensation. Salaries, bonuses, stock options, and perquisites paid to officers and directors. These are heavily regulated and disclosed in detail in the proxy statement (DEF 14A), but the financial statement notes should also reference material components.

Director fees and retainers. Cash fees, stock grants, and other compensation paid to board members.

Management loans. Companies sometimes make loans to executives for home purchases, stock acquisition, or other purposes. If the loan has below-market interest rates, has no maturity date, or is later forgiven, it's particularly suspicious.

Affiliate purchases and sales. A company buys inventory, raw materials, or services from a supplier that is owned by an insider or affiliated with the company. Or, the company sells products to an affiliate.

Affiliate leases. The company leases office space, warehouse space, or equipment from a company owned by an insider. The lease might be at above-market or below-market rates.

Consulting and service agreements. The company pays consulting fees to firms owned by insiders or to insiders directly for services.

Related-party acquisitions. The company acquires another business that is owned by a director, major shareholder, or other insider. These are especially prone to overpayment because the price is not subject to competitive bidding.

Loans to related parties. The company makes loans to officers, directors, or their companies. These might be non-recourse, forgiven, or interest-free.

Guarantees and indemnifications. The company guarantees debt or indemnifies officers or directors against legal liability. These are hidden liabilities that should be disclosed.

A typical related-party transaction disclosure might look like this:

"Dr. Jane Smith, a member of our Board of Directors, is the CEO and principal shareholder of TechServe LLC, a consulting firm. In 2023, we engaged TechServe to provide IT consulting and infrastructure management services. Total fees paid to TechServe in 2023 were $2.1 million. We believe these fees are consistent with market rates for comparable services from independent vendors. The engagement was approved by our Audit Committee, with Dr. Smith recusing herself from the approval decision."

From this disclosure, an investor learns:

  1. The related party: Dr. Smith (director) and her company TechServe
  2. The transaction: IT consulting services
  3. The amount: $2.1M in 2023
  4. Management's assertion: fees are at market rates
  5. Governance: Audit Committee approved it, and the director recused herself

However, the disclosure doesn't say whether TechServe's rates are truly market rates, what the contract term is, or whether the engagement is renewable. An investor skeptical of related-party transactions would ask:

  • How does $2.1M compare to quotes from independent IT consulting firms?
  • Is this a multi-year contract that locks in the company's obligation?
  • Why doesn't the company use independent vendors for this function?

A more troubling disclosure might read:

"We maintain a consulting agreement with advisory company Horizon Partners, which is majority-owned by Thomas Morris, our former CEO and current board member. Under the agreement, Horizon provides strategic advisory services at an annual retainer of $500,000 plus project fees of $200 per hour. In 2023, total fees paid to Horizon were $3.2 million, including $1.8 million for project work. The engagement was approved by the Compensation Committee but was not subject to competitive bidding. The agreement is renewed annually at the current terms."

Red flags in this disclosure:

  • Thomas Morris is a former CEO, meaning he left the company but maintained control via the board
  • The annual retainer of $500K is paid regardless of work performed (seems high)
  • Project fees at $200/hour are not competitive (market rate for strategic advisory is typically $150–$300/hour, but without specifics, we can't judge)
  • No competitive bidding
  • Automatic annual renewal (locked in unless actively terminated)
  • The amount is material ($3.2M)

This is the kind of disclosure that should make investors question governance quality.

Not all related-party transactions are problematic. Paying a director a board fee of $50,000 per year is standard. But certain situations warrant closer scrutiny:

Large transactions. If a related-party transaction is material to the company's financials (more than 1% of revenue, or more than 5% of operating expenses in a category), it deserves examination. A $10M related-party transaction at a $50M revenue company is significant.

Lack of competitive process. If the company negotiated the transaction with a related party without seeking quotes from independent vendors, the price is suspect.

Below-market pricing to the company. If the company is selling to a related party below market price, earnings might be artificially low, or the transaction might be disguised financing. This is less common but worth noting.

Above-market pricing to the company. If the company is buying from a related party above market price, costs are inflated, and earnings are depressed. Or, the company is transferring value to the related party.

