Questions and answers relating to consolidated and company level financial statements prepared under Part 9 of the new CO (Cap. 622) Topic 3 Subsidiary undertakings that are not controlled by the reporting entity under HKFRS 10 Question 3.1: Whether to consolidate non-controlled subsidiary undertakings in order to comply with section 381(1) of the CO Section 381(1) of the CO states that the annual consolidated financial statements must include all subsidiary undertakings of the company (unless immaterial in accordance with section 381(3)). Schedule 1 to the CO defines subsidiary undertakings. But what if the reporting entity does not control the subsidiary undertaking when judged against HKFRS 10? For example, what if the reporting entity owns 51% of the shares but has entered into an agreement with the other shareholders which gives the others power of veto over key operating decisions, such that the reporting entity does not control the investee and instead only has significant influence or joint control? Should the reporting entity consolidate the investee or exclude it from consolidation? [Question 3.2 below considers in more detail how question 3.1 could arise, by explaining the difference between the definition of a subsidiary undertaking under Schedule 1 to the CO and the concept of control under HKFRS 10] Answer: The reporting entity should exclude an entity that is a subsidiary undertaking (within the meaning of Schedule 1 to the CO) from consolidation if it does not control it within the meaning of HKFRS 10, but to do so requires invoking the true and fair override in section 380(6) of the CO, as follows: Section 380(4)(b) of the CO gives statutory backing to HKFRSs by requiring the financial statements to comply with accounting standards issued by the HKICPA. In addition, section 380(6) states that if compliance with s380(4)(a) (i.e. compliance with any other requirements of the CO) would be inconsistent with giving a true and fair view then the financial statements must depart from those requirements to the extent necessary for the financial statements to give a true and fair view. Given this, it is therefore both acceptable and necessary for a reporting entity to exclude subsidiary undertakings (within the meaning of Schedule 1 to the CO) from consolidation when required to do so by HKFRS 10 but, in order to do so, it is necessary for that entity to override section 381(1) (and therefore section 380(4)(a)) of the CO by invoking the true and fair override set out in section 380(6) of the CO. When the true and fair override is invoked, section 380(6) requires the financial statements to provide the reasons for, and the particulars and effect of, the departure. For example, in order to satisfy this requirement the consolidated financial statements could include the following disclosure in the statement of compliance note (e.g. which is typically disclosed as note 1 to the financial statements) and the accounting policy note for its subsidiaries: 1
Statement of compliance These annual consolidated financial statements have been prepared in accordance with all applicable Hong Kong Financial Reporting Standards (HKFRSs), which collective term includes all applicable individual Hong Kong Financial Reporting Standards, Hong Kong Accounting Standards (HKASs) and Interpretations issued by the Hong Kong Institute of Certified Public Accountants (HKICPA) and accounting principles generally accepted in Hong Kong. These financial statements also comply with the applicable requirements of the Hong Kong Companies Ordinance (Cap. 622), with the exception of section 381 which requires a company to include all its subsidiary undertakings (within the meaning of Schedule 1 to Cap. 622) in the company's annual consolidated financial statements. Section 381 is inconsistent with the requirements of HKFRS 10 Consolidated Financial Statements so far as they apply to subsidiary undertakings which are not controlled by the group in accordance with HKFRS 10. For this reason, under the provisions of section 380(6) the company has departed from section 381 and has excluded certain subsidiary undertakings from the consolidated financial statements as disclosed in note yy.* A summary of the significant accounting policies adopted by the group is set out below. * The additional note disclosure would need to satisfy the requirement in section 380(6) to give particulars and the effect of the departure from section 381(1) in this regard cross referencing to where the disclosures have been made which satisfy paragraphs 7 to 9 and 20 to 23 of HKFRS 12 Disclosure of Interests in Other Entities should generally be sufficient. Note: there is no need for the auditor to refer to a true and fair override under section 380(6) in the auditor s report, unless the auditor disagrees with the basis of the override or considers that the disclosures are deficient compared to the requirements of section 380(6). Provided that the auditor is satisfied in respect of these matters, then the override will have no impact on the auditor s ability to provide an unqualified opinion on compliance with the Companies Ordinance. Question 3.2: Identifying non-controlled subsidiary undertakings In what circumstances would an entity meet the definition of a subsidiary undertaking within the meaning of Schedule 1 to the CO but fail to meet the definition of a subsidiary in accordance with HKFRS 10 Consolidated Financial Statements? Answer: Under HKFRS 10 the assessment of control takes into account all facts and circumstances in order to reach a judgement on whether an investor has the practical ability to direct the relevant activities of an investee unilaterally. Specifically, under HKFRS 10, control exists only when the reporting entity has all of the following: 1. power over the investee; 2. exposure, or rights, to variable returns from its involvement with the investee; and 3. the ability to use its power over the investee to affect the amount of the investor's returns. Under this unilateral control model, an investee can only be controlled by one party. It is not possible for an entity to be the subsidiary of more than one party. 2
