Subject : CORPORATE

 
   Title :        D. AUDIT & ASSURANCE - RELATED PARTY TRANSACTIONS - AKK YOU NEED TO KNOW WHILE CONDUCTING COMPANIES AUDIT
   Author : Anil Khicha*  
   
 

Transactions with related parties are a basic human instinct. This applies both for personal & commercial transactions. Such transactions are sometimes influenced by consideration other than commercial. The same is also true when it happens in case of a corporate entity as it is also managed by human beings. There is a possibility that such transactions might have not occurred on `arm's length' consideration. That's why various laws and regulations stipulate the deeper scrutiny and the greater disclosures of such transactions. This article brings all such requirements under Companies Audit at one place which shall be very helpful to professionls. _ Editor

1. Background

1.1 It is a general presumption that the economic activities represented in the financial statements of an entity is the result of arm's length transactions between independent parties not influenced by any consideration other than normal market conditions, unless mentioned otherwise. But the reality sometimes is otherwise. Therefore various regulations and laws demand the greater scrutiny, analysis and disclosures of such transactions for the better and true understanding of financial statements by the user.

1.2 Related party under this article does not restrict the meaning as defined in the Accounting Standard-18 but extended as per the definitions given under different regulations & statutes.

2. Introduction

2.1. Related party transactions adopted by the companies could be a possible tool for corporate abuse. Transfer of economic resources to the related party at less than arm's length price is necessitated for host of reasons ranging from evasion/avoidance of tax liability to siphon-off the resources. Transfer of resources to and from the related party should be at arm's length and at arm's length price.

2.2. Transactions with the related parties are currently subject to the requirements of the accounting standards, and financial as well as cost audit. In addition, various tax laws seek to regulate, and check the possible abuse for taxation purposes. The Companies Act, 1956 does provide for a framework for transactions in which directors, etc., are interested with a view to avoid situation of conflict of interest. The Companies Auditor's Report Order, 2003 (CARO) also stipulates certain reporting requirements on related party transactions.

2.3. The requirements of transfer pricing transactions, at present, are to be addressed through Accounting Standards, (AS)-18.

2.4. Section 217(2AA) casts responsibility on the Board of Directors for (i) preparation of annual accounts in accordance with the applicable accounting standards along with proper explanation related to material departure, (ii) selection and applicability of accounting polices and exercise of judgement so as to give true and fair view. The Directors responsibility as aforesaid would also extend to and cover the related party transactions.

2.5. The Cost Accounting Records Rules provide for proper maintenance of records in respect of transactions with the related parties including to indicate the basis followed to arriving at the rates charged or paid for such activities or services so as to enable determination of the reasonableness of such rates. The cost auditor is required to specifically give his observations, in his report, on cases, where price charged for related party transactions is different from the normal price and impact of such lower/higher price.

2.6. The segment-wise reporting has been dealt with by the AS-17. The segment-wise costing has been dealt with by the relevant Cost Accounting (Records) Rules and audit requirement in regard thereto. Under the Relevant rules, cost statement of each service (segment-wise and elements of cost) is required to be given.

3. Undesirable Corporate Practices Related to Related Party Transactions

Some of the related party transactions, which are usually resorted to for diversion of funds are detailed below :

Purchase of goods or services from a related party at little or no cost or at inflated prices to the entity.

Payments for services never rendered or at inflated prices.

Sales at below market rates to an unnecessary "middle man" related party, who in turn sells to the ultimate customer at a higher price with the related party (and ultimately its principals) retaining the difference.

Purchases of assets at prices in excess of fair market value.

Use of trade names or patent rights at exorbitant rates even after their expiry or at a price much higher than the price, which cannot be described as reasonable.

Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction.

Exchanging property for similar property in a non-monetary transaction.

Selling real estate at a price that differs significantly from its appraised value.

Accruing interest at above market rates on loans.

4. Meaning of Related Party

4.1 As per the Companies Act, 1956 _ For the purpose of the preparation and presentation of financial statements the following parties are considered as related parties.

