IFRS 12 provides one comprehensive disclosure standard for equity instruments in Subsidiaries, Joint arrangements (Joint operations and Joint ventures), Associates and Structured entities. Hence, management needs to exercise a certain degree of judgement in determining whether a new investee is controlled and therefore consolidated. For instance, disclosure and internal documentation is required for how voting rights are evaluated and whether it is a principal or an agent etc.
Classifying these equity instruments requires time, effort and the exercise of considerable judgement based on a comprehensive understanding of the business, operations, and legal rights and obligations the investing entity has obtained in the investee. Also these judgements have to be re-assessed during any significant financial close. This is a true collaboration between the preparer(s) of the Consolidated Financial Statements and management, operations personnel and legal counsel or parent and investees.
The diagram below shows the interaction between IFRS 10, 11 12 and IAS 28 which summarises the consolidation requirements and classification of the different types of investments in equity instruments.
An investing entity may have power even though it cannot yet exercise its decision-making rights. 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.
Power over relevant activities
An investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities of the investee (IFRS 10 10). Can an investor have power currently if its decision-making rights relate to an activity that will only occur at a future date?
X and Y set up a new company to construct and operate a toll road. X is responsible for the construction of the toll road, which is expected to take two years. Thereafter, Y has authority on all matters related to toll road operation. Is it possible for Y to have power over the company during the construction phase although X is responsible for construction and has authority to make decisions that need to be made currently?
Y may have power currently even though it cannot yet exercise its decision-making rights. 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, – see above a) – d.
Also think of:
- De facto control,
- Control with put and call options,
- Debt restructuring in structured entity with limited operations,
- CMBS serviced by a third party on behalf of investors,
- Control of an issuer of credit linked notes and risk enhancing derivatives.
Re-assessment of power
Two years have passed and the toll road has been fully constructed; and Y has entered bankruptcy, and X has assumed management of the toll road operations and is in discussions with the national roads authority to continue managing those operations.
Should X reassess whether it has control of the investee in this situation?
Yes, X should make this reassessment because there has been a change that affects the power criterion (IFRS 10 B80).
A structured entity (SE) was set up by a sponsoring bank to invest in bonds. The most important activity that affects the returns of the SE is the bond selection process. The bonds were selected upon set-up of SE by the sponsoring bank, and the incorporation documents state that no further bonds may be purchased. No further bond selection decisions are therefore required after the SE is set up.
Does the sponsoring bank have power over the SE solely by virtue of its power to select the bonds in which the SE invests?
Asset selection, on its own, is unlikely to give the sponsoring bank power in this scenario. The bonds cannot be replaced, so the power to select bonds (the relevant activity) ceased when the SE was established. However, the sponsoring bank’s active involvement in the design of the SE indicates that the bank had the opportunity to give itself power. All of the contractual arrangements related to the SE and other relevant facts and circumstances should be carefully assessed to determine if the bank has power over the SE (IFRS 10 B51). Power might arise from rights that are contingent on future events.
The sponsoring bank may have power if it can make decisions only upon a contingent event but it cannot make any decision at this moment.
When the sponsoring bank can direct an activity that will only occur in the future upon the occurrence of an event, that power should be considered even before the occurrence of that event (IFRS 10 B13; example 1). Contingent power is a key consideration in assessing who controls those structured entities where no decisions may be required or permitted unless the contingent event occurs (IFRS 10 B53). Contingent power is not necessarily protective only (IFRS 10 B26).
Note: The owners’ interests in structured entities are presented as liabilities of the consolidation entity, and as such there are no non-controlling interest for these structured entities in consolidated equity.
Subsidiaries, Joint arrangements and Associates
Subsidiaries, Joint arrangements and Associates
Subsidiaries, Joint arrangements and Associates Subsidiaries, Joint arrangements and Associates Subsidiaries, Joint arrangements and Associates