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Chapter 26

Related-party disclosures

26.1 AASB 124 ‘Related Party Disclosures’ defines related parties as follows:

Related party—a party is related to an entity if:(a) directly, or indirectly through one or more intermediaries, the party:

(i) controls, is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries);

(ii) has an interest in the entity that gives it significant influence over the entity; or

(iii) has joint control over the entity;(b)the party is an associate (as defined in AASB 128 ‘Investments in Associates’) of the

entity;(c) the party is a joint venture in which the entity is a venturer (see AASB 131 ‘Interests

in Joint Ventures’);(d) the party is a member of the key management personnel of the entity or its parent;(e) the party is a close member of the family of any individual referred to in (a) or (d);(f) the party is an entity that is controlled, jointly controlled or significantly influenced

by, or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e); or

(g)the party is a post-employment benefit plan for the benefit of employees of the entity, or of any entity that is a related party of the entity.

The above definitions of related parties in turn rely upon a number terms. These being control; significant influence; joint venture; close member of the family; and key management personnel.

26.2 Related-party information could be valuable to financial statement users. Transactions involving related parties cannot be presumed to be carried out on an arm’s length basis, as the requisite conditions of competitive, free-market dealings may not exist. This may lead to a situation in which transactions may occur at a price not in accord with fair values. That is, the existence of a related-party relationship may expose a reporting entity to risks, or provide opportunities which would not have existed in the absence of the relationship. A related party relationship may therefore have a material effect on the performance, financial position, and financing and investing activities of a reporting entity. To properly assess the performance of an entity, and the impact of related-party transactions, knowledge of such relationships would be necessary.

26.3 This is an interesting question that could be used to stimulate debate amongst the students. On average, it could be argued that users of financial statements would be aware of the potential implications of related-party transactions. If a reporting entity was not required to make any disclosures, and the reporting entity elected not to voluntarily make any disclosures, then the readers of the financial statements may feel that due to a lack of information the relative risk of the reporting entity is higher, relative to a situation where fuller disclosures were provided. They would be unsure whether the results and financial position of the reporting entity had been impacted by related-party transactions which were not undertaken on an arm’s length basis. That is, the existence of a related-party relationship may expose a reporting entity to risks, or provide opportunities which would not have existed in the absence of the relationship. To properly assess the performance of an entity,

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan 26–1

and the impact of related-party transactions, knowledge of such relationships would be necessary. Without such knowledge and with such uncertainty, the reporting entity may find that it is more expensive to attract capital.

The above argument would relate to all reporting entities. That is, there would be some adverse effects if a reporting entity elected not to make disclosures pertaining to related-party transactions, even if it had no such transactions that were of material consequence. However, specific reporting entities may feel that the disclosure of particular related-party transactions may be of such consequence that the negative implications that would flow from making no disclosures at all may be less than the negative consequence of making specific disclosures. For example, if an entity was to report information that indicated that its directors were being grossly overpaid and that numerous large unsecured loans had been provided to directors on interest-free terms, this could have significant consequences for the ongoing operations of the entity. If this was the perspective held by the management of the entity, then the directors may prefer that no disclosures are made. However, this would obviously not be deemed to be an objective approach to financial reporting (and would also be in contravention of the accounting standards).

26.4 This question is similar to Question 26.3. It could be argued that if a reporting entity failed to make any related-party transaction disclosures then this failure may be met with suspicion by financial statement users. Financial statement users would appreciate that the existence of a related-party relationship may expose a reporting entity to risks, or provide opportunities which would not have existed in the absence of the relationship. If they are unable to obtain information to assess this risk then the market would most likely attribute greater risk (due to greater uncertainty) to the firm and as a result investors would demand a higher return for their investment. As a result, the cost of capital for the firm would be higher.

If a firm was able to provide information about related-party transactions which were not deemed to be of concern to the marketplace then such an entity should be able to attract funds at a lower cost than entities that make no disclosures. If an entity makes disclosures which do concern the market (perhaps indicating that many of the entity’s transactions are with parties related to the directors and on non-arm’s length terms) then such disclosures would not be viewed positively by the market and the negative implications for the entity’s cost of capital may be greater than the implications of making no disclosures at all.

26.5 AASB 124 provides the disclosure requirements for ‘related parties’. The various categories of related parties are discussed in paragraph 9 of AASB 124. Paragraph 9 states:

a party is related to an entity if:(a) directly, or indirectly through one or more intermediaries, the party:

(i) controls, is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries);

(ii) has an interest in the entity that gives it significant influence over the entity; or

(iii) has joint control over the entity;(b)the party is an associate (as defined in AASB 128 ‘Investments in Associates’) of the

entity;(c) the party is a joint venture in which the entity is a venturer (see AASB 131 ‘Interests

in Joint Ventures’);(d) the party is a member of the key management personnel of the entity or its parent;(e) the party is a close member of the family of any individual referred to in (a) or (d);


(f) the party is an entity that is controlled, jointly controlled or significantly influenced by, or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e); or

(g)the party is a post-employment benefit plan for the benefit of employees of the entity, or of any entity that is a related party of the entity.

