Related Party Transactions Issues Analysis (final)

Issues Analysis Related Party Transactions

Prepared by the Staff of the Public Sector Accounting Board
June 2013 TABLE OF CONTENTS
PARAGRAPH Introduction Background Related entities Measurement guidance Transactions undertaken as part of operations Definition of reporting entity Introduction of additional financial reporting objectives Scope exclusion of amalgamations and restructurings Interaction of proposals with other existing Sections Reportable transactions Transitional provisions Applicability of the proposed new standard Presentation of credit when contributed goods and services are recognized Recognition of unrealized gains or losses Parties to a contractual arrangement Reporting gross versus net Reference to other reports in financial statements .01 .02-.06 .07-.09 .10-.18 .19-.22 .23-.25 .26-.28 .29-.30 .31-.32 .33-.34 .35-.39 .40-.41 .42-.45 .46-.47 .48-.49 .50-.51 .52-.53

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Related Party Transactions Issues Analysis (final)

Introduction
.01 This Issues Analysis is a supporting document to the Public Sector Accounting Board (PSAB) Re-exposure Draft, Related Party Transactions. It provides information on how significant matters arising from comments received on PSABs Exposure Draft, Related Party Transactions, have been dealt with in the Re-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 Re-exposure Draft.

Background
.02 An Exposure Draft was issued for comment in September 2012. The comment period ended November 21, 2012. Respondents, although raising specific issues, were generally supportive of the proposed standards for the recognition, measurement and disclosure of related party transactions. Major issues raised by respondents to the Exposure Draft included: (a) whether a related party includes an entity when a member of key management personnel or a close family member of that individual is a member of the management or governing body of the entity; (b) measurement guidance that provides options limits the relevance of the standard and the achievement of comparability and consistency in reporting; (c) the need to clarify the type of transactions that would be considered undertaken as part of operations; (d) the need to define a reporting entity as distinct from a government reporting entity; (e) the need to clarify retroactive or prospective application in transitional provisions; and (f) the introduction of alternative financial reporting objectives not in FINANCIAL STATEMENT OBJECTIVES, Section PS 1100, within the proposed standard. PSAB concluded that the changes to the Exposure Draft represent a "significant change", requiring re-exposure. A number of other changes to the Exposure Draft are also included in the Re-exposure Draft. These changes are not discussed in this Issues Analysis because they are considered clarification of proposals and editorial in nature. The following issues were considered by PSAB but did not result in substantive changes to the proposals in the Exposure Draft: (a) the standard should deal with amalgamations and restructurings involving related parties; (b) uncertainty about the interaction of proposals with other existing Sections; (c) the factors to be considered in identifying reportable transactions; (d) the applicability of the standard to entities that are integral parts of a government and government organizations;
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(e)

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the presentation of the credit as an adjustment to accumulated surplus/deficit when contributed goods and services are recognized by departments and agencies; the recognition of unrealized gains or losses in net assets when there is a difference between the exchange amount and the carrying amount; the need to clarify contradictory guidance on whether parties to a contractual arrangement are related parties; the appropriateness of guidance on reporting gross versus net when an entity is acting as principle or agent; and the appropriateness of making a reference to other public reports in financial statements to demonstrate compliance with the standard.

The following issues raised by respondents to the Exposure Draft were the same or similar to issues raised previously in responses to PSABs Invitation to Comment on definitions and disclosures, and the Issues Paper on recognition and measurement: (a) the need for a new standard; (b) inclusion of key management personnel and close members of their families in the characteristics of related parties; and (c) recognition or disclosure of contributed goods and services. PSAB is of the view that no new information was forthcoming in the responses that would warrant reconsideration of its views discussed in the Issues Analysis, Related Party Transactions, that accompanied the Exposure Draft.

Related entities
.07 A number of respondents argue that the ability of a member of key management personnel of a reporting entity or a close family member of that individual to participate in financial and operating policy decisions of an entity does not mean that they can control those decisions. There was concern that this characteristic of a related party would have the unintended result of increasing the number of entities that would be considered related parties. Obtaining this information is not practical for senior governments and would create a significant administrative burden. It was suggested that only those entities that are under control or shared control by the member of key management personnel or close family members should be included in the characteristics of related parties. PSAB is of the view that this characteristic of a related party should be retained in the final standard. The ability to participate in the financial and operating decisions of an entity may affect the terms and conditions of transactions between the parties and could affect the reported financial position and performance of a reporting entity. The Re-exposure Draft clarifies that entities may be related when a member of the key management personnel of the entity that is preparing financial statements or a close family member of that individual is also a member of the key management personnel of another entity. By definition, these individuals would have authority
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and responsibility for planning, directing and controlling the activities of the other entity. PSAB also proposes to include guidance that indicates that the exercise of judgment is required in determining whether the entities are related. The determination considers the degree of influence the individual is able to exert over the financial and operating decisions of the entity.

