1 NEED TO KNOW IFRS 10 Consolidated Financial Statements
2 2 IFRS 10 Consolidated Financial Statements SUMMARY In May 2011 the International Accounting Standards Board (IASB) published a package of five new standards which set out new requirements for consolidation, joint arrangements and disclosure of interests in other entities. The consolidation principles previously included in IAS 27(2008) Consolidated and Separate Financial Statements and SIC-12 Consolidation Special Purpose Entities have been combined and are now represented in IFRS 10 Consolidated Financial Statements. The amended IAS 27(2011) Separate Financial Statements standard now only includes guidance for separate financial statements. Guidance for jointly controlled entities that was previously included in IAS 31 Interests in Joint Ventures is now provided in IFRS 11 Joint Arrangements. In addition all disclosure requirements that, under the old guidance, were included in the individual standards separately (IAS 27(2008), IAS 28(2008) Investments in Associates, and IAS 31 Interests in Joint Ventures), are now set out in IFRS 12 Disclosure of Interests in Other Entities. IFRS 10 and the other standards are a result of the IASB s and the US Financial Accounting Standards Board s (FASB s) joint project to replace the existing guidance for consolidation in order to reduce diversity in practice and to improve disclosure requirements for structured entities (previously called special purpose entities). IFRS 10 applies to all entities that control one or more entities. However the IASB has introduced an exception for investment entities, which is covered in section 8 of this publication. The new standard introduces a new single control model for all entities. Under the new guidance control is the sole basis for consolidation. The structure of the investee is not relevant. An investor will be required to consolidate an investee if it has all of the following: Power over the investee Exposure, or rights, to variable returns from its involvement with the investee The ability to use its power to affect the amount of the investor s returns. We expect that the results of most assessments of whether an investee should be consolidated will not be affected by the new consolidation model in IFRS 10. The changes brought by IFRS 10 are more likely to arise where ownership structures are complex and/or more than one investor is exposed to variable returns from the investee. However all entities will be required to reassess whether an investee is required to be consolidated. The control assessment could also change because of new guidance for potential voting rights, contractual arrangements with other vote holders, and structured entities (previously termed Special Purpose Entities or SPEs) where IFRS 10 differs from previous guidance. In addition, IFRS 10 contains specific guidance for the following topics, which were not covered (or covered in less detail) by IAS 27(2008)/SIC-12: De-facto control Principal Agent relationships Silos Franchises.
3 IFRS 10 Consolidated Financial Statements 3 Specific thresholds (or bright lines ) have deliberately been excluded from IFRS 10, with key aspects being principles based. This is likely to prevent a particular accounting outcome being achieved through structuring which, to a limited extent, was possible under previous guidance. However, this does mean that judgement may be required in determining whether an investor should consolidate a particular investee. This publication also includes a section on disclosures that are to be made in consolidated financial statements as required by IFRS 12. The main purpose of these disclosures is to provide information that helps users of a reporting entity s financial statements understand the nature of, and risks associated with, its interests in other entities and the effects of those interests on the reporting entity s financial position, financial performance and cash flows. IFRS 12 in addition requires additional disclosures for structured entities regardless of whether an investor is required or not required to consolidate a structured entity. IFRS 10 together with the other standards in the consolidation package (see section 1.3) is effective for annual periods beginning on or after 1 January 2013, with earlier application being permitted provided that all five of the new standards are applied at the same time. The consolidation package was endorsed for use in the EU at the end of 2012 with an effective date of 1 January 2014, with early adoption permitted.
