Related Party

Transactions
 Contents
2

 Who are related parties

 What constitutes related party transactions
 Forms of inappropriate related party
transactions
 Role of audit Committee in respect of related
party transactions
 Disclosure requirements of related party
transactions
Introduction
 The foundation of trust among shareowners,
directors, and managers consists of four
corporate governance pillars: those are
 Transparency
 Accountability
 Fairness and
 Responsibility
Introduction
 Transparency means that shareowners and other key
stakeholders should know why every material decision
has been made.
 Accountability means that Directors are to be held

accountable for their decisions and actions not only to

shareowners but also to key stakeholders in certain
cases.
 Fairness means that all shareowners should receive
equal, just, and unbiased consideration by the directors
and management; and
 Responsibility means that directors should carry out
their duties with honesty, probity, and integrity.
Introduction
 These four pillars provide the foundation for
the principles of corporate governance.
 One of the principles of corporate governance
inter alia states that there should be
equitable treatment of all shareholders,
including minority and foreign shareholders.”
Introduction
 Topic of Related Parties and Related Party
Transactions is specifically connected with
the concepts of conflict of interest, the
governance pillars of transparency, fairness
and responsibility and the Corporate
Governance Principle of “Equitable Treatment
of All Shareowner”.
Who are Related Parties

 Let us first understand who are related

parties in context of an entity.
 “Related Party” is defined in the fourth and
fifth schedules of the Companies Ordinance
1984 and also in the International Accounting
Standard 24
 According to International Accounting
Standard 24, a “related party” is a person or
entity that is related to the entity that is
preparing its financial statement.
Who are Related Parties
IAS 24 then describes a persons or a close
member of that person’s family who may be
deemed as a related party. In this context the
standard states that it is related if it
1. If it has the control or joint control of
reporting entity
2. If it has significant influence over the other
entity
3. If he/she is a member of the key
management personnel of reporting entity or
of a parent reporting entity
Who are Related Parties
IAS 24 also defines as to which entity would be
considered related to the other entity. In this
context entities are considered to be related
parties when one of them is either;
1. Has the ability to control the other entity
2. Can exercise significant influence over the
other entity in making financial and operating
decisions
3. Has joint control over the other

4. Is a joint venture in which the other entity is

a joint venture
Who are Related Parties
5. Functions as key management personnel of the
other entity
Who are Related Parties
In the context of the definitions there are
three important concepts that need
understanding. These are;
 What is meant by control

 What constitutes significant influence, and

 Who are deemed key personnel

Control
 An entity is considered to have ability to
“Control” another entity if it has power to
govern the financial and operating policies of
the other entity so as to obtain benefits from
its activities
Significant Influence
 An entity is considered to possess the ability
to exercise “Significant Influence” over
another entity if it participates in the
financial and operational policy decisions of
that other entity.
 The existence of significant influence by an
entity is usually evidenced in one or more of
the these ways:
Significant Influence
 By representation on the board of directors
 By participation in the policy making process,
including participation in decisions about
dividends or other distributions;
 By material intercompany transactions
 By interchange of managerial personnel; or
 By provision of essential technical information
Significant Influence
 Significant influence may be gained
through agreement or statute or share
ownership.
 An enterprise is deemed to possess the
ability to exercise significant influence if
it directly or indirectly through
subsidiaries hold 20 percent or more voting
power of another enterprise.
Key Management Personnel
 Key management personnel are those
persons having authority and responsibility
for planning, directing and controlling the
activities of the entity, directly or
indirectly, including any director of that
entity. The director may be an executive
or a non executive director.
Substance over Form
 In determining “Related Parties ”
relationships, however the emphasis is on
“Substance” of the relationship rather
than the “Legal Form”
 For example two entities do not necessarily
become related parties simply because
they have a director or other member of
key management personnel in common
 Two venturers do not become related
parties simply because they share joint
control over a joint venture
Substance over Form
 Further, where an entity has 20 percent or
more voting power and it can be clearly
demonstrated that it does not have the
ability to exercise significant influence ,
then those entities will not be deemed as
related parties.
 However, where an entity has less than 20
percent voting power but it can be clearly
demonstrated that it has the ability to
exercise significant influence , then those
entities will be deemed as related parties.
Related Party Relationships

