The Need for Related Party Disclosures

For strategic or other reasons, entities will sometimes carry out certain aspects of their business activities through associates, joint ventures or subsidiaries. For example, in order to ensure that it has a guaranteed supply of raw materials, an entity may decide to purchase a portion of its requirements (of raw materials) through a subsidiary or, alternatively, will make a direct investment in its vendor to assure continuity of supply. In this way, the entity might be able to control or exercise significant influence over the financial and operating decisions of its major supplier (the investee), including ensuring a source of supply and, perhaps, affecting the prices charged. Such related party relationships and transactions are thus a normal feature of commerce and business, and need not suggest any inappropriate behaviour.

A related party relationship could have an impact on the financial position and operating results of the reporting entity because:

1. Related parties may enter into certain transactions with each other which unrelated parties may not normally want to enter into (e.g., uneconomic transactions and transactions done at negotiated terms).
2. Amounts charged for transactions between related parties may not be comparable to amounts charged for similar transactions between unrelated parties (either higher or lower prices than arm's length).
3. The mere existence of the relationship may sometimes be sufficient to affect the dealings of the reporting entity with other (unrelated) parties. (For instance, an entity may cease purchasing from its former major supplier upon acquiring a subsidiary which is the other supplier's competitor.)
4. Transactions between entities 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. The producing entity might not have survived but for these related party sales to the associate, if it did not have enough business with arm's-length customers for the kind of goods it manufactures.
5. The existence of related party relationships may result in certain transactions not taking place, which otherwise would have occurred. Thus, even in the absence of actual transactions with related entities, the mere fact that these relationships exist could constitute material information from the viewpoints of various users of financial statements, including current and potential vendors, customers and employees. Related party information is thus unique, in that even an absence of transactions might be deemed a material disclosure matter.
6. Certain related party transactions may have tax implications, especially if transactions are carried out at negotiated terms across borders.

Because of issues such as those mentioned above, which often distinguish related party transactions from those with unrelated entities, accounting standards (including IFRS) have almost universally mandated financial statement disclosure of such transactions. Disclosures of related party transactions in financial statements is a means of conveying to users of financial statements the messages that certain related party relationships exist as of the date of the financial statements, and that certain transactions were consummated with related parties during the period which the financial statements cover, together with the financial impacts of these related party transactions in the financial statements. Since related party transactions could have an effect on the financial position and operating results of the reporting entity, disclosure of such transactions would be prudent based on the increasingly cited principle of transparency (in financial reporting). Only if such information is disclosed to the users of financial statements will they be able to make informed decisions.

Scope of the Standard

IAS 24 is to be applied in dealing with related parties and transactions between a reporting entity and its related parties. The requirements of this standard apply to the financial statements of each reporting entity. IAS 24 sets forth disclosure requirements only; it does not prescribe the accounting for related party transactions, nor does it address the measurements to be applied in the instance of such transactions. Thus, related party transactions are reported at the nominal values ascribed to them, and are not subject to further interpretation for financial reporting purposes, since there is generally no basis upon which to conclude, or even speculate, about the extent to which related party transactions might approximate or vary from those between unrelated parties with regard to prices or other terms of sale. IAS 24 does, however, prescribe that transactions with related parties will only be described as having taken place at an arm's length if that is factually correct.

IAS 24 is to be employed in determining the existence of related party relationships and transactions; identifying the outstanding balances, including commitments, between related parties; concluding on whether disclosures are required under the circumstances; and determining the content of such disclosures.

Related party disclosures are required not only in the consolidated (group) financial statements, but also in the separate financial statements of the parent entity, venturer or investor. In separate statements: any intragroup transactions and balances must be disclosed in the related party note, although these will be eliminated in consolidated financial reports. When intragroup transactions and balances are eliminated on consolidation such transactions and balances are not required to be disclosed under IAS 24. However, transactions and balances between an investment entity and its subsidiaries that are accounted for at fair value through profit or loss (and therefore not consolidated) need to be disclosed.

