1 The need for disclosure of related parties
A related party transaction is defined as ‘the transfer of resources, services or obligations between related parties, regardless of whether a price is charged’ (IAS 24, para 6).
Transactions between related parties are a normal feature of business. However, users of the financial statements need to know about these transactions because they can distort the financial performance and position of an entity.
Illustration – The need for related party disclosures
Company A owns 75% of the equity shares of B. A sells goods to B at prices significantly above market rate. As a result, the profit of A is more than it would have been had it sold all of its goods to a third party.
Company A is therefore not comparable with that of similar companies. Its performance has been distorted because it trades with an entity over which it has control. This has enabled it to charge prices that are not equivalent to those in arm’s length transactions.
Companies A and B are related parties. Users of the financial statements, such as investors and banks, need to be made aware of the transactions that have occurred between these two companies to enable them to make a proper assessment of the financial statements.
2 Definition of a related party
A related party is defined as ‘a person or entity that is related to the entity that is preparing its financial statements’ (IAS 24, para 9).
IAS 24 (para 9) gives the following rules which should be used to determine the existence of related party relationships:
- ‘A person or a close member of that person’s family is related to a reporting entity if that person:
- has control or joint control of the reporting entity
- has significant influence over the reporting entity
- is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.
- An entity is related to a reporting entity if any of the following conditions apply:
- The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others)
- One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member)
- Both entities are joint ventures of the same third party
- One entity is a joint venture of a third entity and the other entity is an associate of the third entity
- The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity
- The entity is controlled or jointly controlled by a person identified in (a)
- A person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity)
(viii)The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.’
Group accounting is covered in a later chapter. You may therefore find the following definitions useful:
- A subsidiary is an entity over which an investor has control.
- A joint venture is an entity over which an investor has joint control.
- An associate is an entity over which an investor has significant influence.
‘In the definition of a related party, an associate includes subsidiaries of the associate and a joint venture includes subsidiaries of the joint venture’ (IAS 24, para 12).
IAS 24 notes that the following should not be considered related parties:
- two entities just because they have a director or other member of key management personnel in common
- two joint venturers just because they share joint control of a joint venture
- a customer or supplier with whom an entity transacts a significant volume of business.
Substance over form should be applied when deciding if two parties are related.
Further detail on definitions
‘Close members of the family of a person are those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity and include:
- that person’s children and spouse or domestic partner
- children of that person’s spouse or domestic partner
- dependants of that person or that person’s spouse or domestic partner’ (IAS 24, para 9).
Control is defined in IFRS 10. An investor controls an investee when:
- the investor has power over the investee, and
- the investor is exposed, or has rights, to variable returns from its involvement with the investee, and
- the investor has the ability to affect those returns through its power over the investee.
In simple terms, control is normally assumed when one entity owns more than half of the equity shares of another entity.
Significant influence is defined in IAS 28 Investments in Associates and Joint Ventures as the ‘power to participate in, but not control, the financial and operating policy decisions of an entity’ (IAS 28, para 3).
Significant influence is normally assumed when an entity owns between 20% and 50% of the equity shares of another entity.
Joint control is defined in IFRS 11 Joint Arrangements as ‘the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control’ (IFRS 11, para 7).
Key management personnel are defined as ‘those with authority and responsibility for planning, directing and controlling the activities of the entity, including any director (whether executive or otherwise) of that entity’ (IAS 24, para 9).
Test your understanding 1 – Group structures
Consider the following structure:
Required:
Discuss the related party relationships arising from the above structure.
3 Disclosure of related parties
Parent and subsidiary relationships
IAS 24 requires that relationships between parents and subsidiaries should always be disclosed. The name of the parent and, if different, the ultimate controlling party should be given. This applies regardless of whether or not any transactions have taken place between the parties during the period.
The disclosure requirements of IFRS 12 Disclosure of Interests in Other Entities (covered later in this text) also apply
Key management personnel
Total compensation granted to key management personnel should be disclosed. IAS 24 says that this should also be broken down into the following categories:
- short-term benefits
- pension benefits
- termination benefits
- share-based payment schemes.
Disclosure of transactions and balances
If there have been transactions between related parties, and if there are balances outstanding between the parties, the following should be disclosed:
- the nature of the related party relationship
- a description of the transactions
- the amounts of the transactions
- the amounts and details of any outstanding balances
- allowances for receivables in respect of the outstanding balances
- the irrecoverable debt expense in respect of outstanding balances.
