Are Related Party Transactions Red Flags?

Are Related Party Transactions Red Flags?
MARK KOHLBECK, Florida Atlantic University
BRIAN W. MAYHEW, University of Wisconsin – Madison
ABSTRACT
This study investigates whether or not related party transactions serve as “red flags” that
warn of potential financial misstatement. We hand-collect related party transactions for
S&P 1500 firms in 2001, 2004, and 2007 and find a positive correlation between these trans-
actions and future restatements, suggesting restatements are more likely when a firm
engages in related party transactions. The association is concentrated among transactions
that appear to reflect “tone at the top” rather than arguably more necessary business trans-
actions. We also find RPT firms pay lower audit fees. However, “tone RPT” firms that sub-
sequently restate pay higher audit fees, providing evidence that auditors recognize the
individual restatement risks of these firms. Our results suggest that tone-based RPTs serve
as signals of higher risk of material misstatement.
Faut-il voir des signaux d’alarme dans les operations

entre apparentes ?

RESUM
E
Les auteurs se demandent si les operations entre apparentes servent ou non de « signaux
d’alarme » annoncßant des anomalies financieres potentielles. Ils relevent manuellement les
operations entre apparentes des societes composant l’indice S&P 1500 en 2001, 2004 et 2007 et
observent une correlation positive entre ces operations et les retraitements ulterieurs, ce qui sem-
ble indiquer que les retraitements sont plus probables lorsque les societes concluent des opera-
tions entre apparentes. Le lien se manifeste davantage parmi les operations qui semblent refleter
le « ton donne par la direction » plut^ ot que parmi les operations commerciales pouvant être
qualifiees de plus necessaires. Les auteurs constatent egalement que les societes qui concluent
des operations entre apparentes paient moins d’honoraires d’audit. Toutefois, les societes dont
la direction donne le ton aux operations entre apparentes et qui procedent subsequemment a un
retraitement paient des honoraires d’audit plus eleves, ce qui permet de conclure que les audi-
teurs reconnaissent les risques de retraitement que presentent individuellement ces societes. Les
resultats de l’etude semblent indiquer que les operations entre apparentes refletant le ton donne
par la direction signalent un risque plus eleve d’anomalies significatives.
1. Introduction
We examine whether or not related party transactions (RPTs) are “red flags” for increased
risk of material misstatement. We specifically investigate the association between RPTs
and restatements and consider whether all types of RPTs have the same implications as
* Accepted by Sarah Elizabeth McVay. An earlier version of this paper was presented at the 2014 Contempo-
rary Accounting Research Conference, generously supported by the Chartered Professional Accountants of
Canada. We appreciate comments from two anonymous referees, Sarah McVay, Bjorn Jorgenson (discus-
sant), and workshop participants at the 2014 Contemporary Accounting Research Conference, the University
of Wisconsin – Madison, and the 2013 AAA Annual Meeting.
Contemporary Accounting Research Vol. 34 No. 2 (Summer 2017) pp. 900–928 © CAAA
doi:10.1111/1911-3846.12296
Are Related Party Transactions Red Flags? 901
potential red flags. We focus on this more general linkage to investigate whether or not
RPTs capture “tone at the top” suggesting management is more self-interested.
Standard setters have long struggled to balance legitimate business purposes of RPTs
with the heightened risk generated when insiders engage in transactions with the firms they
control. The Financial Accounting Standards Board (FASB) cites the nonarm’s-length nat-
ure of RPTs as their main concern while acknowledging RPTs can have legitimate business
purposes. There are at least two reasons why the nonarm’s-length nature of RPTs increases
the risk that financial statements are misstated or misleading. First, the FASB argues that
RPTs potentially enable wealth transfers between the firm and related parties to the poten-
tial detriment of shareholders. For example, the firm could enter into a purchase transac-
tion with a related party where the price paid is in excess of market. Second, the nonarm’s-
length nature of the transaction also provides a potential mechanism for managers to
manipulate the financial statements (Financial Accounting Standards Board 1982, 15).1
The price paid to a related party for raw materials could be adjusted to either increase or
decrease the gross profit margin, or sales could be accelerated through collusion with the
related party. Consistent with standard setters’ views, internal auditors rate RPTs as the
second most effective red flag in identifying opportunities to commit fraud, after client-
imposed auditor scope restrictions (Moyes, Lin, and Raymond 2005).
In addition to RPTs’ potential direct impact on financial statements, RPTs could send a
“tone at the top” signal that company insiders are open to self-dealing transactions between
the company and its managers, major shareholders, and/or directors.2 Abusive RPTs pro-
vide direct evidence of a willingness to self-deal that suggests additional management-centric
actions such as earnings management are more likely. For example, research shows fraud
firms are more likely to engage in RPTs, although RPTs are seldom the causal mechanism
(Beasley, Carcello, Hermanson, and Neal 2010). Scandals such as WorldCom are consistent
with RPTs signaling tone at the top issues while not directly causing the alleged fraud.3
Despite concerns that RPTs create opportunities for insider opportunism, standard
setters acknowledge that RPTs can serve legitimate business purposes. Evidence suggests
that not all RPTs have negative outcomes attached to them. For example, Kohlbeck and
Mayhew (2010) find that complex business-related RPTs are not associated with impaired
firm value. Ryngaert and Thomas (2012) find ex ante (ex post) RPTs are not (are) associ-
ated with current or future operating profitability.
In our first analysis, we focus on RPTs as indicators of increased risk of financial mis-
statements and hypothesize that the likelihood of restatements is greater for firms disclos-
ing RPTs. Given prior evidence, we do not expect RPTs to cause restatements. Instead we
investigate whether RPTs are a red flag for potential misstatements. We also explore
whether some RPTs can constitute a form of efficient contracting, and expand our empiri-
cal tests to assess whether there are differential misreporting risks associated with different
types of RPTs.
In this expanded analysis, we categorize RPTs by type and counterparty and then
group them into separate “Tone” and “Business” groupings to segregate those
1. This paper does not consider whether companies make the proper disclosures. There is some evidence that
firms previously did not make the necessary disclosures. The Securities and Exchange Commission’s (SEC)
2003 study found that RPTs were not properly disclosed in approximately 8 percent of enforcement actions
examined over the previous six years (SEC 2003). The SEC has issued guidance on two separate occasions
since 2002 that enhance required RPT disclosures.
2. When an outside director enters into an RPT, that director also becomes a so-called “grey” director (Gor-
don, Henry, Lauwers, and Reed 2007). “Grey” directors are considered less independent monitors than
independent directors.
3. WorldCom engaged in RPTs with its CEO Bernie Ebbers. However, these RPTs were not part of World-
Com’s fraudulent misreporting of capital-related expenses.
CAR Vol. 34 No. 2 (Summer 2017)

902 Contemporary Accounting Research
transactions most likely to be associated with tone at the top issues versus those that are
most likely to have legitimate business purposes. Tone RPTs typically include transactions,
such as loans, guarantees, and consulting arrangements, with a director, officer, or major
shareholder (DOS), as the counterparty to these transactions is in a position to benefit
from such transactions. Business RPTs include purchase and sales of product central to
the operations of the company and are commonly transactions with investees of the com-
pany. The closer the transaction is to core operations the more likely it is to be a Busi-
ness-related rather than a Tone-related transaction.
Our second set of analyses considers whether audit fees differ for clients disclosing
RPTs. There are a number of countervailing factors effecting the association between
RPTs and audit fees. From an auditor supply-side perspective, we expect audit fees to pro-
vide an additional measurement of the riskiness of RPTs. To the extent an auditor believes
RPTs signal increased risk of material misstatement, the auditor may charge higher fees to
cover the potential legal or reputational costs. Alternatively, management and directors
who engage in RPTs may focus more on audit price than quality, thereby effectively
demanding less monitoring consistent with the literature on private control benefits (Leuz,
Nanda, and Wysocki 2003). As a result, clients with RPTs, and especially Tone RPTs,
might demand less assurance and accordingly pay lower audit fees.4
We form a sample based on the S&P 1500 in 2001, 2004, and 2007 and hand-collect
RPT details. Our final sample consists of 3,588 firm-year observations over the three years.
We examine the sample using restatement and audit fee models common in the literature.
We find that the likelihood of a restatement is greater when firms disclose an RPT,
consistent with RPTs serving as a red flag. We then partition the RPTs between Tone
RPTs and Business RPTs. The results show a strong association between Tone RPTs,
reflecting poor management tone, and restatements. Business RPTs, in contrast, are not
associated with restatements. These finding suggests that not all RPTs provide the same
signal concerning the veracity of the financial statements. Our sensitivity tests remove
restatements directly related to fraud, and restatements tagged as potentially related party
in nature, and continue to find a significant association between Tone RPTs and restate-
ments. These results support our assertion that Tone RPTs signal a higher risk of material
misstatement, and are not limited to their direct effect.
The audit fee tests suggest fees are approximately 9 percent less for firms that engage
in RPTs overall. The lack of a positive association between audit fees and RPTs is consis-
tent with the auditor’s limited responsibilities for RPTs, and Gordon et al.’s (2007) sum-
mary of audit research suggesting external auditors do not view RPTs as significant risk
factors. One possible explanation for the negative association between RPTs and audit
fees is that RPT firms effectively demand lower-quality audits. This explanation is difficult
to distinguish from RPT clients focusing more on audit fees than quality, and higher-qual-
ity auditors not pursuing RPT firms as clients. Univariate analysis suggests firms with
both Tone and Business RPTs are less likely to hire audit industry leaders than firms with-
out RPTs, consistent with these explanations. Our sensitivity analysis shows Tone RPT
firms that restate pay higher fees than Tone RPT firms that do not restate. This result par-
tially explains the perplexing restatement and audit fee results.
Our study makes a number of contributions. First, our large sample enables us to
conduct more powerful tests of the association between RPT firms and both restatements
4. It is also possible that auditors respond to the increased risk by avoiding the client, in which case we might
see systematically lower-quality auditors and thereby lower audit fees associated with RPTs. Note that we
are not concerned about the incremental audit fees stemming from the RPT directly because the U.S. audit
standards that applied during our sample period required minimal auditor effort with respect to RPTs, as
auditors did not provide assurance that all RPTs were discovered and only required management represen-
tations as evidence to support RPT disclosures.

