Concepts, Rules, and Examples

The Need for Related-Party Disclosures

For strategic reasons, enterprises sometimes carry out certain aspects of their business activity through associates or subsidiaries. For example, in order to ensure that it has a guaranteed supply of raw materials, an enterprise may decide to purchase a major portion of its requirements (of raw materials) through a subsidiary. This is referred to as vertical integration. A variant of this phenomenon could be the following: an enterprise whose subsidiaries are in diverse businesses that are quite dissimilar to the business of the parent may decide to make a substantial trade investment in the business of its major supplier. In this way, it could control or exercise significant influence over the financial and operating decisions of its major supplier (the investee). Such related-party relationships and transactions are a normal feature of commerce and business.

A related-party relationship could have an impact on the financial position and operating results of the reporting enterprise because of any of the following reasons:

1. Related parties may enter into certain transactions with each other which unrelated parties may not normally want to enter into.

2. Amounts charged for transactions between related parties may not be comparable to amounts charged for similar transactions between unrelated parties.

3. The mere existence of the relationship may sometimes be sufficient to affect the dealings of the reporting enterprise with other (unrelated) parties. (For instance, an enterprise may stop purchasing from its major supplier on acquiring a subsidiary which is a competitor of its [erstwhile] major supplier.)

4. Transactions between enterprises would not have taken place if the related-party relationship had not existed. For example, a company sells its entire output to an associate at cost. It would not have survived but for these related-party sales to the associate, since it does not have any takers for the kind of goods it deals in. In other words, the only reason it remains in business is because it is able to sell its total output to an associate that is committed to purchase its total production.

Because of peculiarities such as the above that distinguish related-party transactions from transactions with unrelated parties, accounting standards (including IAS) have almost universally mandated financial statement disclosure of such transactions. Disclosures of related-party transactions in financial statements, in a way, is a means of conveying a message to users of financial statements that certain related-party relationships exist as of the date of the financial statements, or certain transactions were consummated with related parties during the period which the financial statements cover, and the results of these related-party transactions have been incorporated in the financial statements being presented. Since related-party transactions could have an effect on the financial position and operating results of the reporting enterprise, disclosure of such transactions would be prudent based on the much-acclaimed principle of transparency (in financial statements). In this way, the users of financial statements could make informed decisions while using the information presented to them in the financial statements.

Scope of the Standard

IAS 24 is to be applied in dealing with related parties and transactions between a reporting enterprise and its related parties. The requirements of this standard apply to the financial statements of each reporting enterprise.

Applicability

The requirements of the standard should be applied only to the related-party relationships described in IAS 24, paragraph 3, which are summarized below.

1. Enterprises that control (directly or indirectly through intermediaries) or are controlled by, or are under common control with the reporting enterprise. Examples: parent company, subsidiaries, and fellow subsidiaries;

2. Associates, as defined in IAS 28;

3. Individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them significant influence over the enterprise, and close members of the family of any such individual;

4. Key management personnel and close members of the families of such individuals; and

5. Enterprises in which a substantial interest in the voting power is owned, directly or indirectly, by any person described in c. or d. above, or over which such a person is able to exercise significant influence. This includes enterprises owned by

   • Directors of the reporting enterprise;

   • Major shareholders of the reporting enterprise; and

   • Enterprises that have a member of key management in common with the reporting enterprise.

Substance over Form

The standard clarifies that in applying the deeming provisions of IAS 24 to each possible related-party relationship, consideration should be given to the substance of the relationship and not merely the legal form.

Exclusions

IAS 24, paragraph 6, does not consider the following as being related parties for the purposes of the standard. In other words, the standard specifically excludes the following:

1. Two companies having only a common director, notwithstanding the specific requirements of IAS 24, paragraphs 3(d) and 3(e) summarized above. However, if the common director is in fact able to affect the policies of both companies in their mutual dealing, then such a possibility has to be evaluated on its own merits.

2. Certain agencies, entities, or departments which have a major role to play in the enterprises day-to-day business. For example

   1. Providers of finance (banks and creditors)

   2. Trade unions

   3. Public utilities

   4. Government departments and agencies

3. Entities upon which the enterprise may be economically dependent, due to the volume of business the enterprise transacts with them. For example

   1. A single customer;

   2. A major supplier;

   3. A franchisor;

   4. A distributor; or

   5. A general agent.

Exemptions

IAS 24, paragraph 4, exempts disclosure of related-party transactions in the following cases:

1. In consolidated financial statements, in respect of intragroup transactions;

2. In parent company's financial statements, when they are published or made available, say, by being attached to the consolidated financial statements;

3. In financial statements of wholly owned subsidiary, if its parent, which is incorporated in the same country, provides consolidated financial statements in that country; and

4. In financial statements of state-controlled enterprises, with respect to transactions with other state-controlled enterprises.

