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The Role of Related Party Transactions in Fraudulent Financial Reporting

Elaine Henry

Stevens Institute of Technology

Elizabeth A. Gordon

Temple University - Department of Accounting

Brad Reed

Southern Illinois University Edwardsville

Timothy Louwers

James Madison University

June 2007

Motivated by mixed findings in the auditing literature about the importance of related party transactions as red flags indicating potential fraud, this study examines 83 SEC enforcement actions involving both fraud and related party transactions. In addition to comparing the characteristics of firms in this sample with firms examined in other fraud studies, we describe generally how each type of related party transaction might potentially be used to misstate financial reports and then document the types of related party transactions actually occurring in these fraud cases. Overall, the most frequent type of transactions in the enforcement actions were loans to related parties, payments to company officers for services that were either unapproved or non-existent, and sales of goods or services to related entities in which the existence of the relationship was not disclosed. Misappropriation of the company's assets are most often related to transactions where the cash flow is outward, while instances of misstatement of financial reports are more often related to transactions where the cash flow is expected to be inward. Generally, related party transactions are not necessary as mechanisms for fraud, and their presence need not indicate fraudulent financial reporting. An implication is that it is important for the auditing profession to understand the benign nature of most related party transactions, the differentiating features between benign and fraudulent transactions, and the importance of evaluating a company's related party transactions in light of its broader corporate governance structure.

Number of Pages in PDF File: 39

Keywords: Related party transactions, fraud, fraudulent financial reporting, SEC enforcement actions

JEL Classification: M41, M43, G34, G38, M49, K22

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Date posted: June 18, 2007  

Suggested Citation

Henry, Elaine and Gordon, Elizabeth A. and Reed, Brad and Louwers, Timothy, The Role of Related Party Transactions in Fraudulent Financial Reporting (June 2007). Available at SSRN: http://ssrn.com/abstract=993532 or http://dx.doi.org/10.2139/ssrn.993532

Contact Information

Elaine Henry (Contact Author)
Stevens Institute of Technology ( email )
Hoboken, NJ 07030
United States

Elizabeth A. Gordon
Temple University - Department of Accounting ( email )
Philadelphia, PA 19122
United States
2152046422 (Phone)

Bradford J. Reed
Southern Illinois University Edwardsville ( email )
Founders Hall 2110
Edwardsville, IL 62026-1102
United States
Timothy J. Louwers
James Madison University ( email )
School of Accounting
MSC 0205
Harrisonburg, VA 22807
United States
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