ON Tuesday, (July 12), the five-member international panel of judges of the Permanent Court of Arbitration in The Hague unanimously upheld the Philippines’ position that China claiming some 85 percent of the South China sea on the basis of its purported historical boundary or the nine-dash line, is excessive and encroached into the Philippines’ 200-nautical mile exclusive economic zone.
While the Philippine government recognized the ruling as a “milestone decision” and Filipinos everywhere responded with joy and pride, the Department of Foreign Affairs (DFA) called on the citizens to exercise restraint and sobriety as the government, it said, would continue to pursue a peaceful resolution of the dispute to preserved peace and stability in the region. The government’s cautious response is understandable. After all, China is a “valued friend” as our representatives noted during the hearings in The Hague; and how the two parties will proceed from here on will shape the consequences of the ruling for bilateral relations and the two economies.
Right to offset
In an era of globalization, relationship matters not only in politics but also in business and in financial reporting. Thus, reporting of related party transactions and balances in the financial statements have become an area of focus for management, shareholders, and regulators alike. Related parties, as defined in the Philippine Accounting Standard (PAS) 24, Related Party Disclosures, are persons or entities that are related to the entity that is preparing its financial statements (reporting entity) either through control/joint control, significant influence or membership in key management. Related party transactions, on the other hand, are transfers of resources, services or obligations between a reporting entity and a related party, regardless any price is charged. Therefore, it is not uncommon for some not to focus too much on related party transactions since, in their view, the resources, services and obligations are still within the group anyway, so how they are reported is not of much consequence to the consolidated group.
While there is some truth in this simple view of related party transactions, accounting standards and regulatory requirements demand more than just a simple recording of the transfer of resources or obligations. This is evident in PAS 24 and in the various regulatory issuances by both the BIR and SEC. In fact, in Revenue Memorandum Circular (RMC) No. 61-2016 issued on June 14, 2016, the BIR prescribes the policies and guidelines for accounting and recording transactions involving “netting” or “offsetting” of amounts recognized as accrued/trade receivables against amounts recognized as accrued/trade payables. Under the RMC, the practice of offsetting due to/due from and/or payable/receivable transactions of taxpayers and consequently the accounting and recording of the same and its related transactions in the books of the parties is prohibited. While the effectivity of RMC 61-2016 has been suspended by the new BIR commissioner, Cesar Dulay, until further notice, through the issuance of RMC 69-2016, accounting standards still require the complete, accurate and proper accounting of related party transactions.
To illustrate, assume that companies P and W, both VAT-registered, are related parties by virtue of these being owned by the same parent company, Company C. Let us assume further that Company P sold finished goods to Company W amounting to P11,200 while Company W provided services to Company P amounting P5,600. As related parties, Companies P and W, offset receivables and payables from each other and settle only the net amount reported in their respective balance sheets. Companies P and W should recognize the sales and service revenue, respectively, at the gross amount, regardless of whether the transactions are actually offset or there is net settlement of cash flows.
Entries made in the books of each of the entities should be:
To record the sale of finished goods by Company P to Company W (see graph on B4)
To record the rendering of services by Company W to Company P (see graph on B4)
Such recording of the transactions is consistent with the requirements of both the accounting standards and tax regulators as it reflects the full and correct recognition of the amount of revenues and expenses and the relevant taxes. If, at the end of the year, the full amount of the payable and receivable remains outstanding, the companies should recognize the amounts due to and from each other at the net amount in their respective balance sheet if it is established that there is indeed an enforceable right to offset the recognized amounts and that there is an intention to settle on a net basis consistent with the requirements of Philippine Financial Reporting Standards (PFRS) 7, Financial Instruments: Disclosures. The resulting amounts in the balance sheets of Company P and W would be a Due from Company W of P5,600 and Due to Company P of P5,600, respectively.
To further demonstrate the difference had direct offsetting been done; let us look at a possible error if offsetting was erroneously recognized at the time of the transaction. The entry below shows that revenue, expenses and the related taxes could be understated as a result of the incorrect application of the right to offset.
To record the net transactions between Companies P and W: (see graph below)
From the entry, we will note that while the net amounts of receivable and payable between the related parties are the same as the correct entries, the amounts of reported revenues and expenses are understated resulting to misstatements in financial and tax reporting.
Such understatement of reported revenues and expenses have far reaching consequences as it increases the risk that stakeholders are likely to reach business and operating decisions using incorrect financial data. Both companies may likewise have significant tax exposures arising from deficiency income and value added taxes and the consequent interest, penalties and surcharges.
Right is might
In his closing remarks on the last day of hearings on merits at the Arbitration Tribunal in November 2015, then DFA Secretary Albert del Rosario said that international law is the great equalizer among states and that right makes might. The same holds true if we were to put what he said in the context of accounting for related party transactions. The accounting standards ensure consistent overall reporting of related party transactions across all businesses and industries while legal and regulatory requirements generally help level the playing field and ensure that compliance with such requirements provides might to those who comply.
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Catherine H. Santos is a Partner from Assurance and the Assurance Transformation Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.