The standard does not require that any indication be given in the financial statements that transactions occurred that fell within these exemptions.

Significant Influence

The existence of the ability to exercise significant influence is an important concept in relation to this standard. It is one of the two criteria mentioned in the definition of a related party, which when present would, for the purposes of this standard, make one party related to another. In other words, for the purposes of this standard, if one party is considered to have the ability to exercise significant influence over another, then by virtue of this requirement of the standard, the two parties are considered to be related.

The existence of the ability to exercise significant influence may be evidenced in one or more of the following ways:

1. By representation on the board of directors of the other enterprise;

2. By participation in the policy-making process of the other enterprise;

3. By having material intercompany transactions between two enterprises;

4. By interchange of managerial personnel between two enterprises; or

5. By dependence on another enterprise for technical information.

Significant influence may be gained through agreement or statute or share ownership. Under the provisions of IAS 24, similar to the presumption of significant influence under IAS 28, an enterprise is deemed to possess the ability to exercise significant influence if it directly or indirectly through subsidiaries holds 20% or more of the voting power of another enterprise (unless it can be clearly demonstrated that despite holding such voting power the investor does not have the ability to exercise significant influence over the investee). Conversely, if an enterprise, directly or indirectly through subsidiaries, owns less than 20% of the voting power of another enterprise, it is presumed that the investor does not possess the ability to exercise significant influence (unless it can be clearly demonstrated that the investor does have such an ability despite holding less than 20% of the voting power). Further, while explaining the concept of significant influence, IAS 28 also clarifies that "a substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence" (emphasis added).

In the authors' opinion, by defining the term "related party" to include the concepts of control and significant influence, and by further broadening the definition to cover not just direct related-party relationships, but even indirect ones like those with "close members of the family of an individual," the IASC has cast a wide net to cover related-party transactions which would normally not be considered otherwise. This makes disclosures under this standard subjective, and the related-party issue itself a more contentious one, since it lends itself to aggressive interpretations by the reporting enterprise. This obviously could have a significant bearing on the related-party disclosures emanating from these interpretations. On the one hand, based on a strict interpretation of the provisions of the standard, certain hitherto unreported related-party transactions may now have to be disclosed, but on the other hand, reporting enterprises may not do so, based on an aggressive stand taken by them. However, in taking such an aggressive stance, the reporting enterprises are well advised to get ready with good strong reasoning to support any nondisclosure of related-party transactions, lest they cross the thin line of not fully complying with IAS under the revised IAS 1, which may have serious repercussions in terms of financial statement reporting under IAS.

Methods of Pricing Related-Party Transactions

The transfer of resources between business entities is given accounting recognition based on the prices charged for transactions between them. Normally, prices charged in unrelated-party transactions are arm's-length prices. However, a related party may have some degree of flexibility in setting prices for related-party transactions by virtue of either the existence of control or the ability to exercise significant influence over the other party.

Pricing of transactions between related parties can be accomplished in a variety of ways. The following methods are some of the ways that related-party transactions may be priced:

1. Comparable uncontrolled price method

   When merchandise supplied in a related-party transaction and the conditions relating thereto are similar to normal trading conditions, this method is used. Under this method, prices are set by reference to similar (comparable) goods sold in an economically similar (comparable) market to a buyer unrelated to the seller.

2. Resale price method

   When the sale of the merchandise is routed through a related party, or the goods are first transferred to a related party before their actual sale to an independent third party, this method is often used. Under the resale price method, the "resale price" to be charged by the ultimate seller, in this case the intermediary related party, is reduced by a margin in order to arrive at a transfer price to be charged to the intermediary related party, the reseller. The margin represents an amount from which the reseller would seek to cover his costs and make an appropriate profit.

3. Cost-plus method

   When the parties intend to add a certain markup to the cost of the merchandise, this method is used. Under this method, a certain percentage is added as a markup to the supplier's cost. The percentage of markup is normally based on comparable returns in similar businesses or industries based on either capital employed or turnover.

Besides the foregoing three pricing methods, the standard also recognizes these two special situations.

1. Where "no price" is charged between related parties; for instance, in the case of sharing of common services (e.g., secretarial services at the group corporate headquarters) by related companies free of cost, or free provision of management services to certain companies in the group, or the extension of free credit to an associate, resulting in intercorporate debt at no interest; and

2. Where transactions are priced at cost; otherwise transactions would not have taken place if such a related-party relationship did not exist.