4 4 IFRS 10 Consolidated Financial Statements TABLE OF CONTENTS Summary 2 1. The IASB/FASB project Previous Guidance Rationale for change Consolidation package 7 2. Effective date 8 3. Key changes from previous guidance 9 4. Effect of adopting IFRS Accounting requirements Scope General Exemptions Control The single control model Definition Assessment of control Purpose and design Continuous assessment Relevant activities Definition Identification Relevant activities of structured entities Can a structured entity have no relevant activities? Power Rights that give power Current ability to direct Protective rights Substantive rights Voting rights Majority held Majority not held Potential voting rights Other rights 26
5 IFRS 10 Consolidated Financial Statements Exposure to variable returns Link between power and variable returns Principal Agent relationships De-facto agents Specific topics Silos Structured entities Franchises Accounting requirements Non-controlling interests Loss of control Effective date and transition Investment Entities Definition of an investment entity Exception from consolidation Application Guidance Reassessment Disclosures Transitional provisions Disclosure requirements in IFRS Appendix Definitions IFRSs 10, 11 and 12, and IASs 24, 27 and Index 60
6 6 IFRS 10 Consolidated Financial Statements 1. THE IASB/FASB PROJECT Consolidation was among the first convergence projects identified by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). However, although the project was added to the agenda in 2003, substantial progress was not made until This timing links to the global financial crisis, which started in 2007 and prompted additional focus on consolidation and related disclosures Previous Guidance Previous guidance in IFRSs for consolidation was set out in IAS 27(2008) Consolidated and Separate Financial Statements and SIC-12 Consolidation Special Purpose Entities. IAS 27(2008) Consolidated and Separate Financial Statements IAS 27(2008).4 stated that an entity has control over another entity: when it has the power to govern the financial and operating policies of an entity so as to obtain benefits from is activities. The standard further explained that in order for control to exist, an entity needed to have the current ability to exercise that power. The control principle in IAS 27(2008) was based on the legal structure of the arrangement. SIC-12 Consolidation Special Purpose Entities Special Purpose Entities (SPEs) often have predetermined narrow and well-defined objective(s). In some cases, their activities are largely predetermined (sometimes termed an autopilot structure). SIC-12 required an investor to consolidate an SPE if it was exposed to the majority of its residual or ownership risks. Essentially, the control principle in SIC-12 was based on an analysis of risks and rewards Rationale for change The project to replace the existing guidance in respect of consolidation was undertaken for the following main reasons: Diversity arose in practice from the application of IAS 27(2008) and SIC-12. It was not always clear whether an entity meets the definition of an SPE and, in consequence, whether IAS 27(2008) or SIC-12 should be applied. Because they were based on different principles, the consolidation conclusion reached could differ, depending on whether the guidance in IAS 27(2008) or SIC-12 was followed There was a need to enhance disclosure requirements, in particular as a consequence of the global financial crisis. The crisis had highlighted a lack of transparency about the extent to which investors were exposed to risks associated with an investee s involvement with off balance sheet vehicles. These are entities that are not consolidated, but which have the potential to give rise to exposures in the event of losses. As a result the G20 leaders and the Financial Stability Board asked the IASB to improve disclosure requirements for such vehicles.
7 IFRS 10 Consolidated Financial Statements Consolidation package In May 2011 the IASB published a package of five new standards which set out new requirements for consolidation, accounting for joint arrangements, and disclosure of interests in other entities. These are effective for period beginning on or after 1 January , and are required to be adopted as a package (except for the disclosure requirements of IFRS 12 Disclosure of Interests in Other Entities, which can be adopted early on a stand-alone basis). The new standards are: IFRS 10 Consolidated Financial Statements IFRS 11 Joint Arrangements IFRS 12 Disclosure of Interests in Other Entities. In addition, the following standards were revised and renamed: IAS 27(2011) Separate Financial Statements IAS 28(2011) Investments in Associates and Joint Ventures. The consolidation requirements previously included in IAS 27(2008) and SIC-12 have been replaced and are set out in a single standard, IFRS 10. The revised IAS 27(2011) now only includes guidance for separate financial statements. Guidance for jointly controlled entities that was previously included in IAS 31 Interests in Joint Ventures is now provided in IFRS 11. All disclosure requirements that, under previous guidance, were included in the individual standards (IAS 27(2008), IAS 28(2008) and IAS 31), are now set out in IFRS 12. Consequently, the requirements of IAS 27(2008) have been amended and restructured, and are now included in three different accounting standards: IFRS 10 Consolidated Financial Statements IAS 27(2008) Consolidated and Separate Financial Statements IAS 27(2011) Separate Financial Statements IFRS 12 Disclosure Interests in Other Entities Figure 1: Restructuring IAS 27(2008) Consolidated and Separate Financial Statements 1 For entities that report in accordance with EU-endorsed IFRS, the effective date is periods beginning 1 January However, early adoption is permitted, meaning that it remains possible for financial statements to comply with both EU-endorsed IFRS and IFRS as issued by the IASB.
