By Kuo-Ming Hunag & Yu-Hsuan Wu, Senior Partner & Associate of Formosan Brothers, Attorneys-at-Law

Imagine the following: President X of a listed company, Company A, originally planned to obtain financing from a bank a year later, but, due to the rapid decline of the industry Company A was in, Company A’s revenue fell sharply and its stock price plummeted as a result. For the company’s financing needs and to maintain the company’s stock price at a certain level, X came up with the idea of inflating revenue. So, through an agent, X set up a paper company B that seemed to have actual operations and found a former employee Y to act as the representative of Company B. Later, A and B began to conduct fake transactions to inflate revenue.

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Now comes an important question: Are the transactions between A and B transactions with a related party? If they are considered related-party transactions, Company A must disclose them in the notes section of its financial statements. If they are not disclosed, Company A would be running the risk of misrepresentation in financial statements.

As to whether the transactions between companies A and B may be characterized as related-party transactions, Article 2 of the Statement of Financial Accounting Standards No. 6 on “disclosure of related-party transactions” has the definition of a related party, that is: A party is usually a related party of an enterprise if it meets, in form, one of the following scenarios: 1. a company invested by the enterprise where the investment is valued by the equity method; 2. an investor whose investments in the Company is valued by the equity method; 3. a company whose chairman or general manager is the same person as or is the spouse or a relative within the second degree of kinship of the chairman or general manager of the enterprise; 4. a foundation receiving donation from the enterprise in the amount representing 1/3 or more of the total funds of such foundation; 5. a director, supervisor, general manager, deputy general manager, assistant general manager or department head under the direct supervision of the general manager of the enterprise; 6. the spouse of a director, supervisor or general manager of the enterprise; 7. a relative within the second degree of kinship of the chairman or general manager of the enterprise.

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However, those who would engage in criminal acts usually would not conduct transactions under the seven circumstances above. For example, X would not transact with people within his second degree of kinship, such as his spouse or son. If he really wants to, he would find a distant relative. And he would not transact with someone currently on A’s management team. Instead, he would use a former employee or chauffeur. That is, a smart criminal would, before committing a crime, read the relevant laws and try to circumvent them. Therefore, the provision, “when determining whether a party is a related party, in addition to legal forms, one needs to consider the ‘substantive relationship,’” in Article 2 of the Statement of Financial Accounting Standards No. 6 becomes very important.

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Then, what does it mean to have “substantive” control? Although Article 5 of the Statement of Financial Accounting Standards (SFAS) No. 5 mentioned five circumstances, in practice, it is often determined based on whether company A can control the financial, operational, or personnel aspects of company B. For example, it would be suspect of substantive control if the prosecutor and investigator conduct a search at company B and finds that B does not have a bookkeeper; the bookkeeping of Company B is completely handled by Company A. Further on the paperwork of the suspect transactions, one finds that, in addition to the seal of Company B’s president Y to show approval, all of them were instructed by president X of Company A through stick-it notes on whether to proceed or not. Moreover, important personnel matters of Company B are all needed to be approved by X.  

What is horrific and worrisome about the aforementioned examples is that those who truly intend to commit crimes do so through parties that they are not formally related to but can control. And these types of transactions, since they are not conducted between parties who are related “in form,” are often difficult to be discovered by the company’s directors, accounting managers, accountants, or investors. And since they are hard to find, the company’s accounting managers naturally would not want to disclose them in financial statements. As a result, the company’s accounting manager(s) (or even the directors) end up being prosecuted for misrepresentation in financial statements because of those hard-to-find transactions.

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Financial crimes often involve using tools such as nominees and paper companies to conduct irregular transactions and special offenses of breach of trust. However, the legal risk of misrepresentation in financial statements is often overlooked. It is our recommendation that company directors or accounting managers, when choosing continuing education courses, can consider taking courses on misrepresentation in financial statements (especially those on the common features of misrepresentation in financial statements, liabilities of directors and supervisors, or what directors and supervisors can do to self-protect). And, when performing their duties, for transactions that are different from past practices or intuitively perceived to be abnormal, it is recommended that they leave a track record in the relevant discussions, emails, or approval paperwork to appropriately minimize the legal risk of misrepresentation in financial statements.

(This article was published in the Expert’s Commentary Column of the Commercial Times：https://view.ctee.com.tw/tax/37972.html）

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