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USASBE 2008 Proceedings - Page 0564

Disclosure of Related Party Transactions—Transfer Pricing

Under international accounting standards, economic transactions between companies with overlapping ownership are supposed to be clearly disclosed. (The Economist, 2007). This rule also applies to transactions between owners and the company they own, individual companies with common ownership, and vendors.

The related party rule usually applies to materially significant transactions, measured in monetary terms, between parties that can benefit from the transaction(s) and have the influence to manipulate the economic terms of the contract. The economic terms of related party transactions cannot be presumed to be at “arm’s-length”. A transaction is deemed not to be at “arm’s-length” if it deviates from terms offered to customers or the fair market value (FMV) of the product or service involved.

Disclosure is accomplished by providing the details of the related party transactions in the footnotes that accompany the financial statements. Related party disclosure is intended to facilitate financial statement readers’ understanding of the nature and extent of the related party transactions. Such disclosure is intended to prevent companies from window-dressing their financial position and operating results in an attempt to disguise the personal involvement of insiders and enhance the reliability of financial information (Lin & Chen, 2000).

The following are examples of related party transactions that should be disclosed: A company with the equivalent of US $1,000,000 in total assets sells an unused warehouse (FMV of US $100,000) to an owner for US $100,000. This is a related party transaction that should be disclosed in the footnotes of the financial statements. Stakeholders would be informed that the transaction occurred in a proper manner.

If the same owner had paid less than the fair market value for the purchase of the warehouse, the terms of that transaction would also be disclosed and the readers would be warned that that an improper transaction had occurred.

Transfer pricing is another type of related party transaction. Transfer pricing involves economic transactions between commonly controlled enterprises at prices that do not reflect arm’s-length negotiation. An example of transfer pricing is: Company A is located in a 33% tax region and Company B is located in a 20% tax region. If both companies are under common control, the situation provides an opportunity for the two companies to agree to economic transaction terms that decrease the selling price of any products sold only to Company B.

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