Essential Strategies for Related Party Disclosures in Financial Reporting
Accountants preparing financial statements for entities must be familiar with IAS 24, Related Party Disclosures. This standard is in place to ensure that entities disclose transparently and fairly all their dealings with related parties in their financial statements, including potential influences on an entity’s financial position and performance. By adhering to the detailed disclosure requirements of IAS 24, accountants ensure that financial statements reflect a true and fair view of the entity’s financial position, safeguarding against the risks posed by related party transactions.
This is important as the risk of misrepresentation grows when parties can use their relationships to manipulate financial information for their gain. This may mean that significant transactions may occur on different terms to those with unrelated parties, potentially leading to financial statements that do not reflect true market conditions.
To mitigate this risk, IAS 24 provides a framework for accountants by providing detailed disclosures that reveal the extent and nature of these interactions.
Who Are Related Parties?
According to IAS 24, a related party is any person or entity related to the reporting entity, the entity that prepares its financial statements. Related parties can include individuals and entities.
Individuals and their close family members who can exert control, significant influence, or be key management personnel in the reporting entity or its parent.
Control or joint control of the reporting entity.
Significant influence over the reporting entity.
Being a member of the key management personnel.
The following entities are considered to be related parties:
Entities in the same group (parent, subsidiary, fellow subsidiary).
Associates or joint ventures of the reporting entity, or an entity in the same group.
Entities that are joint ventures with a third party, or one entity is a joint venture and the other is an associate of a third entity.
Post-employment benefit plans set up for the benefit of employees of the reporting entity or a related entity.
Entities controlled or significantly influenced by any person mentioned above or providing key management personnel services to the reporting entity or its parent.
Examples of Related Party Transactions
Below are some examples of related party arrangements and transactions commonly found in business:
Sales Transactions: A company sells goods to a related company at a price lower than the market rate.
Impact: Selling goods below market rates can lead to understating revenue in one entity and expenses in another misrepresenting the economic reality and showing healthier operations than reality. This scenario is often used to ‘shift profits’ from one entity to another in a jurisdiction with lower tax rates to avoid paying higher taxes.
Loan Arrangements: An entity grants a loan to a related party with no interest or significantly below-market interest rates.
Impact: Loans to related parties at no or low interest rates can result in recording an investment at a value that does not accurately reflect its economic benefit to the company, potentially requiring impairment or valuation allowances.
Transfer of Assets: A parent company transfers assets to a joint venture that is jointly controlled by itself and another related entity.
Impact: Transferring assets to a joint venture at undervalued rates can affect the balance sheet by understating assets and equity, impacting ratios like return on assets and equity.
Guarantees: A company provides a financial guarantee to secure the borrowing of its sister company.
Impact: Providing financial guarantees can introduce significant liabilities and risk exposure that may not be fully reflected in financial statements, potentially misleading stakeholders about the entity’s risk profile.
Employment Contracts: High-level executives or key management personnel receive significantly higher compensation or more beneficial employment terms than might be typical under similar circumstances.
Impact: Offering above-market compensation can lead to increased personnel expenses, affecting profit margins. It may also raise questions about governance and the fairness of executive remuneration.
Stock Transactions: A major shareholder sells shares back to the company under a buy-back agreement at favourable prices.
Impact: Providing financial guarantees can introduce significant liabilities and risk exposure that may not be fully reflected in financial statements, potentially misleading stakeholders about the entity’s risk profile.
These examples illustrate the variety of ways in which related parties might engage in transactions that could potentially influence the economic and financial reporting outcomes of a business.
Accounting and Disclosure Considerations
IAS 24 mandates thorough disclosure of all related party transactions to prevent any potential misinterpretation of an entity’s financial health. Accountants must disclose:
Relationships and Transactions: Clearly outline the nature of the relationship and detailed information about the transactions, including the amounts and terms involved.
Outstanding Balances and Commitments: Report any outstanding balances with related parties, including their terms and conditions, guarantees involved, and provisions for doubtful debts.
Management Compensation: Disclose the total compensation of key management personnel, broken down into categories like short-term and long-term benefits, termination benefits, and share-based payments.
Special Disclosure Requirements:
Even if no transactions occurred, relationships between a parent and its subsidiaries must be disclosed.
A subsidiary should report the most senior parent whose financial statements are made available to the public.
Identifying Related Parties
Identifying related parties requires understanding complex relationships. Related parties include subsidiaries, affiliates, joint ventures, key management personnel and their close family members. This can get challenging when entities are in complex group structures, especially if the relationships are not formally documented. Yet, it’s crucial for accurate reporting.
To identify related parties, and understand the nature of their relationship with the entity, accountants should inquire from management as they have the most comprehensive knowledge of related party relationships and transactions. They are especially aware of relationships that hold significant economic importance to the entity and thus hold more risks of material misstatement due to the potential for management to manipulate or conceal information through overriding controls.
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