8 8 IFRS 10 Consolidated Financial Statements 2. EFFECTIVE DATE IFRS 10 Consolidated Financial Statements is effective for annual periods beginning on or after 1 January 2013, with earlier application being permitted provided that all five of the new consolidation package standards are applied at the same time. In December 2011 the European Financial Reporting Advisory Group (EFRAG) requested the effective date for the consolidation standards to be deferred to 1 January 2014 to allow preparers sufficient time to implement the new standards and to align it with the effective date for the proposals for Investment Entities. However at its January 2012 meeting, the International Accounting Standards Board (IASB) decided not to postpone the effective date. The consolidation package standards were endorsed for use in the EU at the end of 2012, but have an effective date of 1 January 2014, with early adoption permitted. This provides entities that report in accordance with EU-endorsed IFRS additional time to prepare for the application of the new standards. However, the permission for early adoption allows European entities, that are Foreign Private Issuers and prepare financial statements for their US filings in accordance with IFRS as issued by the IASB, to adopt the new standards with effect from 1 January This is necessary, as the US authorities require FPIs to prepare financial statements in accordance with IFRS as issued by the IASB. Certain other jurisdictions, such as Singapore, which has incorporated IFRS into its local accounting standards, have also delayed the initial adoption of IFRS 10 in order to allow more time for implementation. Unless these jurisdictions permit early application, entities using those local accounting standards will not be able to claim compliance with IFRS as issued by the IASB, and will therefore lose a key benefit of the adoption of IFRS (or incorporation of IFRS into local GAAP). In June 2012, the IASB published Consolidated Financial Statements, Joint Arrangements and Disclosures of Interests in Other Entities: Transition Guidance Amendments to IFRS 10, IFRS 11 and IFRS 12 which clarify certain aspects when an entity transitions from the old consolidation standards to the new consolidation standards issued in May The amendments are effective for annual periods beginning on or after 1 January 2013, with early adoption being required if the new consolidation standards are early adopted. The clarifications are included in section The IASB has set an effective date for the amendments relating to Investment Entities (see section 8) of 1 January 2014 with earlier application permitted. This is to allow the amendments to be applied at the same time as the initial application of IFRS 10.
9 IFRS 10 Consolidated Financial Statements 9 3. KEY CHANGES FROM PREVIOUS GUIDANCE Key changes from the requirements of IAS 27(2008) Consolidated and Separate Financial Statements and SIC-12 Consolidation Special Purpose Entities, as included in the IFRS Foundation s Project Summary and Feedback Statement for IFRS 10, are: IAS 27(2008) and SIC-12 IFRS 10 Control as the basis for consolidation IAS 27(2008) identifies control as the basis for consolidation and focuses on the power to govern the financial and operating policies for assessing control of typical operating entities. In contrast, SIC-12 focuses on risks and rewards for assessing control of special purpose entities. Control without a majority of voting rights Although the idea that an investor could control an investee while holding less than 50% of the voting rights was implicit in IAS 27(2008), it was not explicitly stated. Potential voting rights Only currently exercisable potential voting rights are considered when assessing control. Agency relationships IAS 27(2008) has no specific guidance regarding situations when power is delegated by a principal to an agent. IFRS 10 identifies control as the single basis for consolidation for all types of entities There is no separate guidance with a different consolidation model for special purposes entities; rather, this guidance is incorporated into the single consolidation model in IFRS 10. The new control definition reflects that an investor can achieve power over an investee in many ways, not just through governing financial and operating policies. The investor must assess whether it has rights to direct the relevant activities. Although exposure to risks and rewards is an indicator of control, it is not the sole focus for consolidation for any type of entity. IFRS 10 states that an investor can control and investee with less than 50% of the voting rights of the investee IFRS 10 provides specific application guidance for assessing control (i.e. de-facto control) in such cases. Potential voting rights need to be considered in assessing control, but only if they are substantive Potential voting rights are substantive when the holder has the practical ability to exercise its rights and those rights are exercisable when decisions about the direction of the relevant activities need to be made. Deciding whether potential voting rights are substantive requires judgement. Potential voting rights may need to be considered even if they are not currently exercisable. IFRS 10 contains specific application guidance for agency relationships When decision making authority has been delegated by a principal to an agent, an agent in such a relationship does not control the entity. The principal that has delegated the decision-making authority would consolidate the entity. The application guidance offers a range of factors to consider and contains examples.
