To Consolidate, or Not to Consolidate, That Is the Question IFRS 10 Consolidated Financial Statements

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1 Reporting Alert IFRS Issue 001 November 2011 To Consolidate, or Not to Consolidate, That Is the Question IFRS 10 Consolidated Financial Statements Why Does IFRS 10 Matter to Me? Potential for more consolidations of less than majority-owned entities. IFRS 10 represents a significant change to determining which companies are included in consolidated financial statements. How does this work? Control is not based on percentage of ownership. So even if a company owns less than 50% of the voting rights, control can still happen under IFRS 10. When Is IFRS 10 Effective? For annual periods beginning on or after January 1, Early adoption is permitted if the entire set of consolidation standards (IFRS 10, 11, 12 and revised IAS 27 and 28) are adopted at the same time. One exception: IFRS 12 (disclosure standard) can be adopted early by itself. Method of adoption: Retrospective, as if it had always been consolidated, unless it is impractical (only if the impracticability criteria specified in the standards are met). This publication was originally published by The Canadian Institute of Chartered Accountants in It has been reissued by Chartered Professional Accountants of Canada. 1

2 What Are the Basics of IFRS 10? What is IFRS 10? IFRS 10 identifies control as the single basis for consolidation for all types of entities. Control determines which entities should be consolidated. IFRS 10 establishes principles for presenting and preparing consolidated financial statements when there is control. How is control defined? An investor controls an investee when all three criteria are met: The investor has power over the investee (that is, the current ability to direct activities that affect returns). The investor is exposed (or has rights) to variable returns from the investee. The investor has the ability to use its power to affect its returns from the investee. How is this definition of control applied? IFRS 10 provides help in assessing control in circumstances involving: Potential voting rights (that is, rights to obtain voting rights of an investee, such as those from convertible instruments or options, including forward contracts); Agency relationships (i.e., when power is delegated by a principal to an agent); Control of certain specific assets; Voting rights that are not the main factor in determining control. What is IFRS 12? IFRS 12 is a new standard that specifies the minimum disclosures that must be provided for all forms of relationships with others (including disclosures to be made in consolidated financial statements). What Are the Key Changes? What has changed from the old accounting standards? The biggest changes from IAS 27 and SIC-12 to IFRSs 10 and 12 are as follows: IFRSs 10 and 12 IAS 27 and SIC-12 Determination of whether to consolidate is based on one concept (i.e., control). Determination of whether to consolidate was based on two concepts (i.e., control and risks and rewards). Potential voting rights are considered in assessing control only when substantive (i.e., when the holder has the practical ability to exercise that right). They were considered in assessing control only when currently exercisable. There is specific application guidance for agency relationships. There was no specific guidance. 2 Reporting Alert Issue 001 November 2011

3 IFRSs 10 and 12 Disclosure requirements are expanded where control exists and where control does not exist. IAS 27 and SIC-12 Disclosure requirements where control exists were limited. There were no disclosure requirements under IAS 27 where control did not exist. If control did not exist, most likely these investments would have been covered under IAS 28, Investment in Associates, which has different disclosure requirements. How Does This Impact My Business? Manage Your Business Key Areas to Consider What is the impact on the financial statements? The consolidation of additional entities will potentially impact all line items in the financial statements. Disclosures of the impact on adoption and retrospective adjustment. Does this impact key performance metrics? Potentially all of them! What is the impact of IFRS 10 adoption on contractual arrangements? Loan covenant compliance Bonuses, compensation plans or share-based payment vesting options if they are based on consolidated financials do the metrics used in the plans or contracts need to be revised? Structuring of future contracts (mergers and acquisitions) How do these changes affect data collection? Can your current system and processes provide the needed information? How will you get the additional information from the investee? What are the tax implications? How should we communicate the impact of the changes? in the MD&A investment analysts earnings releases Are there any regulatory or legal implications? (certifications, controls, securities, black-out periods, related parties, sedi filings) Issue 001 November 2011 Reporting Alert 3