and audit fees than prior research (Gordon et al. 2007). It is difficult to assess whether the
limited evidence from prior small-sample studies is due to a lack of power, or RPTs’
potential to serve legitimate business purposes (Gordon, Henry, and Palia 2004; Kohlbeck
and Mayhew 2010). Our large data set provides more power to empirically assess the asso-
ciation between RPTs and restatements. We also provide a breakdown for users to better
partition RPTs.
Second, we provide insight into the questions arising out of Beasley et al. (2010) with
respect to RPTs, management, and fraud. We show that RPTs are associated with materi-
ally misstated financial statements. We further provide evidence of a link between tone at
the top and restatements conceptually consistent with Beasley et al.’s conjecture that RPTs
indicate tone at the top issues resulting in an increased risk of material misstatement.
Third, we add to audit fee research. The lower audit fees we observe for firms that
report RPTs is perplexing. We provide evidence that auditors are at least partially aware
of the red-flag nature of Tone RPTs, charging higher fees for Tone RPT firms that subse-
quently restate. Nonetheless, the lower fees and less frequent hiring of industry specialists
by RPT firms could suggest that RPT firms demand lower-quality audits.
Fourth, our research provides policymakers with insight into RPTs. Many audit
standard-setting bodies recently implemented new related party audit standards (PCAOB
2014; IFAC 2013; AICPA 2012). These new standards focus on RPTs and their apparent
association with the risk of material misstatement due to fraud, while older U.S. standards
and international standards focus on a broader association between RPTs and the risk of
material misstatement.5 Our results suggest requiring audit effort over RPTs is warranted
given we find evidence consistent with RPT clients focusing on fees rather than quality.
Our results also suggest that Tone RPTs signal an overall risk of material misstatement
that current standards do not address.
Finally, this research contributes to an emerging research stream examining RPTs that
has evolved since the audit and accounting failures early in the new century (Erickson,
Mayhew, and Felix 2000; Swartz and Watkins 2003; Gordon et al. 2004; Kahle and Shas-
tri 2004). This research in general suggests a level of opportunism associated with RPTs.
Our results are consistent with a view that Tone RPTs are associated with management
and director opportunism, while Business RPTs do not have such associations.
2. Related party transactions and hypotheses development
Background on related party transactions
RPTs represent potential “self-dealing” between the company and its directors, material
owners, officers, and investees, and as such most countries require some form of additional
monitoring of RPTs. There is significant variation across countries with how to report
and monitor RPTs. Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008) indicate that
the United States takes a moderate approach to regulation and reporting of self-dealing—
more than the average overall, but less than the average of other English-origin countries
For example, Djankov et al. state that shareholder approval of RPTs is not required in
the United States. Minority shareholders are protected through disclosure and ex post
5. Prior to SAS No. 82 on fraud (AICPA 1997), auditing standards list RPTs as part of the operating environ-
ment related to an increased risk of material misstatement. SAS No. 82 narrows the role of RPTs to a
specific fraud risk factor. Subsequent audit standards retain the link between RPTs and fraud, but generally
do not draw a linkage between RPTs and a more general material misstatement risk. ISA 315 includes con-
sidering RPTs in developing an understanding of the client as well as considering RPTs as risk factors for
material misstatements (IFAC 2013). The wording and concern expressed in the ISAs related to RPTs is
similar to U.S. standards, but it clearly expands risk consideration to all material misstatements and not
just fraud.

litigation. In contrast, UK firms must obtain an independent RPT evaluation along with
shareholder approval.
The FASB and SEC set U.S. RPT disclosure requirements. The required financial
statement disclosures for material RPTs include (i) “the nature of the relationship,” (ii) “a
description of the transaction,” (iii) “the dollar amounts of transactions” for each income
statement period presented, and (iv) “amounts due from or to related parties” as of the
balance sheet date (FASB ASC 850-10-50-1). The SEC’s reporting requirements covering
disclosures of “certain relationships and related transactions” are similar to the FASB’s
(SEC 2004), although the SEC establishes a dollar threshold.6 RPT disclosures are most
often located in annual proxy statements and less frequently in the notes to the financial
statements included in annual 10-K filings.7
The FASB specifically states that RPTs are not presumed to be equivalent to an arm’s-
length transaction (FASB 850-10-50-2). In assessing the usefulness of RPT disclosures, the
FASB raises two issues. First, related parties are assumed to be able to obtain more favor-
able terms for the transactions (FASB 1982, 13–14). Second, financial statement reliability
may be negatively affected by RPTs (FASB 1982, 15). The FASB’s concerns capture the
agency cost issues inherently present in RPTs. Despite these concerns, the prevalence of
RPTs among public companies suggests the potential for RPTs to serve an economic pur-
pose within these firms.
The PCAOB issued a new standard for auditing RPTs in June 2014, replacing a stan-
dard that had not changed in over 30 years. Over our sample period, auditors faced two
primary issues when auditing RPTs. First, auditors must assess whether RPT recognition
and disclosure comply with GAAP. The standard required auditors to be aware of poten-
tial RPTs and review RPTs identified by management. In contrast, the new standard
requires more proactive RPT identification. Second, current and prior U.S. audit stan-
dards identify RPTs as potential conduits for fraudulent transactions and resulting mate-
rial misstatements, and as such are part of the auditor’s fraud risk assessment activities
(see AS 12 PCAOB 2014, AU 334). It is important to note that auditors play no role in
deciding whether a company can or cannot enter into a RPT.
Research on related party transactions

There is a relatively small literature on RPTs due to the challenges in collecting RPT dis-
closures (Gordon et al. 2007). None of the major U.S. research databases includes coding
for RPTs, so researchers typically have to hand-collect the data.
Initial RPT studies using U.S. data focus on valuation and performance implications
of RPTs. Kohlbeck and Mayhew (2010) examine firms in the S&P 1500 in 2001 prior to
the issuance of SOX. They find that firms that disclose RPTs have lower valuations and
subsequent returns compared with non-RPT firms. Moreover, they find that firms disclos-
ing DOS RPTs, especially simple avoidable transactions, take the biggest hit to their firm’s
valuation and future returns. Ryngaert and Thomas (2012) examine 234 firms’ RPTs and
classify ex ante and ex post RPTs. Ex ante transactions that predate the counterparty
becoming a related party are not associated with firm performance and are positively asso-
ciated with firm valuation. However, ex post transactions that occur after a party becomes
a related party are inversely associated with profitability, result in share price declines, and
are associated with a higher likelihood of financial distress.
International research also examines the implications of RPTs. Differences in culture
and legal institutions potentially lead to differences in RPT impact (Djankov et al. 2008).
6. The SEC required disclosure of RPTs greater than $60,000 in 2001 and $120,000 in 2004 and 2007.
7. Kohlbeck and Mayhew (2010) find that the disclosure source does not affect their results regarding investor
valuation or profitability.

Nekhilli and Cherif (2011) study 85 French firms listed on the Paris Stock Exchange from
2002 to 2005 and find RPTs are more likely with increased voting rights held by the main
shareholder, larger boards, greater board independence, increased leverage, and a U.S. list-
ing. They also find a negative valuation impact for RPTs carried out directly with major
shareholders, directors, and managers consistent with the larger sample results in Kohl-
beck and Mayhew (2010).
Hu, Shen, and Xu (2009) investigate determinants and size of RPTs in Chinese-listed
firms. They find that high concentration of ownership increases the probability of RPTs,
but the effect is muted when the second and third largest shareholders hold more bargain-
ing power. RPTs are less likely when top executives have higher levels of compensation.
RPT magnitude also is larger when the chairman of the board is also the CEO or when
outside directors receive greater compensation. Jian and Wong (2010) find Chinese firms
report higher than expected level of sales to their owners consistent with propping up sales
volume. These transactions are more prevalent within state-owned firms and those located
in weaker economic regions. Chen, Cheng, and Xiao (2011) study Chinese initial public
offerings (IPOs) and find RPTs appear to be structured to improve (prop up) firm operat-
ing performance pre-IPO.
Combined, the determinants of RPTs vary, but generally are more likely to occur
within firms with weaker governance structures. The evidence is clearer with respect to
negative economic consequences associated with RPTs. Firms disclosing RPTs generally
experience lower profitability and negative valuation implications.
Development of hypotheses
RPTs are susceptible to direct agency costs whereby managers or directors can profit at
the expense of shareholders. This potential self-dealing and opportunism sends a signal
that investor needs are not necessarily management’s primary concern. Such firms are less
likely to engage in high-quality financial reporting and as a result are more likely to expe-
rience financial restatements. The accounting for RPTs and related disclosures do not nec-
essarily resolve the agency problem between insiders that benefit from the RPTs and
shareholders. Disclosure enables shareholders to indirectly influence the transactions, but
does not prevent RPTs. RPT disclosures seldom provide an assessment of the nature of
the transaction, as U.S. GAAP discourages RPT disclosures that assert the transaction is
at arm’s length unless such claims are substantiated. Such determinations require substan-
tial judgment, and the counterfactual arm’s-length transaction often does not exist such
that a determination can be made.
RPTs are associated with the risk that financial statements are materially misstated
through two mechanisms. First, management’s involvement in RPTs may indicate issues
with the tone at the top. If managers are not maximizing shareholder value through
RPTs, there is increased probability that the same managers will use accounting discre-
tion to increase their wealth at the expense of shareholders. WorldCom and HealthSouth
provide examples of companies that materially misstated their financial statements, and
also engaged in RPTs, but did not use the latter to engage in the former. Beasley et al.
(2010) document higher rates of RPTs (79 percent) in firms sanctioned by the SEC
through AAERs than firms not sanctioned (71 percent). They also document evidence
that tone at the top, as measured by CEO and CFO involvement in the fraud, is a key
component in the fraud cases they examined. They assert the presence of RPTs may
reflect greater fraud risk, and that the nature of the RPT transactions has “broader impli-
cations regarding management’s integrity, philosophy, and ethical culture” (Beasley et al.
2010, 5).
Second, insiders who use RPTs to extract private benefits of control will also want to
obscure the financial statements. Whether insiders actively work to obscure the financial

statements or instead minimize efforts to produce transparent reports, the result is an

