The International Accounting Standards Board (IASB) recently issued a new standard, IFRS 10 Consolidated Financial Statements, that is effective for annual periods beginning on or after 1 January 2013.
IFRS 10 replaces the part of IAS 27 – Consolidated and Separate Financial Statements that addresses the accounting for consolidation. What remains in IAS 27 after the implementation of IFRS 10 is the accounting for subsidiaries, jointly controlled entities and associates in the separate financial statements.
The aim of IFRS 10 is to establish a single control model that is applied to all entities including special purpose entities (SPEs). The changes require those dealing with the implementation of IFRS 10 to exercise significant judgement to determine which entities are deemed to be controlled and, therefore, require consolidation by the parent company. IFRS 10 may change which entities are within a group as a result of the new definition of control.
The aim of IFRS 10, which is effective for annual periods beginning on or after 1 January 2013, is to establish a single control model that is applied to all entities including special purpose entities
The IASB introduced these changes partly to respond to the financial crisis, when there was criticism of the accounting rules that allowed certain entities to remain off-balance sheet.
Highlights of IFRS 10
IFRS 10 will not change the consolidation procedures but will change whether an entity is consolidated, by redefining the definition of control.
Meaning of Control under IFRS 10
An entity (investor) is considered to control another entity (investee) under IFRS 10 when it is exposed or has rights to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the entity in which it has an investment.
For an investor to control an investee, the investor must possess the following:
- Power over the investee, which is describe as having existing rights that give the current ability to direct the activities of the investee which significantly affect the investee’s returns.
- Exposure or rights to variable returns from its involvement with the investee.
- Ability to use its power over the investee to affect the amount of the investor’s returns.
Assessing who has control
Where decision-making is controlled by voting rights, and those voting rights entitle the investor to returns, then it is clear that whoever holds a majority of those voting rights will control the investee.
However, in certain cases such as for SPEs it may not be clear whether the investor controls the investee as the investor may not hold a majority of the voting rights in the investee. In these instances, further analysis is needed and each of the factors above needs to be considered in more details to determine if the investor controls the investee.
The diagram below illustrates this assessment:
|Power||Returns||Link between power and returns|
|An assessment should be made to determine which party has power or if the power is shared.
Power arises from rights which may include :
|Assess whether the investor has rights to variable returns from its investment in/involvement with the investee.
|Identify which activities of the investee are considered to be relevant in affecting the investor’s return and also determine whether the investor has power to influence these activities.
When assessing whether the investor has control over the investee, the investor shall initially consider the voting rights and potential voting rights it holds. Common examples of potential voting rights include rights that result from the exercise of an option or conversion feature.
Potential voting rights are only considered if they are substantive in that the investor has the practical ability to exercise the right. Barriers to exercising options such as exercise periods and financial penalties, if exercised during a certain timeframe, should all be considered when determining if the investor has control.
Where one investor does not have a majority of the voting rights other factors need to be considered, such as:
- Agreement with other vote holders
- Other contractual agreements
- practical ability to direct
As mentioned an investor must have rights or be exposed to variable returns from its investment in the investee. These returns can be both positive and negative and exposure to risk both the upside and the downside should be considered.
Links between power and returns
Returns are an indicator of control, as the greater the investor’s exposure to the variability of returns with the investee, the greater the incentive for the investor to obtain rights that will give the investor power.
This link between power and returns is essential in determining if the investor has control over the investee. An investor that has power over an investee but cannot benefit from that power will not control the investee. Likewise, an investor that receives a return from the investee but cannot influence and direct the activities of the investee will be deemed not to control the investee.
IFRS 10 Decision Tree
The decision tree below gives an overview of the analysis to be performed in order to determine if the investor has control over the investee.
This publication, prepared by PKF International Ltd. (Abdul Islam, Senior Manager IFRS Specialist), has been distributed on the express terms and understanding that the authors are not responsible for the results of any actions which are undertaken on the basis of the information which is contained within this publication, nor for any error in, or omission from, this publication.
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