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This article was first published in the July 2010 edition of Accounting and Business magazine.
The International Accounting Standards Board (IASB) has recently issued three standards: IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements and IFRS 12, Disclosure of Interests in Other Entities. The issuance of these standards completes IASB’s improvements to the accounting requirements for off balance sheet activities and joint arrangements.
The standards bring into broad alignment the accounting treatment for off balance sheet activities in International Financial Reporting Standards (IFRSs) and US generally accepted accounting principles (GAAP), and are the IASB’s response to the financial crisis.
IFRS 10 replaces all of the consolidation guidance in IAS 27, Consolidated and Separate Financial Statements, and SIC 12, Consolidation – Special Purpose Entities, although the portion of IAS 27 that deals with separate financial statements remains. The old standard has been renamed IAS 27, Separate Financial Statements.
IFRS 11 replaces IAS 31, Interests in Joint Ventures, and SIC 13, Jointly Controlled Entities – Non-Monetary Contributions by Venturers. And IFRS 12 replaces the disclosure requirements that used to be found in IAS 28, Investments in Associates and Joint Ventures.
IFRS 10: control and power
IFRS 10 makes the concept of control the determining factor in whether an entity should be included within the consolidated financial statements of the parent company, thus building on existing principles. Guidance has been added to the standard to determine the nature of control in cases where assessment is difficult.
IFRS 10 introduces a single consolidation model for all entities based on control, irrespective of the nature of the investee. Control is based on whether an investor has power over the investee; exposure, or rights, to variable returns from its involvement with the investee; and the ability to use its power over the investee to affect the amount of the returns. Thus the definition focuses on the need to have both ‘power’ and ‘variable returns’ for control to be present.
Control is assessed on a continuous basis as facts and circumstances change. A change in market conditions brings about a reassessment of control only if it changes one of the elements of control. The revised definition of control replaces not only the definition and guidance in IAS 27 but also the four indicators of control in SIC 12. The accounting requirements for consolidated financial statements have been transferred from IAS 27 to IFRS 10.
Power is the current ability to direct the activities that significantly influence returns, which can be positive, negative or both. The determination of power is based on current facts and circumstances, is continuously assessed and is a two-step process.
First, the investor considers all the facts and circumstances of the case, including the size of its holding and the dispersion of holdings.
Second, the investor considers whether other shareholders are passive by nature and if the investee is controlled by rights other than voting power, which are the facts normally used to assess power.
If after this latter step there is no clear conclusion, then the investor does not control the entity. An investor with more than 50% of the voting rights would meet the power criteria if there were no restrictions, but even if it held less than the majority of the voting rights an investor could still have power in certain cases.
In the latter case, such things as agreements with other vote holders, other contractual agreements, potential voting rights and de facto power would have to be considered. IFRS 10 provides guidance on participating and protective rights, and brings the notion of de facto control firmly within the guidance.
To have control, an investor needs to have the ability to use its power to affect returns for the investor’s benefit.
The standard also requires an investor with decision-making rights to determine if it is acting as a ‘principal’ or an ‘agent’. Such factors as whether any remuneration is at arm’s length have to be considered. If an investor acts as an agent, it would not have the requisite power, so the entity would not be consolidated.
Because the new standards may change which entities are included in consolidated financial statements, deal structures may also change. Significant judgment may be required to determine whether another entity is controlled, and data may have to be gathered about other shareholders and past voting patterns. Private equity funds, asset managers and some insurance companies will have to assess whether they are principals or agents and therefore whether they have to consolidate their investments.
An entity holding options to acquire additional voting interests or which owns a minority of voting rights will also need to consider the new rules.