10 10 IFRS 10 Consolidated Financial Statements 4. EFFECT OF ADOPTING IFRS 10 We expect that the results of most assessments as to whether an investee should be consolidated will not be affected by the adoption of IFRS 10 Consolidated Financial Statements. Investees consolidated in accordance with IAS 27(2008) Consolidated and Separate Financial Statements and SIC-12 Consolidation Special Purpose Entities that meet all of the following criteria will normally continue to be consolidated: An entity holds the majority of the investee s voting rights There are no contractual arrangements in place that override the voting rights The parent holds an interest in the investee for its own benefit (that is, it is not acting as agent for another party). The changes brought by IFRS 10 are more likely to have an effect where ownership structures are complex and/or more than one investor is exposed to variable returns from the investee. The control assessment could also change because of new guidance for potential voting rights, contractual arrangements with other vote holders, and structured entities, where IFRS 10 differs from previous guidance. There are also topics that are specifically addressed by IFRS 10 for which there was no guidance, or more limited guidance, in IAS 27(2008)/SIC-12. These include: De-facto control Principal Agent relationships Silos Franchises. These will be covered later in this publication. As a result, some entities that were consolidated under IAS 27(2008)/SIC-12 will not be consolidated under IFRS 10. There will also be cases where an entity that was not consolidated under IAS 27(2008)/SIC-12 will be required to be consolidated under the new guidance. It is not yet clear if the effect of IFRS 10 will result in more or less consolidated subsidiaries, although effects analyses carried out to date suggest that slightly more Special Purpose Entiteis (or SPEs, now termed structured entities ) will be consolidated. However, all entities will be required to reassess whether an investee is required to be consolidated. For most majority or wholly owned subsidiaries this assessment will be straightforward but for some investments a fuller analysis will be required. The International Accounting Standards Board (IASB) has also deliberately excluded bright lines from IFRS 10, meaning that in a number of areas judgement will be required when assessing whether an entity (and in determining which entity) should consolidate an investee. 5. ACCOUNTING REQUIREMENTS The accounting requirements for consolidated financial statements have been carried forward unchanged from IAS 27(2008) Consolidated and Separate Financial Statements. This means that: Intragroup transactions are eliminated in full Uniform accounting policies are applied throughout the consolidated group The financial statements of the parent and subsidiaries are required to be prepared to the same reporting date.
11 IFRS 10 Consolidated Financial Statements SCOPE 6.1. General IFRS 10 Consolidated Financial Statements requires a parent entity to present consolidated financial statements. A parent is defined as An entity that controls one or more entities. Consolidated financial statements are defined as the financial statements of a group, in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity Exemptions A parent is not required to prepare consolidated financial statements if it meets all of the following conditions (IFRS 10.4): It is a wholly owned subsidiary or is a partially owned subsidiary of another entity and all of its owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements Its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-thecounter market, including local and regional markets) It did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market Its ultimate or any intermediate parent produces consolidated financial statements that are available for public use and comply with IFRSs. If an entity is considering making use of this exemption, care is required when determining whether the first condition has been met. It would appear that, provided all owners have been notified that it is proposed that consolidated financial statements are not prepared and no notice of objection has been received, an entity that complies with the other requirements could make use of the exemption. However, IFRS 10 (like IAS 27(2008) Consolidated and Separate Financial Statements) sets no time limit for objections, meaning that a parent that prepares only separate financial statements could receive an objection at the time of approval of its financial statements, or even afterwards. It would therefore appear advisable to obtain explicit consent, even though this is not a requirement of IFRS 10. In addition, IFRS 10 does not apply to: Post-employment benefit plans or other long term benefit plans to which IAS 19 Employee Benefits applies; and Investment entities (see section 8). The exemption for employee benefit plans is restrictive, in that it applies only to those plans that fall within the scope of IAS 19. This means that, for example, employee share trusts and similar entities do fall within the scope of entities to be considered for consolidation in accordance with IFRS 10, as they fall within the scope of IFRS 2 Share-based Payment.
12 12 IFRS 10 Consolidated Financial Statements 7. CONTROL 7.1. The single control model Definition IFRS 10 Consolidated Financial Statements introduces a single control model for all entities. An investor controls an investee when: the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Under the new guidance control is the sole basis for consolidation. The structure of the investee is not relevant. Consequently, the requirements of IFRS 10 apply to all investor/investee relationships, including what are now termed structured entities. These are broadly equivalent to Special Purpose Entities (SPEs) that previously fell within the scope of SIC-12 Consolidation Special Purpose Entities Assessment of control IFRS 10.7 notes that an investor controls an investee if it has all of the following: Power over the investee (whether or not that power is used in practice) Exposure, or rights, to variable returns from its involvement with the investee The ability to use its power to affect the amount of the investor s returns. Control = + + Exposure to Power variable returns Linkage between power and returns Figure 2: Assessment of control Although this assessment appears similar to the approach previously required by IAS 27(2008) Consolidated and Separate Financial Statements and SIC-12, there are key differences. In particular, because an investor must satisfy all three of the criteria set out above, under IFRS 10 even if an investor has substantial exposure to variable returns of another entity, this is not sufficient by itself to conclude that control exists. This is in contrast to, for example, the analysis carried out under SIC-12 where exposure to a majority of the benefits of an SPE gave rise to an assumption that control existed. However, in contrast with SIC-12, but consistent with IAS 27(2008), it is not necessary for an investor to be exposed to a majority of the benefits (or returns) of an investee in order for that investee to be accounted for as a subsidiary. All facts and circumstances are required to be considered when an investor assesses whether it controls another entity. The following factors may assist in the determination (IFRS 10.B3): The purpose and design of the investee What the relevant activities are and how decisions about those activities are made Whether the rights of the investor give it the current ability to direct the relevant activities Whether the investor is exposed, or has rights, to variable returns from its involvement with the investee Whether the investor has the ability to use its power over the investee to affect the amount of the investor s returns.
