Issues Analysis Related Party Transactions

Transcription

1 Issues Analysis Related Party Transactions Prepared by Staff of the Public Sector Accounting Board September 2012 TABLE OF CONTENTS PARAGRAPH Introduction Background Need for a new standard Implications of implementation Applicability Key management personnel Recognition and measurement Recognition of contributed goods and services Measurement Disclosures Disclosures about contributed goods and services

2 Introduction.01 This Issues Analysis is a supporting document to the Public Sector Accounting Board (PSAB) Exposure Draft, Related Party Transaction, issued for comment in September It provides information on how significant matters arising from comments received on PSAB s Invitation to Comment, Related Party Transactions Definitions and Disclosures, and Issues Paper, Related Party Transactions Recognition and Measurement, have been dealt with in the Exposure Draft. The analysis has not been issued under the authority of PSAB. Prior to approving a final standard, the Board will review and deliberate responses submitted to the Exposure Draft. Background.02 The Invitation to Comment and Issues Paper were issued for comment in October PSAB received 16 and 17 responses to the Invitation to Comment and Issues Paper, respectively. Respondents, although raising issues with specific proposals, were generally supportive of the definitions and disclosures proposed in the Invitation to Comment. As well, respondents generally supported inclusion of guidance on recognition and measurement..03 Positive feedback was received from respondents on the definition of a related party and disclosure requirements..04 The major issues raised by respondents included: (a) the need for a standard; (b) the implications of implementation; (c) the applicability of the standard; (d) whether key management personnel should be included; (e) the need for recognition and measurement guidance; (f) recognition of contributed goods and services; (g) measurement of related party transactions; (h) the complexity of the disclosures; and (i) disclosures about contributed goods and services were onerous. Need for a new standard.05 PSAB considered the comments of respondents that felt a standard on related party transactions was not needed in the PSA Handbook. In the absence of a standard, public sector entities would be required to develop accounting policies in accordance with GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Section PS Under Section PS 1150, an entity may analogize to an existing primary source of generally accepted accounting principles (GAAP) or refer to other authoritative standards. The selection of an appropriate accounting policy requires that it be consistent with the primary sources of GAAP and the concepts described in FINANCIAL STATEMENT CONCEPTS, Section PS Generally, the definitions and disclosures in a chosen standard would be applied in their entirety. PSAB concluded that there may be negative implications for public sector entities in adopting other authoritative standards.

3 .06 Other standard setters have developed very broad definitions of a related party. For example, related parties commonly include: (a) parties that have the ability to exercise, directly or indirectly, significant influence 1 over another or that are under common significant influence; (b) entities accounted for using the equity method; and (c) individuals that are members of key management personnel of a reporting entity and individuals identified as a close member of the family of that individual..07 Objectives of other authoritative standard setters that drive the requirements in standards may not be consistent with the objectives of public sector financial statements. For example, others focus on transactions with key management personnel including, in some cases, compensation arrangements. This is due to the fact that their responsibilities may enable them to influence the benefits of office that flow to them and their related parties or because of their fiduciary responsibilities and extensive powers over deployment of resources..08 Other authoritative standard setters may have different thresholds when assessing reportable related party transactions. Most authoritative standard setters require that both the qualitative and the quantitative characteristics of materiality are considered. That is, given the nature of the relationship, a transaction may be material regardless of its size..09 Other authoritative standard setters may require the measurement of related party transactions. For example, many require disclosure of the volume of related party transactions, regardless of whether any consideration is exchanged, either as a specific monetary amount or as a proportion of a class of transactions to explain the effect of those transactions on the entity..10 Entities coming into the PSA Handbook that have previously been applying standards in the CICA Handbook Accounting may not be able to continue to do so because those standards do not comply with GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Section PS For example, RELATED PARTY TRANSACTIONS, Section 3840 in Part II of the CICA Handbook Accounting, requires related party transactions be measured at carrying amount except in certain circumstances. Any difference between carrying amount and exchange amount is recognized directly in equity. These requirements may conflict with the financial statement concepts that does not provide for an equity element. In some cases, the standard may conflict with the requirements in TANGIBLE CAPITAL ASSETS, Section PS Significant influence may be gained by an ownership interest, statute, or agreement. In addition, it may be exercised in other ways, such as representation on the governing body, participation in the policy making process, material transactions between entities within an economic entity, interchange of managerial personnel, or dependence on technical information.

