Kohlbeck2017 Are Related Party Transactions Red Flags

Article Type: Original Article
Are Related Party Transactions Red Flags? *
MARK KOHLBECK, Florida Atlantic University
BRIAN W. MAYHEW, University of Wisconsin – Madison
October 17, 2016
* Accepted by Sarah Elizabeth McVay. An earlier version of this paper was presented at the 2014
Contemporary Accounting Research Conference, generously supported by the Chartered
Professional Accountants of Canada. We appreciate comments from two anonymous
referees, Sarah McVay, Bjorn Jorgenson (discussant), and workshop participants at the 2014
Contemporary Accounting Research Conference, the University of Wisconsin – Madison, and
the 2013 AAA Annual Meeting.
Are Related Party Transactions Red Flags?
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 transactions 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 transactions. We also find RPT
firms pay lower audit fees. However, “tone RPT” firms that subsequently 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.
Key words: Related Party Transactions, Audit Risk, Restatements, Audit Fees
This is an Accepted Article that has been peer-reviewed and approved for publication in the
Contemporary Accounting Research, but has yet to undergo copy-editing and proof
correction. Please cite this article as an “Accepted Article”; doi: 10.1111/1911-3846.12296
This article is protected by copyright. All rights reserved.

JEL: M41, M42
Are Related Party Transactions Red Flags?
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 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 non-arm’s-length nature of RPTs as their
main concern while acknowledging RPTs can have legitimate business purposes. There are at
least two reasons why the non-arm’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 potential detriment of
shareholders. For example, the firm could enter into a purchase transaction with a related party
where the price paid is in excess of market. Second, the non-arm’s-length nature of the
transaction also provides a potential mechanism for managers to manipulate the financial
statements (FASB 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 et al. 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 provide direct
evidence of a willingness to self-deal that suggests additional management-centric actions such
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 (Gordon
et al. 2007). “Grey” directors are considered less independent monitors than independent directors.

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 et al. 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) associated with current or future
operating profitability.
In our first analysis, we focus on RPTs as indicators of increased risk of financial misstatements
and hypothesize that the likelihood of restatements is greater for firms disclosing 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 empirical 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 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 company. The closer the transaction is to core
operations the more likely it is to be a Business-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 provide 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 et al. 2003). As a result, clients with RPTs, and
especially Tone RPTs, might demand less assurance and accordingly pay lower audit fees.4
3
WorldCom engaged in RPTs with its CEO Bernie Ebbers. However, these RPTs were not part of
WorldCom’s fraudulent misreporting of capital-related expenses.
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 representations as evidence to support RPT
disclosures.

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 restatements. 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 consistent with the
auditor’s limited responsibilities for RPTs, and Gordon et al.’s (2007) summary 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-quality 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 without 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 partially 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 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 et al. 2004; Kohlbeck and Mayhew 2010). Our large dataset
provides more power to empirically assess the association 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 materially 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 subsequently 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 et al. 2000;
Swartz and Watkins 2003; Gordon et al. 2004; Kahle and Shastri 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 et al. (2008) indicates 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 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 (1) “the nature of the relationship,” (2) “a description of
the transaction,” (3) “the dollar amounts of transactions” for each income statement period
presented, and (4) “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
5
Prior to SAS No. 82 on fraud (AICPA 1997), auditing standards list RPTs as part of the operating
environment 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 considering 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.

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 favorable 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 purpose within these firms.
The PCAOB issued a new standard for auditing RPTs in June 2014, replacing a standard 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 potential RPTs and review RPTs identified
by management. In contrast, the new standard requires more proactive RPT identification.
Second, current and prior U.S. audit standards identify RPTs as potential conduits for fraudulent
transactions and resulting material 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 disclosures
(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 w non-RPT firms. Moreover, they find that firms disclosing 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 associated 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.
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.

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). 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. listing. 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 Kohlbeck and Mayhew (2010).
Hu et al. (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 bargaining 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 et al. (2011)
study Chinese initial public offerings (IPOs) and find RPTs appear to be structured to improve
(prop up) firm operating 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 experience financial
restatements. The accounting for RPTs and related disclosures do not necessarily 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 substantial 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 discretion 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 implications
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 et al. (2006) provide evidence that a sample of 106 firms with revenue
restatements from 1997–2002 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 necessarily
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 restatements.
Our second hypothesis focuses on audit fees. Our main question is whether the potential
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 premium 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 company’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 accordance 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 standards 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 conceal
information in order to protect their private benefits. To the extent RPTs serve as evidence 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 clients engaging in RPTs.
The competing arguments lead us to make a non-directional 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 et al. (2013) and Newton et al.
(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 restatement can affect multiple year-
observations for a sample firm.8
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.

