11.2 Measurement and recognition of related party transactions
3 min read•august 16, 2024
are a crucial aspect of financial reporting. These transactions between entities with close relationships can significantly impact financial statements, requiring careful and to ensure transparency and accurate representation.
Proper accounting for related party transactions involves choosing between and measurements. Consistent application, special considerations for different transaction types, and with are essential for accurate financial reporting and disclosure of these transactions.
Measurement Bases for Related Party Transactions
Fair Value and Carrying Amount
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- Related party transactions typically measured at fair value representing price received for asset sale or paid for liability transfer in orderly transaction between market participants
- Carrying amount used in some cases representing recognized amount of asset or liability on balance sheet
- Choice between fair value and carrying amount depends on transaction nature, party relationship, and applicable accounting standards
- transactions between related parties measured at fair value to reflect
- Non-arm's length transactions may require special consideration (measuring at carrying amount or recognizing difference between fair value and transaction price directly in equity)
Consistency and Special Considerations
- Measurement basis consistently applied to similar related party transactions ensuring comparability and faithful representation
- Special considerations for different transaction types:
- Asset transfers may be accounted for at carrying amount in transferor's financial statements
- Share-based payment transactions may require modified accounting treatment
- Long-term contracts assessed for embedded leases or arrangements requiring separate accounting
Recognition of Related Party Transactions
Disclosure Requirements
- Related party transactions disclosed in including relationship nature, transaction types, and amounts involved
- Disclosure details:
- Outstanding balances
- Terms and conditions
- Guarantees given or received
- Key separately disclosed (compensation and other benefits)
- Group transactions between parent and subsidiaries:
- Eliminated in consolidated financial statements
- Disclosed in separate financial statements
- apply to disclosures but relationship nature may make transaction material regardless of size
Accounting Standards Compliance
- Specific requirements for recognition and disclosure provided by accounting standards (, )
- Standards guide:
- Identification of related parties
- Transaction types requiring disclosure
- Quantitative and qualitative information to be reported
- Compliance ensures consistency and comparability across entities
Substance of Related Party Transactions
Economic Substance Evaluation
- Evaluate economic substance of related party transactions to determine if different from legal form affecting accounting treatment
- Assess potential distortion of and position if not properly accounted for and disclosed
- Consider if transactions conducted on terms equivalent to arm's length transactions
- Analyze impact on key financial ratios and performance metrics (liquidity ratios, profitability margins)
Professional Skepticism and Manipulation Risk
- Assess potential for management to use related party transactions for financial result manipulation or specific accounting outcomes
- Auditors apply when evaluating transactions and disclosures ensuring true and fair view of financial statements
- Consider:
- Unusual transaction terms
- Circular flow of goods or services
- Transactions lacking clear business purpose
Accounting for Common Related Party Transactions
Sales and Purchases
- Recognize between related parties at fair value
- Account for difference between transaction price and fair value appropriately
- Eliminate intragroup sales and purchases in consolidated financial statements avoiding revenue and expense overstatement
- Example: Parent company sells inventory to subsidiary at cost plus 20% markup
Loans and Financing
- Initially recognize loans between related parties at fair value
- Treat difference between fair value and transaction amount as capital contribution or distribution
- Accrue and recognize interest based on market rates even if stated rate differs
- Example: Parent company provides interest-free loan to subsidiary, recognize interest expense at market rate in subsidiary's books
Complex Transactions
- Assess long-term contracts for embedded leases or arrangements requiring separate accounting
- Example: Parent company leases equipment to subsidiary at below-market rate, may need to recognize implicit subsidy
- Consider substance of share-based payment transactions involving related parties
- Example: Parent grants stock options to subsidiary employees, may require modification of standard accounting treatment
Key Terms to Review (24)
Accounting Standards: Accounting standards are authoritative guidelines and principles that dictate how financial statements should be prepared and presented. They ensure consistency, transparency, and comparability of financial reporting across different entities. By following these standards, businesses can effectively communicate their financial position and performance to stakeholders, fostering trust and informed decision-making.
Arm's length: The term 'arm's length' refers to a standard of transaction where the parties involved operate independently and have no relationship that could influence their negotiation or decision-making. This principle is crucial in financial reporting and taxation, ensuring that transactions are conducted as if the parties were unrelated, thereby promoting fairness and transparency.
ASC 850: ASC 850 refers to the Accounting Standards Codification Topic 850, which provides guidance on the identification and disclosure of related party transactions in financial statements. This standard aims to ensure that companies clearly report transactions with related parties to enhance transparency and allow stakeholders to assess the potential impacts on the company's financial position and performance.
Audit risk: Audit risk is the risk that an auditor may issue an incorrect opinion on financial statements due to undetected material misstatements. This concept is crucial for auditors as it influences their approach to assessing the reliability of financial information, particularly when evaluating transactions involving related parties that may not be conducted at arm's length.
Carrying Amount: Carrying amount refers to the value at which an asset or liability is recognized on a company's balance sheet, which is calculated as the original cost minus any accumulated depreciation or impairment losses. This amount plays a crucial role in determining the financial position of a company, especially in the context of transactions involving related parties, where fair value may differ from the carrying amount.
Complex transactions: Complex transactions refer to financial dealings that involve multiple components, conditions, or parties, making them more intricate than standard transactions. These transactions often require careful consideration of measurement and recognition rules to ensure accurate accounting and compliance with regulations, particularly in scenarios involving related parties.
Compliance: Compliance refers to the adherence to established rules, standards, and regulations, particularly in the context of financial reporting and ethical practices. In relation to related party transactions, compliance ensures that organizations follow legal requirements and accounting standards when disclosing and measuring such transactions, thereby promoting transparency and fairness in financial reporting.