4 .11 Although the standards for not-for-profit organizations in the pre-changeover standards in Part V of the CICA Handbook Accounting (4400 series) have been carried forward to the PSA Handbook (PS 4200 series), an increasing number of government not-for-profit organizations are being directed by provincial governments that control them to adopt the PSA Handbook without the standards for not-for-profit organizations. As a result, these organizations that have been reporting related party transactions will also have to adopt an appropriate policy using GENERALLY ACCEPTED ACCOUNTING POLICIES, Section PS Based on the analysis, PSAB is of the view that a standard is required. Inconsistencies in reporting may result due to differences in the authoritative sources that may be chosen for development of an accounting policy and differing interpretation of those standards. Implications of implementation.13 A number of respondents expressed concern about the implications of implementation of this Section. There was concern about the practicality for a government to identify all related parties and transactions for disclosure given: (a) the breadth and nature of government operations and activities; (b) the pervasiveness of related party relationships and transactions that are common in the public sector environment; and (c) the fact that the majority of transactions public sector entities engage in, unlike commercial entities, are non-market transactions to meet policy objectives..14 To address concerns about the implications of implementation, the Exposure Draft clarifies that the objective of this Section is disclosure of sufficient information about the terms and conditions on which transactions between a related parties were conducted and the relationship underlying them that enables users to assess the effect that they may have had on the reporting entity s financial position and financial performance. Judgment is applied in determining what transactions are reported and the level of detail required for fair presentation..15 There is a general concept underlying all standards that they are not intended to apply to immaterial or insignificant items or matters. The Exposure Draft includes a number of additional factors for consideration when exercising judgment in assessing reportable transactions. These factors include, but are not limited to: (a) the nature of terms and conditions attached to the transactions; (b) the financial significance of the transactions; (c) the relevance of the information to users; and (d) the users need for the information to understand the financial statements and make comparisons..16 PSAB is of the view that disclosures are only required when transactions are material to the financial statements. When considering disclosure of related party transactions, the quantitative characteristics of materiality are considered. Certain related party transactions are of such financial significance that it is essential that they be adequately described in the financial statements in order to provide an

5 understanding of the reporting entity's financial results and position. In light of the objectives of financial statements, in general, and this Section as described in this issues paper, disclosures are not intended to identify moral hazards. 2 Applicability.17 While most respondents to the Invitation to Comment agreed that the standard should apply to all public sector entities, a few made the following arguments for exclusion of ministries and departments from the scope of a standard: (a) it is normal in the public sector for governments to establish individual policies regarding inter-organization arrangements that reflect a government's policy objectives, accountability structures and budgetary practices; (b) government departments are not separate entities but rather divisions or segments through which a government organizes its operations; (c) conflict of interest and integrity legislation govern the relationship between government units within the government reporting entity and individuals that are members of key management personnel and their close family members; and (d) disclosure is only necessary in the financial statements of government organizations that are separate legal entities with delegated broad financial powers and operational authority that are currently applying related party disclosure standards in Part V of the CICA Handbook Accounting..18 PSAB considered whether to exclude those government organizations that, as described in GOVERNMENT REPORTING ENTITY, Section PS 1300, are integral to government operations. This Section would only apply in situations when these types of entities issue general purpose financial statements applying the standards in the PSA Handbook. If this is the case, related party transactions are likely to have a financially significant effect on reported financial position and financial performance such that disclosure is necessary for users to understand the financial statements and the operating environment..19 PSAB is of the view that this Section should apply to all public sector entities that for purposes of their financial reporting adhere to the standards in the PSA Handbook because: (a) the ability of one entity to control the financial and operating policies adopted by another entity, and policies regarding inter-organizational arrangements, could have a material effect on the financial position and performance reported by an entity in its financial statements; (b) information relevant to the decisions made by users and for assessing accountability is omitted if disclosures about financially significant transactions with related parties are not included in financial statements; (c) disclosures assists users make comparisons; 2 The risk that a party to a transaction has not entered into a contract in good faith, has provided misleading information or has an incentive to take unusual risks.a moral hazard may occur where the behavior of one party may change to the detriment of another after a transaction has taken place.

