After reading this article we will learn about Inter-Company Transactions and Statutory Cost Audit.
The expression denotes transactions taking place between two or more companies, whether they are related to each other or not, for a variety of considerations of personal and impersonal nature. These transactions between the companies are a normal feature of trade, commerce and industry.
Inter-company transactions may be classified into two categories:
1. Transactions arising out of related party relationships (i.e. related party transaction), and
2. Transactions taking place among parties who are unrelated to each other (i.e. unrelated party transaction).
In Related Party Transactions, the characteristics of control or significant influence by one party over the other party in making financial and/or operational policy decisions are present and the different parts of activities are operated upon by contracts entered into and by agreements or understanding reached between the related parties. The activities operate through intermediaries or subsidiaries or associated companies or holding companies, and the enterprises acquire interests in other enterprises.
In Unrelated Party Transactions, the characteristics of control and significant influence are not present. The transactions, here, take place in the ordinary course of normal business dealings by virtue only of those dealings through a single customer, supplier, distributor or general agent.
In these cases, an enterprise transacts a volume of business, significant or not, merely on the ground of the resulting economic dependence.
The first category of Inter-company dealings i.e. Related Party Transactions require separate disclosure in the Financial Statements as well as in the Cost Accounting Records.
The International Accounting Standard Committee also has issued a directive that the companies should disclose the nature of the related party relationships as well as the types of transactions and the elements of the transactions necessary for an understanding of the financial statements and that of the effects of related party transactions on the financial statements.
Provisions in the Cost Accounting Record Rules:
The Cost Accounting Records Rules provide that in respect of the supplies made or services rendered by the company to its holding company or a subsidiary or a company in the same group as defined in Section 370(IB) of Companies Act or a company in which a Director of the company is also a Director in such holding or subsidiary or associate companies and vice versa, the company should maintain adequate records showing the contracts entered into, agreements or understanding reached, with respect to:
(i) Purchase and sale of raw materials and process materials, components, finished products, by-products, rejected goods including scrap and fixed assets:
(ii) Utilisation of plant facilities;
(iii) Supply of utilities; and
(iv) Administrative, technical, managerial, and any other consultancy services.
These records should be maintained in such a way that they indicate the basis followed for arriving at the rates charged between them so as to enable the determination of the reasonableness of the rates charged or paid for such services.
The fundamental objectives behind such provision in the Cost Accounting Records Rules are:
i. To make the management responsible for the identification and disclosure of related parties (i.e. companies) and transactions with such parties;
ii. To alert the Cost Auditor with a view to recognising these transactions on related party relationships and enabling him the determination of the reasonableness of the rates charged or paid for those dealings and obtaining sufficient ‘appropriate audit evidence’ so as to draw reasonable conclusions concerning the treatment of such disclosures in the cost and financial statements;
iii. To determine whether adequate procedures and controls exist over the authorisation and recording of these transactions;
iv. To ascertain whether such transactions are motivated by unusual considerations other than ordinary business considerations, such as fraud or malpractices; and
v. To bring to light those transactions which appear unusual or irregular in the circumstances, such as:
a. Transactions having abnormal terms of trade e.g. unusual prices or rates, interest rates, guarantees and repayment terms,
b. Transactions which appear to lack a logical reason for their occurrence,
c. Transactions in which substance differs from the form and contents of the contracts and agreements,
d. Transactions processed in a way that appear to be abnormal as compared with similar transactions with unrelated companies,
e. High volume or significant transactions with certain customers or suppliers as compared with others, and
f. The receipt or provision of management services at no charge.
Inter-Company Transactions not Attracting the Provision:
The Inter-company Transactions of the following nature are not deemed to be related party transactions and, therefore, do not come under the purview of the provision:
(i) Transactions between two companies simply because they have a Director in common (but it would be necessary to consider the possibility, and to assess the likelihood as to whether the Director could be able to influence the policies of both the companies in their mutual dealings);
(ii) Transactions between—the Company and the Providers of finance (e.g. Banking Companies, Financial Institutions etc.), the Company and Trade unions, the Company and Public utilities, the Company and the Government Departments/Agencies in the ordinary course of their normal business dealings by virtue only of those dealings (although they may circumscribe and affect the freedom of action of a company or participate in its decision-making process) and
(iii) Transactions between the company and a single customer, supplier, distributor or general agent constituting a business whether of significant volume or not merely by virtue of the resulting economic dependence.
Cost Auditor’s Examination:
While the existence of inter-company relationship and transactions between related companies is considered a normal feature of a business, the Cost Auditor needs to be aware of them because such transactions may affect the cost and financial information and statements of the company, and might have been motivated by the company for the reasons other than ordinary business considerations, such as fraud.
In order to identify the Inter-Company Transactions, the Cost Auditor, depending on the circumstances, may adopt one or more of the following procedures:
(i) Inquiry of management as to the names of all related companies.
(iii) Review of the records of the Stockholders or Shareholders in order to ascertain the names of Principal Stock-holders or, if appropriate, obtaining a list of Principal Stock-holders from the Stock Exchanges.
(iv) Review of minutes of the meetings of the Shareholders and the Board of Directors.
(v) Review of the working papers of the earlier years for the names of known Inter- Related Companies.
