In accordance with the Companies Act of 2013, a more intricate coverage of related party transactions has been implemented, with the act providing an improved comprehension of these transactions compared to its predecessor.
Additionally, strict procedural compliances have been imposed. However, Section 188 still presents room for alteration and diverse interpretations, unlike the prior Section 297 in the Companies Act of 1956.
What are related party transactions?
Financial transactions between two parties who share a pre-existing relationship or have a level of control over each other are known as related party transactions (RPTs).
Such transactions warrant scrutiny and must be carried out in accordance with relevant laws, regulations, and accounting standards.
Joint ventures (JVs) are a prime example of RPTs, where two or more entities pool their resources to create a new entity for the purpose of pursuing a specific project or business goal.
This post will delve into the various facets of RPTs, including JVs, the potential risks they pose, and ways to make full disclosure and manage these transactions in order to avoid possible legal or regulatory concerns.
Relationship between related party transactions
An entity’s financial position and profit or loss can be impacted by its association with related parties.
Such parties may engage in transactions that would not otherwise take place with unrelated parties.
- For instance, the entity may choose to sell goods to its parent at cost, whereas it would sell such goods at different terms to an unrelated customer.
- Furthermore, transactions between related parties may not be executed at comparable amounts as transactions conducted between unrelated parties.
Effect on financial position
An organization’s financial standing and profitability can be subject to influence by the existence of a related party relationship, even if related party transactions do not take place.
The mere presence of the relationship can have a consequential effect on the dealings of the organization with other parties.
For instance, a subsidiary might terminate association with a business partner upon the acquisition by the parent of a fellow subsidiary engaged in the same activity as the former trading partner.
Alternatively, one party may choose to abstain from conducting any action due to the considerable influence of another, such as a subsidiary being advised by its parent not to engage in research and development.
Evaluation of financial statements
Knowledge pertaining to an entity’s transactions, outstanding balances, commitments, and relationships with related parties may significantly influence the evaluations of its operations performed by the users of financial statements.
Such evaluations include assessments of the entity’s potential risks and opportunities.
“Even though related-party transactions are lawful and at times necessary for the smooth operation of a company, it is crucial to acknowledge that they have the potential to cause a conflict of interest or result in unlawful circumstances.
Failure to monitor related-party transactions may lead to fraudulent activities and financial devastation for all those concerned.”
Joint ventures as RPTs
Joint Ventures (JVs) are a widely used type of Related Party Transactions (RPTs) wherein two or more entities pool resources and knowledge to provide a distinct offering or service.
These arrangements can take various forms, from contractual agreements to partnerships, limited liability companies, and joint ventures.
Unlike mergers and acquisitions, JVs offer the advantage of enabling participating entities to maintain their independence while sharing the risks, costs, and profits associated with a particular project.
Joint ventures offer several benefits, including access to new markets and expertise, cost and risk-sharing, and flexibility.
However, joint ventures also present significant challenges and risks, particularly in the context of RPTs.
Categorization of related parties
The regulatory mechanism encompasses various related parties falling under the ambit of related party, and any transactions involving them shall be considered as related party transactions.
Here are the extensive categories of related parties. Please refer to them for further understanding.
The entities that fall within the scope of this policy include:
(i) a director or his relative;
(ii) a key managerial personnel or his relative;
(iii) a firm, in which a director, manager or his relative is a partner;
(iv) a private company in which a director or manager or his relative is a member or director;
(v) a public company in which a director or manager and holds is a director or holds along with his relatives, more than two per cent. of its paid-up share capital;
(vi) any body corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;
(vii) any person on whose advice, directions or instructions a director or manager is accustomed to act:
Nature and characteristics of related party transactions (RPT)
Various forms of related party transactions (RPTs) can be observed, such as sales and purchases, loans, management fees, guarantees, and leasing arrangements, to name a few.
As per the guidelines laid out in the International Financial Reporting Standards (IFRS), an entity or individual that shares a close relationship with a party through ownership, control, or management is deemed a related party.
Additionally, personal connections such as familial ties or other affiliations are also considered while determining relatedness. In such instances, the decision-making process may be influenced by a higher level of control or influence leading to preferential or biased treatment.