increased risk of future restatements.
Prior research provides some evidence on RPTs’ association with accounting quality.
Gordon and Henry (2005) provide evidence that some RPTs are associated with high
absolute abnormal accruals and Cullinan, Du, and Wright (2006) provide evidence that a
sample of 106 firms with revenue restatements from 1997 to 2002 were more likely to have
RPT loans. Bell and Carcello (2000) focus on significant and unusual RPTs but do not
find a link between RPTs and fraud in the 1980s. Although these studies are limited in
scope and find mixed evidence, they suggest a link between RPTs and financial reporting
quality.
The above arguments suggest that RPTs could be red flags to stakeholders—not nec-
essarily because of a specific RPT-related restatement, but of an environment that is more
conducive to lower accounting quality and thus a higher probability of a restatement. Our
first hypothesis stated in the alternative is as follows:
Hypothesis 1. The probability of a restatement is greater for companies disclosing RPTs.
Our first hypothesis assumes all RPTs have the same effect. Although we expect this
effect is present on average, we do not believe all RPTs reflect insider opportunism based
on prior research (Kohlbeck and Mayhew 2010; Ryngaert and Thomas 2012). We identify
a number of different RPT types to explore the potential for RPTs to differ as to potential
opportunism and efficient contracting. Stated differently, all RPT types do not necessarily
have the same risk of lower accounting quality. In fact, in some cases such as spin-offs,
partnerships, etc. the entity has no choice as to whether it engages in RPTs as the mere
presence of these business arrangements creates RPTs. We specifically break down the
types of RPT transactions by the counterparty and the nature of the transaction, and
group the RPTs into those most likely to reflect issues with tone and those that are most
likely to reflect a business purpose. We do not propose formal hypotheses, but we conduct
additional tests to assess whether these different groupings are associated with restate-
ments.
Our second hypothesis focuses on audit fees. Our main question is whether the poten-
tial increased risk of misstatement covered by H1 carries over to audit fees. Extant theory
suggests that audit fees are a function of client size, client complexity, audit quality, and
risk (see e.g., Simunic 1980; Stanley 2011). The increase in fees across these characteristics
captures both auditor compensation for greater effort to complete the audit and a pre-
mium to compensate auditors for incurring greater audit and business risk as well as the
expertise the auditor supplies.
RPTs are likely to be associated with increased audit fees for two reasons. First, while
some RPTs are fairly straightforward, such as loans and guarantees, many other RPTs
represent complex transactions involving multiple parties and operations. These complex
transactions will require more audit effort to evaluate and result in greater fees. Second, a
RPT represents a transaction where certain executives, directors, and owners transact on
behalf of the company and themselves. Such transactions are not necessarily in the com-
pany’s best interest and as a result signal that the client is at higher risk for opportunistic
manager actions. We expect the auditor to increase audit fees to compensate for the
increased audit risk. The increased audit risk is consistent with the increased misstatement
risk covered by H1.
Alternatively, audit fees may not be affected. The applicable audit standard during
our sample period, AU 334 Related Party Transactions, suggests U.S. auditors had limited
responsibilities with respect to RPTs. Paragraph 4 states: “An audit performed in accor-
dance with generally accepted auditing standards cannot be expected to provide assurance

that all related party transactions will be discovered.” This wording sets the tone for the
rest of the standard and suggests auditors’ responsibilities with respect to identifying,
accounting for, and disclosing RPTs are limited. Moreover, the audit fraud and risk stan-
dards focus on the fraud risk associated with RPTs rather than the RPTs’ role in signaling
a general risk of misstatement or management opportunism. This fraud focus minimizes
the fee impact as research shows auditors do not view RPTs’ direct fraud mechanisms
(Gordon et al. 2007).
The literature on private control benefits suggests fees may be lower. Insiders who
control the company and wish to disproportionately benefit from this control will seek to
reduce monitoring (Leuz et al. 2003). This literature asserts that insiders attempt to con-
ceal information in order to protect their private benefits. To the extent RPTs serve as evi-
dence of private control benefits, insiders with such benefits may prefer lower-quality
financial reporting. Such insiders will purchase audits based on price rather than quality.
In effect, they demand less assurance than other companies. This theory suggests such
companies will pay lower audit fees consistent with less demand for audit effort and will
have less demand for industry specialist auditors. An alternative argument for lower audit
fees is that specialist auditors decline to audit more risky clients as signaled by those cli-
ents engaging in RPTs.
The competing arguments lead us to make a nondirectional prediction with respect to
the association between audit fees and RPTs. Our second hypothesis is stated in the null
as follows:
Hypothesis 2. Audit fees do not differ for companies disclosing related party transactions.
Again, we consider the overall association between RPTs and audit fees, as well as
differential associations based on grouping by Tone and Business-related RPTs.
3. Research design
Restatement model
We employ a restatement model similar to those in Francis, Michas, and Yu (2013) and
Newton, Wang, and Wilkins (2013) to investigate whether or not RPTs are red flags. We
define our dependent variable as the year(s) affected by a restatement; therefore, one resta-
tement can affect multiple year-observations for a sample firm.8
Our restatement model is as follows (subscripts are not included for clarity here and
in later equations; all variables are measured as of time t for firm i unless otherwise indi-
cated).
ProbðRESTATEMENT ¼ 1Þ ¼ Fðu0 þ u1 RP VAR þ u2 AU SIZE þ u3 NAT LEADER
þ u4 LNFEES þ u5 FEERATIO þ u6 LNASSETS
þ u7 LEVERAGE þ u8 GROWTH þ u9 ROA
þ u10 LOSS þ u11 LIT þ u12 ACQ þ u13 CHANGE
þ u14 BIG4 þ u15 VAR ROA þ Industry þ Year þ jÞ;
ð1Þ
8. Restatements are commonly discovered and reported after the erroneous financial statements are released.
A single restatement can affect financial statements over multiple accounting periods. By focusing on the
restatement year rather than announcement year, our measure captures misstatement risk and audit quality
when the RPTs are reported, and the audit is performed.

where F is the standard normal distribution function and RP_VAR represents either RP
or RP_TONE and RP_BUSINESS as discussed below. Variables are defined in Table 1.9
Fixed effects for year and industry based on two-digit NAICS codes are also included.
We expect that restatement likelihood is greater when firms disclose RPTs.10 We
define variables to capture differing aspects of the RPT disclosure.11 RP is an indicator
variable equal to one if the firm disclosed any RPTs. The second set considers who the
related counterparty is and the nature of the transaction (Kohlbeck and Mayhew 2010).
DOS (investee) transactions capture RPTs with a director, officer, or significant share-
holder (unconsolidated investments, subsidiaries, and joint ventures of the company). We
classify the nature of the RPT into ten categories consistent with Kohlbeck and Mayhew
(2010). These categories include loans, borrowings, guarantee, consulting arrangement,
legal or investment services, leases, related business activities, unrelated business activities,
overhead reimbursement, or stock transaction.
We then group the RPTs based on an overall tone or business attribute of the RPT.
RP_TONE captures activities that have a higher risk of insiders acting opportunistically.
We start with the assertion that transactions with DOS are more likely to reflect oppor-
tunistic insider behavior than transactions with investees. We then consider the nature of
the transaction and the potential for the organization to benefit from the transaction. Both
leases and related business transactions constitute cases where the organization potentially
benefits in a manner similar to the DOS counterparty, so we group those two types as
Business. We also look at the nature of the investee transactions and conclude that unre-
lated business, consulting and legal and investment services, although rare, are all more
likely to involve opportunities for management opportunism, so we allocate them to the
Tone category (for example, investee unrelated business RPTs may include opportunisti-
cally priced services from a related company that is partially owned by the company).
Accordingly, RP_TONE is an indicator variable equal to one when the firm has RPTs
involving DOS loans, DOS borrowings, DOS guarantees, DOS and Investee consulting,
DOS and Investee legal and investment services, DOS and Investee unrelated business
activities, DOS overhead reimbursement, and DOS stock transactions. RP_BUSINESS
captures normal business activities and is an indicator variable equal to one when the
firms has RPTs involving Investee loans, Investee borrowings, Investee guarantees, Inves-
tee overhead, Investee stock, DOS and Investee leasing activities, and DOS and Investee-
related business activities. The Appendix covers all ten types of RPTs and how they are
allocated into our Tone and Business groupings.
Auditor characteristics include size, market share, and fees. We expect fewer restate-
ments for auditors that generate more audit fees in an industry (AU_SIZE). Industry lead-
ers (NAT_LEADER) are also shown to provide higher quality audits because of industry
expertise and greater resources/reputations suggesting a lower probability of restatement.
LNFEES and FEERATIO capture the potential for economic bonding between the audi-
tor and the client that leads to more restatements (Newton et al. 2013).
Client characteristics focus on size, performance, and industry. The probability of a
restatement is greater for larger firms as these clients typically have more complex
9. We exclude a going-concern opinion variable as there are very few going-concern opinions in our sample.
10. We do not incorporate the dollar value of RPTs. It is difficult to use such a measure for two reasons. First,
not all disclosures provide the magnitude of the RPT, especially 2001 disclosures. The SEC’s disclosure
threshold was $60,000 in 2001 and $120,000 in both 2004 and 2007, furthering the difficulty in comparing
disclosed amounts across time. Second, creating a summary value for each RPT is challenging as they often
have both income statement and balance sheet effects that are not easily combined into a single measure.
We focus instead on the mere presence of RPTs.
11. The SEC requires disclosure of relatives employed by the firm as RPTs, but we exclude them from our defi-
nition of RPTs as this disclosure was not required in 2001.