Measurement guidance
.10 Several respondents commented that the options proposed in the Exposure Draft for measuring related party transactions limit the relevance of a standard. As well, PSABs objective of achieving comparability of reporting through a standard would not be achieved. Others commented that more guidance is needed to assist in determining when the carrying amount, consideration paid/received or fair value is the appropriate measurement base for a specific transaction. Clearer guidance on the specific circumstances under which the three options is appropriate under differing circumstances would encourage consistency in reporting. A few commented that measurement guidance should be harmonized with guidance on related party transactions included in RELATED PARTY TRANSACTIONS, Section 3840 in Part II of the CICA Handbook Accounting. It was argued that the standards in Section 3840, including the concepts of normal course of operations and commercial substance, are well understood by government organizations who previously adopted the standards in the CICA Handbook Accounting. It was felt that aligning the guidance with Section 3840 would result in less diversity in practice and would be easier to apply than the very broad guidance provided in the proposed standard. Several respondents suggested that there was an inconsistency between the definition of exchange amount and the application of the concept in the body of the proposed standard. According to the definition, exchange amount is the amount of the consideration as established and agreed to by the related parties. Yet the measurement principle in the Exposure Draft states that the exchange amount can be: (a) the carrying amount; (b) the consideration paid or received; or (c) fair value. The Re-exposure Draft proposes measurement guidance that is more definitive. Generally, related party transactions would be measured at the carrying amount unless: (a) they are in the normal course of operations on terms and conditions that would have been adopted if the parties were dealing at arms length; or (b) a recipient organization's future economic benefits or service potential is expected to change significantly as the result of the related party transaction. In these latter cases, the transaction is measured at the exchange amount.
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The carrying amount is the amount of an item transferred, or cost of services provided, as recorded in the accounts of the provider organization, after adjustments, if any. Use of the carrying amount retains the amount attached to the item transferred or the cost of the service provided. It reflects the fact that a substantive change in the consolidated interest in the item or service does not occur when the transaction occurs between entities under common control. When the carrying amount is not available, a reasonable estimate of the carrying amount, based on the provider's original cost, may be used to measure the transaction. The exchange amount is the amount of the consideration as established and agreed to by the related parties. The exchange amount may be determined by policy objectives, accountability structures adopted or budgetary practices. Generally, the exchange amount may range between nil and fair value. When related party transactions occur in the normal course of operations, the exchange amount may approximate fair value. This reflects the existing accountability framework for a public sector entity and the way in which operations are managed. This amount would be representative of the economic substance of the transaction and sufficiently reliable to be used for financial reporting purposes. When a recipient organization's future cash flows, or its capacity to provide goods and services, is expected to change significantly as a result of the related party transaction, the exchange amount is the measurement basis. In these circumstances, using fair value may be appropriate.

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Transactions undertaken as part of operations

.19 The Exposure Draft proposed that it may not be necessary or practical for the provider organization or recipient organization to disclose information about related party transactions undertaken as part of normal operations. The proposal was intended to provide relief from disclosures when the transactions between related parties were undertaken on terms and conditions similar to those that would be expected if the parties were dealing at arms length. Several respondents commented that the proposed standard introduced a new concept and asked for clarification of the type of transactions that would be considered a part of normal operations. Both the Invitation to Comment on definitions and disclosures and the Issues Paper on recognition and measurement proposed the term in the normal course of operations as the proxy for differentiating those related party transactions not requiring disclosure or that could be measured at the exchange amount from others. Respondents expressed concern that the concepts, while fairly well understood in the private sector, needed to be put into the context of public sector entities. It was argued that it was common for related parties in the public sector to engage in transactions that would not take place between unrelated parties or
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would be subject to different terms and conditions in the normal course of operations .21 The Re-exposure Draft proposes to reintroduce the term in the normal course of operations to differentiate those related party transactions where disclosures are not required. For the purposes of the standard, a related party transaction in the normal course of operations occurs within a normal business relationship and on terms and conditions that are similar to those of transactions with unrelated parties. In these instances, generally one related party is transacting with both unrelated and related parties in a business relationship. The Re-exposure Draft uses the example of an entity that sells electricity to both other entities under common control of a government and unrelated parties. In this case, disclosure of information about these transactions by the provider organization and the recipient organizations may not be necessary when the terms and conditions are the same as, or similar to, those for unrelated parties.

