IASB issued new standard IFRS 18
On 9 April 2024, the International Accounting Standards Board (IASB) published its new standard IFRS 18 Presentation and Disclosures in Financial Statements that will replace IAS 1 Presentation of Financial Sta…
How to prepare the related parties report correctly?
At the end of the fiscal year the statutory bodies and financial department teams do not have to prepare “only” the financial statements, they need sufficient forces left also for the preparation of the annual report and the related parties report. It is the related parties report that must be prepared by the statutory body of a company within three months from the end of the reporting period and, given the complexity of the closing of accounts, there is often no space to ponder whether the related parties report serves its purpose intended by lawmakers.
The objective of the related parties report is to provide a comprehensive presentation of the controlled entity’s position in the structure of the group of related parties. The position of a company itself is impacted by specific relations arising from its inclusion in the group. The content of the related parties report is also listed, in an exhaustive manner, in Section 82 of Act No. 90/2012 Coll., on Business Corporations (hereinafter the “Business Corporations Act”). As such, all could be clear, however, the preparation of the related parties report brings numerous practical problems and issues.
What is the actual structure of relations in the group and in what form is it supposed to be listed? To what detail should the listed contracts be described? On what financial statements (for which period) should the management base the determination of the limit regarding what activities should be described in the related parties report? And what about the trade secret in respect of the publication of the related parties report in the collection of deeds? Below you will find our reflection on these issues.
Legislation on the related parties report
Although the legislation on this issue has been relatively established, the preparation of the related parties report is not a favourite thing to do. Quite the contrary, it often brings confusion resulting from certain provisions relating to its content that the Business Corporations Act took from the Commercial Code with some differences. Since January 2014, the obligation to prepare the related parties report has applied to all business companies. In January 2021, an extensive amendment to the Business Corporations Act (Act No. 33/2020 Coll.) took effect; among other things, it brings practical solutions for certain ambiguities in the related parties report.
Legal requirements for a related parties report, and thus compliance with the legal regulations, are stipulated predominantly by Section 82 of the Business Corporations Act. Under Section 82 (2) of the Business Corporations Act: “The related parties report will contain:
a) structure of relations between the entities in accordance with paragraph 1
[note of the author – i.e. between the controlling entity and the controlled entity and between the controlled entity and entities controlled by the same controlling entity]
b) role of the controlled entity in the structure of relations according to letter a);
c) manner and means of control;
d) list of actions made in the most recent reporting period at the initiative or in the interest of the controlling entity or entities controlled by the controlling entity, if such actions concerned assets exceeding 10% of the controlled entity’s equity identified from the most recent financial statements for the reporting period immediately preceding the reporting period for which the related parties report is prepared; and
e) list of mutual contracts between the controlled entity and the controlling entity or between the controlled entities.”
The act stipulates some additional obligations.
The prescribed content of the related parties report involved or continues to involve the following frequent issues:
Presentation of the structure of entities and their relations
In practice we encounter rather often only the presentation of the controlling entity, however no presentation of other entities controlled by this entity where there is for example a reference to another document (another part of the annual report, consolidated financial statements and other documents). Or these entities are frequently only listed, refer to our comments below.
We believe that a reference to a document outside the related parties report (be it a document for example within an annual report, or outside of the annual report) is not correct as the related parties report is a comprehensive standalone document as stipulated in Section 82 of the Business Corporations Act. The related parties report should be a uniform document containing the information required by law which can be treated as a standalone document. The report itself conforms to specific statutory provisions and expected “processes” (e.g. review by an expert as part of a legal proceeding under Section 55 et seq. of the Business Corporations Act) and it is obvious that referring to other documents (which may not exist at the time when the related parties report is prepared) prevents the possibility to work with the related parties report as such and verify its correctness.
In addition, the list of the controlled entities does not meet the requirement for the “structured” character of relations in the group. The professional literature recommends describing the specific structure ideally in a manner presenting vertical relations, horizontal (fellow subsidiaries) relations as well as diagonal relations, including direct and indirect controlling or managing relations, for example in the form of scheme (chart) of the group. If we proceed to make a list of names, it is necessary to include the characteristics, i.e. description of a position of members in the group.
Specificity of the listed contracts and actions
Under the Business Corporations Act, the related parties report should contain a list of actions that concern assets above 10% of the equity of the controlled entity and a list of all mutual contracts between the controlled entity and the controlling entity or between the controlled entities. According to the ruling of the Supreme Court (file no. 29 Cdo 3701/2012): “In principle, it is necessary to list at least an entity with which the contract was concluded, its subject-matter, what performance the contracting parties provided (or are to provide) under the contract and potentially – if significant for an assessment of a detriment – other contractual arrangements (e.g. maturity of the agreed price, collateral, etc.)”. In addition, Mr Čech states in the respected commentarial literature that the related parties report will have the appropriate reporting value only when individual actions are identified by significant required information, i.e. information on between whom, on what (including potential information on the number or quantity, if relevant) and for how much it was made. The information on the price may be listed by units or on an aggregate basis. The objective is to make it possible for a recipient of the report – primarily an uninvolved owner or shareholder, or a creditor – to conclude from the description to what extent the controlled entity incurred detriment, if any, from such actions.
As to the actions under Section 82 (2 d) of the Business Corporations Act, it is necessary to list unilateral actions, if any, including (i) participant(s) in a relation, (ii) name of the contract, (iii) subject matter of the performance,
(iv) quantity of performance, (v) value of performance, (vi) the fact that the actions in the specific period exceed 10% of the company’s equity as listed in the most recent financial statements, and (vii) other facts decisive for assessing of a detriment or advantage, such as maturity, collateral, etc.
