Related party transactions are a normal and a common feature of business and commerce these days. However, in some cases, entities may enter into transactions with related parties at terms that unrelated parties might not enter into under normal circumstances. Thus the existence of a related party relationship may have an effect on profit or loss and the financial position of an entity. In order to ensure “transparency in financial reporting, most accounting standards around the world prescribe disclosures of transactions with related parties. IAS 24 is the standard [IAS 24] under the International Financial Reporting Standards that prescribes the requirements for the disclosure of related party relationships in financial statements. This post provides an “easier—to—understand description of IAS 24 with case examples and practical insights. Enjoy!

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The purpose of the standard [IAS 24] {IAS 24] is to make the reader of financial statements aware of the existence of related party relationships and the extent to which an entity’s financial position, profitability, or cash flows may have been affected by transactions with such parties. It should be noted that this is a disclosure Standard and does not deal with recognition or measurement issues, all of which are dealt with by other relevant Standards.

Related party transactions generally are very sensitive subjects in most parts of the world. Often, and sometimes erroneously, it is believed that transactions with related parties are “not a good thing”; usually this is the case in unscrupulous corporate deals where transactions with related parties are used to manipulate results of operation or net assets for economic gain by a group of individuals in control of the entity. Although this may be true in some instances, especially in the recent highly publicized corporate scandals where the board of directors (i.e., “related parties”) allegedly took the shareholders for a ride, in most cases there are valid economic and/or commercial reasons for dealing with related parties.

Example:

An example of related party transactions is a group of companies (with a common parent) having diverse activities wherein entities within the group, in the normal course of business, enter into day-to-day transactions with other entities within the group. For instance, one entity within the group may supply goods or services to another but only after going through a tendering process in competition with third parties. In such a case, the transaction is transparent, as a bidding process was conducted and the price at which the transaction was entered into would in all likelihood have been at market, or arm’s-length, pricing. This is what generally happens in the real world, and, in principle, there is nothing wrong with entering into such a transaction with entities within the group. The standard [IAS 24] merely requires entities that enter into such transactions with other related parties to so state in their financial statements.

 

It is important, however, that a reader of financial statements is made aware of all related party relationships, transactions, and balances as such transactions may not always be at arm’s length and may have occurred only, or indeed transactions may not have occurred, because of the position that a related party has—it can influence, or can be influenced by, that other party, which can impact the reported results, net assets or cash flows.

The requirements of IAS 24 are to be applied in:

  • Identifying related party relationships and transactions
  • Identifying outstanding balances between an entity and its related parties
  • Identifying the circumstances in which disclosure of items in (a) and (b) is required
  • Determining the disclosures that are to be made about those items

 

The standard [IAS 24] is very clear that its provisions apply to disclosure of related party transactions and outstanding balances in the separate financial statements of a parent company, venturer, or investor as, very often, such financial statements may be physically separate from the consolidated financial statements. Equally, the standard [IAS 24] must be applied to subsidiaries for the same reason. No exemption is given for subsidiaries that are consolidated with their parent. Furthermore, transactions with other entities in a group are to be disclosed in an individual entity’s financial statements, although such intra-group transactions are eliminated on consolidation in the financial statements of the group.

 

Practical Insight:

In separate financial statements of a parent company, presented on a stand-alone basis as permitted under IAS 27, transactions with its subsidiaries would be disclosed as related party transactions. However, in “consolidated financial statements” of the parent company, there will be no related party transactions or balances reported between members of the consolidated group, as all such items will have been eliminated upon consolidation by applying the procedures outlined in IAS 27, Consolidated and Separate Financial Statements.

 

 
Explanation and Elaboration Of Definitions [In Accordance With IAS 24]

Most key term and definitions in IAS 24 are a matter of common sense insofar as they specifically include parent companies (in relation to a subsidiary), subsidiaries (in relation to the parent), fellow subsidiaries, associates, joint ventures, and key management. However, a number of definitions require in-depth analysis to comprehend the real meaning behind the terminology used.

Interpretations and clarifications of the various aspects of the definitions follow to enable the standard [IAS 24] to be applied in its true spirit. In fact, this is a requirement of the standard [IAS 24], as IAS 24 categorically states that “in considering each related party relationship, attention is directed to the substance of the relationship and not merely the legal form” [paragraph 10].