TABLE 1
Variable definitions
Variable Definition
RESTATEMENT Indicator variable equal to one if a subsequently announced nonclerical

restatement affected the financial statements of the current year and zero
otherwise
RP_VAR Related party variable consisting of either RP, or RP_TONE and
RP_BUSINESS
RP Indicator variable equal to one if the firm disclosed a related party transaction
RP_TONE Indicator variable equal to one when the firm has RPTs involving DOS loans,
DOS borrowings, DOS guarantees, DOS and Investee consulting, DOS and
Investee legal and investment services, DOS and Investee unrelated business
activities, DOS overhead reimbursement, and DOS stock transactions
RP_BUSINESS Indicator variable equal to one when the firm has RPTs involving Investee
loans, Investee borrowings, Investee guarantees, DOS and DOS and Investee
leasing activities, Investee-related business activities, Investee overhead
reimbursement, and Investee stock transaction
AU_SIZE Natural log of one plus the auditor’s total audit fees in the industry market
NAT_LEADER Indicator variable equal to one if the auditor is the national industry leader in
terms of audit fees, and zero otherwise
LNFEES Natural log of one plus total audit fees in millions
FEERATIO Ratio of nonaudit service fees to total audit and nonaudit service fees
LNASSETS Natural log of year-end assets
LEVERAGE Ratio of total liabilities to total assets at year-end
GROWTH Rate of change in assets during the year
ROA Return on assets computed as the ratio of income before extraordinary items to
total assets at year-end
LOSS Indicator variable equal to one if the company reported a loss in the current
year and zero otherwise
LIT Indicator variable equal to one if the firm operates in a high-litigation industry
and zero otherwise where high litigation industries are those with SIC codes
of 2833–2836, 3570–3577, 3600–3674, 5200–5961, and 7370
ACQ Indicator variable equal to one if the firm engaged in a merger or acquisition
(identified by COMPUSTAT AFTNT for revenue), and zero otherwise
CHANGE Indicator variable equal to one if the company changed auditors during the
year, and zero otherwise
BIG4 Indicator variable equal to one if the auditor is a Big 4 auditor, and zero
otherwise
VAR_ROA Variance of annual return on assets over the prior five years
SHARE Percentage of auditor’s share of the industry market’s audit and audit-related
fees
LATE Indicator variable equal to one if the company filed notice of nontimely filing
during the year, and zero otherwise
BUSY Indicator variable equal to one if the company uses calendar year-end reporting,
and zero otherwise
CI Ratio of the company’s audit and audit-related fees to their auditor’s total audit
and audit-related fees in the industry market
INVRECV Ratio of receivables and inventory to total assets
QUICK Ratio of current assets less inventory to current liabilities
LTD Ratio of long-term debt to total assets
EBIT Ratio of earnings before interest and taxes to total assets at year-end
(The table is continued on the next page.)

TABLE 1 (continued)
Variable Definition
FOREIGN Indicator variable equal to one if the company reports foreign earnings,
and zero otherwise
SEGMENTS Number of reportable segments
GIndex Gomper’s governance index (where higher values indicate weaker shareholder
rights)
accounting (LNASSETS). However, large firms often have more developed accounting
systems which should reduce the number of restatements. As a result, we make no predic-
tion for LNASSETS. Higher levered firms (LEVERAGE) and growth firms (GROWTH)
are expected to have increased risk of restatements (Francis et al. 2013). Clients experienc-
ing other problems such as lower profits (ROA), reporting a loss (LOSS), or are a member
of an industry with high litigation risk (LIT), are also expected to have a greater chance
of a restatement. The probability of restatement is also greater for clients involved in
mergers and acquisitions (ACQ). In addition, a change in auditor (CHANGE) results in a
greater probability of a restatement as the new auditor reviews financial information. The
likelihood of restatements is expected to decrease when the company utilizes a higher-qual-
ity auditor (BIG4). Finally, we include the VAR_ROA as a proxy for innate accounting
quality (Hogan and Wilkins 2008) and expect that the likelihood of restatement decreases
with increasing variance in return on assets.
Audit fee model

Our audit fee model is based on prior research (e.g., GAO 2008, Hay, Knechel, and Wong
2006). We include variables related to client risk and complexity that prior research has
consistently found to explain audit fees. Our audit fee model is as follows:
LNFEES ¼ b0 þb1 RP VAR þ b2 LNASSETS þ b3 SHARE þ b4 LOSS þ b5 LATE
þb6 BUSY þ b7 CI þ b8 CHANGE þ b9 BIG4 þ b10 INVRECV
þb11 QUICK þ b12 LTD þ b13 EBIT þ b14 FOREIGN þ b15 SEGMENTS
þb16 VAR ROA þ Industry þ Year þ e; ð2Þ
where variables are defined in Table 1 for firm i, at time t, in industry k. Fixed effects for
year and industry based on two-digit NAICS codes are also included.
The RP_VAR variables (either RP or RP_TONE and RP_BUSINESS) test the second
hypothesis. A positive coefficient on the RP_VAR variables indicates auditors charge higher
fees to RPT firms consistent with increased audit risk not captured by our control variables.
A negative coefficient is consistent with RP clients procuring lower-quality audits.12
We base control variable predictions on prior research in an effort to control for client
size, risk, audit quality and complexity (GAO 2008; Hay et al. 2006). We expect larger cli-
ents (LNASSETS), clients that incur losses (LOSS), and clients who file notices of non-
timely filings (LATE) are higher risk and therefore have greater audit fees. Likewise, audit
fees are expected to be greater for clients who report on a calendar year-end (BUSY) as
auditor resources are more constrained at this time, represents a significant client to the
auditor (CI), the auditor is a Big 4 auditor (BIG4), or an industry specialization premium
for individual auditor’s market share (SHARE). We make no prediction regarding whether
or not the client changed auditors during the year (CHANGE). An auditor change can
12. A negative coefficient could also indicate lower audit risk.

result in either higher audit fees to reflect start-up cost or lower audit fees consistent with
low-balling to win the audit. Higher audit fees are expected for audit engagements with
greater complexities (SEGMENTS and FOREIGN) and for those with greater risk
(INVRECV and LTD). More profitable and liquid firms (EBIT, QUICK) pose less risk
and should result in lower fees. Finally, audit fees are expected to be higher as the vari-
ance in return on assets increases (VAR_ROA).
4. Sample and empirical results
Description of sample
We start with the S&P 1500 firms in 2001, 2004 and 2007.13 The latter two years are sub-
sequent to the ban in SOX on making loans to many related parties and the high-profile
fraud cases that involved RPTs.14 Further, we consider 2004 and 2007 rather than consec-
utive years because separating the years allows for (i) changes in RPTs to occur in what
are relatively sticky transactions, and (ii) more efficient collection of data. We identify
3,723 firm-year observations from 2001, 2004, and 2007 for which complete financial state-
ment information is available to identify whether or not the firm reported RPTs. We elim-
inate firm-year observations missing asset values, amounts to calculate independent
variables, and prior year observations needed to calculate lagged variables. Our final sam-
ple consists of 3,588 firm-years (Table 2).
Table 2 also reports distributions of restatements and RPT firms by year. As discussed
earlier, we define restatements as the year affected by a subsequently announced restate-
ment. Restatements average 20 percent and 24 percent in 2001 and 2004, respectively, and
decrease to 10 percent in 2007. Almost 65 percent of the sample reports RPTs in 2001.
This drops over the subsequent years to 57 percent in 2007. The decrease is consistent with
the ban of related party loans and increased scrutiny of RPTs in general.
Each RPT is classified by (i) one of ten transaction types described in the Appendix,
and (ii) the nature of the related party (DOS or investee). The frequency distributions
using these classifications for each year are presented in panel A of Table 3. Nine in ten
RPTs are with DOS. We observe a change in the RPT composition over time largely dri-
ven by loans banned by SOX in 2002. We also observe an increase in disclosed unrelated
business activities. Overall, RPTs with investees did not change significantly from 2001 to
2007; although there is an increase in stock transactions and a decrease in loans and guar-
antees. Panel B reports the frequency distributions by year for the Tone and Business
RPT classifications. Business RPTs are relatively flat over time. However, Tone RPTs
decline from 609 in 2001 to 482 in 2007.
We report descriptive statistics in panel A of Table 4. Approximately, 46 percent and
36 percent of the firms report a RPT classified as Tone and Business, respectively. Restate-
ments are present in 18 percent of the sample observations. Both the overall RPT disclo-
sure level and restatement rate are consistent with prior research (Kohlbeck and Mayhew
2010; Newton et al. 2013). The sample consists of larger firms consistent with the nature
of the S&P 1500. The firms are profitable on average but 23 percent of the observations
report losses.
We compare mean data between RP/non-RP firms and restatement/nonrestatement
firms (panel B of Table 4). RP firms are larger, have higher leverage, and are less
13. We focus on the S&P 1500 due to the high cost of hand-collecting related party data. The S&P 1500 provides
a sample of economically important U.S. firms and a cross section of three size categories. These firms are
heavily scrutinized by the market. We expect disclosure to be the most effective for these firms compared to
non-S&P 1500 firms and caution about generalizing our findings to less scrutinized public companies.
14. Our sample excludes most high-profile fraud cases including Enron, WorldCom, Adelphia, and Tyco.
Accordingly, our results are not influenced by the opportunistic RPTs highlighted in these extreme obser-
vations.

TABLE 2
Sample determination
S&P 1500 firms in 2001, 2004, and 2007 for which complete financial statement
information is available to identify RP transaction 3,723
Less firm-year observations
Missing or zero assets 101
Missing amounts to calculate independent variables 26
Missing prior year observation 8
Final sample (firm-years) 3,588
Distribution by year Restatements Related party firms
2001 1,136 225 (19.8%) 740 (65.1%)

2004 1,245 303 (24.3%) 731 (58.7%)
2007 1,207 122 (10.1%) 685 (56.7%)
Total 3,588 650 (18.1%) 2,156 (60.1%)
TABLE 3
Description of related party transactions
Panel A: Frequency distribution by type, related party, and yeara
Directors, officers, and

major shareholders Investees
RPT typeb 2001 2004 2007 2001 2004 2007
Loans 281 178 102 16 9 12

Borrowings 42 29 46 1 0 3
Guarantees 20 14 11 15 4 8
Consulting arrangements 119 98 90 0 2 4
Legal or investment services 215 209 138 2 1 2
Leases 168 169 165 9 11 14
Related business activities 290 292 285 55 44 67
Unrelated business activities 84 119 163 2 8 11
Overhead reimbursement 36 34 41 11 9 11
Stock transactions 159 117 89 11 40 37
Totalc 724 709 645 77 92 120
Panel B: Tone versus business classification
RPT Type 2001 2004 2007
Tone 609 558 482