13 IFRS 10 Consolidated Financial Statements 13 In addition to focusing on an investor s exposure to variable returns, and its ability to affect those returns by exercising its power over the investee, IFRS 10 introduces the new concept of relevant activities (see section 7.2). These are defined as: activities of the investee that significantly affect the investee s returns. This is a new concept that will require careful analysis. Although in some cases, they will be straightforward to identify and attribute, in others the approach will be more complex. In all cases, it will be necessary to analyse the activities of an investee in order to determine which of its activities most significantly affect its profit or loss, and link this to an analysis of whether the investor has control over those activities Purpose and design In its assessment of whether it controls an investee, an investor is required to consider the purpose and design of the investee. This includes: Identification of the relevant activities How decisions about the relevant activities are made Who has the current ability to direct those activities Who receives returns from those activities. In many cases, investors own equity instruments in investees that give the holder proportionate voting rights and a proportionate share in the returns generated by the investee. In those circumstances, provided no additional contractual agreements about decision making are in place, the control assessment will be based around which investor is able to exercise sufficient voting rights to achieve control over the relevant activities. This will often be achieved through holding a majority of the voting rights Continuous assessment IFRS 10 contains an explicit requirement for investor/investee relationships to be reassessed on a continuous basis. Although it was not a requirement of IAS 27(2008) or SIC-12, in practice the existence of control was reassessed when there was a change in facts and circumstances. For example, after the onset of the global financial crisis, a number of SPEs that had not previously been consolidated were subsequently consolidated, due to obligations crystallising that had previously been considered to have a remote risk of arising in practice. However, because certain parts of the analysis required by IFRS 10 are different and can be highly judgemental, in particular when an investee is not wholly owned, the requirement for continuous reassessment may now be more complex. IFRS 10 gives examples of where an investor would need to revist its control assessment. These include: Changes in Power An investor can gain power over an investee because decision-making rights held by another party or parties that previously prevented the investor from controlling an investee have lapsed (IFRS 10.B82) Changes affecting exposure to variable returns For example, an investor that has power over an investee can lose control of an investee if the investor ceases to be entitled to receive returns or to be exposed to obligations (IFRS 10.B83) Changes in the linkage between power and returns Changes in the relationship between the investor and other parties can mean that an investor no longer acts as an agent, even though it has previously acted as an agent, and vice versa (see section for a discussion of principal/agent relationships). For example, if changes to the rights of the investor, or of other parties, occur, the investor is required to reconsider its status as a principal or an agent (IFRS 10.B84). The initial assessment of control or its status as a principal or an agent would however not change because of a change in market conditions (e.g. a change in the investee s returns driven by market conditions), unless the market changed one of the three criteria above or the overall relationship between the principal and the agent (IFRS 10.B84/B85).
14 14 IFRS 10 Consolidated Financial Statements 7.2. Relevant activities Definition Relevant activities are defined as: activities of the investee that significantly affect the investee s returns (IFRS 10 Appendix A). The concept of relevant activities is a key part of the analysis required by IFRS 10. While in many cases these will be straightforward to identify, in others careful consideration will be required. This is particularly the case for structured entities, where the relevant activities only take place in specified circumstances (such as recovery action taken on the occurrence of default of specified debts) Identification In order to identify relevant activities, an investor considers the purpose and design of an investee. In other words, relevant activities depend on the business model of an investee and how revenue is generated. Investees will usually have a range of operating and financing activities that significantly affect their returns. Examples of relevant activities and the ability to direct those activities are: Relevant Activities (IFRS 10.B11) Selling and purchasing of goods or services Managing financial assets during their life (including upon default) Selecting, acquiring or disposing of assets Researching and developing new products or processes Determining a funding structure or obtaining funding. Decisions about relevant activities (IFRS 10.B12) Establishing operating and capital decisions of the investee, including budgets Appointing and remunerating an investee s key management personnel or service providers and terminating their services or employment. Example 1 shows an example of how control could be assessed. Example 1 Assessing control over relevant activities [IFRS 10.B13 Application Example 2] An investment vehicle (the investee) is created and financed with a debt instrument held by an investor (the debt investor) and equity instruments held by a number of other investors. The equity tranche is designed to absorb the first losses and to receive any residual return from the investee. One of the equity investors who holds 30% of the equity is also the asset manager. The investee uses its proceeds to purchase a portfolio of financial assets, exposing the investee to the credit risk associated with the possible default of principal and interest payments of the assets. The transaction is marketed to the debt investor as an investment with minimal exposure to the credit risk associated with the possible default of the assets in the portfolio because of the nature of these assets and because the equity tranche is designed to absorb the first losses of the investee.