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 indicated).
Prob (RESTATEMENT=1) = F (φ0 + φ1 RP_VAR + φ2 AU_SIZE + φ3 NAT_LEADER
+ φ4 LNFEES + φ5 FEERATIO + φ6 LNASSETS + φ7 LEVERAGE + φ8 GROWTH
+ φ9 ROA + φ10 LOSS + φ11 LIT + φ12 ACQ + φ13 CHANGE + φ14 BIG4
+ φ15 VAR_ROA + Industry + Year + κ) (1)
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 shareholder (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 opportunistic 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 unrelated 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 opportunistically priced services from a related company that is
partially owned by the company). Accordingly, RP_TONE is an indicator variable equal to one
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
definition of RPTs as this disclosure was not required in 2001.

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, Investee
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 restatements for
auditors that generate more audit fees in an industry (AU_SIZE). Industry leaders
(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 auditor 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 accounting (LNASSETS).
However, large firms often have more developed accounting systems which should reduce the
number of restatements. As a result, we make no prediction for LNASSETS. Higher levered firms
(LEVERAGE) and growth firms (GROWTH) are expected to have increased risk of restatements
(Francis et al. 2013). Clients experiencing 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-quality
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 et al. 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 = 0 + 1 RP_VAR +  2 LNASSETS + 3 SHARE + 4 LOSS + 5 LATE
+  6 BUSY + 7 CI +  8 CHANGE + 9 BIG4 + 10 INVRECV
+  11 QUICK +  12 LTD + 13 EBIT + 14 FOREIGN + 15 SEGMENTS
+  16 VAR_ROA + Industry + Year +  (2)
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 clients (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 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
variance 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
subsequent 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 consecutive 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 statement information is available to
identify whether or not the firm reported RPTs. We eliminate firm-year observations missing
asset values, amounts to calculate independent variables, and prior year observations needed to
calculate lagged variables. Our final sample 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 restatement.
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
12
A negative coefficient could also indicate lower audit risk.
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
observations.

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 driven 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 guarantees. 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. Restatements are
present in 18 percent of the sample observations. Both the overall RPT disclosure 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 / non-restatement firms
(panel B of Table 4). RP firms are larger, have higher leverage, and are less 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 conversely have lower Gompers
G-Index suggesting stronger shareholder rights. RP firms also 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 correlated 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 LNASSETS and LNFEES, which
largely reflect client size, and between RPT and the Business 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 potential
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 consistent 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 auditors, 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 expectations 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 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 et al.
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 compared 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
The estimated coefficient for RPTs overall is positive, but no longer significant. Turning to Tone
and Business classifications, we find that RPTs classified as Tone are associated 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 directional predictions. We have no theory
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 examine corporate governance based on board of director related
variables or the GIndex.
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
Business RPT variables (untabulated).

to predict a negative association between Business RPTs and restatement, but if we did allow
for a two-tailed test the Business RPT coefficient 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
restatements, 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 non-reliance restatement
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 Business. 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-Gonzalas 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 ownership (n = 321, 70 percent versus
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
consolidated subsidiaries are not related parties as defined by the standards.
20
How we treat the non-section 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).

59 percent). The greater likelihood also applies to both Tone and Business RPTs. We find dual
class itself is positively associated with 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 restatement
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, non-
timely 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 restatement.
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 clients. Auditors are
more likely to be dismissed or resign the audit after a restatement (Huang and Scholz 2012;
Hennes et al. 2014) although the likelihood of dismissal only increases about 6 percent.
Dismissal and resignation both increase auditor opportunity costs at a minimum. Schmidt
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 et al. 1980).
22
We separately examine the variance inflation factors (VIFs) to alleviate potential concerns about
multicollinearity. 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 engagements
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).

(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 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 coefficients reported in Table 7 are consistent with lower demand for audit
quality or, alternatively, 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 significant. In
addition, the interaction term for Tone RPT and restatement is positive and significant. 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 incorporate 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 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
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,
respectively.

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 restatement 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 restatement 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, 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.
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 continue to be
consistent with those reported in Table 6. If RPTs are opportunistic, the association 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 managers
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 simultaneously 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 restatements also
are associated with RPTs. We address this potential endogeneity by first estimating 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
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.

