Related parties under FRS 102
Related parties have long been a contentious issue and unfortunately it seems this is also the case under FRS 102 as well, writes reporting standards expert Steve Collings.
At the outset it is worth noting that if a small entity has an audit, the auditor must not ignore the disclosure requirements of FRS 102, Section 1A Small Entities.
There are specific disclosures which may need to be made in the financial statements. For example, if a related party transaction has not been concluded under normal market conditions.
Auditors must not assume that just because the entity is disclosing information in accordance with Section 1A that related party issues can be ignored because this can increase audit risk (the risk that the auditor expresses an incorrect opinion on the financial statements).
Also, the Companies Act 2006 states that disclosure of transactions which the company has entered into with related parties must be given where such transactions are material and have not been concluded under normal market conditions. This is reflected in FRS 102, paragraph 1AC.35.
Identifying a related party
A related party can be an individual or a business entity (whether incorporated or a sole trader, a partnership or an LLP).
FRS 102, Section 33 distinguishes related parties between persons who may be related parties (para 33.2(a)) and entities who may be related parties (para 33.2(b)). FRS 102, para 33.2(a) says:
‘A person or a close member of that person’s family is related to a reporting entity if that person:
(i) has control or joint control over the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.’
Terms which are shown in bold type mean that they are defined in the glossary. It should be borne in mind that the term ‘close member of that person’s family’ is not a test as to whether a close family member can influence, or be influenced by, that person in their dealings with the entity.
Instead, it is a test of whether the users of the financial statements would regard the close family members as having influence over that person and hence the test is quite wide in its scope.
For the purposes of financial reporting, ‘control’ is usually obtained by virtue of an ownership interest of more than 50% in the entity. Numeric benchmarks are not, however, the only indicator that control exists and so regard must be had to the substance of the relationship (in some situations, control can be obtained even with an ownership interest of 50% or less).
‘Significant influence’ is usually obtained with an ownership interest of between 20 and 50%. As with control, numeric benchmarks are not always an indicator that significant influence exists. There may be other characteristics which could indicate an individual may have the ability to exert significant influence over the business despite having an ownership interest of less than 20%.
The term ‘key management personnel’ is also wide in scope. It is not confined to just the directors of a reporting entity. Managers and supervisors could, for example, be regarded as key management personnel if they have any authority or responsibility for planning, directing and controlling the activities of the entity (either directly or indirectly). Key management personnel may also include directors of subsidiaries who are not on the board of the group.
Entities who are related parties of the reporting entity
FRS 102, para 33.2(b) then outlines the conditions which would give rise to an entity being related to a reporting entity. These conditions are as follows:
‘(i) the entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).
(ii) one entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other is a member).
(iii) both entities are joint ventures of the same party.
(iv) one entity is a joint venture of a third party and the other entity is an associate of the third party.
(v) the entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
(vi) the entity is controlled or jointly controlled by a person identified in (a).
(vii) a person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).
(viii) the entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.’
Entities who are not related parties
FRS 102, para 33.4 states:
‘In the context of this FRS, the following are not related parties:
(a) Two entities simply because they have a director or other member of key management personnel in common or because a member of key management personnel of one entity has significant influence over the other entity.
(b) Two venturers simply because they share joint control over a joint venture.
(c) Any of the following simply by virtue of their normal dealings with an entity (even though they may affect the freedom of action of an entity or participate in its decision-making process):
(i) providers of finance;
(ii) trade unions;
(iii) public utilities; and
(iv) government departments and agencies.
(d) A customer, supplier, franchisor, distributor or general agent with whom an entity transacts a significant volume of business, merely by virtue of the resulting economic dependence.’
|Example – One director in common
Jessie is the director of North Limited and South Limited. During the year to 31 May 2019, North sold goods to South for £10,000 plus VAT.
Under FRS 102, Section 33, two companies are not related just because they have a director in common. More often than not, a director can have influence over the running of the company, but this does not necessarily give rise to North and South becoming related parties as both companies would be expected to go about their own business for the benefit of their respective shareholders.
|Example – Security pledged for borrowings
The facts are the same as above, but now consider a situation where North Ltd has pledged security for South’s borrowings. This would mean that North has put South’s interests before its own and in this case both entities would become related parties for the entire accounting period.
FRS 102, para 33.1A clarifies that transactions entered into between two or more members of a group need not be made in the financial statements provided that any subsidiary which is a party to the transaction is wholly owned by such a member.
|Example – Intra-group trading
Autumn Ltd owns 100% of Winter Ltd. Winter Ltd owns 60% of Solstice Ltd and the non-controlling interests (40%) in Solstice Ltd are external to the group.
During the year to 31 March 2019 all three entities trade with each other.
Winter Limited is a wholly owned subsidiary of Autumn Ltd. Winter Ltd also has control over Solstice Ltd because it owns 60% of the subsidiary. However, Solstice Ltd is not a wholly owned group member and hence transactions with Solstice Ltd would be disclosed within Autumn and Winter’s individual financial statements.