15 IFRS 10 Consolidated Financial Statements 15 The returns of the investee are significantly affected by the management of the investee s asset portfolio, which includes decisions about the selection, acquisition and disposal of the assets within portfolio guidelines and the management upon default of any portfolio assets. All those activities are managed by the asset manager until defaults reach a specified proportion of the portfolio value (ie when the value of the portfolio is such that the equity tranche of the investee has been consumed). From that time, a third-party trustee manages the assets according to the instructions of the debt investor. Assessment Managing the investee s asset portfolio is the relevant activity of the investee. The asset manager has the ability to direct the relevant activities until defaulted assets reach the specified proportion of the portfolio value; the debt investor has the ability to direct the relevant activities when the value of defaulted assets surpasses that specified proportion of the portfolio value. The asset manager and the debt investor each need to determine whether they are able to direct the activities that most significantly affect the investee s returns, including considering the purpose and design of the investee as well as each party s exposure to variability of returns. On inception of the structure, it would be expected that the equity tranche would be significant, in order that the debt holder considered there to be little potential for the equity tranche to be insufficient to absorb anticipated losses. Consequently, the asset manager would consolidate the investee. BDO comment This conclusion is different from that which is typically reached under existing guidance. This is because, in applying SIC-12, it might often be concluded that the asset manager would not consolidate the investment vehicle. This is because a 30% holding does not expose the asset manager to the majority of the risks and rewards associated with the investee. Instead, the investee was created for the benefit of all investors and not only for the asset manager. If more than one investor has power over relevant activities, the investor that directs the most significant activities will have power over an investee under IFRS 10. The significance of an activity is assessed with reference to their potential to affect returns. BDO comment For many investees this criterion in most cases will be straightforward to assess. For entities where the power over an investee s relevant activities is shared by multiple investors or that have predetermined activities the assessment may be highly judgmental. IFRS 10.B13 includes an example with two investors, one responsible for development and regulatory approval of medical product and the other for manufacturing and marketing. The example only provides a list of factors that should be considered but does not conclude which of the investors has control. In addition, care will be required in circumstances in which two or more investors appear to share control in determining whether one of the investors has control (and therefore applies IFRS 10) or the arrangement instead gives rise to joint control (and falls within the scope of IFRS 11 Joint Arrangements).
16 16 IFRS 10 Consolidated Financial Statements Relevant activities of structured entities A structured entity raises funds from the issue of various grades of fixed rate notes and uses the proceeds to acquire a portfolio of high credit quality variable rate residential mortgage loans. The loans are capable of being prepaid, and in practice a small proportion are expected to be prepaid either in whole or in part. The cash flow differences between the variable rate interest receivable and fixed rate interest payable are hedged using interest rate swaps. The activities that have the most significant effect on the structured entity s returns are: Sourcing and acquiring the residential mortgage loans Monitoring prepayment rates Determining how the arrangement is hedged Investing excess funds to generate interest income (which could arise from prepaid mortgages) Managing mortgage assets in the event of default Can a structured entity have no relevant activities? Although they might appear to have been set up on autopilot with no substantive decisions to be taken subsequently, in practice there are very few structured entities that do not have any relevant activities. However, if there really were no decisions at all, then no investor would control (and therefore consolidate) the structured entity. This is regardless of whether an investor sponsored or designed the structured entity and had exposure to variable returns. Consequently, it is possible that there will be a very small number of SPEs that were previously consolidated under SIC-12, due to an entity being exposed to a majority of benefits arising from the SPE s activities, that will not be consolidated under IFRS 10. However, it is necessary to consider the meaning of relevant activities very broadly. For example, in a true autopilot structure, if one party to the arrangement has the unilateral ability to wind up the structured entity at any time, that would be regarded as a relevant activity as that party would have the ability to affect returns by cancelling the arrangement. Alternatively, an arrangement might have activities that are contingent on specified future events. The following example illustrates this point. Example 2 Relevant activities contingent on a future event [IFRS 10.B53 Application Example 11] An investee s only business activity, as specified in its founding documents, is to purchase receivables and service them on a day to day basis for its investors. The servicing on a day to day basis includes the collection and passing on of principal and interest payments as they fall due. Upon default of a receivable, the investee automatically puts the receivable to an investor as agreed separately in a put agreement between the investor and the investee. The only relevant activity is managing the receivables on default because it is the only activity that can significantly affect the investee s returns. Managing the receivables before default is not a relevant activity because it does not require substantive decisions to be made that could significantly affect the investee s returns the activities before default are predetermined and amount only to collecting cash flows as they fall due and passing them to investors. Therefore, only the investor s right to manage the assets on default should be considered when assessing the overall activities of the investee that significantly affect the investee s returns. In this example, the design of the investee ensures that the investor has decision-making authority over the activities that significantly affect the returns at the only time that such decision-making authority is required. The terms of the put agreement are integral to the overall transaction and the establishment of the investee. Therefore, the terms of the put agreement together with the founding documents of the investee lead to the conclusion that the investor has power over the investee even though the investor takes ownership of the receivables on default and manages the defaulted receivables outside the legal boundaries of the investee.