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 literature on
family firms predicts that such firms are more likely to engage in RPTs (Srinidhi et al. 2014). In
our reduced sample, (N = 2,906) RPT disclosures are more likely in family firms than non-family
firms (69 percent vs. 52 percent). Nonetheless, 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 non-family 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 variable and
an indicator variable based on the top 10 percent in the restatement model to control for
increased audit effort in line with Hribar et al. (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 analyses
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.
This research is subject to a couple of caveats and limitations. First, audit fees represent 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 understanding 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 sensitivity 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
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 et al. (2008) for access to their family firm status data.

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 potentially will differ outside of the S&P 1500.
Future research can examine our findings in a broader population of firms.
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APPENDIX
Types of related party transactions
Loans to
The company made loans to related parties. Employee
 DOS Tone 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
The company and the related party have entered into
 DOS Tone an agreement where the related party provides
consulting services to the company.
 Investee Tone
Legal or
investment
services
The company obtains either legal or investment
 DOS Tone 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 The company and the related party are involved in
activities business activities, including research and
development activities that are related to the
 DOS
Bus company’s main operations. The activities typically
 Investee result in sales, cost of sales, R&D expense, receivables,
Bus and payables.
Unrelated business
activities
The related party provides the company services that
 DOS are incidental to the company’s main operations.
Tone
 Investee

Tone
Overhead
reimbursement
The company and the related party have entered into
 DOS an agreement for one party to provide administration
Tone services to the other for a fee.
 Investee
Bus
Stock transactions
Business with investee. The company and the related
 DOS Tone party have entered into transactions involving
transfers of assets, business, and / or ownership
 Investee Bus 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.
TABLE 1
Variable definitions
Variable Definition
RESTATEMENT Indicator variable equal to one if a subsequently
announced non-clerical 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

Variable Definition
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 non-audit service fees to total audit and non-audit
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 non-timely 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
FOREIGN Indicator variable equal to one if the company reports
foreign earnings, and zero otherwise

Variable Definition
SEGMENTS Number of reportable segments
GIndex Gomper’s governance index (where higher values indicate
weaker shareholder rights)
TABLE 2
Sample determination
S&P 1500 firms in 2001, 2004, 3,723

and 2007 for which complete
financial statement information
is available to identify RP
transaction
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 year1
Directors, officers, and
major shareholders Investees
RPT Type2 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
215 209 138 2 1 2
services
Leases 168 169 165 9 11 14
Related business activities 290 292 285 55 44 67
Unrelated business
84 119 163 2 8 11
activities
Overhead reimbursement 36 34 41 11 9 11
Stock transactions 159 117 89 11 40 37
Total3 724 709 645 77 92 120
TABLE 3
Description of related party transactions (continued)
Panel B: Tone vs. Business classification
RPT Type 2001 2004 2007
Tone 609 558 482
Business 412 445 446

Notes:
1 The shaded numbers in panel A are Business-related RPTs, and the unshaded are Tone-related RPTs.
2.Appendix A provides definitions of the related party transaction (RPT) classifications.
3 Between 61 and 80 firms report both DOS and Investee RPTs each year.
TABLE 4
Descriptive statistics
Panel A: Pooled data
Variable 1 Standard 25th 75th

deviation percentil percentil
(N=3,588) Mean e Median e
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 9.373 2.536 8.000 9.000 11.000

(N=3,003)
TABLE 4
Descriptive statistics (continued)
Panel B: Mean data by related party transaction and by restatement
Non-
Non-RP RP Restatemen Restatemen
t t
(n = (n =
Variable 1,432) 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 **
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.

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
0.03 0.064 -0.012 - 0.029 - 0.047 - 0.003 -0.009 - 0.089 0.100 -0.012 0.047 0.035 0.008
1. RESTATEMENT
3 0.034 0.046 0.046 0.055
1.00 0.751 0.615 - - -0.018 0.072 0.102 0.048 0.032 - 0.001 -0.032 0.025 0.007 -0.001 -0.010
2. RP
0 0.066 0.045 0.049
1.000 0.229 - -0.031 -0.013 0.115 0.126 0.089 0.035 - 0.017 -0.022 0.017 0.027 0.018 -0.005
3. RP_TONE
0.047 0.060
1.000 - -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
4. RP_BUSINESS
0.076
1.000 0.224 0.405 - 0.247 0.095 0.023 -0.014 0.017 - 0.004 - 0.328 0.016
5. AU_SIZE
0.255 0.045 0.274
1.000 0.109 0.025 0.123 0.088 -0.009 -0.002 -0.029 - - - 0.130 -0.027
6. NAT_LEADER
0.043 0.045 0.044
1.000 - 0.686 0.267 0.008 0.048 - - 0.036 - 0.112 -