(a) Managers

(b) Directors and their relatives, A firm is which a director/his relative is a partner or a Private Limited Co. in which a director is a member.

(c) Companies under the same management

(d) Subsidiaries

(e) Relatives as provided in section 6 of the Act :

Members of the HUF.

Spouse

Brother and Brother's wife

Sister and sister's husband

Father and mother

Son and son's wife

Daughter and daughter's husband

Paternal and maternal grand fathers and grand mother and

Grand children and their spouses

4.2 As per AS-18 _ Enterprises that directly, or indirectly control the other, like holding company, subsidiaries and fellow subsidiaries.

Associate enterprises, joint ventures and investing parties of the reporting enterprise.

Individuals and their relatives having substantial voting power and exercising influence over the enterprise.

Key management personnel's and their relatives.

Enterprise owned by directors, major shareholders, and also with common key management members.

4.2.1 Parties considered not related :

To companies simply because of a common director.

A single customer, supplier, etc., simply because of economic reasons.

Financiers, trade unions, public utilities, and government departments having normal dealings with the enterprise.

5. Compliance

5.1 As per the Companies Act

5.1.1 Section 211 (3A) : Every profit and loss account and balance sheet of a company shall comply with the Accounting Standards. As per the provision of section 211(7), if any person as is referred to in sub-section (6) of section 209 fails to take all reasonable steps to secure compliance by the company, as respects any accounts laid before the company in general meeting, with the provisions of this section and with the other requirements of this Act as to the matters to be stated in the accounts, he shall, in respect of each offence, be punishable with imprisonment for a term which may extend to six months, or with fine which may extend to ten thousand rupees, or with both.

5.1.2 Section 295(1) : No company (hereinafter in this section referred to as "the lending company") [without obtaining the previous approval of the central Government in that behalf shall, directly or indirectly,] make any loan to, or give  any guarantee or provide any security in connection with a loan made by any other person to, or to any other person by, -

(a) any director of the lending company or of a company which is its holding company or any partner or relative of any such director;

(b) any firm in which any such director or relative is a partner;

(c) any private company of which any such director is a director or member;

(d) any body corporate at a general meeting of which not less than twenty-five per cent of the total voting power may be exercised or controlled by any such 9director, or by two or more such directors together, or

(e) any body corporate, the Board of directors, managing director, or manager where of is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

Section 295 (2) - The above shall not apply to -

(a) any loan made, guarantee given or security provided -

(i) by a private company unless it is a subsidiary of a public company, or

(ii) by a banking company;

(b) any loan made by a holding company to its subsidiary company;

(c) any guarantee given or security provided by a holding company in respect of any loan made to its subsidiary company.

5.1.3 Section 297 : The Boards approval is mandatory for the sale, purchase, or supply of any goods, material or services where in directors are interested directly or indirectly.

5.1.4 Section 299 : Every director is required to disclose to the Board about the nature of his concern or interest in a contract or any arrangement.

5.1.5 Section 299(3)(a) : A general notice given to the Board by a director to the effect that he is a director or a member of a specified body corporate or is a member of a specified firm and is to be regarded as concerned or interested in any contract or arrangement which may, after the date of notice, be entered into with that body corporate or firm, shall be deemed to be a sufficient disclosure of concern or interest in relation to any contract or arrangement so made. Such general notice shall expire at the end of the financial year. By giving a fresh notice it can be renewed for further periods of one financial year. This notice is given in Form No. 24AA.

General Notice, and/or renewal general notice shall be brought to the notice of the Board Meeting. The Act further provides that non-compliance of the above shall be punishable with a fine, which may extend to Rs. 50,000. Further if the directors share holding in the investing company is less than 2% of the paid-up capital of the company the provisions of this section shall not be applicable to such of those companies.

5.1.6 Section 300 : An interested director will not be permitted to participate in discussion or vote. His presence will not count for the purpose of forming a quorum. But a purely independent private limited company is exempted from these provisions.

