A related party transaction is a business-related transaction conducted between two parties that have a relationship with each other. This relationship gives one party the transaction control or influence over the other. Such transactions are legal, but they can create conflicts of interest and there are certain circumstances where they will not be allowed. Companies that are publicly traded are required to disclose related party transactions on their financial statements.
For companies with a legal requirement to disclose, a related party transaction can occur between a company and a major shareholder, officer, director, or family member of any of the previous. Special relationships are enjoyed between companies and people in all of these classes. Companies usually assemble panels to make decisions about proposed related party transactions to determine whether or not a transaction is legal and justifiable.
Things considered when making a decision about a related party transaction include the benefit to the company, as well as the other party, along with the value of the transaction and the nature of the transaction. If the company suspects that a conflict of interest may be created, such as when it is prepared to contract with a vendor in a related party transaction without considering prices at other vendors, it will not go through with the transaction. Likewise, if transactions appear to be illegal business practices, the company will not move forward. Companies also want to avoid scandals and thus, may opt to vote down a proposed transaction even if it is legal, if they feel that people may suspect impropriety.
If the panel determines that a related party transaction is legal and in the best interests of the company, it can give the approval for the transaction to be conducted. There are certainly cases where a related party transaction offers the best deal for the company and is beneficial for shareholders as well. Information about the transaction is recorded in accounting notes on the company's books so that people reviewing financial statements can clearly understand the nature of the transaction.
Companies without reporting requirements are free to engage in related party transactions. Small businesses often take advantage of deals offered by people with whom they enjoy relationships, and return the favor by hiring and promoting these people. These practices are sometimes criticized, especially in small communities where it can be difficult to break into certain areas of the business community as a result of entrenched habits and practices.