There are inherent risks with transactions between related parties. Graham Holt describes the requirements of IAS 24 and IFRS 11
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
This article was first published in the July/August 2016 international edition of Accounting and Business magazine.
Related party relationships are a natural feature of business activity and could have an effect on the financial performance and position of an entity because of related party influence. Even if there are no transactions between related parties, their existence may affect transactions of the reporting entity with other parties because of significant influence. There is an inherent risk that transactions with a related party might be on favourable terms with a potential impact on profitability. Related party disclosure can contain important stewardship information.
The United Nations Conference on Trade and Development (UNCTAD) guidance on good corporate governance recognises that disclosure of related party transactions and any related party relationships where control exists should be disclosed as well as disclosure of the decision-making process for approving related party transactions.
Although IAS 24, Related Party Disclosures (2009), sets out the scope of related party disclosures, it does not apply to the measurement of related party transactions. Prior to the current standard, the definition of a related party in IAS 24 had been the subject of criticism because some believed that it was inherently inconsistent and too complex to apply in practice because it included multiple cross-references that were difficult to interpret.
The International Accounting Standards Board (IASB) therefore simplified the definition of a related party whilst providing relief for government-related entities as regards the amount of information such entities needed to disclose.
A related party can be a person or an entity. Therefore the standard separates the definition of a related party into two parts. First, a related party can be a person or a close member of that person’s family where that person has control or joint control or significant influence over the reporting entity or is a member of the key management personnel.
Second, IAS 24 sets out several conditions where an entity is related to a reporting entity. Examples of these are where the entity and the reporting entity are members of the same group, where one entity is an associate or joint venture of the other and where both are joint ventures of the same third party.
The definition of a related party includes joint ventures but not joint operations. The list of related parties in IAS 24 is exhaustive and joint operations are not included in that list and are therefore outside its scope. The exclusion is not discussed in the standard but it is consistent with the principle that joint operations are viewed as part of the entity itself. It is also consistent with IFRS 12, Disclosure of Interests in Other Entities, which does not require summarised financial information for joint operations.
Additionally, under IFRS 11, Joint Arrangements, each of the transactions, assets and liabilities of a joint operation is attributable to one or other of the participants and each participant recognises the amounts in its own financial statements. Since these transactions are viewed as the participant’s own transactions, a participant in a joint operation does not need to disclose transactions with the joint operation entity as related party transactions.
In formulating the definition of a related party, the IASB adopted the specific approach, which it outlined in the ‘Basis for Conclusions’. When an entity assesses whether two parties are related, it should interpret significant influence as being equivalent to the relationship that exists between an entity and a member of its key management personnel. Thus significant influence and key management personnel relationships are treated as the same level of closeness.
However, the IASB goes on to state that such relationships are not as close as a relationship of control or joint control. All direct relationships involving control, joint control or significant influence are related party relationships. Further if one entity (or person) controls (or jointly controls) a second entity and the first entity (or person) has significant influence over a third entity, the second and third entities are related to each other. Conversely, if two entities are both subject to significant influence by the same entity (or person), the two entities are not related to each other. Finally, if one party is related to a second party, the second party is also related to the first party because of the symmetrical nature of their relationship.
Relationships between a reporting entity and a corporate investor and between a reporting entity and an individual investor are treated in the same manner. In analysing related party relationships, an individual and close members of that individual’s family are treated as one party as are members of the same group. A post-employment benefit plan for employees of the reporting entity is considered to be a related party of that entity and the definition of a related party was extended by the Annual Improvements 2010-2012. This ‘improvement’ clarified that an entity providing key management personnel to the reporting entity is itself a related party of the reporting entity.
IAS 24 contains no specific exemptions for intragroup transactions in consolidated financial statements. When intragroup transactions are eliminated, they are not part of the group financial statements and are therefore not disclosed under IAS 24. However, the amendments to accounting standards relating to investment entities have the effect that intragroup related party transactions between an investment entity and its subsidiaries that are measured at fair value through profit or loss, are not eliminated in the group financial statements.
As a result, transactions and any amounts outstanding between an investment entity and its unconsolidated subsidiaries are disclosed under IAS 24. Many jurisdictions have extensive management remuneration disclosure requirements, which may overlap with the requirements of IAS 24. The financial statements must include the disclosures required by IAS 24, but only have to include the additional local jurisdictional disclosures if so specified in local law.
IAS 24 does not specifically state whether a related relationship should exist at the reporting date for the transactions to be reported. It is, therefore, not apparent whether all related party events and transactions for the period should be disclosed.
Related parties relationships can commence and cease in the period, leaving questions as to whether disclosure should be made of the transactions before or after these relationships started or ended. However, para 18 of IAS 24 states that ‘if an entity has had related party transactions during the periods covered by the financial statements, it shall disclose the nature of the relationship as well as information about those transactions and outstanding balances, including commitments, necessary for users to understand the potential effect of the relationship on the financial statements’.
The principle to be applied is whether there has been sufficient disclosure made to enable users to assess the potential impact of related party transactions on the entity’s financial position and performance. Also, regardless of whether there have been transactions between a parent and a subsidiary, an entity must disclose the name of its parent and, if different, the ultimate controlling party. Where parties become related after the date of the financial statements, but before the financial statements are authorised, it may constitute a non-adjusting event under IAS 10, Events After the Reporting Period.
In determining whether a related party transaction exists, the substance of the relationship and not merely the legal form must be considered. IAS 24 gives examples of situations where parties are not necessarily related. For example, entities may have a common member of key management or may be economically dependent upon each other but these situations do not necessarily mean that the entities are related unless there is some other connection. Similarly, two venturers are not necessarily related parties simply because they share joint control over a joint venture.
In some jurisdictions, entities face challenges in identifying and disclosing related party transactions among government-related entities. Government may not be able to exert sufficient influence over economic transactions with related parties or in some circumstances entities may not be able to identify government related entities. IAS 24 gives an entity exemption from the disclosure of transactions with a related party that is either a government that has control, joint control or significant influence over the entity or is another entity that is under the control, joint control or significant influence of the same government as the entity. If the entity applies the exemption, then there are alternative disclosures which must be made.
Many accounting frauds have involved related party transactions and this has created concern among market participants about appropriate disclosures and the auditing of those transactions. These types of transactions are considered to pose an increased risk of material misstatement in financial statements.
Partially, as a result of these concerns, the US Securities and Exchange Commission has approved a Public Company Accounting Oversight Board standard on auditing transactions with related parties. As a result, companies will need to revisit the controls they have in place to identify, account for and disclose related party transactions.
In order to meet some of the recent requirements, auditors will need management assistance. For example, for any related party transactions that require financial statement disclosure or represent a significant risk, the standard makes explicit that auditors will have to evaluate the ability of the related parties to meet any financial obligations. Clearly, such transactions should be viewed with increased auditor scepticism.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan Business School
CPD technical article
"In determining whether a related party transaction exists, the substance of the relationship and not merely the legal form must be considered"