Vague transaction descriptions. If the disclosure says "consulting fees" without specifying what was consulted on, or "other services" without detail, the company is hiding something.

Multiple transactions with the same related party. If there are leases, consulting agreements, supply contracts, and acquisitions all with the same related party, the related party is central to the company's operations, raising questions about whether the company is independent.

Forgiven loans or indefinite terms. If the company made a loan to an executive and later forgave it, or if a loan has no stated maturity date, the loan was really disguised compensation. This should be disclosed but often is buried deep in the notes.

Related-party acquisitions without impairment. If a company acquired a business from a related party and has never taken a goodwill impairment on that acquisition, it likely overpaid. The related-party relationship prevented arm's-length negotiation.

The acquisition special case: buying from an insider​

Acquisitions from related parties are a particularly important red flag because there is typically no competitive bidding and no external validation of price. If Founder A owns Company A and also owns a related business (Company B), and Company A acquires Company B at a price of $500M, how do we know if $500M is fair?

In a normal acquisition, the target company might receive offers from multiple buyers, creating competitive tension. But when the seller and buyer are related, there is no competition. The price is whatever the two parties agree to.

Many audit failures and accounting frauds have involved related-party acquisitions. In the Valeant case, the company acquired companies from related parties and later took massive goodwill impairments, signaling overpayment. In the Wirecard case, the company had various related-party dealings that later proved to be fictitious.

Red flags in a related-party acquisition disclosure:

  • No third-party valuation or fairness opinion mentioned
  • The acquisition price is not benchmarked to comparable transactions
  • The acquired business has unique characteristics that make comparable transactions unavailable
  • The related party is a founder or long-time insider with historical conflicts
  • The acquisition was closed quickly without a lengthy diligence or negotiation period

The flow shows that materiality, governance, and market process determine how concerned you should be about a related-party transaction.

In the 10-K or annual report, look for:

  1. "Related party transactions" section of the notes. This is usually in the supplemental notes, often just before the segment reporting or consolidation notes. It might also be labeled "Transactions with affiliates," "Management and director fees," or "Certain relationships and transactions."

  2. Item 13 of the 10-K. The SEC requires Item 13 to disclose "Certain relationships and related transactions." It will refer you to the footnotes for full detail.

  3. The proxy statement (DEF 14A). Executive compensation and director fees are heavily detailed in the proxy, which includes related-party transactions by definition. The proxy also often discusses other material related-party transactions.

  4. The balance sheet for accounts related to related-party transactions. Look for "Receivable from affiliate," "Payable to related party," "Shareholder loans," etc.

  5. Segment reporting. If the company has a segment that is primarily a related-party customer or supplier, this is hidden information. A segment's revenue might be heavily dependent on sales to an affiliate.

  6. Management discussion and analysis (MD&A). If a major customer or supplier is not separately named, check if it might be a related party. The company might disclose "our largest customer accounted for 18% of revenue" without naming them; if that customer is a related party, it should be disclosed in the related-party note.

Assuming related-party transactions are always bad. They're not. Companies often have legitimate reasons to engage with related parties (e.g., the founder's real estate company is the natural landlord, or a director's company is a unique service provider). The issue is arm's-length pricing and proper governance.

Focusing only on large related-party transactions. Sometimes, a pattern of many small related-party transactions is more concerning than one large transaction. Multiple transactions suggest the related party is integral to operations, raising dependency and pricing questions.

Ignoring the process and governance. A related-party transaction that was competitively bid and approved by an independent committee is far less concerning than one done without oversight. The disclosure should mention whether the Audit Committee or Compensation Committee reviewed and approved it.

Not checking for related-party debt forgiveness. Some companies forgive loans to executives or allow them to lapse unpaid. This is disguised compensation and should reduce your view of financial reporting integrity. Look for "allowance for doubtful accounts" related to related-party receivables.

Missing affiliate transactions in segment reporting. A segment that sells primarily to an affiliate is not a "real" revenue stream and should not be counted as organic growth. Dig into the customer concentration disclosure to see if major customers are affiliated.