In considering the disclosure requirements of AASB 124, the various required disclosures are to be made by class of related party. As paragraph 18 of AASB 124 states:

The disclosures required by paragraph 17 shall be made separately for each of the following categories:(a) the parent;(b) entities with joint control or significant influence over the entity;(c) subsidiaries;(d) associates;(e) joint ventures in which the entity is a venturer;(f) key management personnel of the entity or its parent; and(g) other related parties.

26.6 Key management personnel are a category of related party identified and defined in AASB 124 as:

those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

26.7 In part, it may be a reaction (or perhaps an overreaction) to the many high-profile cases of the 1980s where it was subsequently shown that some directors abused their positions of trust for the purposes of personal gain. Also, in recent years there has been much publicity given to the salaries and other ‘perks’ being provided to senior corporate executives. Whatever the cause, directors of organisations are in a situation where they have a high degree of discretion with regards to the utilisation of the resources provided by the various parties not involved in the management of the firm. As such, and on the basis of greater accountability, the accounting regulators obviously consider that high levels of disclosure are preferable. Perhaps there is an assumption that in the absence of the required disclosures directors may be in a position to direct greater benefits to themselves, or that in the absence of the disclosures, the users of the accounts would not be receiving the information they demand. Both of these issues could potentially be the subject of some empirical investigation.

26.8 The additional Australian provisions added to AASB 124 relative to its international counterpart IAS 24 (that is, Aus25.1 - Aus25.9.3) require disclosure of particular amounts identified to the extent they occur, and they cannot be withheld from disclosure on the basis of materiality considerations. That is, transactions involving key management personnel are all deemed material regardless of their quantum. Specifically, paragraph Aus1.10 of AASB 124 states: ‘The disclosures required by paragraphs Aus25.1 to Aus25.9.3 of this Standard are deemed material’.

The requirement that all director-related transactions be treated as material is rather strict and perhaps reflects a reaction of the regulators to the corporate excesses of the 1980s. It signifies an acceptance by the regulators that key management personnel, such as directors, should be very accountable for all benefits they receive in their role as directors.


26.9 To determine what disclosures are required we need to refer to AASB 124, and Section 300A of the Corporations Act. Students should review the disclosure requirements included within the Accounting Standards and the Corporations Act. As can be seen, the disclosure requirements pertaining to key management personnel are very extensive. The key management personnel disclosure requirements in AASB 124, paragraphs Aus25.2 to Aus25.9.3, are to be applied by ‘disclosing’ entities. As paragraph Aus25.1 states:

Paragraphs Aus25.2 to Aus25.9.3 of this Standard apply to each disclosing entity (subject to parent entity relief) that is required to prepare financial reports in accordance with Part 2M.3 of the Corporations Act. The disclosures required of disclosing entities by paragraphs Aus25.2 to Aus25.9.3 are in addition to those required by paragraphs 1 to 22.

The disclosure requirements of paragraphs Aus25.1 to Aus25.9.3 relate to all key management personnel, regardless of how many there are. Any discussion of these requirements obviously calls for a definition of ‘disclosing entity’ given that the disclosure requirements are specific to disclosing entities. Paragraph Aus9.1 of AASB 124 notes that ‘disclosing entity is defined in the Corporations Act’. So we need to refer to the Corporations Act for a definition. A review of s. 111 AC to AL of the Corporations Act reveals that ‘disclosing entity’ would include:

• organisations with securities (such as shares, debentures or options) listed on a stock exchange;

• organisations that have lodged a prospectus with the stock exchange; and• issuers of managed investment products held by 100 or more people.

The disclosure requirements set out in AASB 124, paragraphs Aus25.2 to Aus25.9.3, are fairly extensive. To get a proper idea of the disclosure requirements set by the standard we really need to review it in its entirety. Pages 885 to 891 of the text provide an overview of the disclosure requirements included in AASB 124, while pages 891 to 892 provide an overview of the requirements incorporated in Section 300A.

26.10 The valuation of options is a difficult exercise. It is common for directors to be provided with options to shares by their employer, particularly if the employer is listed on a stock exchange. Commonly these options are offered to directors at an exercise price equal to the market price of the shares at the date the options were issued. The rationale for providing these options is that directors will be motivated to increase the value of the shares (and therefore, the value of the entity) and this will be beneficial not only to the directors, but also to other parties with a stake in the firm. Providing them with these options is deemed to be preferable to providing them with other forms of remuneration, such as a fixed salary.