To maintain transparency and prevent conflicts of interest, it is essential to disclose all RPTs.
Approvals required for entering into related party transactions
1. Approval of the Board of Directors:
(a) sale, purchase or supply of any goods or materials;
(b) selling or otherwise disposing of, or buying, property of any kind;
(c) leasing of property of any kind;
(d) availing or rendering of any services;
(e) appointment of any agent for purchase or sale of goods, materials, services or property;
(f) such related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company; and
(g) underwriting the subscription of any securities or derivatives thereof, of the company:
2. Approval of Members of company:
The following related party transactions can be entered into by the company only after obtaining prior approval from the members of the company by passing an ordinary resolution:
The following related party transactions can be entered into by the company only after obtaining prior approval from the members of the company by passing an ordinary resolution:
(i) sale, purchase or supply of any goods or material, directly or through appointment of agent, amounting to ten percent or more of the turnover of the company;
(ii) selling or otherwise disposing of or buying property of any kind, directly or through appointment of agent, amounting to ten percenter more of net worth of the company;
(iii) leasing of property any kind amounting to ten percent or more of the turnover of the company;
(iv) availing or rendering of any services, directly or through appointment of agent, amounting to ten percentor more of the turnover of the company;
The limits specified in sub-clause (i) to (iv) shall apply for transaction or transactions to be entered into either individually or taken together with the previous transactions during a financial year.
(v) For appointment to any office or place of profit in the company, its subsidiary company or associate company at a monthly remmuneration exceeding two and a half lakh rupees.
(vi) for remuneration for underwriting the subscription of any securities or derivatives thereof, of the company exceeding one percent of the net worth.
The turnover or net worth referred in the above sub-rules shall be computed on the basis of the audited financial statement of the preceding financial year.
In case of wholly owned subsidiary, the resolution passed by the holding company shall be sufficient for the purpose of entering into the transaction between the wholly owned subsidiary and the holding company.
Such approval shall not be applicable for transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.
Pros and cons associated with related party transactions
Pros:
- Such transactions can prove advantageous for an entity when it has family members owning substantial ownership stakes in the business. To illustrate, a company that vends its manufactured goods to a related party at cost price may not extend the same pricing to an unrelated customer.
- For improved presentation, it is advisable to disclose this information separately in the Financial Statements.
- Transactions that are permissible between related parties may not be allowed between parties that have no connection to one another.
Cons:
Risks associated with related party transactions (RPTs) are numerous, ranging from potential conflicts of interest to insider trading and fraud.
- If family members do not have a substantial ownership stake in an entity, it may experience losses in these transactions.
- It is within management’s authority to subdue these types of transactions and potentially benefit from doing so.
- It is recommended to disclose financial statements separately in order to ensure accurate representation. Failure to do so may result in an inaccurate and biased view of the financial status.
- “The occurrence of these transactions may adversely affect the financial situation of an organization including its profit and loss statement and overall financial standing.”
“Transparency and regulation of transactions involving related parties.”
Entities are mandated to disclose all Relevant Party Transactions (RPTs) in their financial statements, as per the International Financial Reporting Standards (IFRS) norms.
In addition, it is imperative that organizations conduct Related Party Transactions (RPTs) with unbiased measures in order to avoid any kind of preferential treatment that might influence the decision-making process.
Where such preferential treatment cannot be avoided, organizations must transparently disclose all pertinent details to stakeholders.
Bottom line
Transactions between parties that have a related affiliation, commonly known as related party transactions (RPTs), can take on various forms, such as loans, guarantees, sales, purchases, and leasing arrangements.
Joint ventures (JVs) represent a frequently utilized kind of RPT wherein two or more parties pool their knowledge and abilities to realize a common objective.
Despite their advantages, RPTs can expose entities to significant risks like conflicts of interest, insider trading, self-dealing, and fraud.
Therefore, it is mandatory to report all RPTs in the financial statements and institute appropriate internal control mechanisms to manage such transactions effectively.
Appropriate management and disclosure of RPTs foster transparent and accountable business practices, encourage stakeholder confidence, and adhere to legal and regulatory requirements.