Business 412 445 446
Notes: aThe shaded numbers in panel A are Business-related RPTs, and the unshaded are Tone-
related RPTs. bAppendix A provides definitions of the related party transaction (RPT) classifications.
c
Between 61 and 80 firms report both DOS and Investee RPTs each year.
profitable. With respect to monitoring, RP firms’ auditors are less likely to be industry
leaders and have smaller industry market shares consistent with weak monitoring, but con-
versely have lower Gompers G-Index suggesting stronger shareholder rights. RP firms also

TABLE 4
Descriptive statistics
Panel A: Pooled data
Variable (N = 3,588) Mean SD 25th percentile Median 75th percentile
RESTATEMENT 0.181 0.385 0.000 0.000 0.000

RP 0.601 0.490 0.000 1.000 1.000
RP_TONE 0.459 0.498 0.000 0.000 1.000
RP_BUSINESS 0.363 0.480 0.000 0.000 1.000
AU_SIZE 10.658 1.556 9.710 10.859 12.033
NAT_LEADER 0.316 0.465 0.000 0.000 1.000
LNFEES 7.167 1.192 6.323 7.112 7.941
FEERATIO 0.320 0.245 0.113 0.256 0.497
LNASSETS 14.663 1.676 13.470 14.501 15.762
LEVERAGE 0.550 0.245 0.389 0.550 0.701
GROWTH 0.141 0.382 0.001 0.077 0.180
ROA 0.040 0.137 0.014 0.046 0.084
LOSS 0.235 0.424 0.000 0.000 0.000
LIT 0.207 0.405 0.000 0.000 0.000
ACQ 0.182 0.386 0.000 0.000 0.000
CHANGE 0.132 0.339 0.000 0.000 0.000
BIG4 0.965 0.184 1.000 1.000 1.000
VAR_ROA 0.015 0.203 0.000 0.001 0.002
SHARE 0.251 0.122 0.165 0.239 0.329
LATE 0.049 0.216 0.000 0.000 0.000
BUSY 0.662 0.473 0.000 1.000 1.000
CI 0.094 0.172 0.010 0.029 0.090
INVREC 0.278 0.194 0.122 0.244 0.383
QUICK 2.157 6.547 0.818 1.219 1.973
LTD 0.186 0.174 0.032 0.164 0.289
EBIT 0.088 0.105 0.044 0.084 0.133
FOREIGN 0.990 0.101 1.000 1.000 1.000
SEGMENTS 6.125 5.742 1.000 3.000 10.000
GIndex (N=3,003) 9.373 2.536 8.000 9.000 11.000
Panel B: Mean data by related party transaction and by restatement
Non-RP RP Non-restatement Restatement

Variable (n = 1,432) (n = 2,156) (n = 2,938) (n = 650)
RESTATEMENT 0.166 0.192**

RP 0.593 0.635**
RP_TONE 0.000 0.765*** 0.445 0.528***
RP_BUSINESS 0.000 0.607*** 0.366 0.351
AU_SIZE 10.784 10.574*** 10.683 10.545**
NAT_LEADER 0.341 0.299*** 0.309 0.345*
LNFEES 7.194 7.150 7.193 7.051***
FEERATIO 0.298 0.334*** 0.314 0.344***
LNASSETS 14.453 14.802*** 14.699 14.500***
LEVERAGE 0.536 0.560*** 0.550 0.552
GROWTH 0.126 0.151** 0.142 0.134
ROA 0.048 0.035*** 0.044 0.024**

TABLE 4 (continued)
Panel B: Mean data by related party transaction and by restatement
Non-RP RP Non-restatement Restatement

Variable (n = 1,432) (n = 2,156) (n = 2,938) (n = 650)
LOSS 0.235 0.235 0.217 0.315***

LIT 0.223 0.197* 0.188 0.294***
ACQ 0.170 0.190 0.184 0.172
CHANGE 0.129 0.134 0.125 0.166***
BIG4 0.965 0.965 0.962 0.978**
VAR_ROA 0.017 0.014 0.014 0.018
SHARE 0.258 0.246 0.250 0.254
LATE 0.040 0.055** 0.033 0.122***
BUSY 0.650 0.671 0.689 0.545***
CI 0.086 0.099** 0.095 0.088
INVREC 0.272 0.282 0.276 0.289
QUICK 2.354 2.026 2.242 1.772***
LTD 0.181 0.190 0.186 0.186
EBIT 0.095 0.084*** 0.091 0.076***
FOREIGN 0.990 0.990 0.989 0.992
SEGMENTS 6.383 5.954** 6.193 5.818
GIndex (N = 3,003) 9.620 9.205*** 9.428 9.118**
Notes: *, **, *** Difference between the means is significant at the 0.10, 0.05, 0.01 level using a t-
test of means. Variables are defined in Table 1.
experience higher growth, and have fewer segments. A greater proportion of restatement
firms disclose Tone RPTs. Restatement firms are smaller, less profitable, more likely to be
a member of high-litigation industry and more likely to change auditors. Their auditors
are more likely to be industry leaders.
Table 5 summarizes Pearson correlation coefficients. Tone RPTs are positively corre-
lated with restatements (panel A), and Business RPTs are positively correlated with audit
fees (panel B). The only other significant correlations greater 0.50 are between LN-
ASSETS and LNFEES, which largely reflect client size, and between RPT and the Busi-
ness and Tone RPT variables.
Analysis of restatements
Table 6 documents the association between RPTs and the likelihood of restatements. We
estimate a probit restatement model, and cluster standard errors by firm to address poten-
tial cross-sectional correlation. We provide two estimations of equation (1) in panel A
varying the test variable among indicator variables for firms reporting RPTs overall and
RPTs classified as Tone and Business. The pseudo R2s increase between 0.2 percent and
0.4 percent when including the RPT variables to approximately 6 percent, and the percent
concordant is 67 percent for each estimation; the explanatory power of the models is con-
sistent with prior research (Newton et al. 2013).
The control variables are generally consistent with expectations. The likelihood of
restatements is increasing in audit fees, as well as for loss firms, firms that change audi-
tors, and firms operating in high litigation industries. Restatements are less likely as firm
size, return on assets, and variance in return on assets increase. Contrary to our expecta-
tions but consistent with other restatement research (Francis et al. 2013; Newton et al.
2013), we find that restatements are more likely for national industry leaders. Contrary to

TABLE 5
Pearson correlation matrix
Panel A: Restatement model variables
Variables 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
1. RESTATEMENT 0.033 0.064 0.012 0.034 0.029 0.046 0.047 0.046 0.003 0.009 0.055 0.089 0.100 0.012 0.047 0.035 0.008
2. RP 1.000 0.751 0.615 0.066 0.045 0.018 0.072 0.102 0.048 0.032 0.049 0.001 0.032 0.025 0.007 0.001 0.010
3. RP_TONE 1.000 0.229 0.047 0.031 0.013 0.115 0.126 0.089 0.035 0.060 0.017 0.022 0.017 0.027 0.018 0.005
4. RP_BUSINESS 1.000 0.076 0.027 0.005 0.015 0.084 0.010 0.006 0.026 0.026 0.019 0.009 0.005 0.007 0.000
5. AU_SIZE 1.000 0.224 0.405 0.255 0.247 0.095 0.023 0.014 0.017 0.045 0.004 0.274 0.328 0.016
6. NAT_LEADER 1.000 0.109 0.025 0.123 0.088 0.009 0.002 0.029 0.043 0.045 0.044 0.130 0.027
7. LNFEES 1.000 0.292 0.686 0.267 0.008 0.048 0.073 0.109 0.036 0.293 0.112 0.043
8. FEERATIO 1.000 0.068 0.038 0.010 0.057 0.009 0.035 0.071 0.287 0.120 0.003
9. LNASSETS 1.000 0.441 0.030 0.046 0.169 0.126 0.030 0.127 0.186 0.094
10. LEVERAGE 1.000 0.034 0.203 0.006 0.260 0.084 0.064 0.105 0.024
11. GROWTH 1.000 0.130 0.085 0.011 0.256 0.022 0.016 0.026
12. ROA 1.000 0.342 0.039 0.024 0.043 0.009 0.351
13. LOSS 1.000 0.072 0.009 0.022 0.016 0.092
14. LIT 1.000 0.001 0.093 0.070 0.038
15. ACQ 1.000 0.029 0.023 0.011
16. CHANGE 1.000 0.064 0.028
17. BIG4 1.000 0.045
18. VAR_ROA 1.000
Panel B: Audit fee model variables
Variables 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
1. LNFEES 0.018 0.013 0.004 0.686 0.206 0.073 0.081 0.199 0.156 0.293 0.112 0.055 0.026 0.095 0.034 0.034 0.255 0.043
2. RP 1.000 0.751 0.615 0.102 0.045 0.001 0.035 0.021 0.039 0.007 0.001 0.024 0.025 0.023 0.050 0.001 0.037 0.010
3. RP_TONE 1.000 0.229 0.126 0.031 0.017 0.016 0.015 0.017 0.027 0.018 0.039 0.037 0.031 0.066 0.000 0.027 0.005
4. RP_BUSINESS 1.000 0.084 0.018 0.026 0.022 0.021 0.062 0.005 0.007 0.027 0.004 0.035 0.004 0.020 0.061 0.000
5. LNASSETS 1.000 0.201 0.169 0.039 0.187 0.114 0.127 0.186 0.020 0.011 0.133 0.004 0.028 0.170 0.094
6. SHARE 1.000 0.011 0.000 0.045 0.201 0.097 0.353 0.050 0.024 0.121 0.020 0.023 0.103 0.028
7. LOSS 1.000 0.112 0.022 0.019 0.022 0.016 0.006 0.001 0.068 0.370 0.018 0.046 0.092
Are Related Party Transactions Red Flags?
8. LATE 1.000 0.034 0.025 0.012 0.041 0.002 0.019 0.027 0.099 0.023 0.017 0.004
9. BUSY 1.000 0.010 0.362 0.021 0.132 0.041 0.101 0.063 0.009 0.127 0.011

915

916
TABLE 5 (continued)
Panel B: Audit fee model variables

Variables 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
10. CI 1.000 0.033 0.354 0.040 0.051 0.066 0.064 0.003 0.015 0.025
11. CHANGE 1.000 0.064 0.060 0.026 0.012 0.005 0.024 0.048 0.028
12. BIG4 1.000 0.026 0.026 0.065 0.006 0.011 0.049 0.045
13. INVREC 1.000 0.012 0.046
Contemporary Accounting Research
0.077 0.186 0.144 0.001

