The Related Party Conundrum: A Corporate Governance Nuance

[dropcap]I[/dropcap]nvestors, both in public and private companies are increasingly focused on corporate governance at companies to drive their investment decisions. Transactions with related parties have always been a sticky topic as part of increased governance and this has brought even more to light with issues such as at IL&FS. Considering that the stakeholders in a company are demanding increased scrutiny from the auditors the presence of related party transactions warrants larger skepticism, sometimes even questioning propriety.

[box type=”info” align=”” class=”” width=””]There are a fair number of regulations and guidelines which provide a framework for related party transactions which include the Income Tax Act, Companies Act, Accounting standards, Auditing standards, etc. The crux of this framework aims at ensuring that all transactions between related parties are at arm’s length. Though the stated intent sounds simple and clear, establishing and demonstrating arm’s length is a fairly complex exercise that requires significant judgement.[/box]

The presence of voluminous related party transactions critically increases the risks surrounding accounting assertions made by the management. Sectors such as power, real estate, infrastructure, etc. with complex holding structures, multiple related parties within and outside their groups have only added to the complexities. The first step is to identify and establish the number of related parties. At this juncture, there is always a question mark whether all related parties have been duly identified and disclosed.

[box type=”success” align=”” class=”” width=””]Accountants and Auditors, in today’s context, must use multiple methods and tools to satisfy themselves that all related parties have been fairly identified. For instance, the Ministry of Corporate affairs allows searches to be carried out on the Directors of the Company to identify entities in which the Directors have significant interest. Apart from this quite a few private service providers provide information, on a paid basis, to identify all possible related parties based either on shareholding patterns or directorships held. The secretarial team needs to play an active and integral role in providing assurance to Chief Financial Officers with regards to the completeness of identified related parties, especially in large business houses/groups.[/box]

Establishing the arm’s length consideration becomes even more complex if related party transactions have a pervasive impact across the various components of the financial statements. Even though the auditors’ role is heightened, the management may also have challenges in expressing appropriate accounting assertions especially in the context of Ind-AS/IFRS.

For instance, one may commonly come across inter-company loans given/taken between related parties. Under the Ind AS/IFRS accounting framework the terms of the loan must be evaluated and in case the terms are not at arm’s length (interest-free loans or concessional interest rates) then such financial instruments are to be fair valued and significant judgement needs to be exercised to pass appropriate accounting entries giving impact for such fair valuation.

The alleged issues at IL&FS are a good illustration where multiple companies within the ambit of the Group were used as vehicles to allegedly misappropriate assets prejudicial to the interests of the stakeholders of the Group which included banks and financial institutions who had lent money for various infrastructure projects. The transactions, primarily between related parties, were allegedly structured in a complex manner and this was being camouflaged amongst the sheer volume of related party transactions.

Just to give a sense of volume, there were 169 reported subsidiaries within the Group which the government-appointed chairman, Mr. Uday Kotak, claims is not complete or accurate. This gives us a good idea of the sensitivity surrounding related party transactions thereby warranting extensive checks and balances from the management’s viewpoint.

[box type=”success” align=”” class=”” width=””]The related party conundrum is not easy to solve, not only from a corporate governance perspective but also from an audit perspective. Suitable references need to be drawn from available regulations/guidelines and adequate regulatory processes along with documentation need to be followed to ensure that an appropriate level of diligence is exercised.[/box]

About the author: The author is Partner and Leader, Risk Advisory Services, Consark Advisory Services LLP. Consark is a boutique advisory services firm providing Financial, Risk & Assurance, and Tax advisory services. The author can be reached at kaushik@consark.com. Views expressed in this article are personal.