5.1.7 Section 301 : Every company shall keep one or more registers and enter the following particulars :

(a) The date of the contract or arrangement.

(b) The names of the parties thereto.

(c) The principal terms and conditions thereof.

(d) In the case of contract falling under section 299, the date on which it was placed before the Board.

(e) The names of directors voted for and against the contract or arrangement and the names of those remaining neutral.

Particulars of every such contract or arrangement requiring Board's sanction shall be entered within 7 days of the Board meeting. For non-compliance of this section, the company and every officer of the company who is in default shall be punishable with a fine, which may extend to Rs. 5000 for each default.

The register shall be kept at the registered office of the company. The members of the company can inspect the register and take extracts thereon. The register of contracts shall be placed before the next Board meeting and shall then be signed by all the directors present at the meeting.

5.1.8 Section 209(4) : In order to enable the directors to have a fair knowledge of the affairs of the company, section 209(4) of the Act, provides a right to inspect the books, papers and records of the company. In Maharaj Kumar Mahendra Singh v. Lake Palace Hotels & Motels [1985] 58 Comp. Cases 805 (Raj) it was held that this right is a statutory right and an application to enforce this right is maintainable in the High Court.

5.1.9 Section 314(1) : Except with the consent of the company accorded by a special resolution,

(a) no director of a company shall hold any office or place of profit, and

(b) no partner or relative of such director, no firm in which such director, or a relative of such director, is a partner, no private company of which such director is a director, is a partner, no private company of which such director is a director or member, and no director or manager of such a private company, shall hold any office or place of profit carrying a total monthly remuneration of [such sum as may be prescribed, presently Rs.20000)

5.2 Accounting Standard-18 _ The AS-18 came in the effect for the accounting periods commencing on or after 1st April 2001. The Standard provides for disclosure of related party relationships, and certain particulars of transactions with the related parties, in case of listed companies, and companies whose turnover exceeds Rs. 50 crore.

The application of Accounting Standard involves the following stages/processes :

(i) Identification of related parties, and, then, transactions with those parties.

(ii) Maintenance of proper records and documentation for the transactions entered into with the related parties, and the method/basis adopted for pricing such transactions.

(iii) Ascertainment as to whether the arm's length has been maintained and whether arm's length price has been charged.

  (iv) Disclosure of particulars in regard to related party relationships and related party transactions as integral part of the financial statements. The AS also requires disclosure of particulars in respect of certain types of related parties which might have controlling interest even though no transaction might have had taken place during the course of the year.

(v) Proper disclosures in case of non-compliance to the requirement, the fact of non-maintenance of arm's-length or absence of arm's-length price along with relevant details.

5.3 Under Corporate Governance for listed companies _ 5.3.1. To ascertain whether a director is an independent director, or not, it is clarified that such director should not have any pecuniary relationship or transactions with the company, promoters, management, or its subsidiaries.

5.3.2. If any pecuniary transactions are there it shall be disclosed in the annual report of the company.

5.3.3. All directors of the company shall inform the company about positions held in other companies.

5.3.4. In the Management Discussion and Analysis Report, attached to the Annual Report the company shall state details of all transactions between the company and the directors.

5.3.5. The above details should also inform to the Board of the company.

5.3.6. Consistency should be ensured with the financial statements, CARO Report, and section 301 of the Companies Act, 1956.

6. Disclosure Requirements

6.1 Under the Companies Act, 1956 _ 6.1.1 Section 217(2A)(b) : The statement forming part of the Board's Report u/s 217(2A)(a) shall indicate -

(i) whether any employee was in receipt of remuneration not less than the prescribed sum (presently Rs.2.00 lakh per month), is a relative of any director or manager of the company and if so, the name of such director and

(ii) such other particulars as may be prescribed.

6.1.2 Under schedule VI _ Part I of the Schedule VI to the Companies Act requires some related party disclosures :

(a) Calls unpaid

(b) Secured Loans

(c) Unsecured Loans

(d) Investments

(e) Sundry debtors

(f) Loans and advances

(g) Contingent liabilities.