14. QUICK 1.000 0.099 0.043 0.007 0.009 0.002
15. LTD 1.000 0.169 0.045 0.102 0.018
16. EBIT 1.000 0.005 0.001 0.181
17. FOREIGN 1.000 0.009 0.007
18. SEGMENTS 1.000 0.021
19. VAR_ROA 1.000
Notes: See Table 1 for variable definitions (N = 3,588). Significant correlations (p-value < 0.05) are indicated in bold.
TABLE 6
Restatement analysis
ProbðRESTATEMENT ¼ 1Þ ¼ Fðu0 þu1 RP VAR þ u2 AU SIZE þ u3 NAT LEADER
þu4 LNFEES þ u5 FEERATIO þ u6 LNASSETS þ u7 LEVERAGE
þu8 GROWTH þ u9 ROA þ u10 LOSS þ u11 LIT þ u12 ACQ
þu13 CHANGE þ u14 BIG4 þ u15 VAR ROA þ Industry þ Year þ jÞ
ð1Þ
Panel A: Equation 1 (base model)
Variable Pred. Estimated coefficient v2-statistic Estimated coefficient v2-statistic
Intercept 0.575 1.9 0.543 1.7

RP H1: + 0.090* 2.3
RP_TONE H1: + 0.175*** 8.8
RP_BUSINESS H1: + 0.082 1.8
AU_SIZE 0.015 0.2 0.018 0.3
NAT_LEADER 0.107** 2.8 0.108** 2.9
LNFEES + 0.111** 5.0 0.107** 4.7
FEERATIO + 0.072 0.2 0.062 0.1
LNASSETS +/ 0.100*** 8.2 0.098*** 7.9
LEVERAGE + 0.177 1.4 0.166 1.2
GROWTH + 0.011 0.0 0.004 0.0
ROA 0.342* 2.3 0.340* 2.2
LOSS + 0.128** 3.7 0.124** 3.5
LIT + 0.332*** 11.0 0.325*** 10.5
ACQ + 0.010 0.0 0.009 0.0
CHANGE + 0.108* 1.8 0.108* 1.8
BIG4 0.314* 2.6 0.317* 2.6
VAR_ROA 0.172* 1.9 0.168* 2.0
Year fixed effects Yes Yes
Industry fixed effects Yes Yes
Pseudo R2 (%) 5.5 5.7
Percent concordant (%) 66.7 67.1
N 3,588 3,588
Panel B: Including governance variable
Intercept 0.490 1.0 0.473 0.9

RP H1: + 0.062 0.9
RP_TONE H1: + 0.181*** 7.7
RP_BUSINESS H1: + 0.136 3.9
AU_SIZE 0.024 0.5 0.028 0.6
NAT_LEADER 0.118** 2.8 0.121** 3.0
LNFEES + 0.106** 4.0 0.101** 3.6
FEERATIO + 0.187 1.0 0.183 1.0
LNASSETS +/ 0.105*** 7.8 0.101*** 7.2
LEVERAGE + 0.297** 3.6 0.282** 3.3
GROWTH + 0.024 0.1 0.011 0.0
ROA 0.797 *** 8.2 0.802*** 8.0
LOSS + 0.107 * 2.1 0.104* 1.9

TABLE 6 (continued)
Panel B: Including governance variable
LIT + 0.339 *** 9.6 0.332*** 9.1

ACQ + 0.094 1.3 0.095 1.3
CHANGE + 0.092 1.0 0.097 1.1
BIG4 0.367 * 2.6 0.360* 2.5
VAR_ROA 0.332 ** 3.1 0.329* 2.8
GIndex +/ 0.020 2.5 0.020 2.5
Pseudo R2 (%) 6.1 6.5
Percent concordant (%) 68.1 68.5
N 3,003 3,003
Notes: *, **, *** indicate significance at the 0.10, 0.05, 0.01 level using two-tailed tests (one-tail for
predicted directions) and clustering by firm. Variables are defined in Table 1. The restatement model
is estimated assuming a standard normal distribution function (probit), clustering standard errors by
firm, and including industry (based on two-digit NAICS codes) and year fixed effects.
expectations that high-quality auditing will produce fewer restatements, restatements are
marginally more likely for firms with Big 4 auditors. The Big 4 audit 96.5 percent of our
sample so there is little variation in this variable. Moreover, Newton et al. (2013) finds
that Big 4 has an insignificant effect on restatements in a much larger sample.
We find a higher likelihood of restatements for firms reporting any RPT (0.090,
p-value = 0.06).15 When we break RPT into Tone and Business, we find that restatements
are positively associated with Tone RPTs (0.175, p-value < 0.01). Business RPTs are not
associated with restatements in the predicted direction. This evidence supports H1 for
overall and Tone RPTs.
Corporate governance likely plays an important role in both restatements and RPTs as
prior research has shown that RPTs are more likely when corporate governance is weaker
(e.g., Hu et al. 2009). Controlling for governance reduces alternative explanations for our
results. While numerous governance attributes are available, we use the Gompers GIndex
(Gompers, Ishii, and Metrick 2003), a composite governance measure commonly used in
accounting research. The GIndex captures the presence of weaker shareholder rights.
We estimate our restatement model, including the GIndex, and report the results in
panel B of Table 6. Data availability for our governance variable reduces the sample to
3,003. The explanatory power for the estimations improves slightly to over 6 percent com-
pared to equation (1) suggesting that governance plays a role in understanding restatements.
The estimated coefficients for the control variables are consistent with the estimation
reported in panel A with the following exceptions. Leverage is now significant and positive
as expected. The auditor change variable, which was marginally significant in the base model,
is no longer. The added governance variable, GIndex, is not significant at conventional
levels.16
15. A logit model yields similar results (not tabulated).

16. It is not clear whether weaker governance leads to more restatements (i.e., suggestive of poor accounting
quality) or less (i.e., inability to reveal restatements). This conflict may underlie the insignificant results for
GIndex. We note that the prior restatement research we rely upon to motivate our models does not exam-
ine corporate governance based on board of director-related variables or the GIndex.

The estimated coefficient for RPTs overall is positive, but no longer significant. Turn-
ing to Tone and Business classifications, we find that RPTs classified as Tone are associ-
ated with increased likelihood of restatements (0.181, p-value < 0.01) similar to the
estimation of equation (1).17 Business RPTs are negative, which is counter to our direc-
tional predictions. We have no theory to predict a negative association between Business
RPTs and restatement, but if we did allow for a two-tailed test, the Business RPT coeffi-
cient is significantly negative (0.136, p-value = 0.02). This significance of the Business
RPTs is not present in our main results reported in panel A, nor most of our subsequent
sensitivity tests (untabulated).18 We therefore conclude there is little or no association
between Business RPTs and restatements.
Restatement sensitivity tests

We conduct a number of untabulated sensitivity tests in this section. To assess whether RPTs
provide a general signal of misstatement risk, or more directly predict fraud-related restate-
ments, we remove the 26 restatements that Audit Analytics deems fraud-related from our
sample. The rate of fraud-related restatements for RPT firms compared to non-RPT firms is
not significantly different. Furthermore, when we rerun our analysis, our results are similar
(not tabulated). We also explore whether RPTs are directly associated with the restatements.
Audit Analytics does not provide a direct coding of RPT-related restatements, but code 11
captures related party transactions as part of its restatement types. We remove the 68 code
11 observations and our results are similar (not tabulated).19
Beginning in 2004, restating firms began reporting section 4.02 nonreliance restate-
ment information. Section 4.02 restatements include a statement by management that the
previously issued financial statements are no longer reliable. Such disclosure makes clear
the restatement is material. Our results for Tone and Business RPTs hold when we define
restatement by these more severe restatements (not tabulated).20
Agency costs and private control benefits are both related to RPTs and have potential
to affect our restatement results. Two agency cost controls, firm size and leverage, are
already included in our model. We further examine whether there are incremental RPT
effects for larger firms or more highly levered firms by interacting size and leverage with
Tone and Business, respectively. The interaction with size has no effect on Tone and Busi-
ness. However, the leverage interaction with Business shows a marginally higher likelihood
of restatements for Business RPTs as leverage increases.
The literature on private control benefits uses dual class stock and insider ownership
as proxies for private control benefits (Dyck and Zingales 2004; Guadalupe and Perez-
Gonzalez 2011). We find the dual class stock firms (n = 294) are more likely to disclose
RPTs (74 percent versus 59 percent) as are firms with more than 50 percent insider owner-
ship (n = 321, 70 percent versus 59 percent). The greater likelihood also applies to both
Tone and Business RPTs. We find dual class itself is positively associated with
17. GIndex is negatively correlated with both Tone and Business RPTs at the 0.01 level for each. In another
variation of equation (1), there are no significant interactions between GIndex and either the Tone or Busi-
ness RPT variables (untabulated).
18. For example, it is not significant in any single year estimation, or when we drop financials, use a constant
sample, or use only the first restatement year.
19. Of the 68 code 11 restatements, 45 are for firms in our sample that we identify as related party firms. To
examine the possibility that the other 23 are RPTs that we do not capture, we hand-collected the press
releases related to these restatements. None of the 23 resulted from RPTs. Nearly all involved some level
of intercompany issues with foreign subsidiaries concentrated in revenue recognition and taxes. These con-
solidated subsidiaries are not related parties as defined by the standards.
20. How we treat the nonsection 4.02 restatements does not affect these analyses in terms of whether we drop
them from the analysis. It appears RPTs predict restatements similarly for 4.02 and non-4.02 restatements,
although the association is slightly weaker for non-4.02 restatements (not tabulated).

restatements. However, when we include variables capturing dual class or high insider
ownership as well as interactions with our RPT variables in our models, our main results
are not affected. This result does not change when we instead use a 20 percent cutoff
(n = 624) for insider ownership.
Analysis of audit fees