 Related party relationships are a normal

feature of commerce and business.
 Most related-party relations are
institutionalized activities that oil the gears
of business groups globally.
 Hence, entities may carry on parts of their
activities through subsidiaries, joint ventures
and associates.
Related Party Relationships
 Such Related activities may include
 leasing of property,

 sharing of assets and resources,

 group procurement to take advantage of economies

of scale,
 shared-service arrangements for back-office
functions,
 intercompany financing, and other treasury
management techniques,
 ensuring guaranteed supply of raw material through
a subsidiary or by direct investment in its vendor
(vertical integration)
Related Party Relationships
 Group-ownership structures do not have to
engage in related-party transactions to pose
a risk to investors.
 Simple affiliation can sometimes
compromise minority interest when certain
situations occur.
 These events, often unpredictable and
sometimes controversial affairs involving
controlling shareholders and their related
parties, may not have an impact on the
company’s economic value or even lead to an
immediate decline in its shareholder value.
Related Party Relationships
 They may, however, pose a reputational risk
when they create negative public opinion.
 More importantly, they may hint at larger
governance challenges within the company—
raising uncertainties about its future,
casting a cloud on its outlook, and ultimately
undermining the company’s intrinsic value.
Related Party Relationships
 The profit or loss and financial position of an
entity may be affected by a related party
relationship even if related party transactions
do not occur.
 The mere existence of the relationship may be
sufficient to affect the transactions of the
entity with other parties.
 One party may refrain from acting because of
the significant influence of another
 For example, a subsidiary may be instructed by
its parent not to engage in research and
development.
Related Party Relationships
 A related party relationship could have an
effect on the profit or loss and financial
position of an entity through a transactions
that unrelated parties would not enter into.
 For example, an entity that sells goods to its
parent at cost might not sell the goods on
those terms to another customer.
Related Party Relationships
 Related party transactions and relationships
have direct bearing on the assessments of an
entity’s operations and risks and opportunities
facing the entity
 If these are mingled with transactions with
normal arm’s length customers or vendors, the
users of financial statements would be
impeded in their ability to project future
earnings and cash flow for the entity
Related Party Relationships
 Hence, it is imperative that entities have
robust internal processes in relation to related
parties and also in order to make full
disclosures to the users of financial
statements.

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Related Party Transaction
 As discussed before related parties may or
may not transactions amongst them.
 We have seen before who are related parties
 Now let understand what constitutes “ related
Party Transactions”
 IAS 24 contains the definition of a related
party transaction.
 According to the standard, it represent
transfer of resources, services or obligations
between related parties, regardless of
whether a price is charged.
Related Party Transaction
 There are two key elements of the definition.
 First aspect is that there has to be a transfer
of either resources or services or obligations
or a combination thereof
 Second element is that it is not necessary for
one entity to charge a price, mere transfer of
resources, services or obligations is sufficient
for a transaction to become a Related Party
Transaction
Asia Vs West
 As we saw earlier that for strategic reasons
entities may sometimes carry out transactions
through related parties.
 For example to ensure the supply of raw
materials.
 Related transactions in the West are
different in nature and motivation from those
in Asia.

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Asia Vs West
 In key developed markets, like those in the
West, listed companies are more likely to have
diffused ownership.
 In other words there is a separation of
ownership and control.
 However, in Asia, most companies are family-
owned.

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Asia Vs West
 Hence our corporate governance emphasis on
connected transactions between the major
shareholders and the companies is different in
Asia from the Western world where they have
a more diversified shareholding structure.

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RPT - Forms
 Related Party Transactions can take different
Forms
 These may be operating transactions or
Investment transactions
 The transaction could be in the form of a
business deal or a single or a series of financial
contracts, or it could be an arrangement.

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 RPT - Abusive Transactions
 Nonetheless, there are pitfalls in related-party
transactions and the line between what is legitimate
and abusive can be crossed easily.
 Hence in the current global economic environment,
effective monitoring and curbing of abusive related
party transactions remains high on the agenda of
corporate governance.
 In fact “Abusive Related Party Transactions” – where
a party in control of a company enters into a
transaction to the detriment of non-controlling
shareholders - are one of the biggest corporate
governance challenges


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 RPT - Abusive Transactions
 Therefore Shareholders and other stakeholders need
to know the options for monitoring and curbing such
abusive related party transactions
 And this can be achieved by focusing on disclosure and
the board/shareholders approval system.