Executives view such options favourably. For the majority of firms the price of shares will increase across time. Some of this increase will be due to general price level changes in the economy whilst some of the increase (or decrease) will be due to sound decisions (or poor decisions) being made by the executives. Clearly they do have remuneration value as executives would arguably accept a reduction in fixed salary payments in exchange for the options—but it is difficult to measure the value of the options. At the time of issue there is no opportunity cost to the entity, to the extent that the executives have a right to buy shares at that day’s market price (or higher). The organisation is providing no discounts. However, if the value of the shares (and hence the options) increases across time then at the time the executives exercise the options, the company will receive less than the market value of the


shares. This discount will represent a reward that is ‘paid’ to the directors, and an opportunity cost to the company. Whilst this discount could be treated as a salary expense of the entity, numerous other issues also arise. Should we defer the recognition of the ‘expense’ until the options are exercised, which may be five years after they were issued, or should we recognise the possible discount throughout the life of the options?

If options have an exercise price which is equivalent to the current market price of the shares then there is no incentive for the holders to exercise the options as no gains would be made. The holder would be no better off than if he or she bought the shares directly from the market, rather than through the options. The manager would not exercise the option under these conditions but the argument is that the manager will have an incentive to work hard to increase the value of the company’s shares over the time (life) of the options, and therefore, the value of the options he or she holds. The options are said to have a ‘time value’. In determining the related expense to the organisation, some companies in the past (when there has been limited guidance in accounting standards) have simply looked at the difference between the exercise price and the current share price. This difference is considered to represent the ‘intrinsic value’ of the option. If this difference was nil, as in the Coles Myer case, or negative, then the options were considered to be neutral or ‘out-of-the-money’ and no expense was traditionally recognised when the options were issued (as we will see, this situation has now changed). Conversely, if the difference was positive (there is intrinsic value) the options were deemed ‘in-the money’ and the difference was recognised by some companies as an expense. However, some other companies also considered issues associated with the ‘time value’ of the option and used various models to determine the cost of the option (such as the Black-Scholes model) such that a cost was assigned to the option even if it was ‘out of the money’.

The requirements in relation to attributing a cost to share options provided to executives have changed significantly in recent years. While the options might be issued with an exercise price at or above the market price of the entity’s shares on the date the options are issued (they would not be ‘in-the-money’), they could nevertheless have a fair value greater than zero. In part this value will be based on the time value of the securities—that is, the options are available to be exercised over a period of a number of years and this time value can be significant.

The requirements relating to measuring the cost of share options is included in AASB 2 ‘Share-based Payment’. Pursuant to AASB 2, equity compensation provided as remuneration by the disclosing entity or any of its subsidiaries must be measured using the fair value of its equity instruments at the grant date, less any amount paid or payable by the recipient for that instrument. The fair value of equity instruments at grant date is: in the case of shares and units, the market price at grant date (or estimated market

price if not publicly traded) of an equivalent share or unit (being paid up to the same extent and carrying equivalent entitlements or restrictions);

in the case of options and rights that are publicly traded, the market price at grant date;

in the case of options and rights that are not publicly traded over publicly traded shares or units, estimated using an option-pricing model that takes into account, as at grant date, the exercise price and expected life of the instrument, the current price of the underlying share or unit and its expected volatility, expected dividends and the risk-free interest rate for the expected life of the instrument.


In the case of share options and rights, the method of determining the fair value of the equity instrument depends on the circumstances. If an equivalent option or right is quoted on an active and liquid market, the market value at the grant date is used. If an option or right is not traded but the underlying instrument is publicly traded, an accepted option-pricing model, such as the Black-Scholes (modified for dividends) or a binomial model, can be used.

26.11 Chapter 3 of the textbook (Theories of financial accounting) covers this issue. The idea behind paying management on a basis which is at least, in part, tied to the entity’s results, is that such an arrangement perhaps provides further motivation for management to strive to improve the performance of the organisation. This in turn provides benefits to the owners of the firm. Of course, management may have been working as hard as they can in the absence of the performance-based pay—nevertheless, some management may need the extra encouragement. As Chapter 3 indicates, if management is paid purely on the basis of a fixed salary they, in a sense, become like debt-holders. As such, they may undertake strategies which reduce the variance in the firm’s profits and cash flows—a strategy which would not be in the interests of the owners of the organisation. As Chapter 3 also notes, in rewarding management on the basis of performance it is imperative that they are actually able to influence the basis of the measure of performance on which the bonuses are based.

26.12 This question has been assigned to encourage students to review the disclosures for themselves for the purpose of determining which specific disclosures have the greatest implications in terms of exposing the entity to various risks associated with related-party transactions. Students should justify the selection of particular transactions.

