Research regarding the issues of the arm’s length principle mentioned by I.A.S. 24

Figures & data

Figure 1. Flow of the related party transaction.

Source: Authors’ processing.

Table 1. Functional analysis.

Description	Company X	Company Y
Functions performed
Acquisition of raw materials (timber, wood) – is performed by Company X from various specialised suppliers.	Yes	No
Purchase/ production planning – Company Y performs forecasts on sales and based on these establishes a purchase planning. Company Y provides Company X with this planning, detailing the requirements regarding quantities and timing of delivery. Based on this, Company X establishes a production planning.	Yes	Yes
Production of furniture – is performed by Company X within its own factory.	Yes	No
Design of the furniture models – is performed by Company Y. Practically, Company Y develops drawings regarding the design of the furniture and owns the related patents. Company Y provides Company X with the documentation and drawings regarding the design of the furniture in order for Company X to use them in the production process.	No	Yes
Packing – Company X is responsible for providing an appropriate packaging to protect the products throughout the shipment, from the expedition to destination.	Yes	No
Transport – Company Y is responsible to organise the transport of goods from the warehouse of Company X to its own warehouse.	No	Yes
Quality control – Company Y performs a quality control of the goods purchased from Company X. This control is performed at the time of the goods reception. Also, Company X performs a quality control of the raw materials used in production.	Yes	Yes
Warehousing – given the fact that the production is performed by Company X based on a planning, Company Y being obliged to purchase the goods on the delivery time agreed, the warehousing of the finished products is performed by Company X only for a short period of time (i.e., from the finishing of the production process until the delivery date). However, Company X performs the warehousing of semi-finished products and of raw materials during the production process. Company Y performs the warehousing of the finished products for a longer period, until they are delivered to the final client.	Yes	Yes
Warranty and repair – the warranty is granted by Company Y. Therefore, this company is also responsible for the repair of the goods during the warranty period.	No	Yes
Marketing and advertising – Company Y organises marketing and advertising campaigns in order to identify new clients and promote the goods. This company also participates on different events and trade fairs.	No	Yes
Sales and distribution – is performed by Company Y which owns showrooms and stores.	No	Yes
Risks incurred
Market risk - occurs when a company faces either fierce competition and unfavourable market conditions or incapacity to develop markets or services for target customers. If the number of customers of Company Y decreases, such fact would adversely affect the turnover of this company. However, this situation will not affect the turnover of Company X, because Company Y is obliged to purchase the quantities mentioned within the purchase planning.	No	Yes
Inventory risk – represents the risk that a company registers stocks of finished products or raw materials over a long period of time. This risk also involves the fact that goods being degraded, obsolete, stolen or exposed to natural calamities. Given that both companies perform the warehousing function, the inventory risk is also born by both.	Yes	Yes
(Product) liability risk – Company Y is responsible to perform the quality control of the finished goods at the time of the reception. Given this and taking into account that the warranty function is carried out by Company Y, this company is responsible to remedy the defects associated with the products delivered to its customers. On the other hand, Company X is responsible to remedy the defects identified by Company Y during the quality control process.	Yes	Yes
Assets used
Tangible assets (warehousing, buildings, production equipment etc.)	Yes	Yes
Intangible assets (patents and trademarks)	No	Yes

Source: Authors’ processing.

Table 2. The search strategy.