7. LNFEES
0.292 0.073 0.109 0.293 0.043
1.000 0.068 0.038 0.010 - 0.009 0.035 0.071 0.287 0.120 0.003
8. FEERATIO
0.057
1.000 0.441 0.030 0.046 - - -0.030 - 0.186 -

9. LNASSETS
0.169 0.126 0.127 0.094
1.000 - - 0.006 - - - 0.105 0.024

10. LEVERAGE
0.034 0.203 0.260 0.084 0.064
1.000 0.130 - 0.011 0.256 0.022 0.016 -0.026

11. GROWTH
0.085
12. ROA 1.000 - - -0.024 - 0.009 -

0.342 0.039 0.043 0.351
13. LOSS 1.000 0.072 -0.009 -0.022 -0.016 0.092
1.000 0.001 0.093 - 0.038

14. LIT
0.070
15. ACQ 1.000 0.029 0.023 0.011
1.000 - 0.028
16. CHANGE
0.064
1.000 -
17. BIG4
0.045
18. VAR_ROA 1.000
TABLE 5
Pearson correlation matrix (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
- - - 0.686 0.206 - 0.081 0.199 0.156 - 0.112 - - 0.095 0.034 0.034 0.255 -
1. LNFEES
0.018 0.013 0.004 0.073 0.293 0.055 0.026 0.043
1.000 0.751 0.615 0.102 - 0.001 0.035 0.021 0.039 0.007 - 0.024 - 0.023 - 0.001 - -
2. RP
0.045 0.001 0.025 0.050 0.037 0.010
1.000 0.229 0.126 - 0.017 0.016 0.015 0.017 0.027 0.018 0.039 - 0.031 - 0.000 - -
3. RP_TONE
0.031 0.037 0.066 0.027 0.005
1.000 0.084 - - 0.022 0.021 0.062 - - - - 0.035 - - - 0.000

4. RP_BUSINESS
0.018 0.026 0.005 0.007 0.027 0.004 0.004 0.020 0.061

1.000 0.201 - - 0.187 0.114 - 0.186 0.020 - 0.133 0.004 0.028 0.170 -
5. LNASSETS
0.169 0.039 0.127 0.011 0.094
1.000 - 0.000 0.045 - - 0.353 - - 0.121 - 0.023 0.103 -

6. SHARE
0.011 0.201 0.097 0.050 0.024 0.020 0.028
1.000 0.112 - - - - - - 0.068 - 0.018 - 0.092

7. LOSS
0.022 0.019 0.022 0.016 0.006 0.001 0.370 0.046
1.000 0.034 0.025 - - 0.002 0.019 0.027 - 0.023 0.017 -

8. LATE
0.012 0.041 0.099 0.004
1.000 0.010 - 0.021 - 0.041 0.101 - - 0.127 -

9. BUSY
0.362 0.132 0.063 0.009 0.011
1.000 0.033 - 0.040 - 0.066 0.064 - 0.015 -

10. CI
0.354 0.051 0.003 0.025
1.000 - 0.060 - - 0.005 0.024 - 0.028

11.CHANGE
0.064 0.026 0.012 0.048
1.000 - - 0.065 - 0.011 0.049 -

12. BIG4
0.026 0.026 0.006 0.045
1.000 - - 0.012 0.046 - -

13. INVREC
0.077 0.186 0.144 0.001
1.000 - - 0.007 0.009 0.002

14. QUICK
0.099 0.043
1.000 - - 0.102 -
15. LTD
0.169 0.045 0.018
1.000 0.005 0.001 -

16. EBIT
0.181
17. FOREIGN 1.000 0.009 0.007
1.000 -
18. SEGMENTS
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
Prob (RESTATEMENT = 1) = F (φ0 + φ1 RP_VAR + φ2 AU_SIZE + φ3 NAT_LEADER + φ4 LNFEES
+ φ5 FEERATIO + φ6 LNASSETS + φ7 LEVERAGE + φ8 GROWTH + φ9 ROA
+ φ10 LOSS + φ11 LIT + φ12 ACQ + φ13 CHANGE + φ14 BIG4 + φ15 VAR_ROA
+ Industry + Year + κ)
Panel A: Equation 1 (base model)
Estimated χ 2- Estimate χ 2-
coefficien statisti d statisti
t c coefficien c
Variable Pred. t
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 Yes Yes