Our second hypothesis concerns the impact of RPTs on audit fees. Similar to our restate-
ment analyses, we vary the test variables across our different RP variables and report the
pooled regression results for equation (2) in Table 7.21 The explanatory power of each
audit fee model is approximately 74 percent, consistent with prior research.22
Significant control variables are generally consistent with our expectations. Audit fees
in each of the estimations are increasing in client size, auditor industry market share, loss
firms, nontimely filings, client importance, Big 4 auditors, foreign operations, and number
of segments. Audit fees are lower as the quick ratio and variance of return on assets
increase. Contrary to expectations, we find that audit fees are marginally increasing in
profits and decreasing in relative assets in inventory and receivables.
We find an inverse relation between RP and audit fees (0.094, p-value < 0.01). In
addition, both Tone and Business RPTs are associated with lower audit fees (0.056, p-
value < 0.01, and 0.090, p-value < 0.01, respectively) but are not significantly different
than each other. The inverse associations are consistent with RPT clients demanding less
audit scrutiny than non-RPT clients consistent with the private control benefits literature
(Leuz et al. 2003) or RPT clients emphasizing price over quality.23 The inverse association
for Business RPT is also consistent with the previously documented lower risk of restate-
ment.
Auditors appear to face additional risk of client restatement with RPT firms, and
specifically Tone RPT firms, and yet they appear to accept lower fees from these same
firms. Research suggests auditors face at least moderately higher costs for restatement cli-
ents. Auditors are more likely to be dismissed or resign the audit after a restatement
(Huang and Scholz 2012; Hennes, Leone, and Miller 2014) although the likelihood of dis-
missal only increases about 6 percent. Dismissal and resignation both increase auditor
opportunity costs at a minimum. Schmidt (2012) shows only 4 percent of restatements
result in auditor litigation, suggesting the litigation risk remains relatively low, although
one would expect some impact on audit fees.
We also analyze audit delay (i.e., the number of days between the audit report date
and the fiscal year end) and industry specialization to shed some light on these findings
(Table 8). Greater audit delay is consistent with increased effort and correspondingly
greater audit fees. Industry specialization is consistent with greater audit quality and
greater audit fees. Audit delay is greatest for Business RPTs, but is only one day longer
than those for firms with no RPTs and only marginally significantly different. Industry
21. t-statistics are based on standard errors clustered by firm. In our sensitivity tests, we estimate the audit fee
model based on White’s consistent estimators, and exclude influential observations (Belsley, Kuh, and
Welsch 1980).
22. We separately examine the variance inflation factors (VIFs) to alleviate potential concerns about multi-
collinearity. The VIFs are less than 2. The explanatory power of our audit fees model is slightly lower than
studies covering a wider range in client size but consistent with studies with Big 4 only samples.
23. We are not suggesting that these auditors are somehow not providing at least a minimal level of audit
quality. Over 96 percent of the firms in our sample are audited by the Big 4, which are considered to be
high-quality audit providers. However, there is variation in audit quality across industries and engage-
ments within the Big 4. We suggest RPT firms target lower quality within the Big 4 level of audit quality.
Alternatively, it is possible the specialized auditors avoid these risky clients. We investigate the interaction
between RPTs and our proxies for private control benefits, dual stock and high insider ownership, and do
not find an interactive effect on audit fees (not tabulated).

TABLE 7
Audit fee analysis
LNFEES ¼ b0 þ b1 RP VAR þ b2 LNASSETS þ b3 SHARE þ b4 LOSS þ b5 LATE þ b6 BUSY
þ b7 CI þ b8 CHANGE þ b9 BIG4 þ b10 INVRECV þ b11 QUICK þ b12 LTD þ b13 EBIT
þ b14 FOREIGN þ b15 SEGMENTS þ b16 VAR ROA þ Industry þ Year þ e ð2Þ
Variable Estimated coefficient t-statistic Estimated coefficient t-statistic
Intercept 1.512*** 7.6 1.523*** 7.8

RP H2: +/ 0.094*** 3.6
RP_TONE H2: +/ 0.056** 2.1
RP_BUSINESS H2: +/ 0.090*** 3.2
LNASSETS + 0.464*** 42.7 0.466*** 42.9
SHARE ? 0.763*** 5.9 0.763*** 5.9
LOSS + 0.090*** 2.9 0.089*** 2.9
LATE + 0.391*** 6.6 0.391*** 6.6
BUSY + 0.187*** 5.4 0.187*** 5.5
CI + 1.194*** 9.9 1.195 *** 9.9
CHANGE ? 0.005 0.1 0.003 0.0
BIG4 + 0.409*** 4.6 0.409*** 4.6
INVREC + 0.345*** 3.5 0.354*** 3.6
QUICK 0.005*** 2.5 0.005*** 2.5
LTD + 0.068 0.8 0.073 0.8
EBIT 0.329** 2.4 0.331*** 2.5
FOREIGN + 0.138 1.1 0.132 1.1
SEGMENTS + 0.023*** 9.2 0.023*** 9.0
VAR_ROA + 0.183*** 4.7 0.187*** 5.0
Adjusted R2 (%) 74.0 74.0
N 3,588 3,588
Notes: *, **, *** indicate significance at the 0.10, 0.05, 0.01 level, using two-tailed tests (one-tail for
predicted directions). The t-statistics are based on clustering standard errors by firm, and the model
is estimated including industry (based on two-digit NAICS codes) and year fixed effects. Variables
are defined in Table 1.
specialization, measured as the industry market share, industry leadership (top or top two
auditors), and industry market share greater than 30 percent, is significantly less for firms
with RPTs classified as Tone and as Business, consistent with the procurement of lower-
quality audits argument. Combined, these analyses suggest that the negative RPT coeffi-
cients reported in Table 7 are consistent with lower demand for audit quality or, alterna-
tively, industry specialists may avoid these clients.
When we include a restatement variable in the audit fee model, we find a positive and
significant coefficient (0.056, p-value = 0.07) suggesting that auditors price the risk of
restatement. We then interact the restatement variable with our RPT variables (Table 9).
The main effects for RP, as well as Tone and Business RPTs are still negative and signifi-
cant. In addition, the interaction term for Tone RPT and restatement is positive and sig-
nificant. While overall Tone RPTs continue to be associated with the RPT clients
procuring less assurance overall and as such pay lower fees; it appears that auditors incor-
porate the increased risk of restatement into their fees for the RPT firms who subsequently
restate. When we combine the coefficients, the audit fees for Tone RPT clients with

TABLE 8
Analysis of mean audit report delay and industry specialization
Business Tone Both Tone and

Attribute Non-RPT RPT RPT only RPT only Business RPT
N 1,432 2,156 507 853 796

Audit report delay (days) 53.79 54.19 55.65* 53.32 54.18
Auditor characteristics
Industry market share 0.257 0.246*** 0.244** 0.243*** 0.249
Industry leader (%) 0.341 0.298*** 0.293** 0.297** 0.302*
Industry market share >30% (%) 0.340 0.300*** 0.317 0.298** 0.291***
Industry leaders, 1st or 2nd (%) 0.595 0.568* 0.605 0.542*** 0.571
Notes: *, **, *** Difference based on a comparison with the non-RPT observations is significant at
the 0.10, 0.05, 0.01 level using a t-test of means.
increased restatement risk is similar to non-RPT clients. While Tone RPT firms hire
lower-quality auditors and therefore pay lower fees, auditors charge more to Tone RPT
firms if the client has a greater risk of restatement.
Sensitivity analyses
The sensitivity tests discussed in section are based on the models reported in Table 6,
panel A, and Table 7 and are all untabulated. We start with different RPT measures. We
replace our indicator variables with the natural log of the number of RPTs to provide a
proxy of magnitude. We find similar results for all RPT variables in both models. We also
consider whether the counterparty is the only important factor in classifying RPTs by
using DOS and Investee indicator variables. DOS RPT is significantly positive in the
restatement model. DOS RPT is significantly negative but Investee RPT is positive in the
audit fee model suggesting that transactions with DOS are associated with lower fees, but
RPTs with investees are associated with higher fees.24
To examine the sensitivity of our Tone and Business groupings, we reclassify DOS
leasing activity and DOS-related business activities as Tone, as each has a large number of
RPTs and could affect the results if the classifications change. The adjusted Tone measure
remains significant but weaker in the restatement model; audit fee results for Tone are
unaffected, but the coefficient for Business RPTs is no longer significant. We also group
DOS leasing and related business activities as their own grouping. Both this grouping and
Business RPT are not significant in the restatement model while Tone remains significant.
In the audit fee model, this combined grouping is negative consistent with DOS RPT firms
procuring lower-quality audits. This analysis shows the business classification best captures
the nature of these transactions.
We next consider different time windows and subsamples. We estimate the restate-
ment and audit fee models over a constant sample across the three years. Results are
similar on RPT overall, Tone, and Business in both the restatement and fee models.
Financial institutions represent a unique and large industry group. We both exclude
financial institutions from the sample and then consider interaction terms. Our restate-
ment results continue to hold in both cases. For audit fees, we find that the magnitude
of the inverse effect for firms reporting RPTs is greater for financial institutions. Further,
24. In untabulated analysis, we classify the RPTs as simple and complex following Kohlbeck and Mayhew
(2010). Our results for simple and complex are similar to the Tone and Business classifications, respec-
tively.