6 (d) disclosures describing the terms and conditions of transactions and relationships underlying them, such as outstanding balances and commitments, may affect assessments of an entity s operations, including assessments of the risks and opportunities facing the entity. Key management personnel.20 PSAB debated, at length, the issue of whether the definition of a related party includes individuals who are members of key management personnel of a reporting entity and their close family members. By their nature, key management personnel are related parties. Other government organizations and government not-for-profit organizations have been reporting under RELATED PARTY TRANSACTIONS, Section 3840, or DISCLOSURE OF RELATED PARTY TRANSACTIONS BY NOT-FOR-PROFIT ORGANIZATIONS, Section 4460, both of which include key management personnel and close members of their family in the definition of a related party..21 The majority of respondents to the Invitation to Comment agreed that the definition of a related party should include key management personnel of the reporting entity. There was no clear consensus on the issue of whether the definition includes close family members of key management personnel. However, of concern to the majority of respondents was: (a) the breadth of the proposed definitions of key management personnel and close members of their family; (b) whether elected officials should be included in the definition as most have only indirect authority or responsibility for planning, directing and controlling the activities of a public sector entity; and (c) the level of detail to track and report..22 In an attempt to address the concerns of respondents a number of changes have been made in the Exposure Draft. Although the general definition of key management personnel remains as those persons having authority and responsibility for planning, directing and controlling the activities of the entity. the Exposure Draft is less prescriptive than the Invitation to Comment in identification of who would be considered key management personnel. The Exposure Draft introduces the concept of the degree of influence as a factor in determining whether key management personnel and a controlled entity are a related party of the reporting entity. The definition of close family members has been narrowed as suggested by respondents. The Exposure draft is also less prescriptive than the Invitation to Comment in identifying relationships that would be close members of the family..23 Earlier discussion of reportable transactions is also relevant to the issue of the implications of including key management personnel in the definition of a related party. Again, judgment is applied in determining what transactions are reported and the level of detail required for fair presentation..24 PSAB is of the view that a standard should include key management personnel because of their fiduciary responsibilities, their powers over the deployment of the

7 economic resources, and their responsibility for the strategic direction and operational management of a reporting entity. As well, the definition of a related party should include their close family members. Recognition and measurement.25 PSAB debated at length over whether a related party transaction standard should include recognition and measurement guidance. Governments establish individual policies regarding related party arrangements such as shared services or centrallymanaged services, assets and liabilities that reflect policy objectives, accountability structures and budgetary practices. These arrangements often result in the control, accounting and benefit/loss related to an item to occur in separate entities. There is a divergence of accounting practices for these arrangements among government organizations currently issuing general purpose financial statements, which make comparisons difficult..26 PSAB considered the potential negative implications if a standard does not include guidance. It would mean transactions would be reported at whatever value is determined by government policy or the related parties unless there is a specific existing standard. Unless there is a specific existing standard that stipulates how related party transactions should be recognized and measured, reporting inconsistencies will persist in affecting comparability..27 Application of existing standards may lead to unintended results. For example, in a restructuring, a recipient would recognize assets at fair value under TANGIBLE CAPITAL ASSETS, Section PS This would add complexity to the preparation of consolidated financial statements as gains and losses would have to be tracked and eliminated over the life of the asset. Similarly, investments in, and loans to, related parties with concessionary terms may have to be accounted for as a grant under PORTFOLIO INVESTMENTS, Section 3041, and LOANS RECEIVABLE, Section PS 3050, respectively..28 In the absence of guidance, preparers may access other authoritative sources through the GAAP hierarchy in GENERALLY ACCEPTED ACCOUNTING POLICIES, Section PS 1150, for an appropriate accounting policy. Guidance of other standard setters would generally require transactions to be measured at fair value. For example, International Public Sector Accounting Standard (IPSAS) 23, Revenue from Non-Exchange Transaction (Taxes and Transfers), requires that an asset acquired is measured at fair value. Part III of the CICA Handbook Accounting and the PSA Handbook, ACCOUNTING STANDARDS FOR NOT- FOR-PROFIT ORGANIZATIONS, Sections 4410 and PS 4210, respectively, require contributions be measured at fair value if fair value can be reasonably estimated. NON-MONETARY TRANSACTIONS, Section 3831 in Part II of the CICA Handbook Accounting, requires an asset exchanged or transferred in a non-monetary transaction be measured at fair value. A non-monetary transaction includes transfers of non-monetary assets, liabilities or services without consideration. Again, inconsistencies in reporting may result.