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RPT - Abusive Transactions

Primarily Abusive Related Party Transactions

are directed towards the abuse of shareholders
rights.
In general, investors are exposed to two risks;
That is
 Expropriation of wealth and/or

 Deprivation of wealth

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RPT - Abusive Transactions
 There are two incentives that give rise to
these risks.
 The first is wealth formation, that is achieved
through the transfer of assets and profits of
a publicly traded company to the private
interest of its controlling shareholder.
 The second, which derives from the first, is
appropriation of control that is realized by
either the dilution of minority ownership or by
usurpation of corporate opportunity.

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Expropriation of Wealth - RPT
 Expropriation of wealth refers to those
instances
 when a related-party transaction takes away
existing funds from a listed company
 or exposes it to undue risks and liabilities for
the exclusive benefit of controlling
shareholders.
 Common methods of expropriation are
commercial and financial transactions at
distorted values or for no justifiable reasons.

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Deprivation of Wealth Opportunity
 Whereas Deprivation of wealth refers to
actions by controlling shareholders to
 either enlarge or appropriate the amount of
control they already have over listed entities
 or to take exclusive advantage of wealth-
creating opportunities derived from listed
entities.

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Deprivation of Wealth Opportunity
 Appropriation of control can happen through
such transactions as mergers with related
parties or the issuance of new shares,
convertible bonds, or other equity-linked
instruments to related parties.
 Although valuations in these deals may (or
may not) be fairly determined, the ulterior
motive is for controlling shareholders to
reinforce or consolidate their influence in
the listed company.

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Deprivation of Wealth Opportunity
 As a consequence minority investors suffer
from short-term erosion in the value of their
shares in cases of dilution
 And their interests also get marginalized
because the long-term outcome is long-term
domination of controlling shareholders on the
company’s board.

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Deprivation of Wealth Opportunity

 Controlling interests may want to deprive

minority shareholders by excluding other
shareholders from corporate opportunity
 This usurpation occurs when a controlling
shareholder creates a business opportunity
outside the listed company’s operations.

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Deprivation of Wealth Opportunity
 Hence minority shareholders are robbed of
an opportunity from which the company as a
whole should have had the benefit.
 In many jurisdictions around the world such
usurpation might be considered a damage
caused by a director to potential interest of
the company.

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Deprivation of Wealth Opportunity
 Deprivation of wealth opportunity also occurs
when the majority shareholder takes away
the most valuable asset of a company through
privatization or the sale of its core assets.
 Although shareholders almost always have to
vote on these related transactions, they
sometimes end up getting the raw end of the
deal by being offered an unattractive
valuation with no recourse to a clear
alternative strategy.

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Satyam Computer Services
 While related party transactions may not be
the underlying cause of the fraud, the terms
and nature of such transactions can bring
focused attention on the company, and can
result in exposing an accounting fraud.
 Satyam Computer Services case is a classical
example where fraud came to fore because of
the related parties transactions

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Satyam Computer Services
 The case of Satyam Computer Services in
India has been well documented.
 On December 16, 2008, the board of
directors of Satyam approved the acquisition
of Maytas Properties and Maytas
Infrastructure for $1.3 billion and $300
million, respectively.

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Satyam Computer Services
 Both Maytas Properties and Maytas Infra
were entities related to B. Ramalinga Raju,
the founder and chairman & CEO of Satyam.
 Concerns over valuations of the two entities,
the timing, method of payment, and alleged
concerns around the deal from independent
directors led to greater scrutiny of Satyam
by investors and termination of the proposed
acquisition deals.

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Satyam Computer Services
 Eventually it was revealed that a $1 billion
accounting fraud had been committed through
inflation of cash reserves and overstating
revenues.

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Satyam Computer Services
 In the case of Satyam, the situation focused
attention on corporate governance standards
in India and the process for approving related
party transactions
 This illustrates the broader impact that
abusive related party transactions have on
national economies and perception of market
integrity.