 

Key Management Personnel

Key management personnel include all those who have authority and responsibility for planning, directing, and controlling the activities of an entity. Therefore, these persons need not necessarily be directors. The definition does indeed include “directors, executive or otherwise

Practical Insight-1:

This broad definition will include non executive directors (NEDs) and what in some jurisdictions are termed “shadow directors”—those persons in accordance with whose instructions the directors act, whether those persons are legally called directors or not. This definition also includes key management personnel of the entity’s parent. Thus in most cases it would be difficult to avoid the related party label. However, the standard [IAS 24] does state that two entities are not related solely because they have a director or other key management personnel in common. This statement recognizes the increasing use by significant entities of nonexecutive directors in order to satisfy corporate governance issues and requirements.
Doing this can quite easily result in entities having common directors, as often such persons are retired politicians, civil servants, or prominent corporate executives, any one of whom may sit on various boards in their “retirement.” However, it must be remembered that for management personnel to be “key,” they must have authority and responsibility for planning, directing, and controlling the entity’s activities. For many of these “professional” NEDs, this will not be the case.

 

 
Close Members of the Family of an Individual

The issue of “close members of the family of an individual” is a thorny one. International Accounting Standards have always been designed to cater to cross-border jurisdictions, but this issue has cross-cultural dimensions as well. Although the standard [IAS 24] provides a list of persons that “close members of the family of an individual” are purported to include, the wording of the definition makes it clear that the list is by no means exhaustive. This fact is obvious; the definition is an inclusive one that begins with the word “includes,” thus announcing clearly that “related parties” not specifically mentioned in the definition are not necessarily excluded under this principle and should not automatically be ruled out. In other words, IAS 24 puts the onus on the person applying the standard [IAS 24] to apply the standard [IAS 24] correctly.

The standard [IAS 24] says that “close members of the family of an individual” are those who may be expected to influence, or be influenced by, that individual, in his dealings with the entity. To put it differently, and to sum up, it appears that the other “related parties” not specifically mentioned in this part of the definition, but covered by inference (because the standard [IAS 24] says “includes”), are a matter of interpretation. The burden of applying (accurately) the principle enshrined in the standard [IAS 24] rests squarely on the entity applying the standard [IAS 24]. This task is an onerous one, as under IAS 1, a set of financial statements cannot be described as prepared in accordance with International Financial Reporting Standards (IFRS) unless the provisions of each and every Standard are fully complied with.

Practical Insight-2:

This principle allows cross-cultural interpretation of the expression “close member of the family of an individual.” For example, regarding siblings: In some cultures, the younger sibling may always defer to the elder. In other cultures, this may not be the case. Furthermore, in some cultures, where the families are very closely knit, relatives other than sons or daughters could also be considered as “close members of the family” because they could very well influence the individual in his or her dealings with the entity. However, in other countries, where each individual independently makes business decisions, this may not be the case. According to one school of thought, this anomaly could, to some extent, be avoided if the standard [IAS 24] provided an exhaustive and prescribed list of “close members of the family of an individual” (as is the case in accounting standards of some countries).

 

 
Practical Insight-3:

Yet another “gray” area is that of “children” of an individual. The standard [IAS 24] states that children are related parties but does not clarify whether it is referring only to minors. If the definition is stretched to include even “adult children,” it could give rise to disagreement based on the principle of substance over form. It may be possible to interpret this area in the light of one of the other elements of the definition of “close members of the family of the individual”—that of “dependents” of the individual. In some cases, parents may be dependent on a child for financial, emotional, or physical support; thus they are related parties. This interpretation could be extended to the definition of children also, so that if the children are not dependent, they are not necessarily related parties for the purposes of the standard [IAS 24]. This is, however, a very fine line to draw and possibly an aggressive interpretation.

 
Case Example:

Accounting-Financial-Tax.com Inc. is a manufacturer of automobile spare parts. It transacts business through a business model that has worked for several years and has made the entity a successful enterprise that is rated in the top 10 businesses in its field by a trade journal. Accounting-Financial-Tax.com Inc. believes in working with reliable and dependable vendors and also sells only to entities that it can either control or exercise significant influence over. The business model works in this way:

(a) Accounting-Financial-Tax.com Inc. purchases everything it needs from Lie Dharma Inc., a well-known supplier. Due to the high quality of the material that Lie Dharma Inc. has provided over the last 10 years, Accounting-Financial-Tax.com Inc. has never purchased from any other supplier. Thus it may be considered economically dependent on Lie Dharma Inc.

(b) Accounting-Financial-Tax.com Inc. sells 70% of its output to a company owned by a director and the balance to an entity that is its “associate” by virtue of Accounting-Financial-Tax.com Inc. owning 35% of the share capital of that company.