17 IFRS 10 Consolidated Financial Statements Power Rights that give power An investor has power over an investee if it has existing rights that give it the current ability to direct the relevant activities. Only substantive rights (see 7.3.4) are considered, with protective rights (see 7.3.3) being disregarded. (IFRS and B9). The distinction between substantive and protective rights can be significant in the analysis of which investor (if any) has the unilateral power to control an investee. The fact that an investor directs relevant activities is an indicator that the investor has power, but it is not conclusive. For example, another party might have power over an investee but choose, for whatever reason, not to make use of it (IFRS 10.12) Current ability to direct An investor only needs to have the ability to control relevant activities, and it is not relevant whether the investor actually exercises this ability. In this respect, IFRS 10 is similar to IAS 27(2008). However, IFRS 10 also clarifies that power exists when an investor has the ability to direct the relevant activities of an investee, even if those relevant activities occur only when particular circumstances arise or specific events occur (IFRS 10.B53) Protective rights Protective rights are defined as (IFRS 10 Appendix A): Rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate. Because of the way in which power is analysed in accordance with IFRS 10, the distinction between substantive and protective rights (the latter being a new term introduced by IFRS 10 that requires explicit consideration) is important. An investor that only holds protective rights, which meet this definition, has no power over an investee and consequently does not control the investee. The standard follows the logic that protective rights are designed to protect interests of the holder without giving it power over the investee, and cannot prevent another party from having power over an investee (IFRS 10.B27). Protective rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances. The fact that a right only arises in exceptional circumstances however is not in itself conclusive that it is a protective right (IFRS 10.B26). Examples of protective rights in the standard are (IFRS 10.B28): A lender s right to restrict borrower s activities (if these could change credit risk significantly to the detriment of the lender) Capital expenditure greater than that required in the ordinary course of business requiring approval by noncontrolling interest holders Issue of debt or equity instruments requiring approval by non-controlling interest holders A lender s right to seize assets of a borrower in the event of default.
18 18 IFRS 10 Consolidated Financial Statements Substantive rights Only substantive rights are considered when power is assessed. In order for a right to be substantive, the holder must have the practical ability to exercise the right. The standard requires that substantive rights held both by the investor and by others are assessed (IFRS 10.B22). IFRS 10 acknowledges the assessment of whether rights are substantive requires judgment. It provides examples of factors that need to be considered, split into the headings barriers to exercise, agreement of other parties required and exercise benefits right holder (IFRS 10.B23). Barriers to exercise The existence of any barriers (economic or otherwise) that prevent the holder from exercising the rights are required to be considered. Examples of such barriers include but are not limited to (IFRS 10.B23): Financial penalties and incentives An exercise or conversion price that creates a financial barrier (for example, the exercise price of options that would give the holder sufficient voting rights to obtain control of an entity may be deeply out of the money and therefore uneconomic to exercise see section 7.3.8) Terms and conditions that make it unlikely that the right is exercised (e.g. a condition that sets a very narrow limit to the timing of exercise) The absence of an explicit, reasonable mechanism to allow the holder to exercise its rights (this might link to the founding documents of an investee, or applicable laws and regulations) An inability for the holder to obtain the information necessary to exercise its rights Operational barriers or incentives (e.g. in circumstances where there is a manager of an entity, the absence of other managers willing or able to provide specialised services or provide the services and take on other interests held by the incumbent manager) Legal or regulatory requirements (e.g. where a foreign investor is prohibited from exercising its rights). Agreement of other parties required When exercising a right requires the agreement of more than one party, the following factors should be considered: Whether a mechanism is in place that provides the parties with the practical ability to exercise the right. The absence of such a mechanism would indicate that the rights may not be substantive The number of parties that have to agree on the exercise of the rights. The more parties that are required to agree to the exercise of the rights, the less likely it is that those rights are substantive Removal rights exercisable by an independent board of directors are more likely to be substantive than if the same rights were exercisable individually by a large number of investors. Exercise benefits right holder There is a further question of whether the party holding the right would benefit from its exercise. For example, for potential voting rights, the terms and conditions are more likely to be substantive when the instrument is in the money, or the holder would benefit in other ways (for example, from realising synergies). To be substantive, rights also need to be exercisable when decisions about the relevant activities are made. This will always be the case when rights are currently exercisable. However, a right can also be substantive if it is not currently exercisable but is exercisable when the relevant activities are made.
