Though related party transactions (RPT) are a common feature of business and commerce these days, in some cases, entities may enter into transactions with related parties at terms that unrelated parties might not enter into under normal circumstances.
Therefore, related party transactions have become a highly discussed subject which is at the cross-road of corporate governance, disclosure, transparency and market integrity rules. Especially following the Enron scandal, six-time winner of Fortune Magazine’s most innovation company in America, it was observed that the management used financial engineering and related party transactions to disguise Enron’s financial condition for over three years.
Though research in this area has provided rather a mixed image of the role of related party transactions in fraudulent financial reporting, many high profile accounting frauds around the world including Sri Lanka, in recent years have involved in related party transactions in some way. Analysts say the collapse of Golden Key and many other companies in the Ceylinco Group, was also basically to do with inter-company transactions, among other problems.
IAS 24 is the standard under the International Financial Reporting Standards that prescribes the requirements for the disclosure of related party relationships in financial statements and in Sri Lanka, the corresponding Accounting Standard is IAS 30, which is based on IAS 24.
Most key terms and definitions in IAS 24 are a matter of common sense insofar as they particularly include parent companies (in relation to a subsidiary), subsidiaries (in relation to the parent), fellow subsidiaries, associates, joint ventures, key management and close members of the family of an individual. “Key management personnel” include all those who have authority and responsibility for planning, directing, and controlling the activities of an entity. Consequently, these persons need not necessarily be directors though the definition includes “directors, executive or otherwise”.
This definition covers “shadow directors” as well—those persons in accordance with whose instructions the directors act, whether those persons are legally called directors or not as per the Companies Act, No. 7 of 2007. Although the standard 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, and thereby recognises that this issue has cross-cultural dimensions as well.
Even though it seems that some parties, by virtue of their relationship with the entity, may appear as related parties falling within the scope of IAS 24, the standard makes it clear that the following parties are not necessarily related parties as envisaged in the standard:
a) 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.
b) Customers, suppliers, franchisors, distributors, or general agents are not related to an entity solely because the entity is economically dependent on them. Therefore, a regular supplier of raw material does not automatically become a related party though the entity is economically dependent on it.
c)Two entities are not related parties simply because they have common directors or other members of key management personnel in common. This statement recognises the increasing use by significant entities of non-executive directors in order to satisfy corporate governance issues and requirements.
d)Two ventures are not related parties simply because they share joint control over a joint venture. The standard 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.
The earlier practice in Sri Lanka was that most shareholders or stakeholders of companies were only informed of related-party transactions a year after it happened through the annual report. If I recall the article titled, “Reporting of Related Party Transactions Too Late to Shareholders”, published in Financial Times, The Sunday Times, April 26, 2009, it was stated that the then Chairman of the Securities and Exchange Commission (SEC), Udaya Sri Kariyawasam at a forum on ‘Related Party
Transactions’ in Colombo raised the question in terms of adequate transparency on whether such disclosure should be made at the time the transactions are done–not a year later.
In response to this, a Directive was issued under section 13 (c) of the SEC Act by the Securities and Exchange Commission to incorporate disclosure requirements in respect of RPT by listed entities in the listing rules. This requires an “immediate disclosure” if the investment is and/or the amount due from related parties exceeds 10% of the latest audited equity or 5% of the latest audited total assets whichever is lower. The said disclosure shall include the following: the transaction date, the parties to the transaction, the relationship between the parties, a description of the transaction, the total consideration and terms of the transaction and the rationale for entering into the transaction. Equity is defined as net assets excluding preference shares. Related party is defined in SLAS 30-Related Party Disclosures (revised 2005). This change to the Listing Rules shall be effective from September 1, 2010.
However, in Sri Lanka there are many financial institutions which are not listed and accordingly not subject to the CSE listing rules, specially many companies of the collapsed Ceylinco Group were private companies.
Therefore, it is essential that the regulators shall make it mandatory for financial institutions to be listed to safeguard the long-term investments of the public. The proposed amendment to the Regulation of Insurance.
Industry Act, No. 43 of 2000 as amended states that an Insurer within three years of being issued with a license by the Insurance Board (IBSL) shall have itself listed on the Stock Exchange. An Insurer who already holds a valid license issued by the IBSL shall be required to have itself listed on the Stock Exchange. See IBSL Annual Report, 2009 at p.13.
Alternatively, Sri Lanka Accounting and Auditing Standards Monitoring Board shall be empowered to inquire into companies under its own initiative, thereby enabling it to supervise compliance with SLAS 30.
However, under the second alternative, investors of unlisted companies are not communicated immediately of RPTs, which needs to be addressed.
(The writer is a lawyer based in Australia)