Related Party Transactions, Part 2: Assessing Economic Loss

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Forensic Friday - Related Party Transactions Part 1

By Natasha Milne

I am often asked if related party transactions should be taken into account when analysing a business or an entity, for the purposes of undertaking a valuation or the assessment of economic loss. That is, should they be included, excluded or adjusted to some other amount?

The first step in determining how to treat related party transactions is recognising the purpose of the engagement and analysis being undertaken. If it is to:

  1. Value a business, then you need to ascertain what that business would be worth based on arms-length transactions being undertaken by the related parties (i.e. as if the dealings were between independent, unrelated, and well informed parties who have no interest in the transactions consequences to the other party);
  2. Value a company or a trust, this incorporates the business value as discussed above, along with the value of the other assets and liabilities of the company or trust including related party loans and obligations (and in some cases assessing what those loans should be, if that is different to what is recorded); or
  3. Assess economic loss then you need to consider the effect of the loss causing event, which may or may not be impacted by related party transactions.

Accordingly, the occurrence of related party transactions will affect the above assessments differently.

Say we have a company owned by Mr G. that operates a printing business from a factory. Further analysis of this company and the business it operates reveals the following related party transactions:

  • Mr G. pays himself above market rates, as the business is very profitable;
  • Mrs G. undertakes bookkeeping and other administration each week, but isn’t paid a wage;
  • The factory is owned by Mr G.’s Family Trust for which is pays less than commercial rent, and in some instances no rent;
  • A management fee is paid to Mr G.’s brother, who does not work in the business or provide any goods or services;
  • A related company (ABC Pty Ltd, also owned by Mr G.) owes money to this company (i.e. a receivable loan) but pays no interest and there is no loan agreement; and
  • This company owns shares in ABC Pty Ltd (i.e. an investment), which it purchased for $2.

These related party transactions may distort the true performance of the business and the true position of the company.

Valuations – Company / Trust  / Business

Part 1 of this article considered related party transactions in the context of undertaking valuations.  Part 2 deals with the assessment of economic loss.

Assessment of economic loss

The objective of one methodology for the assessment of economic loss is to put the affected party back into the position they would have been in, but for a particular event that has caused the loss to occur. This requires an assessment of how the business would have performed if that event did not occur, which can then be compared to what actually occurred.

In this instance, the event causing loss was the printing equipment being damaged by flooding from the neighbouring factory’s operations. As a result, the business made no sales for a period of 2 months, and suffered a loss of profits as a consequence.

In assessing economic loss, while some transactions may not be on an arms-length / commercial terms, the important consideration is to what extent these amounts have changed over the period being reviewed (i.e. before and after the flood) and if they distort the true effects of the flooding on the business.

Based on the example set out above, the following considerations would determine the required adjustments for the related party transactions, to assess the economic loss:

  • Has there been any variation in the amount paid to Mr G.? If the payments increased, was this as a result of the flood (such as doing additional work) or an isolated decision (such as Mr G.’s lifestyle)? It may be relevant to consider the performance of the business before any owner’s remuneration, for consistency.
  • Has Mrs G. continued to not receive a wage? In the event Mrs G. started to receive a wage following the flooding, an adjustment would be required, so that a consistent comparison could be made.
  • Has there been any variation in the rent paid? If so, was this change as a result of the flood, or other external factors that would have occurred in any event (such as an annual increase)? Did the Family Trust not charge rent while the business was closed, in an attempt to help the business?
  • The ‘management fee’ is not a true expense of operating the business, and appears to be a personal arrangement whereby Mr G. is providing the company’s funds to a related party. The effect of the payment of ‘management fees’ reduces the profits of the business, and should be removed to undertake a consistent analysis of the true performance of the business.
  • The flooding does not affect the collectability of the related company loan, and accordingly it is not relevant to the assessment of loss.
  • The value of the investments made by the Company would not be affected by the flooding, and accordingly would not be relevant to assessing the losses suffered by the business from the flood.

The losses from the flooding will be overstated where costs and increases in costs that aren’t as a result of the flooding have occurred (such as payments to related parties that do not correspond to the services they have provided).

Appropriate financial analysis and understanding what is ‘behind the numbers’ is vital in reaching the correct conclusions, as each business or entity’s circumstances will be unique, and should be considered as such.

Want to know more?

If you would like to know more about Related Party Transactions, please contact Forensic Services Senior Associate Natasha Milne.

An Important Message

While every effort has been made to provide valuable, useful information in this publication, this firm and any related suppliers or associated companies accept no responsibility or any form of liability from reliance upon or use of its contents.  Any suggestions should be considered carefully within your own particular circumstances, as they are intended as general information only.

 

 

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