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Definition of reporting entity

.23 One respondent was concerned that the Exposure Draft used the term reporting entity in a number of places, yet reporting entity is not defined in the CICA Public Sector (PSA) Handbook. The respondent questioned whether the term was intended to refer to the government reporting entity as defined in GOVERNMENT REPORTING ENTITY, Section PS 1300. If not, it was suggested that a definition was required.
The purpose of GOVERNMENT REPORTING ENTITY, Section PS 1300, is to

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define the scope of the government reporting entity (i.e., the government's financial reporting entity) in terms of the organizations whose financial affairs and resources would be included in government financial statements. It also establishes standards on how to account for and disclose those organizations in government financial statements. The Section has no application to other entities that are preparing general purpose financial statements. .25 The Re-exposure Draft eliminates references to reporting entity. The Reexposure Draft clarifies that a related party can be an entity or an individual that is related to the entity that is reporting on its financial position and changes in financial position.

Introduction of additional financial statement objectives

.26 One respondent was concerned that the Exposure Draft introduced alternative financial reporting objectives (i.e., demonstrating accountability for the use of resources for which a reporting entity is responsible and for assessing whether resources were administered in accordance with the limits established by legislative authorities). It was argued that these objectives are not included in, nor
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are they consistent with, FINANCIAL STATEMENT OBJECTIVES, Section PS 1100. .27 The respondent felt that financial statement objectives should be included in the conceptual framework and not be presented in a specific standard. Also, any proposed changes to financial reporting objectives should be exposed and approved prior to concluding the standard. The proposal in the Exposure Draft was intended to suggest factors that might be considered in making a decision as to whether to recognize or disclose information about contributed goods and services in financial statements. The wording in the Re-exposure Draft has been modified to clarify that the proposals are not intended to introduce additional objectives to those in FINANCIAL STATEMENT OBJECTIVES, Section PS 1100.

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Scope exclusion of amalgamations and restructurings

.29 Several respondents questioned the scope exclusion for amalgamations and restructuring. Since these transactions are common in the public sector and almost always carried out between related parties, it would be appropriate to deal with this topic in the proposed standard on related party transactions. Guidance is needed to ensure consistency. There is an ongoing project on restructurings. The intended outcome of the project on restructurings is to provide accounting and financial reporting guidance that reflects the nature and economic substance of a wide range of restructuring transactions.

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Interaction of proposals with other existing Sections

.31 Several respondents expressed uncertainty regarding how contributed tangible capital assets would be accounted for when the transaction is between related parties. The respondents commented that the uncertainty was created due to inconsistencies between existing standards in the PSA Handbook and the proposals in the Exposure Draft. GOVERNMENT TRANSFERS, paragraph PS 3410.14, states that the transfer of a tangible capital asset is recognized as an expense by a transferor at the net book value of the tangible capital asset transferred. Paragraph PS 3150.14 states that the cost of a contributed asset is considered equal to its fair value at the date of contribution. The Exposure Draft proposed that the transaction would be measured at exchange value, which could be the carrying amount, considerations paid or received or fair value. Two respondents felt that tangible capital assets acquired through related party transactions should be clearly excluded from the scope of TANGIBLE CAPITAL ASSETS, Section PS 3150. A review of existing Sections of the PSA Handbook indicates that only one consequential amendment is necessary. The Re-exposure Draft proposes
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consequential amendments to TANGIBLE CAPITAL ASSETS, paragraph PS 3150.14. This amendment clarifies the applicability of the proposed standards for related party transactions and Section PS 3150.

Reportable transactions
.33 The Exposure Draft asked respondents if they agreed that in determining whether a related party transaction is reportable, it is only the quantitative characteristics of materiality that are considered. Most respondents disagreed. While quantitative characteristics are a key consideration, additional qualitative factors may also be considered. Many respondents commented that other factors that should also be considered in making the determination of whether a transaction is reportable were already reflected in the Exposure Draft. Consequently, no changes are proposed in the Reexposure Draft.

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Transitional provisions
.35 Several respondents commented that the proposals should specify whether the proposals are to be applied prospectively or retroactively. Most felt the transition provisions should allow prospective adoption as it could be costly for entities to go back and restate their past related party transactions.
ACCOUNTING CHANGES, Section PS 2120, allows that new accounting policies

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may be applied retroactively or prospectively when a government changes an accounting policy in order to comply with new Public Sector Accounting Standards. Specific provisions as to prospective or retroactive application contained in other Public Sector Accounting Standards override the standards in Section PS 2120. For clarity, the transitional provisions in the Re-exposure Draft state that the proposed standard may be applied retroactively or prospectively. .37 Under the proposed standard, related party transactions would be measured at the carrying amount and some at the exchange amount. Therefore, adoption of the new accounting policy may affect both operating results and accumulated surplus or deficit. It may be difficult to obtain the necessary financial data to apply the proposed standard retroactively. In these circumstances, ACCOUNTING CHANGES, Section PS 2120 allows prospective application. While prospective application would not require recognizing past events and transactions under the new accounting policy retroactively or recognizing the cumulative effect of the change on accumulated surplus or deficit, the new accounting policy applies to any outstanding related balances existing at the date of adoption. Any adjustments to the outstanding balances are recognized in the period of adoption. As argued by respondents, the cost of restatement may not be warranted.
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PSAB is of the view that, as argued by respondents, the cost of restatement may not be warranted. Therefore, the transitional provisions in the Re-exposure Draft propose that restatement of assets or liabilities is not required when the related party transaction occurred prior to the date of adoption.