6.2 Under AS-18 _ 6.2.1 Name of the related party and nature of the related party relationship should be disclosed irrespective of whether or not there have been transactions between the related parties.

If there have been transactions between the related parties, the following details shall be disclosed :

1. Name of the party,

2. Details of relationship,

3. Nature of transactions,

4. Amount of transactions,

5. Other relevant details necessary for understanding the financial statement,

6. The amount outstanding,

7. Provisions for doubtful debts,

8. Details of amount written off or written back.

Listed companies are required to disclose the related party transactions in the quarterly and half-yearly financial statements also.

6.2.2 Transactions requiring disclosure

(a) Purchases or Sale of goods of both finished and work in progress.

(b) Purchases or Sales of fixed assets.

(c) Rendering or receiving of any services.

(d) Agency arrangements.

(e) Leasing and hire purchase transactions.

(f) Agreements of licence.

(g) All kinds of financing the business.

(h) Giving or taking guarantees and agreeing for collateral's arrangements.

(i) Management contracts including providing employees on deputation.

6.2.3 Disclosure not necessary

The above disclosures need not be furnished in case of bankers and their customer's transactions, intra-group transactions with regard to consolidated financial statements, and transactions between government controlled enterprises.

However it does not cover inter-divisional transfer between the various segments of a company.

7. Directors' Responsibilities

7.1 The Board of Directors has to ensure compliance with the Accounting Standards and the provisions of corporate laws.

7.2 Informations to be provided _ In order to comply with the disclosure requirements, all directors of the company shall furnish the following informations to the company. This information shall be given every year.

1. List of relatives of the directors.

2. Names of companies in which the director hold shares, the number of shares held in each of these companies and the latest paid up capital of each company.

3. Names of companies in which a relative of director holds shares and the number of shares held in each of these companies.

4. Names of companies in which the director is a director.

5. Names of companies in which a relative of the director is a director.

6. List of partner ship firms in which the director or his relative is a partner and the names of other partners in those firms.

7. List of proprietory companies in which the director or his relative is a sole proprietor.

7.3 Issues involved _ It is practically very difficult for any individual director to ascertain the share holding details, investment details of all his relatives. Further many of the relatives as defined in the Companies Act, will not have day-to-day contact with the individual concerned.

Further many of the relatives will not disclose their investment details etc to the directors concerned.

8. Auditors' Responsibilities

8.1 The Companies Act _ As per section 227(3)(d) of the Act, the auditors' report should state whether in the opinion of the auditors the profit and loss account and the balance sheet comply with the accounting standards referred to in sub-section (3C) of section 211.

The statutory auditor is required to verify the related partly relationship, and, the related party transactions. On that basis he is expected to express his opinion on the adequacy or otherwise of the disclosures made, and on reasonableness of the consideration/price charged in those transactions. If not satisfied, he is required to qualify his report bringing out the facts and the exact impact on the true and fair view of the financial statements.

8.2 Companies Auditors Report Order, 2003 _ Companies Auditors Report Order, 2003, requires specific observations of the auditor regarding related party transactions as follows :

8.2.1 n Has the company granted any loans, secured or unsecured to companies, firms or other parties covered in the register maintained under section 301 of the Act. If so, give the number of parties and amount involved in the transactions; and

whether the rate of interest and other terms and conditions of loans given by the company, secured or unsecured, are prima facie prejudicial to the interest of the company ; and

whether receipt of the principal amount and interest are also regular ; and

if overdue amount is more than rupees one lakh, whether reasonable steps have been taken by the company for recovery of the principal and interest ;

has the company taken any loans, secured or unsecured from companies, firms or other parties covered in the register maintained under section 301 of the Act If so, give the number of parties and the amount involved in the transactions ; and

whether the rate of interest and other terms and conditions of loans taken by the company, secured or unsecured, are prima facie prejudicial to the interest of the company ; and

whether payment of the principal amount and interest are also regular.