TABLE 9
Audit fee analysis controlling for restatements
Estimated Estimated
Variable coefficient t-statistic coefficient t-statistic
Intercept 1.516*** 7.7 1.520*** 7.8

RP H2: +/ 0.104*** 3.8
RP_TONE H2: +/ 0.078*** 2.8
RP_BUSINESS H2: +/ 0.090*** 3.0
RESTATEMENT + 0.023 0.5 0.000 0.0
RESTATEMENT9RP ? 0.055 0.9
RESTATEMENT9RP_TONE ? 0.107* 1.8
RESTATEMENT9RP_BUSINESS ? 0.005 0.1
LNASSETS + 0.464*** 43.0 0.465*** 43.1
SHARE ? 0.764*** 6.0 0.763*** 6.0
LOSS + 0.088*** 2.9 0.086*** 2.9
LATE + 0.377*** 6.4 0.380*** 6.5
BUSY + 0.191*** 5.6 0.192*** 5.7
CI + 1.197*** 10.0 1.200*** 10.0
CHANGE ? 0.005 0.1 0.003 0.1
BIG4 + 0.407*** 4.7 0.409*** 4.7
INVREC + 0.349*** 3.6 0.356*** 3.7
QUICK 0.005** 2.5 0.005** 2.5
LTD + 0.069 0.8 0.074 0.9
EBIT 0.337** 2.5 0.336** 2.5
FOREIGN + 0.137 1.2 0.129 1.1
SEGMENTS + 0.023*** 9.3 0.023*** 9.1
VAR_ROA + 0.183*** 4.5 0.185*** 4.8
Adjusted R2 (%) 74.0 74.1
N 3,588 3,588
Notes: *, **, *** indicate significance at the 0.10, 0.05, 0.01 level, using two-tailed tests (one-tail for
predicted directions). The t-statistics are based on clustering standard errors by firm, and the model
is estimated including industry (based on two-digit NAICS codes) and year fixed effects. Variables
are defined in Table 1.
the negative audit fees for Tone and Business RPT firms are driven by financial institutions
for Tone RPTs, and all other firms for Business RPTs. We also exclude nonrestatement years
of the restatement firms as such firms may have lower disclosure quality in general. There is
no change in the restatement model results.25 We estimate the restatement and audit fee
models annually. The positive association between Tone RPT and restatements is present in
2001 and 2004; results are not significant but the sign remains consistent for 2007. The 2007
results are marginally significant when we control for internal control weakness reports. The
negative associations between audit fees and Tone and Business RPTs hold for each year.
Post-SOX, firms report on internal control weaknesses (ICW). Since ICW are likely related
to restatements and may be related to RPTs, we estimate our model for 2004 and 2007 with
available ICW data. Although, ICW are significantly associated with restatements as we
expect, our restatement and audit fee results hold.
25. We also exclude restatements and RPTs associated with leasing to address the potential confounding
effects from SEC-concentrated enforcement efforts around lease reporting and find similar results.

Restatements can affect multiple years; we therefore limit the restatement to the first
year while excluding other years of the same restatement. Tone and Business RPTs con-
tinue to be consistent with those reported in Table 6. If RPTs are opportunistic, the asso-
ciation with restatements will depend on the whether it increases or decreases income. We
separately analyze income increasing and income-decreasing restatements and find that
our results are only associated with income-decreasing restatements, consistent with man-
agers opportunistically overstating earnings.
We consider the relation between restatements and fees when we control for the
hypothesized association between RPTs and restatements in the audit fee model; our
results are unaffected. We also estimate the restatement and audit fee models simultane-
ously, using 2SLS. In the restatement model, estimated coefficients are similar to those
reported in Table 6. For the audit fee model, the estimated coefficients are similar to those
reported in Table 7 with the exception that Business RPT is no longer significant.
It is possible that factors, such as governance characteristics, that influence restate-
ments also are associated with RPTs. We address this potential endogeneity by first esti-
mating a prediction model where RP is a function of client size, leverage, number of block
holders, insider ownership, and the Gompers GIndex. We then calculate an inverse Mills
ratio based on this estimation and include it as an additional explanatory variable. The
estimated coefficients for our RPT variables in the restatement model are similar, and the
RPT coefficients’ magnitudes in the audit fee model are smaller and Tone RPT is only
marginally significant. We also find that our audit fee results are robust to inclusion of the
GIndex.26
We next determine if the effects we find are associated with family firms.27 The liter-
ature on family firms predicts that such firms are more likely to engage in RPTs
(Srinidhi, He, and Firth 2014). In our reduced sample (N = 2,906), RPT disclosures are
more likely in family firms than nonfamily firms (69 percent versus 52 percent). Nonethe-
less, including a control for family firms does not change our restatement results. We
also investigate whether the RPT effect differs for family firms by interacting family firms
with RPTs. The interaction results indicate that the lower audit fees for Tone RPTs is
related to nonfamily firms, while the lower audit fee effect for Business RPTs is related
to family firms.
As our final robustness test, we include abnormal audit fees both as a continuous vari-
able and an indicator variable based on the top 10 percent in the restatement model to
control for increased audit effort in line with Hribar, Kravet, and Wilson (2014). Again,
our results hold.
5. Conclusion
We report two primary findings. First, RPTs and especially Tone RPTs are associated
with restatements, suggesting these RPTs are red flags for an increased risk of material
misstatement. Second, we find RPTs are associated with lower audit fees. Additional anal-
yses reveal some evidence that firms with RPTs procure lower audit quality by hiring
industry specialists less often. We also find, however, that among Tone RPTs that are
associated with subsequent restatements, audit fees are higher, suggesting that auditors, at
least to some extent, understand the differing implications of RPTs. The audit fee results
are generally consistent with research, suggesting external auditors do not consider RPTs
a significant risk, and with RPT firms focusing more on price and less on audit quality.
26. Our restatement and audit fee models use independent variables based on the findings from prior research
in each area. We also estimate our models, using a common set of variables including LNASSETS, LOSS,
CHANGE, BIG4, VAR_ROA, SHARE, LTD, ROA, FOREIGN, SEGMENTS, and NAT_LEADER; our
inferences are not affected.
27. We thank Chen, Chen, and Cheng (2008) for access to their family firm status data.

This research is subject to a couple of caveats and limitations. First, audit fees repre-
sent both what auditors supply and clients demand. We do not have access to underlying
audit hours. Such data would enable the analysis of audit effort and further our under-
standing of the auditor response. Research into client demand for assurance could also
provide insights into the observed association between RPTs and audit fees.
Second, we employ the restatement coding provided by Audit Analytics. This coding
does not necessarily focus on the role of RPTs in restatements. There could be a more
direct association between RPTs and restatements than we hypothesize. That said, in sen-
sitivity analyses we attempt to isolate restatements related to RPTs and continue to find a
general association between RPTs and restatements suggesting a signaling role for RPTs
that goes beyond a direct causal linkage. Finally, we examine RPTs among the S&P 1500,
which represent the highest-profile public companies in the United States. To the extent
these firms receive higher scrutiny than other companies, the results of our analysis poten-
tially will differ outside of the S&P 1500. Future research can examine our findings in a
broader population of firms.
Appendix
Types of related party transactions
Transaction Grouping Description
Loans to
• DOS Tone The company made loans to related parties. Employee loan programs are
considered one related party transaction
• Investee Bus
Borrowings from
• DOS Tone A related party has either loaned amounts or guaranteed debt of the
company
• Investee Bus
Guarantees
• DOS Tone The company guaranteed debt of a related party
• Investee Bus
Consulting
• DOS Tone The company and the related party have entered into an agreement
where the related party provides consulting services to the company
• Investee Tone
Legal or investment services
• DOS Tone The company obtains either legal or investment services from the related
party
• Investee Tone
Leases
• DOS Bus The company has entered into an agreement with the related party to
lease space or aircraft
• Investee Bus
Related business activities
• DOS Bus The company and the related party are involved in business activities,
including research and development activities that are related to the
• Investee Bus company’s main operations. The activities typically result in sales,
cost of sales, R&D expense, receivables, and payables
(The(The
appendix
table is continued on the next page.)

Appendix (continued)
Transaction Grouping Description
Unrelated business activities

• DOS Tone The related party provides the company services that are incidental to
the company’s main operations
• Investee Tone
Overhead reimbursement
• DOS Tone The company and the related party have entered into an agreement for
one party to provide administration services to the other for a fee
• Investee Bus
Stock transactions
• DOS Tone Business with investee. The company and the related party have entered
into transactions involving transfers of assets, business, and / or
• Investee Bus ownership interests
Notes: The transaction categories are from Kohlbeck and Mayhew (2010), Appendix A1. DOS
refers to transactions with directors, officers and shareholders. Investee refers to transactions with
unconsolidated investments, subsidiaries, and joint ventures of the company. Tone and Bus indicate
whether grouped with our tone or business groupings.
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Are Related Party Transactions Red Flags?

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Are Related Party Transactions Red Flags?

MARK KOHLBECK, Florida Atlantic University

BRIAN W. MAYHEW, University of Wisconsin – Madison

Faut-il voir des signaux d’alarme dans les operations

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CAR Vol. 34 No. 2 (Summer 2017)

Research on related party transactions

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CAR Vol. 34 No. 2 (Summer 2017)

statements or instead minimize eﬀorts to produce transparent reports, the result is an

Hypothesis 1. The probability of a restatement is greater for companies disclosing RPTs.

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RESTATEMENT Indicator variable equal to one if a subsequently announced nonclerical

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Audit fee model

12. A negative coeﬃcient could also indicate lower audit risk.

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Distribution by year Restatements Related party ﬁrms

2001 1,136 225 (19.8%) 740 (65.1%)

Panel A: Frequency distribution by type, related party, and yeara

Directors, oﬃcers, and

RPT typeb 2001 2004 2007 2001 2004 2007

Loans 281 178 102 16 9 12

Panel B: Tone versus business classiﬁcation

RPT Type 2001 2004 2007

Tone 609 558 482

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Panel A: Pooled data

Variable (N = 3,588) Mean SD 25th percentile Median 75th percentile

RESTATEMENT 0.181 0.385 0.000 0.000 0.000

Panel B: Mean data by related party transaction and by restatement

Non-RP RP Non-restatement Restatement

RESTATEMENT 0.166 0.192**

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Panel B: Mean data by related party transaction and by restatement

Non-RP RP Non-restatement Restatement

LOSS 0.235 0.235 0.217 0.315***

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Panel A: Restatement model variables

Panel B: Audit fee model variables

(The table is continued on the next page.)

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Panel B: Audit fee model variables

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0.077 0.186 0.144 0.001

Panel A: Equation 1 (base model)

Variable Pred. Estimated coeﬃcient v2-statistic Estimated coeﬃcient v2-statistic

Intercept 0.575 1.9 0.543 1.7

Panel B: Including governance variable

Variable Pred. Estimated coeﬃcient v2-statistic Estimated coeﬃcient v2-statistic

Intercept 0.490 1.0 0.473 0.9

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Panel B: Including governance variable

Variable Pred. Estimated coeﬃcient v2-statistic Estimated coeﬃcient v2-statistic

LIT + 0.339 *** 9.6 0.332*** 9.1

15. A logit model yields similar results (not tabulated).

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Restatement sensitivity tests

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LIT + 0.339 * 9.6 0.332* 9.1

Intercept 1.512* 7.6 1.523* 7.8

Intercept 1.516* 7.7 1.520* 7.8