FRS 102 creates ‘element of confusion’ around related party disclosures
Steve Collings explores the confusion created by the related parties and disclosure of related party transactions in the latest version of FRS 102.
One of the notable impacts of the EU Accounting Directive (‘the directive’), which is reflected in the Companies Act 2006, is to reduce the levels of disclosures which a small company is required to make in its financial statements.
FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland is mandatory for small companies for accounting periods starting on or after 1 January 2015, although early adoption of the framework is permissible. The presentation and disclosure requirements applicable to small companies are outlined in Section 1A Small Entities, which is found in the latest version of FRS 102 (currently the September 2015 edition).
Related parties have often caused an element of confusion, largely because of their subjective nature, and over the years standards that deal with related party disclosures have been amended to cope with a wide variety of potential related parties and transactions with those parties.
This was done with the objective that the users of the financial statements have their attention drawn to the possibility that the reported financial position and results may have been affected by the existence of related parties and material transactions with them during the year. The directive unfortunately adds to that subjectivity for small company directors, because it will require more professional judgement to be exercised; largely on the part of the directors, but also on the part of the accountant preparing the financial statements.
Many accountants will be aware from reading around the subject of FRS 102 or attending CPD courses that the revised Companies Act 2006, which reflects the provisions of the directive, reduces the number of disclosures required by law for small companies. Where related parties are concerned, the directive only requires a small company to make ‘limited’ related party disclosures and this is reflected in Section 1A of FRS 102 at paragraph 1AC.35.
Practitioners should also be aware that SI 2015/980 removes the requirement to disclose directors’ remuneration in the financial statements. The reduction in related party disclosure requirements and the directors’ remuneration issue for small companies are two areas where, potentially, problems are going to emerge.
What are ‘limited’ related party disclosures?
Paragraph 1AC.35 of FRS 102 says:
‘Particulars must be given of material transactions the small entity has entered into that have not been concluded under normal market conditions with:
a)owners holding a participating interest in the small entity;
b)companies in which the small entity itself has a participating interest; and
c)the small entity’s directors [or members of its governing body].’
The phrase ‘… under normal market conditions’ seems to be generating lots of debate and is a phrase which is not defined within the glossary to FRS 102. The term itself can be taken to mean that transactions which have not been undertaken on an arm’s length basis can be classed as not concluded under normal market conditions.
In some cases, it will be clear that a transaction has not been concluded under normal market conditions. For example, where the small company may sell a fixed asset (e.g. an investment property) at a significant discount to a director; such a discount would not ordinarily be given to an unconnected party, and hence that transaction would be regarded as one that has not being concluded under normal market conditions and hence disclosed in accordance with paragraph 1AC.35. Paragraph 1AC.35 would require the following particulars to be disclosed:
- the amount of the transaction;
- the nature of the related party relationship; and
- other information concerning the transaction which would be necessary for an understanding of the financial position of the small entity.
As mentioned above, SI 2015/980 (which amended the Companies Act 2006 to reflect the provisions of the directive) removed the requirement for small entities to make disclosures concerning directors’ remuneration.
In practice it is not uncommon to organise directors’ remuneration and dividends in a tax-efficient manner and quite often directors are paid up to the PAYE threshold, with the balance of remuneration being taken in the form of dividends.
Directors’ remuneration would be disclosable under paragraph 1AC.35 if it is concluded that such remuneration has not been undertaken under normal market conditions. In this particular context, views certainly differ on what ‘normal market conditions’ means. Some commentators argue that ‘normal market conditions’ could be what would be regarded as ‘market rate’. Views are polarised in this respect as other commentators do not agree that normal market conditions equate to market rate.
The answer, which in fairness is not really an answer, is that it would be down to professional judgement as to whether directors’ remuneration has been concluded under normal market conditions and, therefore, does not require disclosure; or whether evidence suggests that directors’ remuneration has not been concluded under normal market conditions and hence is caught under the disclosure requirements of paragraph 1AC.35. This is one of several areas of FRS 102 which requires the use of professional judgement.
Paragraph 1AC.35 refers to directors’ remuneration as follows:
‘Transactions with directors, or members of an entity’s governing body, include directors’ remuneration and dividends paid to directors.’
In addition, paragraph 1AC.35 also acknowledges that while the standard only requires material transactions with related parties that have not been undertaken on an arm’s length basis to be disclosed, if a small company chooses to disclose all related party transactions then the company would still be compliant with the law.
Deciding on whether to disclose
Clearly, FRS 102 is going to bring many challenges to both company directors and practitioners, and the issue concerning related parties is just one of many that are emerging as FRS 102 edges closer to mandatory implementation for small companies.
Professional accountants have a duty to prepare financial statements in accordance with UK GAAP and company law, as well as in accordance with their professional body’s ethical requirements. Directors of small companies have a legal obligation to prepare financial statements which give a true and fair view, and nothing in law has changed in this respect for small companies (micro-entities are subject to the ‘deeming provisions’ in the micro-entities’ legislation, but there are no such equivalent provisions for small companies).
Practitioners are advised to make professional judgement calls as to whether directors’ remuneration has been concluded under normal market conditions and the advice is to document any decisions reached. Documenting such decisions (or, indeed, any other decisions which require professional judgement) will prove to be beneficial if any of the judgements made on the part of the director or the practitioner are challenged further down the line, either by HMRC or the firm’s professional body during a routine monitoring visit. As mentioned, FRS 102 requires judgement in a lot of areas and it’s advisable to document decisions made because views can, and invariably do, differ (as they are at present).
As mentioned above, the issue concerning related parties and disclosure of related party transactions is causing an element of concern among a lot of accountants, and this is only one of several ‘new’ requirements brought about in accounting and financial reporting because of the revisions to company law by virtue of the directive.
The FRC are currently undertaking the triennial review of FRS 102, although changes to the standard are not expected to take effect before 1 January 2019. The FRC would like to hear constructive comments on any aspect of FRS 102, together with its implementation, or any other UK and Ireland accounting standard.
These comments will be used to inform the development of proposals for changes to accounting standards, which will be subject to formal consultation at a later date (which is expected to be during 2017) with a planned effective date of 1 January 2019.
To submit comments, please email [email protected] and include views on the benefits of the new standards as well as constructive suggestions for improvements or areas where implementation posed challenges.