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Examples of Inappropriate RPT
There are several ways companies indulge in abusive
related party transactions. Some of the example
are;
 Excessive dividend payments to the parent
company relative to the income of company
 The extension of credit to a parent company or
other related party with no serious attempts to
collect the outstanding receivables
 Investments, loans or deposits, sales of assets or
services to a parent company or other related
party at less than market rates of return

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Examples of Inappropriate RPT
 Loan guarantees on behalf of the parent
company or other Related Party with no
guarantee fee being charged from related
party
 Assets or services purchases from a parent
company or other related party where the
price of the asset or service is in excess of
market value
 Rental agreements with the parent company or
other related party where the rent paid or
received is greater or less than market value
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Board Oversight and Approval
 The board is charged with making decisions in
the interests of all shareholders.
 Within the decision making process of the
board, independent directors, the audit
committee, and internal/external auditors are
all required to play a significant role in
monitoring and curbing abusive related party
transactions

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Board Oversight and Approval
 Members of the Board and key executives
also have an obligation under the Company
Ordinance and Code of Corporate Governance
2012 requires to inform the board in advance
of any related party transaction causing
material conflicts of interest and conclude
the transaction with the approval of the
board through an effective monitoring system

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Role of Directors

 The law also states that directors who have

conflict of interest should not be part of the
decision making process

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Role of Directors
 It may be appropriate for companies to
prohibit directors from engaging in such
transactions.
 In order for non-controlling shareholders to
check whether the board effectively
monitors and approves related party
transactions, the company needs to develop
and disclose a policy/guide for monitoring
related party transactions.

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Role of Independent Directors

 Audit Committee and Independent directors

can play a crucial role in monitoring abusive
related party transactions.
 Independent judgment is critical to
monitoring related party transactions and to
ensure that agreed transactions are in the
interests of the company and all
shareholders.

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 Standards for Approval of
Transactions
Boards must set some standards for approving
related party transactions.
Boards would like to know;
 Whether the terms are fair to the company

 Whether the transaction is material to the

company
 The role the related party has played in
arranging the related party transaction
 Standards for Approval of
Transactions
 The structure of the related party transaction
 The interest of all related persons in the
related party transaction
 Requiring the related person to resign from or
change position within an entity that is
involved in the related party transaction with
the company
Standards for Approval of
Transactions
 Assuring that the related person would not
be involved in negotiating the terms of the
transaction or in the ongoing relationship
between the company and the other persons
or entities involved in the related party
transaction
RPT – Rules & Regulations
 As in most jurisdictions, related-party
transactions are governed by layers of rules,
regulations, and standards meant to ensure
that they are conducted in a way that does
not abuse the rights of independent
shareholders.

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RPT – Rules & Regulations
 One such layer is built on local accounting
standards, which typically apply to all
corporations and are determined by the
relevant government agency, in collaboration
with the self regulatory organizations of the
accounting and auditing professions.
 The second layer consists of stock exchange
listing rules, which set the requirements for
disclosure of financial and nonfinancial
information.

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Role of Audit Committee
Similarly Code of Corporate Governance 2012
contains such rules and requires certain steps
to be taken by the Board of directors. The code
requires that;
 The details of all related party transactions
should be placed before the Audit Committee
of the company and upon recommendations of
the Audit Committee the same should be
placed before the board for review and
approval.

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Role of Audit Committee
(b)The related party transactions which are not
executed at arm's length price should also be
placed separately at each board meeting along
with necessary justification for consideration
and approval of the board. This is to be done
on recommendation of the Audit Committee
of the listed company.

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Role of Audit Committee
(c)The board of directors of a company should
approve the pricing methods for related party
transactions that are made on the terms
equivalent to those that prevail in arm’s
length transaction. This should be done only if
such terms can be substantiated.

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Role of Audit Committee
d) Every company is required to maintain a party
wise record of transactions, in each financial
year, entered into with related parties in that
year along with all relevant documents and
explanations. In respect of each transaction
the record of related party transactions
should dive details of:

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Disclosures
 Name of related party;
 Nature of relationship with related party;
 Nature of transaction;
 Amount of transaction; and
 Terms and conditions of transaction, including
the amount of consideration received or given.

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 Pricing Methods
 There are Five Transfer Pricing Methods
 Comparable Uncontrolled Price Methods