4 What s My Action Plan? Key Milestones Adopting IFRS 10 will require time, effort and the exercise of considerable judgment because of the lack of bright lines. Below are some key steps to consider for your action plan: Gather information about the rights of other shareholders. Set up new procedures to address the need for an ongoing assessment of control. Assessment on an ongoing basis of facts and circumstances indicates changes to control such as:»» Change in how power over investee is exercised.»» Gain or loss of power of an investor over an investee due to an event that did not involve the investor.»» Change in exposure or rights to variable returns from investee.»» Change in nature of the relationship agent versus principal. Retrospective review to assess the impact of the new standard to see if any currently nonconsolidated entities need to be consolidated or vice versa. Significant judgment involved should involve legal counsel, operations personnel, management, audit committees and independent auditors in discussions on material areas of judgment. An area of significant judgment would be assessing the extent of power of an investor, their ability to direct the activities that most significantly affect the entity s returns. Consider current and potential voting rights, removal rights, rights to appoint key personnel and decision-making rights within a contract. Determine date when new definition of control is met. Identify and measure the FV of all assets and liabilities at that date if consolidation is now needed. Assess if the current financial reporting (IT) system can handle consolidating more entities and can the future and retrospective consolidated amounts be determined using the current financial reporting system Assess the impact on mergers and acquisitions. Consider the impact of the new standard during any merger and acquisition activity. Address financial reporting impact and disclosure requirements as set out in IFRS 10 and 12. Determine MD&A disclosures and impact on key metrics. Consider education and training available on this topic. Resources Need more information? CICA has compiled some external resources to help you understand and apply IFRS Reporting Alert Issue 001 November 2011

5 Appendix A: Key Impacts for Smaller Entities Overview of IFRS 10 This Business Reporting Resource illustrates some of the issues most likely to be relevant to smaller companies in assessing under IFRS 10 whether they have control over another entity. The standard is effective for annual periods beginning on or after January 1, An entity (a parent) that controls another entity (its subsidiary) must prepare consolidated financial statements (unless certain narrow exemptions apply), presenting its own and its subsidiary s assets, liabilities, equity, income, expenses and cash flows as those of a single economic entity. Since IFRS 10 contains a revised definition of control, investors (parent companies) will need to revisit their previous conclusions about the accounting treatment for their investees. An investor controls an investee if and only if: it has power over the investee; it has exposure, or rights, to variable returns from its involvement with the investee; and it has the ability to use its power over the investee to affect the amount of those returns. Under the first criterion, an investor has power over an investee when it has existing rights giving it the current ability to direct the relevant activities that significantly affect the investee s returns (IFRS 10 refers to these as the relevant activities ). This document focuses primarily on issues relating to applying this criterion, because the challenges for companies will usually arise in this area. IFRS 10 requires that an investor reassess whether it controls an investee, if facts and circumstances indicate changes to one or more of the core elements of control, as summarized in the overview. Using hypothetical questions and answers, the following table illustrates some of the questions that may arise. These examples refer to common shares; however, they would apply in the same way to other kinds of rights in investees, such as limited partnership units. Control with majority voting power We hold over 50% of the common shares of Company A. Is it clear that we control Company A or is there more to consider? It s usually clear in this situation that you control Company A. This assumes nothing exists to prevent you from directing Company A s activities, either directly by exercising your voting power or by being able to appoint a majority of the members of its governing body. You might not control Company A if despite your majority interest in the common shares: another party (not your agent) has the right to direct its activities instead, perhaps because you entered a contract limiting your capacity to act, or because of special rights attaching to preferred shares or other instruments. Also, you might not control Company A if you re unable to exercise your voting rights; for instance because the relevant activities are being directed by a regulator or a receiver. Issue 001 November 2011 Reporting Alert 5