(c) Accounting-Financial-Tax.com Inc. stores inventory in a warehouse that is leased from the wife of its director. The lease rentals are at arm’s length.

(d) Accounting-Financial-Tax.com Inc. has provided an interest-free loan to a company owned by the chief executive officer (CEO) of Accounting-Financial-Tax.com Inc. for the purposes of financing the purchase of delivery vans which the company owned by the CEO is using for transporting goods from the warehouse of the supplier to the warehouse used by Accounting-Financial-Tax.com Inc. for storing inventory.

The question is: Which transactions would need to be disclosed as related party transactions under IAS 24?

 

Let us examine each of the transactions in order to determine whether they would warrant disclosure as related party transaction under IAS 24:

(a) Notwithstanding the fact that Accounting-Financial-Tax.com Inc. purchases all its raw materials from Lie Dharma Inc. and is economically dependent on it, Lie Dharma Inc. does not automatically become a related party. Thus for the purpose of IAS 24, purchases made from Lie Dharma Inc. are not considered related party transactions.

(b) Seventy percent of the sales are to an entity owned by a “director” (i.e., an entity controlled by a key management person), and 30% of the sales are made to an entity that Accounting-Financial-Tax.com Inc. has “significant influence” over. Thus both sales are to related parties as defined in IAS 24 and would need to be disclosed as such.

(c) The lease of the warehouse, although at arm’s length, has been entered into with the wife (a “close member of the family”) of a “director” (a key management person) and thus needs to be disclosed as a related party transaction.

(d) The interest-free loan to an entity owned by a director needs to be disclosed as a related party transaction. The fact that it is interest-free may warrant disclosure because it may not be construed as an “arm’s-length transaction” since Accounting-Financial-Tax.com Inc. would not normally provide unrelated parties with interest-free loans.

Note: IAS 24, paragraph 21, requires that “disclosures that related party transactions were made on terms equivalent to those that prevail in arm’s-length transactions are made only if such terms can be substantiated”. Furthermore, the rental expenses paid for hiring a delivery van belonging to an entity owned by a director also would need to be disclosed as a related party transaction since these charges are paid to an entity “controlled” by a key management person.

 

 
Related Party Transactions In a Joint Ventures

The standard [IAS 24] clarifies that two parties to a joint venture are not related solely through their contractual relationship. The joint venture would be a related party of each venturer by definition, but, if the joint venture contract is the only relationship between the two venturers, this does not make them related.

 

Compensation to Key Management Personnel

In the past, it has always been arguable as to whether “directors’ remuneration” was a related party transaction. While in some jurisdictions law requires disclosure, it has been debated as to whether IAS 24 referred to such transactions. The standard [IAS 24] now makes very clear that such transactions are included, no matter how they are termed.

 

Related Party Transactions

The definition of related party transactions is critical to the proper application and implementation of the standard [IAS 24]. It encompasses a transfer of resources, services, or obligations, regardless of whether a price is charged. This definition includes, therefore, free-of-charge services, which can be some of the more difficult transactions to detect. It will also include guarantees, provision/receipt of collateral, and settlement of obligations.

Practical Insight:

The pricing of related party transactions is often a sensitive subject, particularly if pricing is not at arm’s length. This area can be a difficult one that is open to judgment. For example, an entity may sell 60% of its production to a related party at unit prices substantially lower than what it charges other third parties for the balance 40% production. None of the third parties accounted for more than 5% of the sales. It may be very difficult to determine whether the volume discount was at a market rate. It can be even more difficult to determine arm’s length if there are no sales to third parties.

 

 
In such cases, the standard [IAS 24] states that a transaction can be described as at arm’s length only if it can be substantiated. Thus it is the responsibility of the management to prove the market value of transactions if it wishes to describe transactions as “at market value.”

 

Scope Exclusions Of IAS 24

Although apparently some parties, by virtue of their relationship with the entity, may appear as related parties falling within the scope of IAS 24, the standard [IAS 24] clarifies that the following parties are not necessarily related parties as envisaged in the standard [IAS 24]:

  • Providers of finance, trade unions, public utilities, and government departments and agencies are not necessarily related parties simply by virtue of their normal dealings with an entity, even if they participate in decision-making processes or affect freedom of action.
  • Customers, suppliers, franchisors, distributors, or general agents are not related to an entity solely because the entity is economically dependent on them.
  • Two entities are not related parties simply because they have common directors or other members of key management personnel in common.
  • Two venturers are not related parties simply because they share joint control over a joint venture.

