Arm's Length Transaction

What is an arm's length transaction?

IAS 24.5 defines an arm's length transaction by its terms, not by who the parties are. Two related parties can transact at arm's length if the price and payment terms match what they would agree with an independent counterparty. The concept functions as a measuring stick: the auditor holds the related party transaction up against a hypothetical independent transaction and asks whether the terms are equivalent.

ISA 550.23 requires the auditor to evaluate whether related party transactions outside the entity's normal course of business are appropriately accounted for and disclosed. Where the entity asserts under IAS 24.19 that a related party transaction was conducted at arm's length, the auditor cannot accept this assertion at face value. The auditor needs evidence. Market comparables are the strongest form: what do similar transactions between unrelated parties look like in terms of pricing, payment periods, guarantees, and contractual conditions?

In practice, arm's length evidence is often incomplete. A management fee charged by a parent company to a subsidiary may have no direct comparable because the services are bespoke. In those cases, the auditor evaluates whether the methodology for setting the fee is reasonable (cost-plus, time-based, benchmarked to external consultancy rates) and whether the entity can demonstrate the basis. ISA 550.24 requires the auditor to obtain sufficient appropriate evidence about such assertions. "We've always charged this rate" is not evidence. A documented basis with external reference points is.

Why it matters in practice

The most common error is accepting management's arm's length assertion without testing it against external evidence. ISA 550.24 requires the auditor to obtain sufficient appropriate evidence about the assertion. A working paper that states "management confirmed the transaction was at arm's length" without any independent corroboration (market comparables, independent valuation, documented pricing methodology) does not satisfy the standard.

Teams sometimes evaluate the arm's length nature of a transaction by looking only at the price and ignoring other terms. Payment periods, guarantees, penalty clauses, and termination rights are all part of the arm's length assessment under IAS 24.5. A related party transaction priced at market rate but with 180-day payment terms (when unrelated parties receive 30-day terms) is not at arm's length in substance.

Worked example: Navarro Transportes S.L.

Client: Spanish logistics company, FY2024, revenue €120M, IFRS reporter, 70% owned by a family holding company (Navarro Group S.L.) that also owns a warehouse business and a fuel distribution company. The team identifies four categories of transactions with group entities: warehouse rental of €2.4M per year, fuel purchases of €8.1M, a management fee of €600K, and an intercompany loan of €5M at 3.2% interest.

For the warehouse rental, the team compares the €2.4M annual rental against market data. Two comparable industrial warehouse leases in the same logistics zone near Valencia were entered into by unrelated parties during FY2024: one at €18/m² per month and one at €20/m² per month. Navarro's rental equates to €22/m² per month. The premium of 10–22% over market rate raises a question about whether the terms are arm's length.

For the intercompany loan, the 3.2% interest rate is compared against Navarro's external borrowing rate (4.1% from Banco Santander on a comparable facility). The intercompany rate is below market rate by 90 basis points. The holding company provides no documentation of a credit assessment or rate-setting methodology. Management asserts that all intercompany transactions are at arm's length, but for the warehouse rental and the intercompany loan, the evidence does not support this assertion. The team evaluates whether IAS 24.19 disclosure of the arm's length assertion is appropriate given the evidence, or whether additional disclosure of the terms is needed.

Arm's length transaction vs related parties

An arm's length transaction is defined by its terms. A related party relationship is defined by the identity and connections of the parties. A transaction can be between related parties and still be at arm's length if the pricing and conditions match what independent parties would agree. Conversely, an entity can have dozens of related party relationships where every transaction is conducted at market-normal terms.

The audit issue is that related party relationships create the conditions under which non-arm's-length transactions can occur without the commercial friction that would normally correct the pricing. IAS 24.19 permits arm's length assertions, but only when they can be substantiated. ISA 550.23 and 550.24 require the auditor to evaluate the evidence behind the assertion. The relationship identifies the risk. The arm's length assessment tests it.

Key standard references

• IAS 24.5: Defines an arm's length transaction by its terms – what independent, unrelated parties would agree to in comparable circumstances.
• IAS 24.19: Permits the entity to assert that a related party transaction was at arm's length, but only if that assertion can be substantiated.
• ISA 550.23: Requires the auditor to evaluate whether related party transactions outside normal business are appropriately accounted for and disclosed.
• ISA 550.24: Requires the auditor to obtain sufficient appropriate evidence about arm's length assertions made by the entity.
• IAS 24.18: Disclosure requirements for related party transactions, including the nature of the relationship and amounts involved.

Related terms

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