6 Control without majority voting power other voting rights We hold 40% of the common shares of Company A. We don t hold any other instruments of Company A that might be converted to common shares in the future. Do we control Company A? It s certainly possible, but it depends on the specific facts. IFRS 10 says an investor with less than a majority of the voting rights in another entity still has sufficient rights to give it power over that entity, when it has the practical ability to direct the relevant activities. You make this assessment by considering the size of your shareholding, relative to the size and dispersion of the other shareholders. The more voting rights you hold compared to anyone else, and the greater the number of other vote-holders that would need to act together to outvote you, then the more likely it is you have the practical ability to direct Company A s relevant activities. You might support this assessment by looking at voting patterns at past shareholder meetings, or other applicable information. Control without majority voting power versus significant influence The same situation as above, except we now only hold 30% of the common shares of Company A. The answer is also essentially the same, turning on whether you have the practical ability to direct the relevant activities unilaterally. However, IFRS 10 does emphasize that the more voting rights an investor holds, the more likely it is to have existing rights giving it the current ability to direct the relevant activities. The lower your holding, the easier it would be for other vote-holders to act together and outvote you, particularly if some of those other parties also have significant holdings. Ultimately, IFRS 10 doesn t draw a bright line to define the point where control can or can t exist; however, it s likely a holding of 30% would often be insufficient to provide control. In the event control does not exist, the 30% holding would very likely be sufficient to give you significant influence over Company A and therefore would require applying the equity method of accounting, as described in IAS 28. Control without majority voting power other factors We again hold 40% of the common shares of Company A, and no instruments that might be converted to common shares in the future. We ve looked at other shareholders as discussed above, but we still can t decide whether we have control. What else can we do? Consider whether any other evidence exists of whether you have the practical ability to direct the relevant activities of Company A, for example: its key management personnel, or a majority of its board, are related parties. you re in a position to direct Company A to enter into, or veto any changes to, transactions for your benefit. you have a special relationship with Company A because key managers are former employees of yours; you fund a significant portion of its operations; it depends on you for critical technology, supplies, support or personnel; or because you support assets critical to its operations, like licences or trademarks. a significant portion of its activities is conducted with you or on your behalf. None of these factors in itself indicates that you have power over Company A. However, they do indicate your interest is more than passive, and in conjunction with the rights attaching to your 40% voting rights, may contribute to concluding you have control. 6 Reporting Alert Issue 001 November 2011

7 Control without majority voting power potential voting rights Currently we hold a 35% interest in Company A, which doesn t give us control. However, we also hold convertible preferred shares which we could convert at any time into common shares, for no additional consideration, to increase our interest to more than 50%. Do we control Company A? In assessing control, IFRS 10 requires you consider your potential voting rights as well as your current voting rights. Potential voting rights are rights to obtain voting rights of an investee, such as convertible instruments or options. If these are substantive meaning you have the practical ability to exercise them then you take them into account in assessing whether you have control, along with your existing voting interest. This doesn t necessarily mean you base your conclusion simply on adding the two amounts together. IFRS 10 also requires you assess the various terms and conditions of the instrument, and your apparent expectations, motives and reasons for agreeing to those terms and conditions. In this case, if you acquired the convertible preferred shares and Company A issued them to you with the expectation of converting them at some future point, then a strong argument exists that you currently control Company A. However, you also need to consider potential voting rights held by other parties, as well as all the factors addressed for previous questions. Control without majority voting power whether potential voting rights are substantive Again, we hold a 35% interest in Company A, which doesn t give us control. We have warrants which we could convert at any time into common shares, for an aggregate consideration of $5 million, to increase our interest to more than 50%. We don t have $5 million available and we have no likelihood of getting it in the foreseeable future. Do we control Company A? IFRS 10 emphasizes that in assessing whether you have power, you only consider your current and potential rights in an investee if those rights are substantive if you have the practical ability to exercise them. Warrants and other convertible instruments might be subject to various legal, economic or other barriers preventing them from being exercised. Exercising the instruments might require the consent of others, and this might be unavailable. If the conversion price attaching to potential voting rights creates a financial barrier preventing or deterring you from converting those rights in the foreseeable future, then the rights may not be substantive. However, this also requires considering all the relevant factors. For instance, if $5 million is a bargain price given Company A s current economic value, and you could readily raise financing for that amount on reasonable terms, then perhaps this isn t a real financial barrier. Issue 001 November 2011 Reporting Alert 7

