Financial Distress Assessment Using Related Party Transactions

From Indian Journal of Corporate Governance

Financial distress in companies occurs periodically, and when it becomes critical, it often leads to the extreme step of closure of the firm owing to insolvency. A company that is unable to sustain its operations owing to competition and innovation will face financial distress periodically. Common symptoms of financial distress in a company are high debt balances and an inability to pay outstanding interest and loan installments. Financial distress also occurs when the company incurs continuous losses for 3 years or more (Altman et al., 1994; Lin et al., 2016). These losses lead to cash shortages and the inability to pay the operational expenses of the company.

In India, the central bank (Reserve Bank of India, 2021) has identified non-performing assets (NPAs) as those loans to borrowers who are unable to pay their loan installment or interest for more than 90 days from the date, they were due. It is also defined as an asset that becomes non-performing and ceases to generate income for the financial institution.

A process has now been established through which the financially distressed company can be sold completely or asset-wise to new investors. The legislation enacted ensures that there is a timetable for the resolution of this insolvency. The act now allows creditors to file applications against defaulting companies with the National Company Law Tribunal (NCLT) for the start of the Corporate Insolvency Resolution Process as laid down in the new regulations. This article studies the financial data of 18 companies that have insolvency proceedings initiated against them by NCLT. The study focuses on key accounting variables and the related party transactions (RPTs) over the period from 2010 to 2016 for these companies.

Investigations by regulatory bodies have found that tunneling is a method of earnings management where the dominant owners divert funds into their associated companies through transactions with them (India Corporate Fraud Perception Survey, 2018, published by Deloitte). They can take the form of payments against purchases of various current and fixed assets or in the form of sales made to these companies. These can also be loans given to the related firms by the majority owners before the company declares bankruptcy (Gordon et al., 2004).

This article analyses the value of three RPTs: sales made to related parties, loans to related parties and payments made to these companies for services and supplies over the period the company faces financial distress. The article reviews the trend of these transactions over 7 years for 33 companies out of which 18 are in financial distress from 2010 onwards.

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