Beyond Balance Sheets: Why Fraudsters Love Related Party Transactions

Related party transactions are the preferred modus operandi for organisations involved in fraudulent financial reporting. But also swindling managers and employees aiming to misappropriate company assets have a preference for related parties. That fraudsters love related party transactions becomes immediately clear by just looking at major corporate scandals over the years. One key reason for using related parties is the opportunity it provides to control and manipulate both sides of a transaction, while concurrently concealing the true nature of such transactions. Let’s have look on how fraudsters use related party transactions in financial reporting fraud and how you can spot the rot.

Financial reporting is a key component of our economy, as it supports investor confidence and facilitates capital allocation. Above all, it creates transparency by providing accurate and timely information about the financial health of businesses. Financial reporting empowers investors, banks, creditors, and regulators to make informed decisions.

Moreover, transparent financial reporting does not only attract investments, it also supports effective governance, compliance, and sound economic policies. Financial reporting is the primary tool for organisations to communicate with their stakeholders and plays a crucial role in fostering trust, accountability, as well as the overall stability of the economy. In turn, fraudulent financial reporting seriously undermines this trust, accountability and stability.

Every year, the Association of Certified Fraud Examiners releases their Report to the Nations; a study into occupational fraud. This study shows that financial reporting fraud schemes are the least common. However, they are among the most costly. Important to note is that the cost of financial reporting fraud is not only financial, its impact goes much further than ‘just’ possible bankruptcy of and investors losing their investment. It can seriously impact people’s lives, including job losses, reduced benefits, and damage or complete loss of retirement savings. Moreover, it leads to the erosion of trust financial markets as well as distortion of market efficiency.

Understanding related parties

Related party transactions involve a transfer of resources, services, or obligations between entities with pre-existing relationships, regardless of whether a price is charged. These relationships may include an individual or that individual’s family, subsidiaries, affiliates, or entities under common control. Examples of related party transaction include:

1. Group entities – Transactions between entities that are part of the same group, which means that each parent, subsidiary and fellow subsidiary is related to the others.

2. Entities under common control – Transactions between entities that are under the common control of the same individual, group of individuals, or entity.

3. Key management personnel – Transactions involving key executives or members of the management team and the entity.

4. Close family members – Transactions with close family members, such as spouses, children, or siblings.

5. Entities with significant influence – Transactions between an entity and another entity over which it has significant influence but not control.

While related party transactions are not inherently fraudulent, they provide an unique opportunity for manipulation when conducted with the intent to deceive stakeholders about a company’s financial health or hide the true nature of certain transactions. Many of the fraudulent financial reporting cases we have investigated included the use of related parties in some shape or form. Often this goes hand in hand with the misappropriation of assets. For this specific reason and the risk of conflict of interest, financial reporting standards include specific rules for organisations to separately disclose related party transactions in their financial statements.

For example, International Financial Reporting Standard IAS 24 defines a related party as: “…a person or an entity that is related to the reporting entity: (1) A person or a close member of that person’s family is related to a reporting entity if that person has control, joint control, or significant influence over the entity or is a member of its key management personnel. (2) An entity is related to a reporting entity if, among other circumstances, it is a parent, subsidiary, fellow subsidiary, associate, or joint venture of the reporting entity, or it is controlled, jointly controlled, or significantly influenced or managed by a person who is a related party”.

In the context of preventing and detecting fraud through related party transactions, the financial reporting definitions, such as articulated in IAS 24, are defined too narrow in our opinion. We have investigated major corporate scandals where organisations orchestrated financial reporting fraud schemes using purported ‘third parties’. Despite these entities not meeting the formal financial reporting criteria such as defined in IAS 24, and being officially designated as non-related parties, our investigations revealed these third parties were, in fact, under the influence of a former employee. This former employee was found to be instructed by the organisation’s CEO. In essence, the CEO exercised control at both ends and created numerous fictitious transactions between the organisation and the purported third party, while on paper had no control or joint control.

Why fraudsters love related party transactions

Although, those charged with governance, supervisory boards, banks, internal audit and external auditors perfectly recognise the fraud risk in transactions with related parties, we have seen failures with spotting the actual red flags way too many times.

If we would have been tasked with committing financial reporting fraud or asset misappropriation, we obviously would employ a combined scheme of tricks, smokes and mirrors. One of the first tricks we would use is related parties and ditto transactions. Related party transactions would be our favourite pick for committing fraud because of the following:

1. The ability to pull the strings on both sides of a transaction – Fraudsters love related party transactions because it gives them the opportunity to exert control over both sides of a transaction. This allows them to set up fraudulent activities, while concealing the true nature of such transactions. The fraudster will be able to execute a transaction, agree a contract, an agreement or design scheme to realise their fraud objectives. Like the example of the CEO provided above. The CEO sets up and approves a transaction with a purported independent third party, while in reality, the third party is influenced by the CEO. This provides the perfect opportunity to misappropriate assets, inflate revenues, or hide liabilities.

2. Boost your revenues – You can engage in transactions with related parties to create fictitious sales and thereby artificially boosting revenues. For example, recording fictitious sales to a related entity to meet revenue targets. However, employing such a scheme also requires that you need to get creative with the corresponding receivables that result from the artificial revenues.

