A European example of related party disclosures omitted from interim financial statements

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 13th edition:

• “The issuer manufactures industrial metals. One major shareholder owned 64% of its shares. The ‘other financial assets’ balance increased significantly during the first quarter of 2011 and totalled 17% of equity, however the issuer provided no explanation about the change in other financial assets in its interim financial statements as at March 31 2011.
• Other financial assets included the shares of company B, which were bought in January 2011. The transaction resulted from a decision by the issuer’s board of directors to invest excess cash in shares. At the same time it was decided that the issuer would enter into an option contract with its major shareholder, who was also the chairman of the board of directors, allowing the issuer to sell the shares of company B for the same price as it had bought them in January 2011. This provided protection against the risk of the share price subsequently decreasing.
• The option contract stated that the issuer could sell company B’s shares to its major shareholder at any time it chose during the contract term, until the end of April 2011. As the price of shares of company B decreased during spring 2011, the issuer decided to sell these shares to its major shareholder based on the option contract. The sale took place on April 13, 2011 at a price considerably higher than the market price at the date of the sale. As the shares were sold at the same price as they were bought, the transaction had no impact on the net profit of the issuer. The issuer did not include any related party disclosures in its March 2011 interim financial statements.”

The enforcer (as ESMA likes to term it) disagreed with this non-disclosure. The report doesn’t have much to say about why it disagreed though, beyond citing IAS 34.15, which includes “related party transactions” in a list of “events and transactions for which disclosures would be required (in an interim financial report) if they are significant” and the general disclosure requirements of IAS 24. One might conclude actually that if this is the best available example to illustrate the importance of related party disclosures, then maybe they’re not worth worrying about.

Faith repaid!

After all, the mechanism described here is one in which the issuer apparently remained entitled to any gains arising on the shares, while being protected against any losses. If the statements had disclosed the arrangement at March 31, 2011, as the enforcer concluded they should have, then this would indeed have drawn attention to a respect in which (citing IAS 24.1) the issuer’s financial position has been affected by the existence of related parties. But to put it blandly, it’s an entirely benign, positive kind of affect, and it’s impossible to see how the existence of the arrangement would have influenced a user’s decisions about anything. I mean, the fact of 64% of the company being controlled by a single shareholder would presumably already be amply clear from the public record, so anyone who invests in the entity should be aware that to a great extent they’re putting their faith in this individual. ESMA made sure here that investors received a nice story about how their faith was repaid (at least this once), but (without wanting to deny the virtues of even-handed regulation) it would be a more compelling anecdote if it illustrated an incident in which it wasn’t.

Actually, the report doesn’t seem interested in the most interesting aspect of all this, namely the accounting treatment for the arrangement, including whether the ultimate sale wouldn’t have been better reported as a loss in the income statement, and a corresponding contribution to equity by the shareholder. Anyway, at least ESMA gives us a situation that provides something to think about (even if not the same thoughts they may have intended). Most related party disclosures, in contrast, really don’t prompt much engagement at all. The great majority of the information they provide flows from transactions such as payments to law firms or other organizations in which a director or a member of senior management is a partner or officer. Of course, it’s entirely true that the related party aspect of these arrangements may have affected profit or loss, by imposing or facilitating a pricing structure different from what would likely have been negotiated with non-related parties. But since the financial statements provide no basis for even vaguely speculating on whether that actually was the case, or on whether it worked to the issuer’s favour or detriment, it’s impossible to see what users can generally do with the information other than shrug and move on.

The opinions expressed are solely those of the author