8 Protective rights held by other parties We hold over 50% of the common shares of Company A; none of the issues addressed above apply. However, we ve given one of our minority shareholders the right to approve or veto any new equity issuances. Does this mean we ve relinquished control over Company A? An investor s rights in an investee may be protective relating only to fundamental changes in the investee s activities or applying only in exceptional circumstances. They re designed to provide some protection for their holders, but without conveying power over the investee; the fact of another party having protective rights in your subsidiary doesn t in itself prevent you from controlling it. It s important of course to ensure these rights are indeed protective in their nature and intent and that they don t have broader implications. Examples of protective rights in IFRS 10 are: a lender s right to restrict a borrower from undertaking activities that could significantly change its credit risk to the lender s detriment; a lender s right to seize a borrower s assets if it fails to meet specified repayment conditions; and the right of a party holding a non-controlling interest to approve capital expenditure greater than what s required in the ordinary course of business, or to approve the issue of equity or debt instruments. The last item confirms that your minority shareholder s rights are protective; therefore you haven t relinquished control over Company A. Contracts and economic dependence We don t have specific rights in Company A arising from voting power, contracts, or other means. However, Company A is economically dependent on us because we re by far its biggest customer. As a result, we re often on the premises, involved in a range of discussions and interactions. Could this mean we control Company A? IFRS 10 observes that power can result from contractual agreements. These might be with other vote holders, allowing an otherwise non-controlling investor to direct enough votes that it obtains power. Other kinds of contractual agreements can also provide such power, in combination with voting rights: for example, through a contract, an investor might obtain the ability to direct an investee s manufacturing processes. However, IFRS 10 specifies that in the absence of any other rights, an investee being economically dependent on an investor doesn t lead to the investor having power over the investee. The economic dependence may generate various degrees of influence, but this falls short of being able to direct the activities that significantly affect the investee s returns. 8 Reporting Alert Issue 001 November 2011

9 Assessing the relevant activities We hold 50% of the common shares of Company A: an unrelated party holds the other 50%. It s not a joint venture because we re unilaterally responsible for directing certain aspects of Company A s activities; the other party directs certain other aspects. How do we decide which of us (if either) controls Company A? You need to assess which of you has the current and unilateral ability to direct the relevant activities of Company A that most significantly affect its returns. This includes assessing: Company A s purpose and design; the factors determining its revenue and profit margin and overall value; the effect on its returns resulting from the decision-making authority of you and the other investor with respect to those factors; and your exposures to variability of returns. Other matters may be equally or more significant depending on Company A s activities for instance, if it s currently in the development stage, then it s relevant to consider which of you has greater authority over development-related activities. If you conclude you have the current ability to direct the activities most significantly affecting Company A s returns (albeit that it also has significant activities you don t direct), then you have power over Company A. As the next item discusses, you then revisit this assessment over time if circumstances change. Reassessing conclusions about control We assessed our relationship to Company A last year and concluded we should consolidate Company A. However, the assessment was in some ways a close call and we re not sure it would come out the same way today. When should we revisit this? IFRS 10 requires reassessing whether you control Company A, if facts and circumstances indicate changes to one or more of the core elements of control summarized in the overview. For smaller companies, this will usually result from changes in their degree of power over the investee. This might result, for instance, because of changes in the composition of the other shareholders, or because certain potential voting rights expire or others are created. Where your conclusion on control depends on factors that could change, you need to establish a process to monitor the relevant factors and to revisit the analysis whenever appropriate. IFRS 10 addresses all aspects of consolidation accounting, including the accounting treatment for a former subsidiary when control is lost. Disclaimer CICA Reporting Alerts provide an orientation to matters in an accounting standard or securities regulation, focused on the needs of smaller public company CFOs and audit committee chairs. Reporting Alerts are prepared by the Guidance and Support group at The Canadian Institute of Chartered Accountants (CICA) in consultation with CICA s Small Company Advisory Group. They have not been approved by any Board or Committee of the CICA and neither CICA nor the authors accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material. Copyright Copyright 2011 The Canadian Institute of Chartered Accountants Issue 001 November 2011 Reporting Alert 9