Disclosure should be made whether or not a price was charged.
IAS 24 specifies that an entity may only disclose that related party transactions were made on terms equivalent to those that prevail in arm’s length transactions if such terms can be substantiated.
Government-related entities
A reporting entity is exempt from the above disclosures in respect of transactions and balances that they have with a government that has control, joint control or significant influence over the reporting entity
If this exemption is applied, IAS 24 requires that the following disclosures are made instead:
- details of the government and a description of its relationship with the reporting entity
- details of individually significant transactions
- an indication of the extent of other transactions that are significant in aggregate.
Test your understanding 5 – Picture and Frame
Joanne Smith has owned 60% of the equity shares of Picture and 70% of the equity shares of Frame for many years. On 1 January 20X4, Picture entered into a lease agreement with Frame. Under the terms of the lease, Picture would lease one of its unused warehouses, with a remaining useful life of 20 years, to Frame for five years. Consideration payable by Frame would be $10,000 a year in arrears. Market rentals for similar sized warehouses tend to be around $100,000 per year.
Required:
Discuss the correct treatment of the above transaction in Picture’s financial statements for the year ended 30 June 20X4.
Test your understanding 1 – Group structures
Entity A:
Entities that are within the same group are related to one another. Entities B and C are therefore related parties of A.
D is an associate of C. C is a member of A’s group. This means that D is a related party of A.
Entity B:
Entities that are within the same group are related to one another. Entities A and C are therefore related parties of B.
D is an associate of C. C is a member of the same group as B. This means that D is a related party of B
Entity C:
Entities that are within the same group are related to one another. Entities A and B are therefore related parties of C.
Entities are related if one is an associate of another. C and D are therefore related parties.
Entity D:
Entities are related if one is an associate of another. D and C are therefore related parties.
Entities are related if one is an associate of a member of a group of which the other entity is also a member. D is an associate of C. Companies A and B are in the same group as C. This means that D is also a related party of A and B.
Test your understanding 2 – Individual shareholdings
Situation A:
Mr P is a related party of both entity A and entity B as he is able to exercise either control or significant influence over each entity.
Mr P controls entity A and has significant influence over entity B.
Therefore, A and B are related parties.
Situation B:
Mr P is a related party of both entity A and entity B as he is able to exercise significant influence over each entity.
Mr P does not control either entity A or entity B. Therefore, A and B are not related parties.
Test your understanding 3 – Key management personnel
Mr P has control over entity A, meaning that Mr P is a related party of A.
Mr P is a member of key management personnel of B, so is a related party of B.
A and B are related parties, because Mr P controls A and is a member of key management personnel of B.
Entity B controls entity C so B and C are related parties.
Mr P is a member of key management personnel of the parent of C, so Mr P and C are related parties.
This means that entities A and C are also related parties (Mr P controls A and is a member of key management personnel of the parent company of C).
Related parties
Test your understanding 4 – Family members
Mr T and Mrs T are close family.
Mr T controls entity A. Mr T and Mrs T are related parties of entity A.
Mrs T has significant influence over entity B. Mrs T and Mr T are related parties of entity B.
Mr and Mrs T control entity A and have significant influence over entity B.
A and B are related parties.
Test your understanding 5 – Picture and Frame
According to IFRS 16 Leases, a finance lease is a lease where the risks and rewards of ownership transfer to the lessee. The lease between Picture and Frame is only for a fraction of the asset’s remaining useful life and the lease payments are insignificant. The lease is therefore an operating lease. Picture should recognise lease income on a straight line basis over the lease term. Therefore, $5,000 ($10,000 × 6/12) should be recognised in the current year’s statement of profit or loss, as well as a corresponding entry to accrued income on the statement of financial position.
Picture and Frame are under joint control of Joanne Smith, so this means that they are related parties. Disclosure is required of all transactions between Picture and Frame during the financial period. Picture must disclose details of the leasing transaction and the income of $5,000 from Frame during the year.
Disclosures that related party transactions were made on terms equivalent to an arm’s length transaction can only be made if they can be substantiated. The lease rentals are only 10% of normal market rate meaning that this disclosure cannot be made.
