This article was first published in the November 2011 Ireland edition of Accounting and Business magazine.
The International Accounting Standards Board (IASB) issued IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements and IFRS 12 Disclosure of Interests in Other Entities effective for annual periods beginning on or after 1 January 2013.
IFRS 10 replaces the portion of IAS 27 Consolidated and Separate Financial Statements that addresses the accounting for consolidated financial statements.
In addition, the issues raised in SIC-12 Consolidation – Special Purpose Entities are now included in IFRS 10. What remains in IAS 27 is limited to accounting for subsidiaries, jointly controlled entities and associates in separate financial statements.
On 25 August 2011, the IASB published an exposure draft (ED), Investment Entities, which proposes an exception to the principle in IFRS that an entity consolidates all controlled entities.
Instead, the ED would require an investment entity (as defined) to measure all controlled investments at fair value, with changes recognised in profit or loss.
If finalised, this ED would amend the requirements of IFRS 10 to require investment entities to measure all controlled investments at fair value.
Key highlights of IFRS 10
A single model of control replaces the two models that previously existed (i.e., power over operating and financial policies for some entities, versus risks and benefits for others).
An investor controls an investee when it has power, exposure to variable returns and the ability to use such power to affect those returns.
- Impact for asset managers and funds:
- More entities may be consolidated than under current IFRS;
- Consolidation decisions will need to be evaluated on a continuous basis, and not just at implementation or at each reporting date;
- Key financial statement metrics may be impacted (e.g., debt/equity ratios);
- Communications with stakeholders, such as investors, finance providers and regulators, will be necessary to inform them of the effects of changes to the group structure; and,
- Additional disclosures will be required.
IFRS 10 uses the term ‘investor’ to refer to a reporting entity that potentially controls one or more other entities, an ‘investee’ to refer to an entity that is, or may potentially be, the subsidiary of a reporting entity.
For an investor to control an investee, the investor must possess all of the following:
- Power over the investee, which is described as having existing rights that give the current ability to direct the activities of the investee that significantly affect the investee’s returns. Such activities are referred to as ‘relevant activities’ e.g., determining operating policies, making capital decisions, appointing key management personnel, etc;
- Exposure, or rights, to variable returns from its involvements with the investee. Returns can be positive, negative or both; and,
- Ability to use its power over the investee to affect the amount of the investor’s returns.
When decision-making rights have been delegated to an asset manager, or are being held for the benefit of others, it is necessary to assess whether the decision-making party is a principal or an agent. The following factors, among others, are considered:
Scope of authority
An asset manager will usually have discretion over the key activities of the funds, i.e., day-to-day investment decisions. These will be limited by the investment management agreement. The extent to which the manager is able to adjust this agreement, and the discretion the agreement allows, will be an indication as to whether the manager is acting as an agent or principal.
Additionally, significant involvement in the design of the fund may indicate that the asset manager had the opportunity and incentive to obtain rights that result in it having the ability to direct the fund’s relevant activities.
Rights held by other parties
When a single investor holds substantive rights to remove the asset manger without cause, in isolation, this fact would be sufficient to conclude that the asset manager is an agent.
An asset manager cannot be an agent unless the following two factors are present (although these factors, in isolation, are not sufficient to conclude that an asset manager is an agent):
- Its remuneration is commensurate with the level of skills required to provide those services; and,
- Its remuneration agreement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated on an arms length basis. It is also important to consider the magnitude and variability of the asset manager’s remuneration relative to the fund’s returns.
When an asset manager or its related parties hold other interest in an investee, this may indicate that it is not an agent as this interest may influence the decisions made by it.
Issues for funds
Potential voting rights
Substantive potential voting rights, such as currently exercisable options, that, if exercised, would give a fund the ability to direct the relevant activities of an investee, may indicate that the fund controls the investee.
Holding less than a majority of voting rights
A fund holding less than a majority of an investee’s voting rights may still control an investee when the investee’s relevant activities are controlled by voting rights and other voters are widely dispersed.
Power over a portion of an investee
IFRS 10 also sets out requirements for how to apply the control principle in circumstances where the investor has control over specified assets of an investee. i.e., control could exist at a level below a legal entity, that is, or a ‘deemed separate entity’.
Protective rights are those rights that are designed to protect the interests of the holder, without giving that party power over the entity to which those rights relate and hence does not constitute power over the investee.
In assessing control, the purpose and design of the structured entity, as well as the expected returns, are considered. This may lead to a different conclusion than when, under SIC-12, an entity did not previously consolidate, because the investor did not have rights to the majority of expected returns.
An investor is required to reassess whether it controls an investee if the facts and circumstances indicate that there are changes to one of the three elements of control. For example, if an asset manager provides all of the seed money for a fund upon inception, it is possible that the asset manager controls the fund at inception, but this conclusion may change as third parties invest in the fund and dilute the asset manager’s interest.
Disclosure requirements, which are now included in a separate standard, IFRS 12, must enable users to understand:
- Significant judgments and assumptions made by the investor in determining whether it controls the investee.
- Interest that non-controlling shareholders have in the group’s activities. 25
- Effects of restrictions on the investor’s ability to access and use assets, or settle liabilities, of consolidated entities, as a result of whether the assets or liabilities are held in the group.
- Nature of, and changes in, the risks associated with the investor’s control of, or involvement with structured entities.
Application of IFRS 10 is retrospective, with consolidation applied from the date of gaining control. However, if it is not practical to apply the standard fully retrospectively, consolidation is required from the earliest date practical, which may be the current period. The effective date is 1 January 2013, but entities may apply IFRS 10 early, if they also early adopt IFRS 11 and 12.
Fergus Condon FCCA is director, Financial Accounting Advisory Services, Ernst & Young and is a member of the ACCA Global Forum for Corporate Reporting.