Applicability of the proposed standard

.40 One respondent expressed concern that the proposed guidance did not consider the fundamental difference between government departments or agencies, which are integral parts of a government, and government organizations. It was argued that transactions between parts of the larger integrated entity, such as those between departments and agencies, are governed by the policies of the jurisdiction and, therefore, are different in nature to those occurring between separate corporate entities. Another respondent commented that a related party standard on recognition and measurement should reflect the substance of the arrangement and not be rules-based. PSAB is of the view that it must deal with the issue of related party transaction recognition, measurement and disclosure based on existing financial statement concepts in the PSA Handbook. The issue is beyond the scope of this project.

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Presentation of credit when contributed goods and services are recognized

.42 The Exposure Draft proposed that if contributed goods and services are recognized, the recipient organization reports the contributed goods and services in the statement of operations as an expense. It also recognizes an equivalent amount as a credit in the statement of operations. One respondent suggested that the credit should be presented as an adjustment to accumulated surplus/deficit when contributed goods and services are recognized by government departments or agencies. The respondent argued that this presentation would be consistent with the proposed treatment for appropriations used in the Exposure Draft, Use of Appropriations. For other government organizations, the credit should be made to the statement of operations following the guidance in GOVERNMENT TRANSFERS, Section PS 3410. This different treatment reflects the fundamental difference between these types of organizations. PSAB is of the view that contributed goods and services confer economic benefits on the recipient entity. If contributed goods and services are recognized, the benefit should be reported as revenue in the statement of operations. This would be consistent with FINANCIAL STATEMENT OBJECTIVES, Section PS 1100, which states that financial statements should provide information about the sources, allocation and consumption of recognized economic resources in the accounting period.
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Recognition of the credit directly in accumulated surplus or deficit would not be consistent with existing financial statement concepts. Different accounting and reporting treatment is not appropriate for transactions with similar economic substance.

Recognition of unrealized gains or losses

.46 A group of respondents argued that when there is a difference between the exchange amount and the carrying amount, the unrealized gain or loss should be reported in net equity. This treatment would be consistent with RELATED PARTY TRANSACTIONS, Section 3840. PSAB is of the view that recognition directly in accumulated surplus or deficit would not be consistent with existing financial statement concepts.

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Parties to a contractual arrangement

.48 One respondent argued that the Exposure Draft was contradictory. It states that parties to a contractual arrangement that establish control of an entity would not be related parties. At the same time, the characteristics of related parties include entities that have shared control over or that are subject to shared control of a reporting entity. The Re-exposure Draft clarifies that the intention is that parties to a contractual arrangement are not automatically related parties. That is, the entity that is the subject of the shared control arrangement is related to each party to the contractual arrangement. However, the reporting entity and other entities to the contractual arrangement are not related simply by the fact that they are parties to the contractual arrangement.

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Reporting gross versus net

.50 The Exposure Draft proposed that, although a provider organization and recipient organization should report on a gross basis under a cost allocation model, net reporting may be appropriate depending on whether the entity was acting as a principle or agent. Respondents argued that issues related to revenue recognition, such as identification of a principle or agent in an arrangement should not be addressed in a related party transaction standard. The Re-exposure Draft does not state that it may be appropriate to report on a net basis. Exclusion of the guidance from the final standard avoids any issues related to conflicts with FINANCIAL STATEMENT PRESENTATION, paragraphs PS 1201.083 and PS 1201.085. It is a matter of judgment as to whether an entity is acting as principle or agent and whether reporting should be done on a gross versus net basis.

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Reference to other reports in financial statements

.52 One respondent was concerned that the Highlights to the Exposure Draft indicated that other public reports could be used to demonstrate compliance with the proposed related party transactions standard. The respondent argued that compliance with the PSA Handbook should occur within a set of financial statements, not in another public report. The comments in the Highlights were intended to address concerns about the implication of including key management personnel and close members of their families in the definition of related parties. Many respondents to the Invitation to Comment on definitions and disclosures and the Exposure Draft have commented that many jurisdictions have addressed financial transactions with key management personnel through governance and internal policy. Although it was not suggested that reference to these other reports could be regarded as compliance with the standard, it was intended to suggest that disclosure of governance and internal policies with reference to other reports where detailed information is available could be one way of complying with the standard. The exercise of professional judgment in the determination of what constitutes fair presentation or good practice in a particular case would make that determination.

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