by John Hughes
It seems like a good idea to go back to dissecting Al Rosen’s list of IFRS-related problems (see my November 3 posting), which he laid out as follows:
- More specifically, some of the most common issues that will pose problems for investors include: adjusting up and down the value of various assets at the time of adopting IFRS, with significant potential impact on future income; disguising executive greed by not quantifying and fair-valuing related-party transactions; building up hidden reserves for the purpose of manipulating future income; recording revenue years in advance of it actually being earned (if ever); hiding deteriorating cash flows through poor disclosure and netting together transactions; and adjusting the value of inventory up and down to meet short-term performance metrics.
Let’s consider “disguising executive greed by not quantifying and fair-valuing related-party transactions.” The core issue here, I believe, is that the Canadian GAAP standard, CICA 3840, addresses both measuring and disclosing related party transactions, whereas the closest IFRS equivalent, IAS 24, only deals with disclosure. Therefore IFRS doesn’t specifically address when a transaction with a related party would be at book value, versus fair value, or some other amount.
My understanding is that the CICA has raised this issue in some form with the IASB, but it’s yet to lead to any authoritative outcome. The IASB does have an open project on business combinations under common control, but it’s currently paused; in any event, this project wouldn’t address individually-bargained transactions, such as situations where an executive sells a piece of land directly to a public company (which seems to be the kind of thing Rosen is getting at). As best as I know, this remains a matter of judgment under IFRS, and there’s certainly no guarantee the accounting would always follow Canadian GAAP. It’s significant, for instance, that IFRS 2 Share-Based Payment – unlike its Canadian GAAP equivalent CICA 3870 – doesn’t exempt related party transactions from its normal fair value measurement requirements.
Rosen implies through his choice of words that related party transactions are currently fair-valued under Canadian GAAP, which is misleading to say the least. The core principle of CICA 3840 – although with two important exceptions – is that such transactions are measured at the carrying amount, not at fair value. There’s one exception for transactions in the normal course of operations, which are measured at the exchange amount (the agreed-to consideration) if they have commercial substance – this covers legal fees provided by directors and suchlike. Assuming these exchange amounts represent normal commercial billing practices, it would be hard to argue how you’d rationally measure them any differently under IFRS.
The second exception is for transactions not in the normal course of operations (such as that sale of land). These are also measured at exchange amount if the change in the ownership interests of the item transferred or benefit of the service provided is substantive (usually meaning at least a 20% change in the ownership interests) and the exchange amount is supported by independent evidence. This independent evidence might come from independent appraisals, comparable recently quoted market prices, comparable independent bids on the same transaction, or comparable amounts of similar transactions actually undertaken with unrelated parties.
But none of this means that “exchange amount” equals “fair value.” Two related parties might agree to a certain transaction amount which might be supportable with reference to (say) an appraisal (which might merely provide a wide range of possible fair values), or other recent activity. That’s not at all the same as saying that the transaction, if subjected to all the rigour and competitive bidding and so forth of a true open market process, and accompanying due diligence, wouldn’t generate a completely different value than the agreed-to exchange amount. If Rosen or anyone else thinks Canadian GAAP does mean measuring related party transactions at fair value, then that’s surely a false sense of security. Maybe we’re better off then under IFRS, where the absence of such measurement guidance forces us onto the alert. And certainly the disclosures under IAS 24 shouldn’t provide any less transparency about the existence and amounts of such transactions (actually, they should provide a bit more).
The suggestion that accounting standards alone are responsible for preventing the disguising of executive greed (this manifestation of it anyway) also overlooks various other disclosure and valuation requirements that might apply under securities law (for example, Annual Information Form disclosures about management interests in material transactions). Even so, as noted, Rosen makes a reasonable core point about a mismatch in measurement standards between Canadian GAAP and IFRS. If two related parties agree to a questionable transfer price for some asset, and paper that up with some flimsy evidence, it may be somewhat more difficult under IFRS for auditors or others to challenge that value, compared to Canadian GAAP (depending how brave, principles-based (!) and conceptually rigorous they are in their approach to things). Some further guidance on this area would certainly be useful. On the broader point, I agree that all things being equal, extensive related party transactions are usually (not always though) a cautionary flag. That flag won’t fly any lower any IFRS though; it’s just that the colours on it might be a little different. But then, how many of us are that good at interpreting such coloured flags in the first place?
The opinions expressed are solely those of the author.