FAQ​

Q: Are all related-party transactions required to be disclosed?

A: No, only "material" related-party transactions must be disclosed. Materiality is a judgment call, but the SEC generally expects disclosure if the transaction is more than 1% of revenue or total assets, or involves significant concerns about conflict of interest. Companies sometimes dispute whether a transaction is material; the SEC staff will challenge undisclosed transactions if they are deemed significant.

Q: Can a related-party transaction be at arm's-length?

A: Yes. A related party can transact with the company at market rates and terms. An example: a director's consulting firm bids competitively against other firms to provide services, and wins based on merit and price. Or, a company leases office space from a building owned by a director at the market rental rate. The relationship is disclosed, but the terms are arm's-length. These are lower-risk transactions.

Q: What happens if a company fails to disclose a material related-party transaction?

A: This is a serious disclosure violation. The SEC can bring enforcement action against the company and its officers. Restatement of financial statements is possible if the omitted transaction affected reported numbers. For investors, undisclosed related-party transactions are a major red flag for financial reporting integrity. If you discover that a company omitted a material related-party transaction, you should consider selling the position.

Q: Can insiders force a related-party transaction through majority voting?

A: Yes. If an insider owns a significant stake or controls the board, they can approve transactions favorable to themselves. This is why strong independent board governance is important. Companies that have independent directors, an audit committee without related-party conflicts, and a requirement for majority-of-unaffiliated-shareholders voting on related-party transactions are less at risk of abuse.

Q: How is "market price" or "arm's-length terms" determined for related-party transactions?

A: The company, its auditors, or a third party can conduct a benchmarking study comparing the related-party transaction terms to transactions with unrelated parties. For example, if a consulting firm owned by a director is being paid $500/hour, the company might benchmark that against rates charged by other consulting firms for similar work. If the director's firm's rates are in the 25th percentile (i.e., cheaper than 75% of competitors), the rates are arm's-length. If they're at the 75th percentile (more expensive than 75% of competitors), they're above-market.

Q: What is the difference between a related-party transaction and insider trading?

A: Related-party transactions are company transactions with affiliated parties (disclosed in the notes). Insider trading is the buying and selling of the company's stock by insiders, usually disclosed on Form 4. A director might have both: they might serve on a committee that approves a related-party transaction AND sell shares of the company's stock. These are separate disclosures and separate risks.

Q: Can a related-party transaction be a sign of financial distress?

A: Sometimes. If a company enters into transactions with related parties that it would not do with unrelated parties (e.g., the company borrows from a director at a favorable rate because banks won't lend), it's a sign of financial distress or reduced creditworthiness. Related-party financing can be a yellow flag that the company is under stress.

Acquisition disclosures and purchase accounting — Related-party acquisitions are especially prone to overpayment.

Goodwill and impairment testing — Related-party acquisitions that are later impaired signal overpayment.

Segment reporting — Understanding which customers and suppliers are related parties and which are independent.

Executive compensation disclosures — The proxy statement details executive and director compensation, which are related-party transactions.

Fair value hierarchy — How fair value is estimated for related-party transactions when market prices are unavailable.

Summary​

Related-party transactions are a governance and financial-reporting red flag that investors should take seriously. While not all related-party transactions are problematic, they require scrutiny because they involve conflicts of interest. A company that has many related-party transactions, lacks competitive process in those transactions, or discloses them vaguely is signaling weak governance or intentional self-dealing.

The most important principle is arm's-length pricing: related-party transactions should occur at the same price and terms as if the parties were unrelated. When a company discloses that a transaction occurred at "market rates" and was "approved by the Audit Committee," it's a lower-risk signal. When the disclosure is vague, the process lacked independent oversight, or the transaction appears one-sided, it's a red flag.

For investors, the related-party transactions note is a window into the integrity of management and the strength of the board. Spend time reading it carefully, especially for acquisitions and large service contracts. The governance quality you observe in the handling of related-party transactions often reflects the governance quality you'll see in other areas of the business.

Next​

Read the next article on contingencies and pending litigation to understand how companies disclose legal risks and uncertain obligations.

Article length: 2,986 words.