3. Hide your liabilities – Use related party transactions to shift liabilities off the organisations’ books. Through related party transactions, the organisation initiates the transfer of its debt obligations to the the related entity under the control or influence of management. This could involve formally assigning the debt or creating financial arrangements that shift the responsibility for servicing the debt to the related party.

4. Roundtripping – You can circulate funds or assets through a series of transactions using related parties. The orchestrated transactions are designed to create the appearance of a legitimate business cycle. These could involve sales, purchases, or other financial interactions between the organisation and related parties.

5. An easy way to commit asset stripping – Related party transactions can be used for asset stripping. You may transfer valuable assets to related parties at below-market prices, depleting the organisation’s value while benefiting the related party which you secretly control. Or you could use the organisation’s assets for personal use by such as using assets as collateral for a personal loan or a loan to a related party.

6. Create complex structures to hide stuff – Related party transactions can involve complex structures, making it easier for you to hide illicit activities within the complexity of these structures and corresponding arrangements. This complexity can act as a smokescreen, making it challenging for those charged with governance, supervisory boards, banks, or auditors to uncover fraudulent behavior.

7. An opportunity for manipulation – Related parties often lack independence, as there may be pre-existing relationships or common interests. This is exactly the reason why financial reporting standards have specific rules for disclosing related party transactions. This lack of independence creates opportunities for collusion and manipulation of transactions for personal gain. But be aware, sometimes fraudsters create entities for the sole purpose perpetrating financial reporting fraud. These entities are then presented to be independent third parties but in fact are under the control of the individuals involved in the fraud scheme.

8. Opportunity for bribes – You can use related party transactions to facilitate illicit payments to for example public officials by directing business transactions to or through related parties.

In following blogs we will further detail how such schemes work in practice. Now we understand why fraudsters love related party transactions, lets have a look at how you can detect fraud through related parties.

Detecting fraud through related party transactions

The starting point of managing the risk of fraud through related parties is to have a robust internal control framework and ethical culture in place. Weak or absent internal controls and oversight mechanisms to monitor and control related party transactions, make it easier for fraud to occur. A robust internal control framework should include policies and procedures governing related party transactions. For example, mechanisms to identify and monitor related parties, segregation of duties, employee training and awareness, as well as third party risk management procedures including due diligence and whistleblower mechanisms.

However, even the most robust control frameworks can be rendered ineffective if there is a lack of awareness or vigilance regarding the potential for collusion and management override. Individuals in positions of authority may exploit their power to manipulate or bypass implemented internal controls. This challenge extends beyond the technicalities of control frameworks and emphasises the human element in managing the risk of fraud. For a further understanding of how fraudsters circumvent internal controls, read our “Illusion of Control” blogs. Addressing the threat of collusion and management override requires a combination of detection safeguards, an ethical culture, transparency, and periodic independent assessments/audits. What are red flags that you should be mindful of?

For significant and unusual transactions, particularly those occurring at or near year-end, investigating the possibility of related parties and the sources of financial resources supporting the transactions. Particularly check if there is management involvement. When key members of management closely tied parties involved in transactions may indicate potential conflicts of interest, manipulation of financial reporting and biased decision-making.

Transactions that are recorded late or that show signs of backdating, potentially indicate an attempt to manipulate financial statements after the fact. Inadequate documentation or supporting evidence for related party transactions is per definition a red flag. Proper documentation is crucial for justifying the nature and terms of such transactions.

Related party transactions involving substantial amounts, as they may have a material impact on the company’s financial statements, warrant additional scrutiny. Check whether the transaction is at arm’s length.

Excessive complexity in the corporate structure or related party relationships, may be designed to obscure the true nature of such transactions.

Undisclosed related parties. Thoroughly investigate transactions that involve previously unidentified related parties or parties that do not have the substance or the financial strength to support the
transaction without assistance from your organisation. Especially if such transactions include non-standard or unusual terms, e.g., no interest, extended repayment periods for loans.

Particularly be mindful of what we call the “not a related party confirmation“. Fraudsters love related party transactions as part of their fraud scheme and they will do their utmost to (proactively) convince stakeholders that the transactions are not with a related party. They will manipulate such stakeholders by fabricating explanations and documents, such as confirmations. In the investigations we have done, we have encountered various instances where ‘not a related party confirmations’ were fabricated to deceive stakeholders such as external auditors. These confirmations, at times, were even prepared by legal professionals or accountants to further establish its legitimacy. If you encounter such confirmations, exercise heightened scrutiny on the parties involved!

But most importantly, especially for those charged with governance and supervisory roles, accountants, internal auditors and external auditors, always ask yourself: Does it make sense? If you see a related party transaction, especially when it is significant or unusual transaction, request supporting information and investigate its legitimacy. Always keep in the back of your mind that you might be mislead by fabricated documentation or some nonsense explanation. Thus, check the business rationale and whether the economics make sense.

So, why do fraudsters love related party transactions? Because it gives them the opportunity to manipulate and deceive as well as hide the true nature of the transactions. Always be skeptical when you see related party transactions, forewarned is forearmed.

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