Chapter 14 HKAS 24 Related Party Disclosures

Chapter 14 HKAS 24 Related Party Disclosures

Exercise 1

(a)(i)

Parties are considered to be related if one party has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operating decisions. Parties are also considered to be related if they are subject to common control or common significant influence.

(a)(ii)

A related party transaction is a transfer of resources or obligations between related parties, regardless of whether a price is charged.

(a)(iii)

Control is defined as ownership, directly or indirectly, of more than one half of the voting power of an enterprise, or a substantial interest in voting power and the power to direct, by statute or agreement, the financial and operating policies of management of the enterprise.

(a)(iv)

Significant influence is defined as participation in the financial and operating policy decisions of an enterprise, but not control of those policies. Significant influence may be exercised by representation on the board of directors, or by participation in the policy making process, material intercompany transactions, interchange of managerial personnel or dependence on technical information.

(b)

(i) Comparable uncontrolled price method

The price for a transaction between related parties is set by referring to the price in a comparable uncontrolled transaction – a transaction between unrelated parties where the products, markets and transaction terms are substantially similar to the related party transaction. This method is appropriate when both the characteristics of the products and the economic circumstances surrounding the related party transactions are substantially the same as those between independent parties.

(ii) Cost-plus method

The price for transactions between a manufacturer and a related purchaser is based on mark-ups over the cost achieved by a comparable manufacturer in unrelated transactions. The mark-ups are determined by referring to those earned for products of significant similarity. This method is appropriate when a manufacturer sells semi-finished products to related manufacturing companies for further processing.

(iii) Resale price method

The method determines the price for the sale of goods between a supplier and a related reseller (distributor, wholesaler or retailer) by subtracting an appropriate re-sale profit margin from the price at which the goods are re-sold by the related company to independent customers. The profit margin is determined by referring to the gross margin achieved by an independent reseller dealing with similar products under same general economic conditions. This method is appropriate where the reseller provides little value-added service for the products.

(c)

(i) S Ltd is directly controlled by H Ltd, hence they are related parties. However, no disclosure is required for transactions between members of a group because consolidated financial statements present information about the holding company and subsidiaries as a single reporting enterprise. Any offset of transactions between members of the group is eliminated on consolidation.

(ii) Parties are considered to be related if one party has the ability to exercise significant influence over the other party. Since H Ltd and A Ltd are associated, they are related parties. Transactions between associates are not eliminated on consolidation, and therefore require separate disclosure as related party transactions.

(iii) Mr Leung is a key management personnel of H Ltd, hence they are related parties. The transaction between Mr Leung and H Ltd is a related party transaction and therefore must be disclosed in the consolidated financial statements of H Ltd.

(iv) Since B Ltd is owned by a close relative of the key management personnel of H Ltd, B Ltd and H Ltd are related parties. The transaction between B Ltd and H Ltd is a related party transaction and therefore must be disclosed in the consolidated financial statements of H Ltd.

Examination Style Questions

Answer 1

(a)

HKAS 24 Related party disclosures says that a party is related to an entity if:

–  the party, directly or indirectly, controls, is controlled by or is under common control with the entity (e.g. parent/subsidiary or subsidiaries of the same group)

–  one party has an interest in another entity that gives it significant influence over the entity (e.g. an associate) or has joint control over the entity (e.g. joint venturers are related parties)

In addition members of key management and close family members of related parties are also themselves related parties.

(b)

In the absence of related party disclosures, users of financial statements would assume that an entity has acted independently and in its own best interests. Principally within this assumption is that all transactions have been entered into willingly and at arm’s length (i.e. on normal commercial terms at fair value). Where related party relationships and transactions exist, this assumption may not be justified. These relationships and transactions lead to the danger that financial statements may have been distorted or manipulated, both favourably and unfavourably. The most obvious example of this type of transaction would be the sale of goods or rendering of services from one party to another on noncommercial terms (this may relate to the price charged or the credit terms given). Other examples of disclosable transactions are agency, licensing and leasing arrangements, transfer of research and development and the provision of finance, guarantees and collateral. Collectively this would mean there is hardly an area of financial reporting that could not be affected by related party transactions.

It is a common misapprehension that related party transactions need only be disclosed if they are not at arm’s length. This is not the case. For example, a parent may instruct all members of its group to buy certain products or services (on commercial terms) from one of its subsidiaries. In the absence of the related party relationships, these transactions may not have occurred. If the parent were to sell the subsidiary, it would be important for the prospective buyer to be aware that the related party transactions would probably not occur in the future. Indeed even where there are no related party transactions, the disclosure of the related party relationship is still important as a subsidiary may obtain custom, receive favourable credit ratings, and benefit from a superior management team simply by being a part of a well respected group.

(c)

The subsidiaries of Hideaway are related parties to each other and to Hideaway itself as they are under common control. One of the important aspects of related party relationships is that one of the parties may have its interests subordinated i.e. it may not be able to act in its own best interest. This appears to be the case in this situation. Depret (or at least one of its directors) believes that the price it is charging Benedict is less than it could have achieved by selling the goods to non-connected parties. In effect these sales have not been made at an arm’s length fair value. The obvious implication of this is that the transactions have moved profits from Depret to Benedict. If the director’s figures are accurate Depret would have made a profit on these transactions of $6 million (20 – 14) rather than the $1 million it has actually made. The transactions will also affect reported revenue and cost of sales and working capital in the individual financial statements of Benedict and Depret. Some might argue that as the profit remains within the group, there is no real overall effect as, in the consolidated financial statements, intra-group transactions are eliminated. This is not entirely true. The implications of these related party sales are serious:

–  Depret has a minority interest of 45% and they have been deprived of their share of the $5 million transferred profit. This could be construed as oppression of the minority and is probably illegal.

–  there is a similar effect on the profit share that the directors of Depret might be entitled to under the group profit sharing scheme as Depret’s profits are effectively $5 million lower than they should be.

–  shareholders, independent analysts or even the (independent) managers of Depret would find it difficult to appraise the true performance of Depret. The related party transaction gives the impression that Depret is under-performing. This may lead to the minority selling their shares for a low price (because of poor returns) or calls for the company’s closure or some form of rationalisation which may not be necessary.

–  the tax authorities may wish to investigate the transactions under transfer pricing rules. The profit may have been moved to Benedict’s financial statements to avoid paying tax in Depret’s tax jurisdiction which may have high levels of taxation.

–  in the same way as Depret’s results appear poorer due to the effect of the related party transactions, Benedict’s results would look better. This may have been done deliberately. Hideaway may intend to dispose of Benedict in the near future and thus its more favourable results may allow Hideaway to obtain a higher sale price for Benedict.

A14-3