To illustrate this, let us consider the following example of a vertical integration:

• Subsidiary A sells most of its production to fellow Subsidiary B, at cost, because Subsidiary A was specially established by the parent company in order to ensure the timely supply of raw materials to Subsidiary B, which has traditionally experienced stoppages in work due to erratic supply of essential raw materials. Thus, a major portion of the production of Subsidiary A is sold to Subsidiary B. Also, the product that Subsidiary A produces has no demand in the market it operates in; thus it sells most of its production to its fellow subsidiary at cost (since it would be unable to break even otherwise).

Financial Statement Disclosures

IAS 24 recognizes that in many countries certain related-party disclosures are prescribed by law. Particularly transactions with directors, because of the fiduciary nature of their relationship with the enterprise, are mandated financial statement disclosures in those countries. In fact, the corporate legislations in some countries go a step further and require certain disclosures which are even more stringent than the disclosure requirements under IAS 24, or for that matter, disclosure requirements under most leading accounting standards.

For example, under the Companies Act of a certain country, besides the usual disclosures pertaining to related-party transactions, under the corporate law, companies are required to disclose not just year-end balances that are due to or due from directors or certain other related parties, but are required to disclose even the highest balances for the period (for which financial statements are presented) which were due to or due from them to the corporate entity. In the authors' opinion, the IASC might consider specifically adding such a requirement to the current list of disclosures under IAS 24, since the present requirement to disclose only outstanding balances with related parties as of the balance sheet date lends itself to manipulations by the reporting enterprises.

For example, an enterprise which has advanced large sums of money to its directors could make arrangements with the directors to get them to repay the loans to the enterprise a few days before the last day of the reporting period and agree to loan back to those directors these amounts right after the first day of the next reporting period. Under the present disclosure requirements in IAS 24 (discussed below), it does not appear that such amounts of loans to directors (despite being material) would need to be disclosed, since none of them were actually outstanding at the end of the reporting period. However, if the requirements of IAS 24 were extended to include disclosure of not just outstanding balances at the end of the reporting period, but also the highest balance(s) due to or due from related parties during the period for which the financial statements are presented, then such manipulations, like the above-mentioned artifice, would be caught under such broad disclosure requirements.

In the authors' further opinion, such additional disclosures appear to be within the spirit of the standard and would go a long way in improving or rather enhancing transparency in financial reporting. It should be noted that under IAS 30, paragraph 58(a), banks and similar financial institutions are specifically required to make this additional disclosure (for a detailed discussion of disclosures of related-party transactions in the case of banks and similar financial institutions, see Chapter 24).

IAS 24, paragraph 19, provides examples of situations where related-party transactions may lead to disclosures by a reporting enterprise in the period that they affect.

• Purchases or sales of goods (finished or unfinished, meaning work in progress)

• Purchases or sales of property and other assets

• Rendering or receiving of services

• Agency arrangements

• Leasing arrangement

• Transfer of research and development

• License agreements

• Finance (including loans and equity participation in cash or in kind)

• Guarantees and collaterals

• Management contracts

The foregoing should not be considered an exhaustive list of situations requiring disclosure, and as very clearly stated in the standard, these are only "examples of situations . . . which may lead to disclosures." In practice, many other situations are encountered which would warrant disclosure. For example, a maintenance contract for maintaining and servicing computers, entered into with a subsidiary company, would need to be disclosed by the reporting enterprise.

IAS 24, paragraphs 20 and 21, require disclosure of a related-party relationship where control exists, irrespective of whether there have been transactions between the related parties. In the authors' opinion, it is worth noting that an important aspect of this requirement which may not be very obvious to the reader is that disclosure is only necessary under this requirement of the standard in the case of a related-party relationship that arises only through control. Thus, by inference, one would conclude that in the case of a related-party relationship by virtue of significant influence, there is no need to disclose a related-party relationship under this requirement of the standard, unless there have been actual transactions based on this relationship.

To illustrate this point, let us consider the following example:

• Company A owns 25% of Company B, and by virtue of share ownership of more than 20% of the voting power, would be considered to possess the ability to exercise significant influence over Company B. During the year, Company A entered into an agency agreement with Company B; however, no transactions took place during the year between the two companies based on the agency contract. Since Company A is considered a related party to Company B by virtue of the ability to exercise significant influence, no disclosure of this related-party relationship would be needed under IAS 24, paragraphs 20 and 21. In case, however, Company A owned 51% or more of the voting power of Company B and thereby would be considered related to Company B on the basis of control instead, disclosure of this relationship would be needed, irrespective of whether any transactions actually took place between them.