8 .29 There was general agreement among respondents to the Issues Paper that the standard include recognition and measurement guidance. Respondents commented that existing guidance in the PSA Handbook is focused on summary financial statements of the government reporting entity in which related party transactions and unrealized gains/losses are eliminated. The PSA Handbook does not provide guidance to government organizations that prepare financial statements. Guidance will help address an increasing number of accounting issues resulting from the adoption of PSA Handbook standards by government organizations that previously followed other standards. A standard is needed to provide preparers with guidance on when one of three potential measurement bases is most appropriate; namely, exchange value, carrying value, and fair value..30 PSAB is of the view that recognition and measurement guidance should be included in a related party transaction standard. Issues of recognition and measurement generally arise when related party transactions occur between entities that are part of the same reporting entity. While the PSA Handbook currently contains a number of principles that could be referenced to address measurement of transactions between related entities, to a large extent, they address transactions between entities that are part of the public sector reporting entity and apply when a government is preparing its own consolidated financial statements. They do not necessarily address recognition and measurement of related party transactions in the financial statements of individual entities. Recognition of contributed goods and services.31 Contributed goods or services are related party transactions and could have a material effect on the financial position and performance reported in financial statements..32 There was no clear consensus among respondents to the Issues Paper on whether contributed goods and services should be recognized in financial statements and, if so, how they should be reported. Some commented that recognition in financial statements would reflect all significant resources consumed by a recipient entity and ensure that full cost-of-service is provided. There was an argument that a robust disclosure standard would address these issues without requiring recognition. It was argued that the decision as to which contributed services should be recognized by the recipient depends on the context in which the government operates and is a policy decision of the government. If a government organization is established as a centralized service delivery agency, accounting guidance should not define these as unrecognized related party transactions or require allocation of centrally administered costs to other government organizations..33 PSAB is of the view that a reporting entity has the option to, at a minimum, disclose information about contributed goods and services or, when those goods and services would otherwise have been purchased, recognize a revenue and expense. The Exposure Draft proposes that the determination of whether contributed goods and services should be disclosed or recognized would require

9 the exercise of judgment based on an assessment of the information needs of users and taking into account the nature of operations and legislative control. Measurement.34 The Issues Paper proposed taking a similar approach to the RELATED PARTY TRANSACTIONS, Section It proposed that, as a rule, related party transactions should be measured at carrying amount. Most respondents agreed with the proposal. A contrary argument was made that related party transactions should be reported at the value determined by government policy or the related parties unless there is a specific existing standard in the PSA Handbook stipulating how particular transactions should be measured..35 The Issues Paper proposed that in certain circumstances it would be appropriate that related party transactions are measured at the exchange amount. It introduced the concepts normal course of operations and commercial substance as a proxy for differentiating those transactions that may be measured at the exchange amount. Respondents expressed concern that the concepts, while fairly well understood in the commercial sector, needed to be put into the context of public sector entities..36 Respondents also commented that a standard should not affect how governments are organized, accountability structures adopted or budgetary practices. An accounting standard should not drive operational decision-making with respect to how a government manages its activities, allocates costs, or charges for interdepartmental provision of goods and services..37 In light of the difficulties with the definitions of normal course of operations and commercial substance in the context of the public sector, PSAB is of the view that a standard should not be prescriptive in how related party transactions are measured. The ED proposes that related party transactions should be recorded at the exchange amount which could be either carrying amount, consideration paid or received or fair value. Guidance is provided as to when each option may be appropriate Disclosures.38 The majority of respondents agreed with the proposed disclosure requirements commenting that they provide sufficient and useful information for users to understand the impact of the related party transactions on the financial position and performance of the entity. Only one respondent commented that the requirements were too complex..39 PSAB is of the view that judgment determines the level of detail to be disclosed to achieve the objectives of this standard and fair presentation. Earlier discussion about reportable transactions is also relevant to disclosures that would be made..40 The Exposure Draft also provides some relief from disclosures. It may not be necessary or practical for the provider organization or recipient organization to disclose information about transactions undertaken by an entity as part of its

10 operations on terms and conditions it is reasonable to expect would have been adopted if the parties were dealing at arm s length. Disclosures would be made if it is determined that the information would assist users of financial statements understand the operating environment. Disclosures about contributed goods and services.41 A number of respondents felt that a requirement to disclose information about every related party transaction that has not been given accounting recognition could prove an onerous task. It is argued that such disclosure would not benefit users as there would be too much information. As well, it was argued a requirement to provide sufficient information to enable users to understand the effect unrecognized transactions have had on operations and performance may be interpreted as having to quantify that effect. The standard could force entities to determine the cost of the goods and services exchanged. The difficulty to reasonably measure and the costs of doing so could be excessive and far outweigh the benefits to users..42 The Exposure Draft proposes that a reporting entity should disclose the nature of related party transactions that have not been given accounting recognition. The information would include either a qualitative or quantitative indication of the extent of unrecognized related party transactions..43 The Exposure Draft does not intend that related party transactions that were not given accounting recognition would have to be quantified. It is acknowledged that in the absence a quantitative indication of the extent of such transactions, it may be difficult for users to determine the terms and conditions on which they might have occurred if the parties were unrelated. However, a qualitative explanation about the transactions would help users of financial statements detect and explain possible differences or evaluate their significance to the performance of the entity..44 PSAB is of the view that disclosure of contributed goods and services is necessary because they could have a material effect on the financial position and performance reported in financial statements. Relevant information is omitted if disclosures about significant related party transactions are not included because such transactions may result in reported operating results or a financial position significantly different from that which would have been obtained if the related parties were autonomous.