(vi) Inquiry of the other Auditors (specially Financial Auditor) currently engaged in the company’s audit, or predecessor Auditors, as to their knowledge of additional related companies or parties.
(vii) Review of the Income-Tax Returns of the Company.
In view of a specific provision in the Cost Accounting Record Rules, it is the responsibility of the management to provide the names of identified related companies to the Cost Auditor so that he is in a position to recognize transactions with those companies during the course of cost audit. While performing his normal audit work, the Cost Auditor should be alert for transactions which may appear unusual or irregular in the circumstances.
Such transactions may indicate the existence of related companies previously unidentified, for example:
(i) Transactions having abnormal terms of trade, such as unusual rates or prices, unusual interest rates, inconsistent guarantees and repayment terms,
(ii) Transactions which prima facie appear to lack a logical reason for their occurrence,
(iii) Transactions in which the substance differs from the contents of contracts and agreements,
(iv) Transactions being processed in a way other than the normal way for processing similar transactions with the unrelated companies,
(v) High volume or significant transactions with certain classes of customers or suppliers as compared with others, and
(vi) Transactions that have taken place but not recorded, such as, receipt or payment of management services at no charge.
In examining the identified Inter-Company Transactions, the Cost Auditor should apply his audit procedures so as to obtain necessary audit evidence keeping in view the purpose, nature and extent of these transactions. However, there may be instances where evidence of Inter-company Transactions is limited, such as, the Parent company issues an instruction to its Subsidiary to record Royalty expense.
In these types of cases and circumstances, the Cost Auditor’s audit procedure should consider the following, e.g.:
(i) Confirming the terms and amount of the transaction with related company or with the Auditor of such related company,
(ii) Inspecting evidence in possession of the related company, and
(iii) Confirming or discussing information with the persons who are associated with the transaction, such as, Banks, Solicitors, Lawyers, Guarantors and Agents.
Methods to Price Inter-Company Transaction:
In an ordinary course of business activities, the accounting of a transfer of resources (e.g. Materials, Utilities, etc.) and services (e.g. Facilities, Technical know-how, Technology- transfer, Research and development, Management contracts or Consultancy services, etc.) is usually based on the ‘price’ agreed to between the parties. Between unrelated parties or firms the price is determined at an arm’s length.
But in the case of Inter-Related
Companies, the terms and conditions for transfer of resources and services may have an element of flexibility so as to suit the needs and circumstances of those companies. The process of fixation of price or determination of rates in these cases is generally influenced by either of the related companies.
So the degree of flexibility in the price-setting mechanism involved in Inter-Company Transactions is different from those taking place between unrelated parties and companies.
There are a variety of methods used to price Inter-Company Transactions.
These methods are enumerated below:
(i) Comparable Uncontrolled Price Method:
In this method, the price or rate is determined with reference to comparable goods sold in an economically comparable market to a buyer unrelated to a seller. In inter-company transactions where the terms and conditions relating to the transfer of goods and services are similar to those in normal trading transactions, this method is quite often used.
This method being reasonable and justifiable is usually accepted as a good method by the Auditor.
(ii) Resale Price Method:
In this method the transfer of goods takes place between the Inter-Related Companies before the sales are affected to an independent customer. This method is quite often used in pricing inter-company transactions for the goods as well as for transfer of other resources, such as. Rights and Services.
This method reduces the resale price by a margin-representing an amount from which the reseller would seek to cover his expenses and in addition, would make an appropriate profit to arrive at the transfer price to the reseller. This method is associated with the problems of judgement in arriving at compensation- appropriate to the reseller’s contribution to the process involved.
(iii) Cost-plus Method:
This method seeks to add up an appropriate mark-up to the supplier’s cost. In this method, difficulties are experienced in determining both the elements of cost attributable and the ‘mark-up’. In inter-company transactions, it is quite likely that the total cost approach will be adopted with no regard for the cost that should be.
However, the method of comparable return in similar industries on turnover or capital employed may assist in determining a transfer price, but cannot possibly depict a correct picture in all circumstances.
(iv) ‘No Price’ Method:
Sometimes, prices of inter-company transactions are not determined under any of the methods described above. Sometimes, no price is charged, for example, providing management services at no cost, extending free credit on a debt.
(v) Only ‘at cost’:
Sometimes, it may happen that the transactions would not have taken place between the inter-related companies had there been non-existence of any relationship. For example, a company which sold a large portion of its production to its parent company ‘at cost’ might not have been able to find an alternative customer if the parent company had not purchased the production.
Reasonable Determination of Rate-Cost Auditor’s Role:
This is an area which possibly requires an objective analysis and judgement rather than subjective considerations. Again, the price which is considered reasonable to one may be unreasonable to another in view of contingent circumstances. However, the cost auditor should study the reasonability or otherwise of the prices from practical angle and guide his own reasoning by applying the principles of uniformity, consistency, materiality and disclosure.
He should, therefore, examine the available records very carefully and enquire about the circumstances and situations that have led to either of the companies in the determination of prices. After obtaining a written representation from the management about the prices actually charged or paid for inter-company transactions, the cost auditor should consider the effect of those transactions in the cost and financial statements.