Per IAS 24, paragraph 22, if there have been transactions between related parties, the reporting enterprise should disclose

• The nature of the related-party transaction

• The type of transactions

• The elements of the transactions necessary for an understanding of the financial statements

The elements necessary for an understanding of the financial statements, as per IAS 24, paragraph 23, would normally include

• An indication of the volume of the transactions, either as an amount or an appropriate proportion

• Amounts or appropriate proportions of outstanding items

• Pricing policies

Thus, for example, when an enterprise purchases raw materials amounting to $5 million from an associated company, and these purchases account for 75% of its total purchases for the year, the following disclosures under the above requirement would seem appropriate:

• During the year, purchases amounting to $5 million (alternative wording: 75% of purchases for the year) were made from an associated company. These purchases were made at normal commercial terms. At December 31, 2003, the balance remaining outstanding from this associated company amounted to $ 2.3 million.

IAS 24, paragraph 24, requires that items of a similar nature may be disclosed in aggregate. However, when separate disclosure is necessary for an understanding of the effects of the related-party transactions on the financial statements of the reporting enterprise, aggregation is not proper.

A good example of an aggregated disclosure is total sales made during the year to a number of associated companies, instead of separately disclosing sales made to each associated company. Further, an example of a separate disclosure (as opposed to aggregated disclosure) is the disclosure of year-end balances from various related parties disclosed separately by category (e.g., directors, associated companies, etc.) In the latter case, it makes sense to disclose separately by categories of related parties, instead of aggregating all balances from various related parties together and disclosing, say, the total amount due from all related parties as one amount. In fact, separate disclosure in this case seems necessary for an understanding of the effects of related-party transactions on the financial statements of the reporting enterprise.

IAS 24, paragraph 24, reiterates one of the exemptions from disclosure mandated earlier in the standard, (i.e., in paragraph 4[a]). which was discussed earlier in this chapter. Per IAS 24, paragraph 24, disclosure of transactions between members of a group is unnecessary in consolidated financial statements, since the consolidated financial statements present information about the parent and subsidiaries as a single reporting enterprise. However, in the case of associated companies, since they are not presented as a single reporting enterprise, and intracompany transactions are not eliminated (due to use of the equity method of accounting), separate disclosure of related-party transactions is warranted.

IAS 24, paragraph 18, specifically mentions other IAS, wherein disclosures of related-party transactions have been prescribed as well. The following IAS have been cited by IAS 24:

• IAS 5, which calls for disclosure of significant intercompany transactions and investments in, and balances with, group and associated companies

  Note

  This standard has been repealed and replaced by IAS 1 which contains similar disclosure requirements.

• IAS 27, which requires disclosure of a list of significant subsidiaries

• IAS 28, which requires disclosure of a list of significant associates

• IAS 8, which requires disclosure of extraordinary items and exceptional items (i.e., those that are of such size, nature, or incidence that their disclosure is relevant to explain the performance of the enterprise) that arise in transactions with related parties

Proposed Changes to Related-Party Disclosure Requirements

The IASB's Improvements Project has resulted in proposed changes to IAS 24. The changes proposed will revise the scope of required disclosures.

Language would be added to clarify that the standard does not require disclosure of management compensation, expense allowances, and similar items paid in the ordinary course of an entity's operations.

Examples of related parties presently would be relocated within the standard. The present exemption of financial statements of state-controlled enterprises from disclosing transactions with other state-controlled enterprises would be eliminated—thus, related-party disclosures would be more broadly defined under the revised IAS 24. The definition of related parties would be expanded to include parties with joint control over the entity; joint ventures in which the entity is a venturer; and postemployment benefit plans for the benefit of employees of the entity, or of any entity that is a related party of the entity. However, two venturers would not be deemed related parties simply because they share control over a joint venture.

The proposed amendment will also clarify, in the definition of related party, that nonexecutive directors are key management personnel. A definition of "close members of the family of an individual" would also be added.

The IASB proposes to eliminate the current IAS 24 discussion of methods used to price transactions between related parties. There is no requirement for remeasurement of related-party transactions. It would be made a requirement that amounts of related-party transactions be disclosed—the current practice of disclosing proportions of transactions and outstanding balances in respect of related parties would be banned henceforth.

IAS 24's present set of examples of transactions that are to be disclosed if they are with a related party would be expanded to include a settlement of liabilities on behalf of the entity or by the entity on behalf of another party.

New disclosure requirements about outstanding balances with related parties would be added also. These include their terms and conditions including whether they are secured, and the nature of the consideration to be provided in settlement; details of any guarantees given or received; and provisions for doubtful debts. The established subclassification of amounts payable to, and receivable from, different categories of related parties would be extended to provide a more comprehensive analysis of these related-party balances and would also apply to related-party transactions.

A requirement will be added by amended IAS 24 to disclose the expense recognized during the period in respect of bad or doubtful debts due from related parties. It will be clarified that any representations that related-party transactions were made on terms equivalent to those that prevail in arm's-length transactions can be made only if such disclosures can be substantiated. Finally, the current provision relating to the expected disclosure of pricing policies for related-party transactions would be eliminated.