Undoing the knots

Mar 17 2014, 02:58 IST
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SummaryDeciphering the economic substance of related party transactions

There is an expectation of greater commitment from stakeholders as well as heightened focus from regulators on the need for both “true and fair” accounting and transparent disclosures of business transactions. The value of disclosures is greater than before, especially in today’s volatile business environment involving uncertainties, complex transactions and related-party relationships. With this background, let us discuss financial reporting of related-party transactions (RPTs) and relationships, the existence of which is a normal feature of doing business.

In some cases, RPTs span the entire gamut of an entity’s operations. It is, therefore, important to properly account and disclose them in the financial statements, so that users can assess their impact on the entity’s performance and financial position, including incumbent risks and opportunities. This is relevant because related parties could possibly influence the terms and how transactions are carried out: sometimes entering into transactions which unrelated entities may not have otherwise agreed to—“lacking commercial substance or not at fair value or arm’s length”. The present Indian GAAP provides explicit guidance on disclosure of RPTs; however, there is limited guidance and diversity in accounting for certain RPTs when compared to international GAAP.

Operating transactions: A parent company provides its shares as awards to employees of its subsidiary, sometimes without any cross charge. Similarly, a significant promoter shareholder forms a trust and donates its own shares to provide awards to the entity’s employees. From that entity’s perspective, there is an inflow of resources being receipt of shares from the parent/trust and a corresponding consumption of those resources when share-based awards are provided as benefits for employees’ services. To reflect the economic substance of this transaction, under international GAAP, the entity would record an increase in equity representing “shareholder contribution” and a corresponding employee compensation, thereby reducing its reported results. In the absence of a mandatory accounting standard on share-based payments under the present Indian GAAP, there could be diversity in practice.

Financing transactions: A parent company or a significant shareholder provides interest-free or concessional loan to an entity. Under international GAAP, such loan would be initially recorded with the fair value being its present value discounted using an appropriate market interest rate. The difference between the loan amount and the fair value, i.e., “the benefit or contribution received from the shareholder”, would be recorded in equity. Subsequently, such loan would be measured at amortised cost using the effective interest method, thereby recording an interest expense in

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