IAS 24 does not address the issue of timing when two parties become or cease to become related and whether disclosures are required of transactions with a party that was related for only part of the reporting period. The recommended practice is that where a transaction took place while the party was related, it should be disclosed. In respect of balances with related parties, these should be disclosed either if the transaction took place when the parties were related, or if the parties were related at the reporting date. In respect of parent and ultimate parent disclosures, where there was a change during the reporting period, this change should be disclosed including details of the previous parent, new parent and ultimate controlling party.

Applicability

The requirements of the standard should be applied to related parties as identified in the definition of a related party.

Substance over Form

The standard clarifies that in applying the provisions of IAS 24 to each possible related party relationship, consideration should be given to the substance of the relationship and not merely to its legal form. Thus, certain relationships might not rise to the level of related parties for the purpose of necessitating disclosure under the provisions of IAS 24. Examples of such situations:

1. Two entities having only a common director or other key management personnel, notwithstanding the specific requirements of IAS 24 above.
2. Agencies and entities such as:
   1. Providers of finance (e.g., banks and creditors);
   2. Trade unions;
   3. Public utilities;
   4. Government departments and agencies.
3. Entities upon which the reporting entity may be economically dependent, due to the volume of business the entity transacts with them. For example:
   1. A single customer;
   2. A major supplier;
   3. A franchisor;
   4. A distributor; or
   5. A general agent.
4. Two venturers, simply because they share joint control over a joint venture.

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 stipulated 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 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 entity;
2. By one company having influence over a decision by the virtue of a casting vote at a meeting of directors or shareholders;
3. By participation in the policy-making process of the other entity;
4. By having material intercompany transactions between two entities;
5. By interchange of managerial personnel between two entities; or
6. By dependence on another entity for technical information.

Significant influence may be gained through agreement, by statute or by means of share ownership. Under the provisions of IAS 24, similar to the presumption of significant influence under IAS 28, an entity 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 entity (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 entity, directly or indirectly through subsidiaries, owns less than 20% of the voting power of another entity, 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).

Financial Statement Disclosures

IAS 24 recognises that in many countries certain related party disclosures are prescribed by law. In particular, transactions with directors, because of the fiduciary nature of their relationship with the entity, are mandated financial statement disclosures in some jurisdictions. In fact, corporate legislation in some countries goes further and requires certain disclosures which are even more stringent than the disclosure requirements under IAS 24, or under most national GAAP.

For example, under one regulation, in addition to the usual disclosures pertaining to related party transactions, 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 also required to disclose the highest balances for the period (for which financial statements are presented) which were due to or due from them to the corporate entity. Such a requirement may exist since in the absence of this disclosure, balances at year-end can be “cleaned up” (e.g., via short-term bank borrowings) and the artificially low amounts reported can provide a misleading picture to financial statement users regarding the real magnitude of such transactions and balances.

There is nothing in IAS 24 that prohibits supplemental information from being provided over and above the requirements of the standard. Commitment to a “substance over form” approach, with the goal of maximising representational faithfulness and ensuring transparency of the financial reporting process, would, indeed, make expanded disclosures appear all but mandatory. While many do seek to satisfy the mere letter of the requirements under IFRS, the “principles-based” approach of these standards would, it could easily be argued, demand that preparers (and their auditors) undertake to comply with the spirit of the rules as well.

IAS 24 provides examples of situations where related party transactions may lead to disclosures by a reporting entity 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.
• Licence agreements.
• Finance (including loans and equity participation in cash or in kind).
• Guarantees and collaterals.
• Commitments linked to the occurrence or non-occurrence of particular events, including executory contracts (recognised and unrecognised).
• Settlement of liabilities on behalf of the entity or by the entity on behalf of another party.

The foregoing should not be considered an exhaustive list of situations requiring disclosure. 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 contract for maintaining and servicing computers, entered into with a subsidiary company, would need to be disclosed by the reporting entity in parent company financial statements.