26.13 Comparing the positions of the two parties provides an interesting contrast. The Business Council of Australia (BCA) has as its membership individuals who hold senior positions within various Australian corporations. Such individuals’ remuneration would be subject to the disclosure requirements of Section 300A. In summary, the BCA submission stated:

The media is embracing a position that CEO pay levels are unreasonable; Media attention might cause the government to take inappropriate and

counterproductive actions; Requiring remuneration disclosures might lead to increases in remuneration

expenses across all companies; Disclosing the salaries of junior executives might lead to them being ‘poached’ by

other organisations; The disclosure requirements breach general requirements for privacy; It is the role of the Board to determine remuneration levels of executive managers,

and is not a role that shareholders should be given; The vote on executive remuneration levels can effectively be a no-confidence vote in

the management of the entity; A limited number of corporate excesses have lead to excessive disclosure

regulations.

By contrast, the position of the Chairperson of the Australian Shareholders’ Association (ASA) can be summarised as:

Shareholders have a right to be involved in approving the level of remuneration being paid to senior executives;

There is much cynicism amongst shareholders when it comes to executive remuneration;


Directors and senior management have ‘acquiesced in soaring executive remuneration’ and it is a nonsense to blame such increases on disclosure requirements;

Shareholders will be better able to make corporate managers focus on long-term shareholder value (rather than short-term senior executive interests).

Students should be encouraged to consider which position they are more likely to agree with. The position of the BCA does appear to be very protective of the interests of the senior executives and does seem to promote a position which limits the shareholders’ (owners’) involvement in the corporations. The position of the ASA, by contrast, is that corporate executives must accept a greater accountability for their performance and remuneration and must not blame any rises in corporate executive remuneration on any disclosure regulations that might have been introduced.

26.14 This is an interesting question as it requires consideration of costs and benefits of disclosures. When considering disclosures within financial reports it is particularly difficult to reliably determine the actual costs and benefits. Any attempt at quantifying such costs and benefits would be particularly difficult.

From the company’s perspective, the costs of the disclosure would include those associated with collecting the data as well as the extra costs associated with printing and distributing the data. There could also be costs associated with the reactions readers may have to the various related-party transactions. These reactions may have implications for the company’s cost of attracting capital and there could also be costs associated with defending particular transactions. The benefits that would accrue to the company would be dependent upon the types of transactions that have been undertaken. If the company is able to show that the related-party disclosures were of an arm’s length nature or did not expose the company to any significant risks then this would be viewed favourably by the market, which in turn may enable the company to attract funds at a lower cost.

From the financial statement reader’s perspective, the costs would include the time that would be devoted to reading, understanding and assimilating the various items of information pertaining to related-party transactions. Related-party transaction disclosures can be quite extensive. However, knowledge of the related-party transactions should provide benefits to users in that they would be better able to determine whether related-party relationships exposed the reporting entity to risks, or provided opportunities which would not have existed in the absence of the relationship.

26.15 This information pertaining to related-parties disclosure takes up many pages of the annual report and provides a degree of detail which some would argue is just too much. There does come a point where the provision of too much information becomes counterproductive. Students should discuss the various items of information being disclosed and whether they consider such disclosures are ‘value-adding’.

26.16 Clearly, the BCA is opposed to the requirements that shareholders will have a non-binding vote on executive remuneration. The use of the term ‘perverse outcomes’ to explain the impacts of the requirement shows the strong position being adopted by the BCA. Perhaps it would have been better for their argument if they were not to embrace such emotive language, but rather, wrote in a style that appeared more objective. The implication of the shareholder vote, from the perspective of the BCA, can be summarised as:

The shareholder vote will create higher barriers for appointing senior executives;


It will lead to an inability to bring in executives with necessary skills, which will in turn impact shareholder value;

Companies will typically abide by the shareholder vote and hence might not make an executive’s contract unconditional until the remuneration agreement is approved by the shareholders;

The new executive is placed in an ‘impossible situation’ (again note the emotive tone of the BCA’s position);

The offer of appointment by the new company will ‘finish’ the career of the executive at their existing employee (But is this really a logical position? Would not it indicate that the manager is in demand elsewhere and hence is perhaps worth greater remuneration?);

The executive will demand an ‘up-front’ payment to compensate them for the risks that the remuneration contract will not be agreed to by the shareholders;

The upfront payment will need to be ‘considerable’ given that the executive will be putting their career at risk (In a corporate world where people frequently move, does this really make any sense?);

If the shareholders vote against the remuneration proposal they will lose the executive and the upfront payment.

Students should be encouraged to think about the merit and logic of the BCA position. It really does seem to be a very biased position—and one that would do little to enhance the credibility of the positions being embraced by the BCA on this and on other issues.


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