 

 

Related Party Disclosures

In order to enable users of financial statements to better understand the financial position of an entity and to form a view about the effects of related party transactions on an entity, IAS 24 has mandated extensive disclosure requirements with respect to related party transactions.

According to IAS 24, paragraph 12, an entity should disclose:

  • Relationships between parents and subsidiaries regardless of whether there have been any transactions between them
  • The name of the entity’s parent and, if different, the ultimate controlling party. If neither the entity’s parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so shall also be disclosed.

 

According to IAS 24, paragraph 16, 6.2, an entity should disclose key management personnel compensation in total and for each of these categories:

(a) Short-term employee benefits
(b) Postemployment benefits
(c) Other long-term benefits
(d) Termination benefits
(e) Share-based payments

 
IAS 24, paragraph 17, states that if there have been transactions between related parties, an entity should disclose the nature of the related party relationship as well as information about the transactions and outstanding balances necessary for an understanding of potential effect of the relationship on the financial statements. At a minimum, disclosures shall include:

  • The amount of the transactions
  • The amount of outstanding balances and
  • Their terms and conditions
  • Whether they are secured or unsecured
  • The nature of the settlement consideration
  • Details of guarantees given or received
  • Provisions for doubtful debts against balances outstanding
  • Provisions for doubtful debts recognized as an expense

 
According to IAS 24, paragraph 18, these disclosures are required to be disclosed separately for each of these categories of related party:

  • Parent
  • Entities with joint control or significant influence over the entity
  • Subsidiaries
  • Associates
  • Joint ventures in which the entity is a venturer
  • Key management personnel of the entity or its parent
  • Other related parties

IAS 24, paragraph 22, states that items of a similar nature may be disclosed in aggregate except when separate disclosure is necessary for an understanding of the effects of related party transactions on the financial statements of the entity.

 

Case Example:

Lie Dharma Putra Inc. is part of a major industrial group of companies and is known to accurately disclose related party transactions in its financial statements prepared under IFRS. With the sweeping changes that were made to the various Standards under the International Accounting Standards Board’s Improvements Project, the entity is seeking advice from IFRS specialists on whether the following transactions need to be reported under IAS 24 and, if so, to what extent, and how the related party transactions footnote should be worded.

[1]. Remuneration and other payments made to the entity’s chief executive officer (CEO) during the year 20XX were:

a. An annual salary of $2 million
b. Share options and other share-based payments valued at $1 million
c. Contributions to retirement benefit plan amounting to $1 million
d. Reimbursement of his travel expenses for business trips totaling $1.2 million

[2]. Sales made during the year 20XX to:

a. Melia, Inc., parent company: $35 million
b. Delia, Inc., associate: $25 million

[3]. Trade debtors at December 31, 20XX, include:

a. Due from Melia, Inc.: Gross: $10 million, Net of provision: $7 million
b. Due from Delia, Inc.: $15 million (these receivables are fully backed by corporate guarantees from Delia, Inc.)

Required: Please advise Lie Dharma Putra, Inc. on related party transactions that need to be disclosed and draft a sample related party transactions footnote to guide the entity.

 

Solution:

[1]. All the listed items are required to be disclosed in Lie Dharma Putra, Inc.’s financial statements prepared under IFRS. The only exception is the reimbursement of the travel expenses of the CEO amounting to $1.2 million; as this sum is not “compensation,” it is not required to be disclosed under IAS 24.

[2]. Footnote: Related Party Transactions

(a). Lie Dharma Putra, Inc. enters into related party transactions in the normal course of business. During the year 20XX, these related party transactions were entered into with related parties as defined under IAS 24. The transactions resulted in balances due from those parties that, at December 31, 20XX, were:

(1) With the parent company (Melia, Inc.)

  • Sales = $35 million
  • Included in trade debtors (due from parent company) = $10 million
  • Provision for doubtful debts = $ 3 million

 

(2) With an “associate”

  • Sales $25 million
  • Included in trade debtors [due from an associate]* $15 million

Note: *Amount due from an associate is secured by a corporate guarantee given by the associate.

(b). For the year ended December 31, 20XX, Lie Dharma Putra, Inc. made these payments to its CEO, part of the “key management personnel”:

  • Short-term benefits (salary) = $2 million
  • Postemployment benefits (retirement benefit plan contribution) = $1 million
  • Share-based payments (stock options, etc.) = $1 million
  • Total $4 million