A new draft of guidelines from RJ on the treatment of intra-group transactions is a missed opportunity.
Gert the Dutchman
In November 2022, the Council for Annual Reporting (RJ) issued draft guideline 260 ‘Treatment of results of intra-group transactions in the annual accounts’. This draft directive has virtually no substantive changes compared to the current directive, but only aims to increase readability and accessibility.
A missed opportunity for me because I believe that the rules of Directive 260 provide a fragmented representation of the economic reality of intra-group transactions which misrepresents the assets and performance of the companies.
It is an interesting topic and relevant to many companies. I would like to refer the interested reader to a publication in the October 2020 MAB which discusses this issue in more detail and also discusses the IFRS and US GAAP rules. I limit myself here to Annex A of the proposed directive, which deals with the elimination (in the parent company’s annual accounts) of unrealized profits on subsequent transactions between the parent company and the subsidiary.
The example in Annex A to draft Directive 260
A has a capital share of 40 per cent. in B, which is included in A’s accounts at net worth. In year 1, A supplied goods to B for NOK 1,000 at a price of NOK 800. B sold half of these goods to a third party on the balance sheet date. An amount of 100 of the margin of 200 has therefore not yet been realized.
According to the draft directive, A must remove an amount of 40 (40 per cent of 100) (deducted turnover*) in its annual accounts, in return for capital shares or accruals and deferred income. When B sells the goods in year 2, the amount of 40 must be calculated as revenue.
Financially, I agree with RJ that the 40 percent share in B means that the full result can only be considered realized if B has resold the goods to a third party. From A’s perspective, there is a result of 40 which does not yet accrue to the shareholders of A because risks and rewards as far as these goods are concerned have not yet been transferred by A to a third party, but to a related party in which A has a minority interest (the 40 per cent share in B).
Objections to the treatment method in draft guideline 260
I have a number of objections to the accounting method in the proposed directive, which ignores the financial reality of the transaction and does not fairly represent As’s assets and results:
- The elimination rule creates a fictitious reality (provided that the price of NOK 1,000 for the item is in line with the market): it is strange to add 40 to the turnover, after all A delivered 1,000 items in year 1, and not 960. Also the picture given in year 2 is incorrect: A delivers no goods but still shows a turnover of 40.
- It also does not make sense to adjust the amount of 40 to the book value of the investee because the book value of the holding is not flattered by transactions from non-market shareholders (assuming the price of 1,000 is at market).
- The item accruals and deferred income does not meet the definition of debt as contained in DAS 940: “a present obligation of the legal entity that arises as a result of past events, the settlement of which is expected to result in an outflow from the legal entity of resources that generates financial benefits to hide in”. Because there is no unfulfilled performance by A (the goods are delivered to B after all), the accruals and deferred revenue item cannot be considered a liability (‘deferred revenue’) of A.
Treat the unrealized part of the result as ‘minority share’
A simple solution meets these objections: treat the result of this transaction in year 1 in full in the income statement and include the ‘unrealized’ part of 40 as ‘minority interest’ (reducing result). The balance sheet at the end of year 1 contains a ‘third party share’ of 40. The net profit in year 1 of 160 then accrues to the shareholders of A. If the remaining goods are resold by B in year 2, the ‘third party share’ of 40 is recognized in the income statement (increasing profit), with which it (after allocation of profit) accrues to the shareholders of A.
Article 2:411, subsection 2 of the Dutch Civil Code allows unrealized profits to be treated separately as ‘third-party share’: ‘The share of the group’s equity and in the consolidated result that does not accrue to the legal entity is indicated.’ Unrealized results on transactions with capital shares also do not accrue to the legal entity and can similarly be included as a separate item in the balance sheet and income statement. Section 501 of DAS 217 ‘Consolidation’ also allows this: In the balance sheet, the third party’s share is ‘recognised immediately after equity’. In the income statement, the third party’s share of the result is shown as the last item [..] deducted from the group result’.
The advantage of this accounting method is that no items are included in the balance sheet for A that contradict the definition of terms in DAS 940, that the share in equity and profit of share B is faithfully represented, and that the profit and loss statement gives a true and fair view image of the performance A has delivered (in both years).
The described solution can also be easily applied to upstream transactions with associated companies: Assume that B supplies assets to A with a book profit of 200. The book profit included in A’s recognized share of B’s profit and equity (40 percent of 200 = 80) will only accrue to the shareholders of A upon write-off or sale of the relevant assets by A. In year 1, A accounts for a (positive) participation result of 80 (which is in line with economic reality) and a negative third-party share of 80. All in all, nothing accrues to the shareholders of A in year 1, which is also in line with economic reality. The draft directive stipulates that A accounts for a result of participation of zero in year 1, while in reality it amounts to 80.
It would be good if RJ amends Guideline 260 after twenty years so that unrealized results on intra-group transactions are faithfully reflected in the balance sheet and income statement, doing justice to the economic reality. You can respond until 31 January 2023 (firstname.lastname@example.org).
* The current guideline also allows the elimination of 40 to be counted as a negative result of capital shares. This option has rightly been deleted in the draft directive.