Related Party Transactions and Earnings Management

Abstract

In this paper, we investigate whether related party transactions are associated with earnings management. If a firm's executives and/or board members engage in related party transactions to expropriate the firm's resources, then they have incentives to manage earnings either to justify (or increase) these perquisites or possibly to mask such expropriation. An alternative view is that related party transactions rationally fulfill other economic demands of a company, for example, by providing access to in-depth skills and expertise or providing an alternative form of compensation. If this were the case, there would be no incentives to manage earnings since the related party transaction need not be obscured or offset; consequently, we would not expect a relation between earnings management and related party transactions. In our paper, we first provide a comprehensive empirical description of the types of related party transactions in which companies engage and then investigate whether related party transactions are associated with earnings management. We present a description of the number of, the parties involved with, the types of and where available, the dollar amounts of related party transactions for 331 publicly-traded companies in fiscal years 2000 and 2001. In our earnings management tests, we present evidence that adjusted absolute abnormal accruals (our earnings management measure), are positively associated with limited types of transactions such as fixed-rate financing from related parties. Overall, it appears that concerns about related party transactions as a factor associated with earnings management are warranted, but for only certain related party transactions. The mere presence of related party transactions is not necessarily an indication that a firm is likely to engage in greater earnings management.

Keywords: Related party transactions, corporate governance, earnings management, accounting

JEL Classification: M4, G39