The CO does not refer to relevant accounting standards when defining subsidiary undertaking. Instead, the approach taken in the CO is as follows: Subsidiary undertaking is defined in Schedule 1 to the CO. This Schedule has been brought forward unaltered compared to Schedule 23 of the predecessor Companies Ordinance (Cap. 32). Section 2 of Schedule 1 sets out the various ways in which an entity is a parent undertaking (and therefore the investee is a subsidiary undertaking): Section 2(1)(a) of Schedule 1 refers to the definition of a holding company, when the investee is a body corporate. In this respect, section 13 of the CO (which has been brought forward from section 2(4) of the predecessor Companies Ordinance (Cap. 32)) sets out three different ways that a company (company H) may be a holding company of another body corporate (company S), either directly or indirectly: (a) H controls the composition of S s board; OR (b) H controls more than half of the voting rights in S; OR (c) H holds more than half of S s issued share capital, excluding any part of it that carries no right to participate beyond a specified amount in a distribution of either profits or capital. Sections 2(1)(b) and 2(2) of Schedule 1 include four other ways that a company (company H) can be the parent undertaking of another undertaking (an undertaking could be a body corporate, a partnership or an unincorporated association carrying on a trade or business) (undertaking S): (a) H holds the majority of voting rights in S; OR (b) H is a member of S and has the right to appoint or remove a majority of S s board of directors; OR (c) H is a member of S and controls alone, pursuant to an agreement with other shareholders or members, a majority of the voting rights in S; OR (d) H has the right to exercise dominant influence over S by way of provisions in a document regulating S with respect to operating and financial policies (as per section 2(7) of Schedule 1). The list of conditions in section 2(1)(b) of Schedule 1 overlaps broadly speaking with the list in section 13 of the CO (Holding company) of the conditions that make a body corporate a holding company of another body corporate, so that overall there appear to be four different ways that an entity could be regarded as the parent undertaking or holding company of another entity under Cap. 622: (i) By owning the majority of shares; (ii) By controlling the majority of voting rights; (iii) By having rights to control the board composition; and/or (iv) By having the contractual right to dominate the board decisions. 3
Compared to HKFRS 10 there are two key matters missing from section 13 and Schedule 1: 1. There is no indication of a hierarchy. For example, if one entity holds the majority of the shares and another entity has the right to appoint the majority of the board, there is no indication in the CO as to which entity has the greater power over the investee each way of qualifying as a holding company or parent undertaking appears to have equal status under Schedule 1. 2. There is no statement that an undertaking can only have one holding company or parent undertaking i.e. there is no indication in the CO that an entity is required to use judgement to identify which parent undertaking (if any) has unilateral power over the investee. Given the above key differences between HKFRS 10 and the CO, it is possible that an investee could meet the legal definition of subsidiary undertaking in the CO without the reporting entity meeting the control criteria set out in HKFRS 10 in respect of that investee. This situation is not expected to be common but may arise depending on the facts and circumstances relating to each individual investee. This situation could also have arisen under the predecessor Companies Ordinance (Cap. 32). However, section 124(2)(b)(ii) of the predecessor Companies Ordinance (Cap. 32) included an over-riding exemption provision, such that a subsidiary can or should be excluded from consolidation if the result of consolidating that entity would be misleading. This exemption worked in practice to ensure that only entities that were controlled within the meaning of HKFRS would be consolidated under the predecessor Companies Ordinance (Cap. 32). This exemption (i.e. the exemption from consolidation which was present in section 124(2)(b)(ii) of the predecessor Companies Ordinance (Cap. 32)) is missing from s381(3) of the CO. Therefore, as discussed above in our answer to question 3.1, where this situation arises under Cap. 622 (i.e. for financial years beginning on or after 3 March 2014) it is necessary to invoke the true and fair override to depart from section 381(1) in order to prepare consolidated financial statements which comply with HKFRS 10 by excluding subsidiary undertakings which are not controlled by the reporting entity. When the true and fair override is invoked, section 380(6)(b) requires financial statements to provide the reasons for, and the particulars and effect of, the departure from the requirements of the CO (see our answer to question 3.1). Question 3.3: Whether to disclose names of directors of non-controlled or immaterial subsidiary undertakings excluded from consolidation When disclosing the names of directors of subsidiaries in the directors report, is it necessary to disclose the names of the directors of all subsidiary undertakings (within the meaning of Schedule 1 to the CO) including those that have not been consolidated? For example, what if an investee is classified as a joint venture under HKFRS 11 Joint Arrangements but is 4
