Peeling away financial reporting issues one layer at a time

IAS 24: Related Party Disclosures Are Too Transparent to Suit China

Earlier this month, Compliance Week published an article entitled, "Related-Party Transactions Bane of China's IFRS." I had been generally aware that China's eagerness to fully embrace IFRS had been tempered by its reluctance to furnish the required related party disclosures per IAS 24, and that it was working with the IASB to relax the related party rules in IFRS, and the article does a very nice job of fleshing out the details and describing the dynamics. The IASB has published an exposure draft of amendments to IAS 24 to reduce the related party disclosure requirements, with perhaps more still to come.

China's economic reforms may have started almost 30 years ago, but it will continue to remain distinctly different from other large economies for years to come in that a significant amount of their GDP is produced by state-owned enterprises. Approximately 150 corporations report directly to the central government, thousands of others (including subsidiaries of these 150 corporations) are owned by provincial and municipal governments, and many companies that were partially privatized retain the state as a majority or influential shareholder. (source: Forbes.com)

The Compliance Week article reports that China's stated motivation to change IFRS is costs/benefits based. Their position is that since so many companies are state-owned, and therefore related, disclosing them all would cost too much and provide little information of value to users of the financial statements. Alain Texeira, a director of technical activities states, "We had a genuine concern that if you disclose so many parties as related parties, you'll get hundreds of pages of disclosure and the real related parties will be masked…"

"Hundreds of Pages"?

Just for jollies, I pulled up the latest annual reports filed with the SEC for the eleven Chinese companies listed on the New York Stock Exchange. Although I would have to go back and verify this, I have a high degree of confidence that each company stated that it was in compliance with IFRS; therefore, IAS 24 would be the operative standard for the related party disclosures in the notes. IAS 24 is broadly similar to SFAS 57, but IAS 24 also requires disclosure of compensation information to executives – which incidentally, are to found elsewhere in SEC filings.

All of these companies disclosed that either a government entity was either a majority owner, or owned a large enough percentage to be able to exercise significant influence. As relatively large companies, the volume of transactions with other government-owned entities could be expected to be on the high side, along with the number of pages in the notes to their financial statements dedicated to related party disclosures. As SEC registrants, the adequacy of their related party disclosures would have been subject to review at least once every three years; and related party disclosures are almost always the focus of an SEC staff review.

In contrast to hundreds or tens of pages, I found that the average number of pages devoted to the related party transaction note accompanying the financial statements was merely five. The individual disclosures ranged from a low of three to a high of seven pages, so there weren't even outliers. Not to beat a dead standard setter, don't forget some of these pages would have been utilized in every case to provide executive compensation information.

A More Clear-Eyed Cost/Benefit Analysis

Let's set aside the hyperbole and take a principles-based look at the role related party disclosures serve in financial reporting.

Shareholders and potential investors use financial statements to help them assess "stewardship" and "value." Stewardship refers to management's responsibility to use assets efficiently and in the interests of shareholders; value refers to the future profitability of the enterprise. One of the fundamental presumptions underlying the value of financial statement information is that the transactions on which they are based take place between disinterested parties. If this were not the case, there is less assurance that transactions were negotiated to the maximum advantage of the shareholders of the enterprise, or that historic transactions can be validly extrapolated to predict the future.

There is really no good solution to deal with oft-encountered situation where this unrelated-party presumption is seriously challenged. The best that can be expected is for liberal and extensive disclosures to alert the reader of the financial statements of material related party transactions. Not only should the disclosures help an investor assess the information value of the financial statements provided, but the sunlight provided by related party disclosures deter those who may be able to negotiate transactions with a company on a basis that is something less than arm's length from doing so.

Will China Lead a Race to the Bottom?

Related party disclosures are just one more example of where IFRS tends to be diverging from the quality of financial reporting that results in the relatively low cost of capital we currently enjoy in the United States. China is a highly distinct economy and any attempt to craft disclosure rules that respond to the peculiar needs of its economy and society are likely to clash with what is best for U.S. investors. (So much for the idea that one single set of accounting standards can work well the world over!) As the second-largest economy in the world, China is already demonstrating its willingness to use its economic clout to shape IFRS to his own needs, which as I have stated, would not just deprive investors of relevant and reliable information, but could further increase the risk of loss due to fraud.

Is six or seven pages of disclosures too much to ask to guard against the risk of fraud — and fraud perpetrated by a sovereign state against foreign investors no less? I find it ironic and telling that around the time when the IASB is considering relaxing its related party disclosure requirements to accommodate China, the SEC (albeit before the arrival of Chairman Cox) ratcheted up its MD&A disclosures (see Financial Reporting Release 61) to include information about transactions with any person or entity that may have the potential to exercise leverage in negotiations with the company, even if the formal definition of a "related party" under GAAP has not been met.

Maybe the day will come when transparency in financial reporting has the same currency in China as it has in the U.S., but there can be no doubt that day is still a long way off. In the meantime, do we converge our accounting with theirs, or do we hold to our principles until China rises to ours? In case you have any doubts, that's a rhetorical question.

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