Details	Description of the criterion applied
I. Criteria applied in the Amadeus database
1. Criterion applied: status of activity
This criterion was applied in order to eliminate inactive companies, factor that could distort the financial results.	We have selected active companies and companies with an unknown status.
2. Criterion applied: geographic criterion
The geographic criterion is established by each country, within the domestic legislation. For example, in Romania the comparability analysis should take into account territorial criteria in the following order: national, EU, pan-European, international.	Initially we selected companies which perform their activity on the Romanian market. Given that we did not obtain a sufficient number of comparables (i.e., 5), we extended the search on the EU market.
3. Criterion applied: the activity code
By using the activity code, entities performing activities similar to those analysed can be identified. In this respect, we used the NACE REV. 2 classification.	We selected companies which have the following activity codes: 3102 - Manufacture of kitchen furniture; 3103 - Manufacture of mattresses; 3109 - Manufacture of other furniture.
4. Criterion applied: independence
The purpose of applying this criterion is to ensure the independence of comparable companies in order to eliminate the risk of intra-group transactions (i.e., it is questionable if the intra-group transactions are at market level, and thus they should be eliminated). When applied this type of criterion, we considered the Romanian legislation, according with a 25% ownership percentage is used in order to analyse the independence of a company (i.e., in order to determine if that company is an affiliated company). We applied various criteria in order to ensure the independence of the companies from the sample, as follows:
4.1. Type of financial statements
Only companies with financial data from unconsolidated financial statements were selected.
4.2. Shareholders
We selected companies in which no shareholder holds directly or indirectly a percentage of 25% or greater than 25% of the shares.
4.3. Subsidiaries
We eliminated companies that own an interest in subsidiaries of 25% or more.
5. Criterion applied: multiple years
In order to perform an analysis of the year 2015 (when the related party transaction analysed was performed) we used the weighted average of the profitability indicators from the three most recent years for which the financial information was available.	In our analysis, we used the financial data of comparable companies, according to each of the two situations presented within Section 1 of this paper, as follows: situation 1: years between 2012 and 2014; situation 2: years between 2013 and 2015.
II. Quantitative criteria
1. Criterion applied: availability of financial information
The purpose of this filter is to eliminate companies that do not have financial data available in order to calculate the profitability indicators needed to perform the comparability analysis.	We eliminated companies which do not have financial information available in Amadeus for all the years analysed. More exactly, if a company did not have available the financial information for all the three years analysed, it was eliminated from the sample.
III. Qualitative criteria
1. Criterion applied: availability of information
The purpose of this filter is to ensure availability of sufficient information, based on which to perform the selection of the final set of comparable companies.	We eliminated companies which do not have sufficient public data in order to analyse their business activity. More exactly, we eliminated companies which did not have an official website or have this site under construction at the moment of our search (i.e., April 2017). We also eliminated those companies which have a website with an insufficient content in order to determine if they are comparable with the tested party (i.e., Company X).
2. Criterion applied: independence
The purpose of applying this criterion is to ensure the independence of comparable companies in order to eliminate the risk of intra-group transactions.	We eliminated companies, which according with the information published on their website, are member of a group of companies.
3. Criterion applied: comparability between the activities carried out
The purpose of applying this filter is to ensure that the entities selected in the final set are comparable to the tested party (i.e., Company X).		For the companies which were not eliminated until this last stage of the search, we performed a detailed analysis of the information published on their websites and eliminated those companies which do not have a functional profile similar with that of Company X (i.e., have other business activity). Companies accepted as comparables are those which manufacture furniture and are contract manufactures (i.e., perform an activity similar with that performed by Company X).

Source: Authors’ processing.

Table 3. Results on the Romanian market.

	Period 2012–2014		Period 2013–2015
Summary of selection criteria	No. of companies checked	No. of companies rejected	No. of companies checked	No. of companies rejected
Initial sample (returned by Amadeus)	14
Quantitative criteria
Lack of financial information	14	0	14	0
Qualitative criteria
Insufficient information	14	6	14	6
Member of a group	8	0	8	0
Other business activity	8	6	8	6
No. of companies accepted	2		2

Source: Authors’ processing.

Table 4. Results on the E.U. market.

	Period 2012–2014		Period 2013–2015
Summary of selection criteria	No. of companies checked	No. of companies rejected	No. of companies checked	No. of companies rejected
Initial sample (returned by Amadeus)	143
Quantitative criteria
Lack of financial information	143	37	143	42
Qualitative criteria
Insufficient information	106	25	101	24
Member of a group	81	8	77	9
Other business activity	73	64	68	59
No. of companies accepted	9		9

Source: Authors’ processing.

Table 5. Inter-quartile range.

Inter-quartile range	W.N.C.P. 2012–2014	W.N.C.P. 2013–2015
Minimum	−3.21%	−2.31%
Quartile 1	0.61%	0.11%
Median	1.55%	1.74%
Quartile 3	1.82%	2.55%
Maximum	7.11%	6.44%

Source: Authors’ processing.

Appendix 1. Comparable independent companies

Company	Operating revenue th EUR				Operating P/L th EUR				N.C.P. (%)				W.N.C.P. 2012–2014	W.N.C.P. 2013–2015
	2012	2013	2014	2015	2012	2013	2014	2015	2012	2013	2014	2015
Adriatica S.R.L.	4156	4222	4127	3938	96	52	76	72	2.36	1.26	1.87	1.86	1.82	1.66
Cocinas Terol SL	579	812	847	1015	50	49	49	47	9.55	6.39	6.18	4.86	7.11	5.74
Comodex Societate Cooperativa Mestesugareasca	509	570	637	548	9	9	8	(16)	1.72	1.61	1.35	−2.76	1.55	0.11
Erdholz SRL	1782	1628	1742	1726	36	35	19	33	2.06	2.21	1.10	1.95	1.78	1.74
Glicerio Chaves Horneros SL	42,145	39,930	41,127	46,817	3262	2191	1133	4416	8.39	5.81	2.83	10.42	5.65	6.44
Muebles Orga SL	1272	1051	1110	1187	(65)	(14)	10	(7)	−4.86	−1.32	0.88	−0.62	−1.98	−0.35
Nadem S.R.L.	4013	3186	3023	2456	(84)	(334)	80	49	−2.06	−9.50	2.72	2.05	−3.21	−2.31
Netcucine S.R.L.	36,169	35,629	40,437	40,985	728	820	100	1188	2.05	2.36	0.25	2.98	1.49	1.83
SAN Martino S.R.L.	3051	2293	2731	2602	(45)	49	45	96	−1.46	2.19	1.66	3.81	0.61	2.55