Disclosure of Parent-Subsidiary Relationships

IAS 24 requires disclosure of relationships between parent and subsidiaries irrespective of whether there have been transactions between the related parties. The name of the parent entity must be provided in the subsidiary's financial statement disclosures; if the ultimate controlling party is a different entity, its name must be disclosed. One reason for this requirement is to enable users of the reporting entity's financial statements to seek out the financial statements of the parent or ultimate controlling party for possible review. If neither of these produces consolidated financial statements available for public use, IAS 24 provides that the name of the “next most senior parent” that produces financial statements must be stated in addition. These requirements are in addition to those set forth by IFRS 10, IFRS 11, IFRS 12 and IAS 28.

To illustrate this point, consider the following example:

Apex, who owns 25% of Bellweather, and by virtue of share ownership has more than 20% of the voting power, would be considered to possess the ability to exercise significant influence over Bellweather. During the year, Apex entered into an agency agreement with Bellweather; however, no transactions took place during the year between the two companies based on the agency contract. Since Apex is considered a related party to Bellweather by virtue of the ability to exercise significant influence, rather than control (i.e., there is not a parent-subsidiary relationship), no disclosure of this related party relationship would be needed under IAS 24. If, however, Apex owned 51% or more of the voting power of Bellweather it would thereby be considered related to Bellweather on the basis of control and disclosure of this relationship would be needed, irrespective of whether any transactions actually took place between them.

Disclosures to Be Provided

Per IAS 24, if there have been transactions between related parties, the reporting entity should disclose:

1. The nature of the related party transaction; and
2. Information about transactions and outstanding balances necessary to understand the potential effect of the relationship on the financial statements.

   At a minimum, the following disclosure shall be made:

   1. The amount of the transaction;
   2. Amount of outstanding balances and their terms and conditions, including whether they are secured and details of any guarantees given or received;
   3. Provision for doubtful debts related to the amount of the outstanding balances;
   4. Any expense recognised during the period in respect of bad or doubtful debts due from the related parties.

The disclosures required are to be made separately for each of the following categories:

1. The parent;
2. Entities with joint control or significant influence over the entity;
3. Subsidiaries;
4. Associates;
5. Joint venture in which the entity is a venturer;
6. Key management personnel of the entity or its parent; and
7. Other related parties.

Comparatives

IAS 24 does not address the basis on which comparative financial information should be presented. Often, challenges arise in respect of parties that are related in one period but not in the other. However, under the objectives of IAS 24 as set out above, it is recommended that disclosures be provided for transactions and balances with parties that were related during the respective years presented.

For example, A sold goods to B in 20XX and 20XX-1. In 20XX, A acquired a 25% interest in B. Related party transactions would only be disclosed for the 20XX financial statements because the transactions in 20XX-1 were not carried out and influenced by relationship as defined under IAS 24.

On the other hand, if A had a 25% interest in B in 20XX-1 which was disposed of at the end of 20XX-1, the transactions for 20XX-1 should be disclosed under IAS 24 but not the transactions for 20XX.

Government-Related Entities

The reporting entity is exempt from the disclosure requirements for related party transactions and outstanding balances, including commitments for the following entities:

1. A government that has control, joint control or significant influence over the reporting entity; and
2. Another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity.

If the exemption is applicable, the reporting entity must disclose the following:

1. The name of the government and the nature of its relationship with the reporting entity (i.e., control, joint control or significant influence).
2. The following information in sufficient detail to enable users of the entity's financial statements to understand the effect of related party transactions on its financial statements:
   1. The nature and amount of each individually significant transaction; and
   2. For other transactions that are collectively, but not individually, significant, a qualitative or quantitative indication of their extent.

Judgement is used to determine the level of detail to be disclosed for significant transactions. The reporting entity should consider the closeness of the related party relationship and the following factors in establishing the level of significance of the transaction:

1. Significance in terms of size.
2. Whether or not the transaction was carried out on non-market-related terms.
3. Whether or not the transaction was outside the entity's normal day-to-day business operations, such as the purchase and sale of businesses.
4. Whether or not the transaction was disclosed to regulatory or supervisory authorities.
5. Whether or not the transaction was reported to senior management.
6. Whether or not the transaction was subject to shareholder approval.