Disclosure Requirements: Disclosure requirements are the rules and regulations that dictate the information companies must provide to stakeholders in their financial statements and accompanying notes. These requirements ensure transparency, allowing investors, regulators, and other interested parties to make informed decisions about a company's financial position and performance. Compliance with these requirements is crucial as it relates to various financial reporting topics, including regulatory oversight, consolidation practices, foreign currency dealings, fair value assessments, and the recognition of related party transactions.
Economic substance: Economic substance refers to the concept that the economic realities of a transaction should be reflected in its accounting treatment, rather than just its legal form. This principle is essential in assessing the true financial position and performance of an entity, as it helps to prevent manipulation through accounting practices that may misrepresent actual financial activities.
Fair value: Fair value is the estimated price at which an asset or liability could be exchanged between knowledgeable, willing parties in an arm's length transaction. This concept is crucial for accurately reflecting the true value of financial instruments, assets, and liabilities in financial statements, impacting recognition, measurement, and disclosures across various scenarios.
Financial performance: Financial performance refers to the measurement of how well an entity utilizes its assets and manages its expenses over a specific period, typically assessed through financial metrics such as profit margins, return on equity, and revenue growth. This term is essential for evaluating an organization's operational efficiency and profitability, which can be significantly influenced by related party transactions that may affect the true financial position and results of operations.
Financial Position: Financial position refers to the state of a company's financial health at a specific point in time, represented through its assets, liabilities, and equity. It provides a snapshot of what the company owns and owes, helping stakeholders assess the organization’s solvency, liquidity, and overall financial stability. Understanding financial position is crucial when evaluating related party transactions as these can significantly impact how assets and liabilities are reported and measured.
Financial Statement Notes: Financial statement notes are supplementary explanations and disclosures that accompany the main financial statements, providing additional context and detail about the financial position and performance of a company. They help stakeholders understand the assumptions, accounting policies, and specific items presented in the financial statements, including any related party transactions that may impact the overall financial health of the business.
IAS 24: IAS 24, or International Accounting Standard 24, addresses the disclosure of related party transactions and relationships. It aims to ensure that financial statements provide relevant information about these transactions, enabling users to understand the potential impact on the entity's financial position and performance. This standard recognizes that related party transactions may not always be conducted at arm's length, necessitating clear disclosures to avoid misleading financial reporting.
Internal Controls: Internal controls refer to processes and procedures implemented by an organization to ensure the integrity of financial and accounting information, promote operational efficiency, and safeguard assets. They are designed to prevent errors and fraud, ensuring compliance with laws and regulations while also enhancing the reliability of financial reporting. Strong internal controls are essential for maintaining transparency and accountability in financial operations.
Loans and Financing: Loans and financing refer to the process of borrowing money to fund various activities or investments, with an obligation to repay the borrowed amount, usually with interest. These transactions can involve different entities, including banks, financial institutions, and related parties, where special considerations must be given to ensure transparency and proper measurement in financial reporting.
Management personnel transactions: Management personnel transactions refer to the financial dealings and exchanges that occur between an organization and its key management personnel, which can include executives, directors, and other individuals in positions of authority. These transactions can involve salaries, bonuses, loans, or other compensations that may influence the financial reporting and overall performance of the organization, especially in the context of related party transactions.
Manipulation risk: Manipulation risk refers to the potential for a company to engage in unethical or deceptive practices to influence financial reporting and misrepresent its financial position. This risk is particularly prevalent in related party transactions, where the interests of connected parties may lead to biased or distorted financial information, impacting the reliability and integrity of financial statements.
Materiality Considerations: Materiality considerations refer to the principle that information is material if its omission or misstatement could influence the economic decisions of users relying on the financial statements. This principle is essential for ensuring that financial reports provide a true and fair view of an entity's financial position, particularly in contexts where related party transactions may occur, as these can significantly impact the perceived integrity of the financial information presented.
Measurement: Measurement refers to the process of quantifying the value of an asset or liability and determining its appropriate accounting treatment. In the context of related party transactions, measurement plays a crucial role in ensuring that these transactions are reported accurately and fairly, reflecting their true economic substance rather than just their form. This is essential to maintain transparency and uphold the integrity of financial statements.
Professional Skepticism: Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. It is essential for auditors to remain alert to conditions that may indicate possible misstatement due to error or fraud, especially when dealing with transactions involving related parties, where the risk of bias and manipulation is often higher. This mindset encourages auditors to gather sufficient and appropriate evidence to support their findings, fostering transparency and accountability in financial reporting.
Recognition: Recognition is the process of officially acknowledging and recording an event, transaction, or item in financial statements. It ensures that transactions are accurately reflected in a company's financial records at the right time and value, playing a critical role in how related party transactions are reported and understood.
Related Party Transactions: Related party transactions refer to business dealings between two parties that are linked by a pre-existing relationship, such as family, business partnerships, or ownership stakes. These transactions are crucial to understand because they can impact the financial statements and performance of an entity. Recognizing and measuring these transactions accurately is essential for fair financial reporting, as they can sometimes be conducted at non-market terms, thus potentially distorting the true economic position of the parties involved. Transparency through disclosure is vital to ensure that stakeholders are aware of any potential conflicts of interest or biases in these dealings.
Sales and Purchases: Sales and purchases refer to the transactions that occur when a company sells goods or services to customers and acquires goods or services from suppliers. These transactions are essential for the operation of businesses, impacting revenue generation and inventory management. Properly measuring and recognizing these transactions is crucial, especially in the context of related party transactions, where both parties have a close relationship that can affect pricing and terms.