19 IFRS 10 Consolidated Financial Statements 19 The example below illustrates how the exercisable criteria is applied. Example 3 Exercisable substantive rights [IFRS 10.B24 Application Example 2] Company A (the investee) is controlled through equity share voting rights. It has annual shareholder meetings at which decisions to direct the relevant activities are made. The next shareholders meeting is scheduled in eight months. However, shareholders that individually or collectively hold at least 5% of the voting rights can call a special meeting to change the existing policies over the relevant activities, but a requirement to give notice to the other shareholders means that such a meeting cannot be held for at least 30 days. Policies over the relevant activities can be changed only at special or scheduled shareholders meetings. This includes the approval of material sales of assets as well as the making or disposing of significant investments. Scenario 1 An investor (Company X) holds a majority of the voting rights in Company A. Company X s voting rights are substantive because X is able to make decisions about the direction of the relevant activities when they need to be made. The fact that it takes 30 days before Company X can exercise its voting rights does not stop it having power. Company X has both the practical ability to exercise its rights and those are exercisable when decision about the direction of relevant activated need to be made. Scenario 2 An investor (Company Y) holds an option to acquire the majority of shares in Company A. The option is exercisable in 25 days and is deeply in the money. Company Y has rights that are essentially equivalent to the majority shareholder (Company X) in Scenario 1. Company Y can make decisions about the direction of the relevant activities when they need to be made as the option is exercisable within 25 days which is before a meeting could be convened (30 days). So the existing shareholders are unable to change the existing policies over the relevant activities. This and the fact that the option is deeply in the money means it is substantive. It gives Company Y the current ability to direct the relevant activities even before the option is exercised. Scenario 3 An investor (Company Z) is party to a forward contract to acquire the majority of shares in Company A. The forward contract s settlement date is in six months time. Company Z does not have a substantive right at the moment as it does not have the current ability to direct the relevant activities. The existing shareholders have the current ability to direct the relevant activities because they can change the existing policies over the relevant activities before the forward contract is settled in six months time. However Company Z may conclude that is has control once it gets within 30 days of the settlement date.
20 20 IFRS 10 Consolidated Financial Statements Substantive rights that are exercisable by other parties can prevent an investor from having control. This is even the case if other investors cannot initiate decisions. It is sufficient for another investor to have the ability to approve or block decisions about relevant activities. These rights are however not considered if they are merely protective (IFRS 10.B25). Some investees are designed so that the direction of their activities and returns is predetermined until a particular circumstance arises or an event occurs. This means that only those activities that relate to that event will significantly affect returns and thus are relevant. The fact that the circumstances or events have not happened does not mean that the rights are only protective (IFRS 10.B53). Relevant activities that are subject to direction by others (e.g. government, court or administrator) are not considered in the control assessment even if the investor holds a majority of voting rights. This is because the investor s rights are not considered substantive (IFRS 10.B37). However, this does not automatically mean that an entity that is subject to direction by a government, court or administrator cannot be controlled by an investor. Instead, it is necessary to establish whether that direction results in the government, court or administrator having power over the most significant relevant activities. Consequently, although the guidance in IFRS 10 might initially appear conclusive, judgement is still required Voting rights An investor concludes that it has control over an investee if it owns the majority of shares of its investee that have equal voting rights attached, and those shares have a proportionate entitlement to a share of the returns of the investee. However, this is subject to whether another party holds potential voting rights which, if acquired, would result in that other party having control (see section 7.3.8). IFRS 10 also provides guidance for cases where an investor does not hold the majority of voting rights Majority held An investor is required to consolidate an investee if it holds more than 50% of the voting rights through shares which is the most common consolidation scenario. This assumes that decisions about relevant activities are determined by majority vote; the threshold could be different if, for example, a 75% majority is required. The rights either need to entitle the holder to vote on the relevant activities or to select the majority of the board that directs the relevant activities (IFRS 10.B35). This scenario will apply to almost all subsidiaries that are held by means of ordinary share that have voting rights attached Majority not held IFRS 10 notes that an investor can have power even if it holds less than the majority of voting rights. The standard provides specific guidance for the following scenarios (IFRS 10.B38): Contractual agreements with other vote holders Rights from other contractual arrangements (economic dependencies) De-facto control Potential voting rights A combination of the above.
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