effects
Pseudo R2 5.5% 5.7 %
Percent 66.7% 67.1%

concordant
N 3,588 3,588
TABLE 6
Restatement Analysis (continued)
Panel B: Including governance variable
Estimated χ 2- Estimated χ 2-
Coefficien statisti Coefficien statisti
Variable Pred. t c t c
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
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
Industry fixed Yes Yes

effects
Pseudo R2 6.1% 6.5%
Percent 68.1% 68.5%

concordant
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.
TABLE 7
Audit fee analysis
LNFEES = 0+ 1RP_VAR + 2 LNASSETS + 3 SHARE +  4 LOSS + 5 LATE + 6 BUSY + 7 CI
+  8 CHANGE + 9 BIG4 + 10 INVRECV + 11 QUICK + 12 LTD + 13 EBIT
+  14 FOREIGN + 15 SEGMENTS + β16 VAR_ROA + Industry + Fixed + 
Estimated t- Estimated t-
Variable Coefficient statistic Coefficient 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
Industry fixed Yes

Yes
effects
Adjusted R2 74.0% 74.0%
N 3,588 3,588
Notes:
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.

TABLE 8
Analysis of mean audit report delay and industry specialization
Both Tone
and
Business Tone RPT Business
Attribute Non-RPT RPT RPT only only 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 0.340 0.300 *** 0.317 0.298 ** 0.291 ***
>30% (%)
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.

TABLE 9
Audit fee analysis controlling for restatements
Estimated t- Estimated t-
Variable Coefficient statistic Coefficient 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
RESTATEMENT × RP ? 0.055 0.9
RESTATEMENT × 0.107 * 1.8

?
RP_TONE
RESTATEMENT × 0.005 0.1

?
RP_BUSINESS
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

Industry fixed effects Yes Yes
Adjusted R2 74.0% 74,1%
N 3,588 3,588
Notes:
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.

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Article Type: Original Article

Are Related Party Transactions Red Flags? *

MARK KOHLBECK, Florida Atlantic University

BRIAN W. MAYHEW, University of Wisconsin – Madison

October 17, 2016

Are Related Party Transactions Red Flags?

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Are Related Party Transactions Red Flags?

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2. Related party transactions and hypotheses development

Background on related party transactions

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Research on related party transactions

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

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Prob (RESTATEMENT=1) = F (φ0 + φ1 RP_VAR + φ2 AU_SIZE + φ3 NAT_LEADER

+ φ4 LNFEES + φ5 FEERATIO + φ6 LNASSETS + φ7 LEVERAGE + φ8 GROWTH

+ φ15 VAR_ROA + Industry + Year + κ) (1)

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Audit fee model

LNFEES = 0 + 1 RP_VAR +  2 LNASSETS + 3 SHARE + 4 LOSS + 5 LATE

+  6 BUSY + 7 CI +  8 CHANGE + 9 BIG4 + 10 INVRECV

+  11 QUICK +  12 LTD + 13 EBIT + 14 FOREIGN + 15 SEGMENTS

+  16 VAR_ROA + Industry + Year +  (2)

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4. Sample and empirical results

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We report descriptive statistics in panel A of Table 4. Approximately 46 percent and 36 percent

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Restatement sensitivity tests

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Analysis of audit fees

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American Institute of Certified Public Accountants (AICPA). 1997. Statement of Auditing

American Institute of Certified Public Accountants (AICPA). 2012. Statement of Auditing

Beasley, M. S., J. V. Carcello, D. R. Hermanson, and T. L. Neal. 2010. Fraudulent Financial

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International Federation of Accountants (IFAC). 2013. Handbook of International, Quality

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Accounting Review 87 (3) 1033-1065.

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Types of related party transactions

 DOS Tone A related party has either loaned amounts or

 DOS Tone The company guaranteed debt of a related party.

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S&P 1500 firms in 2001, 2004, 3,723

Less firm-year observations:

Missing or zero assets 101

Missing amounts to calculate

Missing prior year observation 8

Final sample (firm-years) 3,588

Distribution by year Restatements Related

RP_TONE 0.000 0.765 * 0.445 0.528 *

AU_SIZE 10.784 10.574 * 10.683 10.545

FEERATIO 0.298 0.334 * 0.314 0.344 *

LNASSETS 14.453 14.802 * 14.699 14.500 *

ROA 0.048 0.035 * 0.044 0.024

LATE 0.040 0.055 0.033 0.122 *