Following is a case on the assessment whether certain stakeholders in a transaction/structure have obtained control over a certain entity in the transaction in line with the requirements of IFRS 10 Consolidated financial statements. Only one stakeholder can be in control! [IFRS 10 B16] Or no stakeholder is in control. Or one stakeholder is in control and has to consolidate the investigated entity in its consolidated financial statements. Here is the case.
An investor is a large owner of Entity D with other investors holding significantly lower percentages of ownership. The ‘normal’ assessment of control ‘checklist’ is:
The investor that has the ability to direct the activities that most significantly affect the returns of the investee has power over the investee (IFRS10 B13). The criteria in IFRS 10 B13 example 1 should be applied, which include consideration of:
- the purpose and design of the investee;
- the factors that determine profit margin, revenue and value of the investee. For example, the construction of the road may be under the supervision of the national roads authority. X is contracted to build the road under government supervision and, subject to audit, will recover its costs plus a specified percentage of margin. That margin will be returned through adjustment of the amount of tolls that will flow to X, so that X has first call on the cash flows generated by tolls. Y will manage the toll road operations, including maintenance, and will have be able to claim a management fee equivalent to any residual cash in the entity after all operating expenses have been paid, including payments to X. Y has the ability to set tolls. Alternatively, the arrangement could set out that the government regulates the tolls that can be charged with little variation in expected revenue but gives the investee more discretion over how the toll road is constructed, with X and Y sharing equally in the net cash flows of the investee;
- the effect on the investee’s returns resulting from each investor’s decision-making authority with respect to the factors in b); and
- investors’ exposure to variability of returns.
All these criteria can be negative and still there is an entity de facto in control or not!! Let’s see how such an assessment is made…
– Entity D manufactures and sells glass bottles to investor G at market price. The majority of sales (95%) are made to investor G; however, entity D can also sell to other customers without additional cost.
– Entity D was established to allow investor G to gain a steady supply of glass bottles.
Entity D issues two classes of shares. investor G holds Class A shares. The 17 other investors hold Class B shares. Both classes have equal voting rights.
The 6 largest Class B investors hold 14%, 8%, 7%, 6%, 5% and 4% respectively. All other investors hold less than 3% each.
The Class B investors have, in the past, participated actively in meetings and, on occasion, rejected resolutions put forward by investor G.
Strategic decisions are made at shareholders’ meetings, and operational decisions are made at directors’ meetings. Daily operations are handled by a Manager, based on powers granted by the shareholders and directors.
Does investor G have control of entity D?
The involvement of investor G has to be assessed based on contractual and non-contractual involvement (or absence thereof) that exposes this investor to variability of returns from the performance of entity D.
Investor G does not seem to control entity D in this circumstance. This is based on the following assessment:
- Power over entity D is exercised mainly through shareholders’ and directors’ meetings. investor G does not have majority representation in both meetings. IFRS 10 B41 indicates that an investor with less than a majority of the voting rights may have de facto control if considering all facts and circumstances the (less than majority) investor has the current ability to direct the relevant activities of Entity D (see the criteria in IFRS 10 B42 – B46), other potential evidence is analysed below.
- However, de facto control does not seem to exist. A minimum of six Class B investors could collaborate and outvote investor G. Similarly, six directors (out of the seven directors not appointed by G) could collaborate to outvote the five directors appointed by investor G.
- Under IFRS 10 B44 example 6, de facto control did not exist where only two other investors needed to collaborate. Under see IFRS B45 example 7, the situation was unclear where 11 other shareholders needed to collaborate.
- Collaboration by six investors falls in between. However, the remaining 17 investors have participated actively in past meetings and, on occasion, outvoted investor G. This suggests that investor G does not have de facto control of entity D [IFRS 10 B45].
- IFRS 10 B46 indicates that if the situation is unclear after considering all factors, there is no de facto control, investor G does not seem to meet the ‘clear’ evidence of de facto required by the standard. The standard states that economic dependence alone does not lead to the investor having power over the investee [IFRS 10 B40].
Point of consideration
As this exercise shows assessing control based on IFRS 10 has become much more of a ‘substance over form’ process, what has really happened in the past and what does this mean for the current situation at hand, it is not an accident that clear is in brackets in the conclusion.
Assessing de facto control for an operating entity
Assessing de facto control for an operating entity
Assessing de facto control for an operating entity Assessing de facto control for an operating entity Assessing de facto control for an operating entity