Additionally, it is not possible to avoid the listing of certain actions on the grounds that they were divided into parts that individually do not exceed 10% of the equity. It is always necessary to assess the circumstances of the actions and consider what their overall impacts are, or whether they are interconnected with other actions.
Trade secret
In practice, we often encounter the failure to list the required information under Section 82 (2) (d) and (e) with verbal explanation that this information is trade secret. Since 2021, the response to dealing with such situation has been brought by the Business Corporations Act itself and we would like to emphasise it. The practice when the related parties report does not contain any information or statements that this information is not listed for a certain reason, will have to inevitably respond to that for the year 2021. On 1 January 2021, an extensive amendment to the Business Corporations Act (Act No. 33/2020 Coll.) took effect and it explains in paragraph 5 of Section 82 how to address the trade secret in the report: “The related parties report does not disclose the information that is protected or classified under another legal regulation (e.g. Act No. 412/2005 Coll., on Protection of Classified Information and Security Eligibility, and other regulations). In such case, the report must contain a statement saying that it is incomplete and for what reason the required information is not stated.”
The issues of trade secret were addressed in the past by the Supreme Court which stated (ruling of 17 December 2014, file no. 29 Cdo 3701/2012) that the “description of individual contracts does not have to contain some of the listed information if this information is trade secret or if there was a reason regarding that information for which the Board of Directors may refuse to provide the information/the provision of which to the owner the statutory body of the company may refuse…and it is not possible to request that the company lists it in the related parties report, which is available to anyone as a document stored in the collection of deeds”.
It is important to emphasise that this incompleteness of the report must be described. We will again find the reasons in the above quoted ruling of the Supreme Court which states that “even in such case the description of concluded contracts must, in addition to the explanation why some of the above information is not stated, allow an assessment whether the controlled entity incurred detriment as a result of these contracts. For this reason, it must be obvious whether the concluded contract adhered to standard business conditions, and if it is not the case, how it derogated from these conditions.”
Paragraph 6 of Section 82 instructs the person preparing the related parties report to generalise the information which is trade secret in a manner to serve the purpose of the report: “The information that is trade secret is listed in the related parties report in a reasonable degree of generalisation that meets the purpose of the related parties report.” But how should the generalisation be addressed? The guideline is provided in an explanatory memorandum, which resulted in the amendment to paragraphs 5 and 6 of Section 82 of the Business Corporations Act, by Mr Čech: “In a specific case, the statutory body lists in the report for example the sale of passenger cars for CZK 300,000 – 500,000 per piece and states that there are 4,000 to 6,000 pieces; the information is stated by providing a range. This manner of dealing with the information that is trade secret is used for example in the resolutions by the European Commission in economic competition issues as well as in the resolutions by the Office for the Protection of Competition; as such it is not a new concept that would be unknown to the Czech legal system.”
Financial statements used for an assessment of the information on the equity in paragraph 2 of Section 82 (d)
The amendment to the Business Corporations Act additionally added interesting information to the statutory requirement in paragraph 2 of Section 82 (d). We can say that it contributed to the solution for another frequent issue – what financial statements should actually be used to determine the limit from which it is necessary to list the actions exceeding 10% of equity. The answer is: the financial statements as of the closing day of the reporting period preceding the one for which the report is prepared. In this issue, the opinions of the expert commentators also differed in the past and it is useful that the amendment brough clarity to this issue. One part of experts objected that it was not possible, given the time requirements, to use the information from the period for which the report is prepared. The statutory body would learn the information on whether and what actions should be included in the report for the period ended for example as of 31 December 2020 at the beginning of 2021 and it would have only several weeks for the report preparation. In addition, these financial statements are usually not approved by the relevant body of a business corporation and likely not reviewed by an auditor at the moment when the report on related parties is prepared. The other part objected that the financial statements for the reporting period of the related parties report should be used; however, lawmakers gave priority to the first described option in the end.
Detriment
Furthermore, the amendment to the Business Corporations Act cancelled the legal requirement originally described in letter f) regarding detriment, specifically an assessment whether the controlled entity incurred detriment, and an assessment of its settlement under Sections 71 and 72 as this provision has already been included in paragraph 4 of Section 82 which requires as follows: “In its report on relations, the statutory body shall also evaluate the advantages and disadvantages resulting from the relations between the entities referred to in paragraph 1, and indicate whether the advantages or disadvantages prevail and what risks are involved for the controlled entity. At the same time, the statutory body shall indicate whether, how and in what time the damage, if any, was or will be settled pursuant to Section 71 or 72”.
Control by the controlling entity only for a certain part of the year
The discussed issues of the report include the cases when a company is controlled by the controlling entity only for a part of the year or the controlling entity changed during the year. In legal practice, there are two opposing views. One of them is an opinion that the report should be prepared for the entire period and all controlling entities and actions should be listed together with the time definition of the control. The second possible approach is to list the actions with the controlling entity only for the period during which the company was controlled by the specific controlling entity. The controlled entity reflects relations with them in the report only for the period during which they were part of the same group, i.e. throughout the period in which they were interconnected with the controlled entity which prepares the report.
For this reason, this issue continues to be without a clear legal solution; let us note again that the purpose of the report should provide the guidance: the report should provide a comprehensive presentation of the the controlled entity’s position in the structure of the group of related parties.
Conclusion
In conclusion, let us mention that the principal objective in the preparation of the related parties report should be “quality” and completeness of information listed in the report so that this information serves the purpose of the report. We believe that our article will make the otherwise hectic end of the year easier.
