This article was first published in the April 2012 Singapore edition of Accounting and Business magazine.
The question of which businesses to include in your group of companies used to be determined simply: the ones in which you own more than 50% of the shareholdings.
But as the available financing and investment options have evolved over time, so have the increased complexities of business structures. Today, the question of what to consolidate no longer has a simple answer. In fact, that involves significant judgment from both financial controllers and accountants, especially when the investor does not have majority shareholding in its investees.
This increasing complexity of corporate structures made it more apparent that consolidation literature should also evolve in tandem to address such topics like ‘off balance sheet’ special purpose entities. SIC Interpretation 12, Consolidation – Special Purpose Entities, was thus introduced in 1998. Similarly in the US, the collapse of Enron in 2001 served to further emphasise this need and the standard on variable interest entities, FIN 46, Consolidation of Variable Interest Entities – an interpretation of ARB No. 51, was introduced.
With the financial crisis seven years later, it became even more important to have a more cohesive set of consolidation principles and comprehensive guidance for the accounting community, to reflect the economic substance of relationships between entities and ensure consistent consolidation decisions were being applied. Consistency, transparency and comparability in the accounting and disclosure of such relationships became even more vital than before.
In May 2011, International Financial Reporting Standard (IFRS) 10, Consolidated Financial Statements, effective for annual periods beginning on or after 1 January 2013, was issued. An equivalent standard for Singapore based on IFRS 10, FRS 110, comes into effect on 1 January 2013.
This brings about a significant change to the process for determining which entities should be included in the consolidated financial statements. Simply put, it does not change ‘how’ an entity should consolidate another; rather, it changes ‘whether’ an entity is consolidated, by reviewing the boundaries of determining control.
Under IFRS 10, a relationship, rather like the Bermuda Triangle between three elements: power, returns and linkage, is used to determine control (see below).
However, unlike the fabled disappearances, companies that fall within the triangle will be brought onto the books.
1) Evaluating power
The first step is to identify the relevant activities of the investee – that is, those activities that affect the returns of the investee. While this sounds straightforward, it may not always be so. You need to understand the purpose and design of an investee to determine its relevant activities. For example, would the relevant activities for a cord blood bank be the collection and processing of the cord blood or the subsequent storing of the cord blood, or a combination of both?
Having the rights and ability to direct the relevant activities of the investee and, through that, influencing the returns is what gives the investor the power over the investee. It requires companies to consider not only the typical voting rights but also other forms of rights such as potential voting rights, rights to appoint key personnel or the decision-making rights for financial and operating policies of the investee.
2) Assessing returns
Conceptually similar to SIC 12, this element also looks at the exposure an investor has or the rights to returns due to the involvement it holds in the investee. The premise being that the greater the exposure to varying returns, whether positive, negative or both, direct or indirect, the greater the likelihood that an investor would be motivated to have more control over an investee. Thus the focus is really on the existence of an exposure to variable returns, rather than the amount of the exposure to variable returns.
3) Power and returns
The magnitude of the returns is not what determines if the investor holds power, but rather, it is the exposure to the variability of returns (both positive and negative) from the investee. The greater the exposure to the variable returns, the greater the incentive for the investor to gain power over the investee.
This linkage is the third element under the new accounting standard and is essential to control. An investor that has power over an investee, but cannot benefit from that power, does not control that investee. For example, the Monetary Authority of Singapore (MAS) regulates banks and financial institutions in Singapore. However, having and exercising this power does not give the MAS any direct returns.
Vice versa, an investor that receives a return from an investee, but does not have power to direct the activities that significantly affect the returns received, does not control that investee. This can be a bank which receives interest from its loan to a customer; the interest received is the return but it does not give the bank power over the customer’s relevant activities or direct its profits.
IFRS 10 may significantly change which entities fall within the consolidated group. For financial sector players like private equity funds, fund and asset managers, the impact may be greater. The new control principle within this standard is purposefully lacking in bright lines, hence adopting it will require the considerable judgment by the management and accountants, especially in understanding the business operations, legal rights and obligations.
Much like the implementation of any new standard, the devil is in the detail. The challenge in adopting this one lies in the sufficiency of information, especially when you need to review the rights of other shareholders and establish a process to assess control continuously. The question is: how can companies execute this?
This poses practical difficulties in coping with the changes affecting the three elements, including the possibility that over time, the construct within a group of entities may change from one period to the next. For example, if a fund manager provides all the seed money for a fund upon inception, it is possible that the fund manager controls (and therefore consolidates) the fund at inception. But this conclusion may change as third parties begin to invest into the fund and dilute the fund manager’s interest, potentially leading to a loss of control. But that assessment involves significant judgment by management, such as how large does an investor’s interest need to be, in relation to others? Or conversely, how widely dispersed do other investors need to be?
Additionally, valuation of these investees at various points in time where facts and circumstances change would be a challenging task. Further, companies need to ensure that, eventually, the accounting makes sense for the economics of the business.
Companies should also start thinking about how they intend to modify their systems or processes to accumulate data for the new disclosure requirements or to meet the continuous need to evaluate key judgments. Identifying key triggers for a reassessment of the three elements of control may be a place to begin, but the execution would be a continuous journey, especially in educating the stakeholders on a changing balance sheet between reporting periods. More judgment is expected and management may need to consider various intricacies when applying these judgments. This may require additional external assistance, not only in gathering information, but also analysing what is relevant for the business.