 Re sale price methods

 Cost plus method

 Profit split method

 Transactional Net margin

 These five methods represent the manner of

applying the arm’s length principle
 Pricing Methods
 The selection of a method always aims at
finding the most appropriate method for a
particular case.
 No one method is suitable in every possible
situation, nor is it necessary to prove that a
particular method is not suitable under the
circumstances.
Difficulties faced in Auditing of
RPT
 External auditors can play a limited role
in respect of related party transactions
Difficulties faced in Auditing of
RPT
 The complexity of group structures and
the inter-connectedness of enterprises
(most notably under the ‘complicated
network ownership’ structure) means
auditors face significant challenges in
being skeptical of material information
on related party transactions
Difficulties faced in Auditing of
RPT
 Such transactions may not be easily
tracked by a company’s internal control.
It is difficult, for example, to spot a
deal between a company and a private
entity whose controlling shareholder is a
relative. Likewise, a subsidiary that
initiated a related transaction may not
have made the proper audit
documentation to adequately report the
transaction back to the head office
Difficulties faced in Auditing of
RPT
 External auditors therefore have to rely
on management and principal owners to
identify all related parties and related-
party transactions.
 In general, auditors assume that related-
party deals are made under the normal
course of business until proven otherwise;
however, understanding the rationale for
deals that do not follow the normal
pattern entails questioning directors, who
may not necessarily cooperate.
Procedure to Implement
External auditors usually
 Understand and evaluate the company’s
procedures for identifying, authorizing
and accounting for related party
transactions.
 Obtain sufficient evidence to gain
comfort that related party transactions
have been properly recorded and
disclosed
 Verify correctness of information for
disclosure items (i.e. nature of the
relationships, amount, and description)
Auditor should Consider
Additionally the look at
 Whether the form of such transactions
is overly complex
 Whether management has discussed the
nature of and accounting for such
transaction
 Whether the management is placing
more emphasis on the need for a
particular accounting treatment than on
the underlying economics of the
transaction
Auditor should Consider
 Whether the transaction that involves
unconsolidated related parties, including
special purpose entities, have been
properly reviewed and approve by the
audit committee or board of directors
 Whether transactions involve previously
unidentified related parties that do not
have the substance or the financial
strength to support the transaction
without assistance from the entity under
audit
Disclosure
 Transactions between enterprises that
are considered related parties must be
adequately disclosed in financial
statements of the reporting entity
 IAS 24 prescribes extensive disclosures
in this regard
 Disclosures
 Parents and Subsidiaries are bound by IAS 24
to disclose relationship irrespective of
whether there have been transactions
between them. The IAS requires disclosure
of “Related Party Relationship” where control
exists. Thus by inference it could be
concluded that in case of a “Related Party
relationship” by virtue of “ Significant
Influence” there is no need to disclose a
related party relationship under this standard
unless there has been an actual transaction
based on relationship.
Disclosures
In case of related party transactions, the reporting
entity is mandated to disclose
 The nature of the related party relationship

 The information about the transaction

 The amount of transaction

 The amount of existing balances including

commitments and their contractual terms and
conditions as well as any existing guarantee
provided or received
 Provisions for doubtful debts related to
outstanding receivables
 Compensation to key management personnel
Disclosures
 IAS 24 does not make it mandatory that
related party transactions be at arms
length
 It is also important that Related party
transactions are not stated in the
financial statement to be on arms length
unless arms length can be substantiated
 Certain relate party transactions to be
approved in manner specified in
Companies Act 2017 ( Loan to
associates)
Disclosures
 IAS 24 recognizes that in many countries
certain related party disclosures are
prescribed by law
 In fact, corporate legislation in some countries
goes further and requires certain disclosures
which are even more stringent than the
disclosures requirements under IAS 24

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Disclosure
 For example, under the Companies Act of a
certain nation, in addition to the usual
disclosures pertaining to related party
transactions, under the corporate law,
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 which were due to or
due from them to the corporate entity

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Disclosure
 IAS 24 also provides examples of situations
where related party transactions may lead to
disclosures
 However that is list is not exhaustive

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Disclosures
 The standard requires that items of similar
nature may be disclosed in the aggregate.
However, when separate disclosure is
necessary for an understanding of the effects
of the related party transactions on the
financial statements of the reporting entity,
aggregation would not be appropriate

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Disclosures
 For example an aggregate disclosure of total
sales made during the year to a number of
associated companies may be made
 However on the other hand, year end balances
due from various related parties may be
disclosed category wise, say advances to
directors, associated companies

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Conclusion
 Boards have to ensure that trust of the
stakeholders in an entity is not lost and
rights of all the shareholders are
protected vigorously.
 To achieve these objective it is imperative
that boards ensure that there is a robust
process or recording, analyzing and
approval of the related party transactions.
 They also need to make certain that all
disclosures are transparently made
Potential Risk
 Failure to identify and appropriately disclose
significant related party transactions may lead
to
 Material misstatement of the financial

statements
 Hindering the financial statements from
giving a true and fair view of the state of
affairs of the entity and of the results of
its operations
 Corporate insiders to prop up earnings and
tunnel resources from the entity
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Thank you