8.2.2 n whether the particulars of contracts or arrangements referred to in section 301 of the Act have been entered in the register required to be maintained under that section ; and

whether transactions made in pursuance of such contracts or arrangements have been made at prices which are reasonable having regard to the prevailing market prices at the relevant time.

8.2.3 Whether the company has made any preferential allotment of shares to the parties and companies covered under the register maintained under section 301 of the Companies Act? If so, whether the price at which shares have been issued is prejudicial to the interest of the company.

8. 3. AAS-23 _ Related Parties _ 8.3.1 The purpose of this standard is to establish standards on the auditor's responsibilities and audit procedures with regard to related party transactions.

8.3.2 The Auditor should perform such audit procedures, which are capable of obtaining suitable audit evidence regarding the identification and disclosure of related parties and transactions with them.

8.3.3 The primary responsibility of identifying and disclosing all material related parties transactions is that of management.

8.3.4 The responsibility of `due care' in the performance of the appropriate audit procedures in the audit of such transaction is that of the auditor. Because transactions with related parties run the risk of shift, transfer, postpone income of the reporting enterprise in favour of entities that are related.

8.3.5 The auditor cannot depend solely on management's representations about adequacy and completeness of the information but also has to evaluate internal control procedures to ascertain about the existence and complete disclosure of such transactions.

8.3.6 The auditor must review transactions for abnormal terms and also transactions with abnormal terms and transactions, which are vulnerable to the risk of material misstatement. The auditor must seek independent enquiry, confirmations, representation and explanations.

8.3.7 He must carry out substantive verification of all material transaction apart from carrying out analytical review.

8.3.8 Issues involved for verifying details by the Auditor _ It is practically difficult for the auditor to verify the details given by the directors concerned. No auditor may have the details of the entire investment of the directors and their relatives, etc. As such the auditor has to rely on to a greater extent on the statements given by the directors and to this extent the reporting will be questionable.

9. Specimen list of transactions and the method of reporting such transactions with related parties are given below

Description 

Parties where control exists

Associate/fellows subsidiaries

Key management personnel and relatives

Transactions during the year

Current year

Previous year

Current year

Previous year

Current year

Previous year

(1) Purchases

 

 

 

  

 

 

(2) Sales A  

                 

(3) Commission/(fees) received A  

                

(4) Commission/(fees) paid A  

              

(5) Share of income from partnership firm A  

              

(6) Interest received A  

              

(7) Interest paid A  

              

(8) Expenses recovered A  

            

(9) Rent received A  

             

(10) Rent paid A  

             

(11) Lease rent received A  

              

(12) Lease rent paid A  

             

(13) Finance charges received A  

             

(14) Finance charges paid A  

            

(15) Sale/(Purchase) of shares A  

            

(16) Deposits made/(received) A  

            

(17) Advances given/(received) A  

           

(18) Remuneration paid A  

            

(19) Remuneration re-ceived A  

           

(20) Sitting fees paid (received) A  

            

(21) Guarantee given/(withdrawn) A  

           

Balances as at end of the year A  

            

(1) Loans and Advances A  

           

(2) Sundry Debtors A  

           

(3) Sundry Creditors A  

           

(4) Guarantees out-standing A  

           

10. Conclusion

10.1 Compliance of AS-18 has started giving some positive results in the direction of better presentation and disclosure of financial transactions with related parties. The CARO, 2003 will further strengthen the process.

10.2 The ultimate objective of the disclosures of related party transactions is to benefit the users. It may be better if the requirement under section 274(1)(g) is included as a part of the Directors' Responsibility Statement (under section 217 (2AA) instead of being a part of the Auditors' Report.

10.3 The Report of the Expert Group on Transfer Pricing Guidelines, Department of Company Affairs, Ministry of Company Affairs, Government of India has given a number of suggestions to further improve the disclosure and scrutiny of related party transactions.

________________

*The author is a Chartered Accountant.

   

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