considered to be a subsidiary undertaking under Schedule 1 to the CO do the names of the directors of the joint venture need to be disclosed? Answer: No. The requirement to disclose the names of the directors of the subsidiaries is found in section 390(3) of the CO. This section, when read together with sections 389(2) and 390(1) of the CO, requires the names of the directors to be disclosed in respect of the subsidiary undertakings included in the annual consolidated financial statements for the financial year regardless of the place of incorporation of the subsidiary undertaking. As the investee has been classified as a joint venture, it is accounted for using the equity method of accounting (rather than being consolidated) under HKAS 28 Investments in Associates and Joint Ventures. Accordingly, it is not considered to be 'included' in the annual consolidated financial statements. Therefore, the requirement under section 390(3) does not apply to those subsidiary undertakings (within the meaning of Schedule 1 to the CO) which have not been consolidated because HKFRS 10 does not permit the subsidiary undertakings to be consolidated (see questions 3.1 and 3.2 above and question 5.1). Similarly, the requirement under section 390(3) does not apply to those subsidiary undertakings that have been excluded from consolidation because of immateriality (in accordance with section 381(3)). Question 3.4: Whether to include non-controlled or immaterial subsidiary undertakings in a consolidated business review that have been excluded from consolidation When preparing a consolidated business review for the directors report in accordance with section 388(2) of the CO, is it necessary to include all subsidiary undertakings (within the meaning of Schedule 1 to the CO) including those that have not been consolidated? For example, what if an investee is classified as a joint venture under HKFRS 11 Joint Arrangements but is considered to be a subsidiary undertaking under Schedule 1 to the CO do the activities of the joint venture need to be disclosed in the business review? Answer: No. The requirement in section 388(2) of the CO is to prepare a consolidated directors report that complies with Schedule 5 to the CO (amongst other things). Section 4 of Schedule 5 refers to the subsidiary undertakings included in the annual consolidated financial statements for the financial year when specifying the scope of a business review prepared under section 388(2). As the investee has been classified as a joint venture, it is accounted for using the equity method of accounting (rather than being consolidated) under HKAS 28. Accordingly, it is not considered to be 'included' in the annual consolidated financial statements. Therefore, the requirement to include the activities of subsidiary undertakings in the business review does not apply to those subsidiary undertakings (within the meaning of Schedule 1 to the CO) which have not been consolidated because HKFRS 10 does not permit the subsidiary undertakings to be consolidated (see questions 3.1 and 3.2 above and question 5.1). 5
Similarly, the requirement under section 390(3) does not apply to those subsidiary undertakings that have been excluded from consolidation because of immateriality (in accordance with section 381(3)). Question 3.5: Meaning of subsidiary undertakings in the Companies (Disclosure of Information about Benefits of Directors) Regulation (C(DIBD)R or Cap. 622G) The C(DIBD)R refers to subsidiary undertakings. Does this just mean the subsidiary undertakings included in the consolidated financial statements in the same way as in the answers to questions 3.3 and 3.4 above? Answer: No, it means any investee which satisfies the definition of subsidiary undertaking set out in Schedule 1 to the CO (as per section 2 of the C(DIBD)R). It therefore includes non-controlled subsidiary undertakings as explained in the answer to question 3.2 above. One example of a non-controlled subsidiary undertaking would be an investee over which the company has joint control by way of a shareholders agreement, if the company owns more than 50% of the shares of that investee. So far as HKFRS is concerned this is a joint venture within the meaning of HKFRS 11, however, owning more than 50% of the shares is one way in which the investee meets the definition of subsidiary undertaking set out in Schedule 1. In such a case, this joint venture will be excluded from consolidation, but will still fall within the scope of the disclosure requirements of the C(DIBD)R. For example, if a director of the company is also a director of such a joint venture company, then the disclosure of directors emoluments under Part 2 of the C(DIBD)R should include amounts paid to that director in respect of his/her services to the joint venture as this is a form of qualifying service as defined in section 3 of the C(DIBD)R, being services provided to a subsidiary undertaking while a director of the company. Last revision date: 19 June 2015 Please refer to our cover page for background information on the Q&As 6