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The IUP Journal of Accounting Research and Audit Practices:
Related Party Transactions and Earnings Management: An Empirical Examination of Selected Companies in India
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A number of publicized accounting frauds around the world, such as Satyam fraud (India), Enron failure (USA), Tyco failure (Ireland), show that firms use Related Party Transactions (RPTs) to manage earnings for financial reporting purposes or to divert firms’ resources to their controlling shareholders at the expense of minority shareholders. This study aims to explore the relationship between RPTs and earnings management practices of selected companies in India. The amount of discretionary accruals derived from modified Jones models (Dechow et al., 1995) is used as a proxy to measure earnings management. Based on 218 firm-year observations taken from BSE-200 index based companies for the financial year 2014 and 2015, this study finds that there is a statistically significant relationship between RPTs and earnings management. The findings also reveal that the effect of new RPT regulations in mitigating earnings management is not significant.

 
 
 

In India, Related Party Transactions (RPTs) have come under serious scrutiny in the recent years. After the Satyam scam, regulators are very serious about regulating the abusive nature of RPTs. Section 188 of the Companies Act, 2013, revised Clause 49 (RC 49) of the SEBI listing agreement and Ind AS 24 are the governance measures for regulating the abusive nature of RPTs in India. A related party is a person or entity that is related to the entity that is preparing its financial statements (Ind AS 24). An RPT is a transfer of resources, services or obligations between a company and a related party, regardless of whether a price is charged (RC 49 VII-A of SEBI listing agreement). The most specific feature of RPTs is that they have dual effect as compared to other transactions. These are: transaction efficiency and conflict of interest. Transaction efficiency means RPTs are considered as sound business exchanges and fulfill firm needs. Conflict of interest may arise if the controlling shareholders use RPTs for diverting firm resources for their own personal benefit. RPTs will be more efficient than non-RPTs and firms can reduce their transaction cost by related-party sales (Wong et al., 2015). Some of the corporate scandals like Satyam fraud, Adelphia and Tyco scandal prove that RPTs are one of the tools that managers use to divert firm’s resources for their personnel benefit. Related-party loans and guarantees are the most frequent type of transactions that will expropriate minority shareholders’ right (Henry et al., 2007). Firms prop up their earnings by conducting abnormal related-party sales (Jian and Wong, 2010). There is a positive association between RPTs and earnings management (Chalardpodjanaporn, 2008; Daie and Hasnan, 2012; and Vakilifard and Salmanian, 2015). Group controlled firms use RPTs to prop up their earnings and manipulate their reported income (Jian and Wong, 2010; Kuan et al., 2010; Munir et al., 2013; Pazzoli and Venuti, 2014; and Vaklifard and Salmanian, 2015). The laws do not prohibit RPTs because these are normal business transactions, and within business groups these transactions facilitate an effective allocation of resources among affiliated firms with same group. RPTs are value destroying only if they are used for the management opportunism. In India, RPTs are widespread and present in almost all companies. Almost 80% of companies had transactions with their subsidiaries, 46% of companies had transactions with associates and all companies had transactions with key managerial persons (Srinivasan, 2013). Family-owned businesses and concentrated ownership have been an important feature of Indian corporate sector.

 
 
 

The Regulatory Framework on RPTs in India,Minority Shareholders’ Interest and RPTs, Corporate Governance and Earnings Management, Detection of Earnings Management, Regression Analysis.