If, however, Autumn Ltd owned the remaining 40% of Solstice Ltd, then Solstice would become a wholly owned subsidiary within the group and all three companies would be able to take advantage of the exemption from disclosing all trading among themselves.
Disclosure requirements for non-small entities (FRS 102, Section 33)
It should be noted at the outset that FRS 102 (both Section 33 and Section 1A) does not require the names of the transacting related parties to be disclosed. Instead, the standard requires the entity to disclose the nature of the related party relationship. This applies to both small and non-small entities.
FRS 102, Section 33 requires the following to be disclosed:
Relationships between a parent and a subsidiary are to be disclosed, regardless of whether or not there have been any related party transactions as required by FRS 102, paragraph 33.5.
The entity must disclose the name of its parent and, where different, the ultimate controlling party. When neither the parent nor the ultimate controlling party produce publicly available financial statements, the name of the next most senior parent that does so (if any) is to be disclosed.
Key management personnel compensation
Key management personnel compensation is consideration of all forms paid, or payable, to key management personnel (KMP) in exchange for services rendered.
Please note, this is not the same as the directors’ emoluments/remuneration and other benefits disclosure which is required under company law.
For the purposes of KMP compensation, it includes all employee benefits (eg salaries, benefits in kind, paid leave, profit-sharing and bonuses) including share-based payments which are dealt with in FRS 102, Section 26 Share-based Payment.
It is the cost of the compensation to the entity and must be disclosed in totality for all members of KMP (names need not be given, nor does it need to be disaggregated into remuneration, pension contributions etc).
There is an exemption in FRS 102 (March 2018) from disclosing KMP in totality. This can be applied when the entity is required by law or regulation to disclose directors’ remuneration (or equivalent) and KMP and the directors are the same body.
Keep in mind that KMP is not confined to just the directors – it can involve anyone with authority for planning, directing and controlling the entity, hence supervisors and managers who are not directors may be included in KMP. Therefore, there are a lot of entities which will be unable to apply the exemption in FRS 102, para 33.7A.
The exemption in FRS 102 (March 2018), para 33.7A was one of the amendments made by the FRC during the triennial review of the standard. It therefore applies to accounting periods commencing on or after 1 January 2019, but can be early adopted provided all the amendments arising from the triennial review are applied at the same time.
The only two amendments which can be early adopted separately without having to early adopt all the amendments are the directors’ loan and tax effects of gift aid payments amendments.
Related party transactions
Related party transactions do not have to have a price attached to them in order for them to need disclosure. They can be entered into at nil consideration and even such transactions are disclosable.
When the entity has entered into related party transactions it must disclose the nature of the related party relationship and provide further information about the transactions, outstanding balances and commitments which are necessary for an understanding of the (potential) effects of the relationship on the financial statements.
Keep in mind that this is the whole purpose of related party disclosures – to inform the user that the financial statements may have been affected by the existence of related parties and transactions and balances with those related parties.
According to FRS 102, paragraph 33.9, as a minimum related party disclosures must include:
‘(a) The amount of the transactions.
(b) The amount of outstanding balances and:
(i) their terms and conditions, including whether they are secured, and the nature of the consideration to be provided in settlement; and
(ii) details of any guarantees given or received.
(c) Provisions for uncollectible receivables related to the amount of outstanding balances.
(d) The expense recognised during the period in respect of bad or doubtful debts due from related parties.’
The above disclosures must be made for each of the following categories:
- Entities with control, joint control or significant influence over the entity.
- Entities over which the entity has control, joint control or significant influence.
- Key management personnel of the entity or its parent (in the aggregate).
- Entities that provide key management personnel services to the entity.
- Other related parties.
As noted above, FRS 102, para 1AC.35 does not require the names of transacting related parties to be disclosed. Instead, it follows the principles in Section 33 and requires the nature of the related party relationship to be disclosed.
The Small Companies and Groups (Accounts and Directors’ Report) Regulations 2008 (SI 2008/409) state that an entity may disclose details of transactions which the company has entered into with related parties.
However, both the Act and Section 1A do specifically require disclosure of material transactions which have not been undertaken under normal market conditions with:
(a) owners holding a participating interest in the company;
(b) companies in which the company has a participating interest; and
(c) the company’s directors (or members of its governing body).
In respect of such transactions, FRS 102, paragraph 1AC.35 requires the small entity to disclose:
‘(a) the amount of such transactions;
(b) the nature of the related party relationship; and
(c) other information about the transactions necessary for an understanding of the financial position of the small entity.’
The above disclosure requirements are the legally required minimum as per the Companies Act 2006.
However, it must be borne in mind that directors of small entities have a legal duty to ensure that the financial statements give a true and fair view, and hence directors must consider whether additional related party disclosures need to be made in order to achieve this.
FRS 102, Section 1A is not absolutely conclusive in every respect and potentially anything in FRS 102 is disclosable for a small entity if doing so enables a true and fair view to be given. Professional judgment in this area will be necessary.