Table of Contents
- How to determine whether control exists under the rules of IFRS?
- Step 1: Identify relevant activities of an investee and how decisions about those activities are made
- Step 2: Evaluate power
- Step 3: Assess returns
- How to determine whether control exists under the rules of US GAAP?
- Are any entities exempt from consolidation?
- How to account for investments if control does not exist?
Entities may conduct business directly as well as through strategic investments in other entities. It is important to make a distinction between different types of investments as each of these has their own way of being accounted for.
Strategic investments can be distinguished as:
- Investments controlled by the reporting entity, i.e. subsidiaries,
- Investments jointly controlled by the reporting entity and one or more other parties, i.e. joint arrangements,
- Investments which are not controlled or jointly controlled, but over which the reporting entity has significant influence, i.e. associates.
Investments controlled by the reporting entity are accounted for in accordance with IFRS 10 Consolidated Financial Statements under IFRS as adopted by the EU and ASC 810 Consolidation under the US GAAP.
Simplified rule of both standards is that, if an entity controls another entity, it must consolidate, whereas if an entity does not control another entity, it does not consolidate.
How to determine whether control exists under the rules of IFRS?
IFRS 10 establishes a single control model that applies to all entities, including structured entities. Meaning that investor controls an investee 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 investee. Therefore, an investor is required to possess all the three essential elements in relation to an investee:
- power over the investee,
- exposure, or rights, to variable returns from its involvement with the investee, and
- an ability to use its power over the investee to affect investor’s returns.
In many cases, when decision–making is controlled by voting rights that also give the holder exposure to variable returns, it is clear that the investor who holds a majority of those voting rights controls the investee.
Investor holds 100% of the voting rights of an investee, i.e. an operating entity
It is clear that operating and financial policies are the relevant activities of that entity
It is clear that voting rights give power over those operating and financial policies
Whoever has the votes has power
If the voting shares also entitle the holder to returns, the holder has control
In other cases (such as when there are potential voting rights, or an investor holds less than a majority of the voting rights), it may not be so clear. In such instances, further analysis is needed. Thus, it would be useful to take the below steps:
Step 1: Identify relevant activities of an investee and how decisions about those activities are made
Relevant activities are those that significantly affect returns. Usually, these are operating and financing activities of an investee.
Relevant activities could, for example, be:
- Selling and purchasing of goods or services
- Managing financial assets during their life (including upon default)
- Selecting, acquiring or disposing of assets
- Researching and developing new products or processes
- Determining a funding structure or obtaining funding
Decisions about relevant activities include:
- Establishing operating and capital decisions of the investee, including budgets
- Appointing and remunerating an investee’s key management personnel or service providers and terminating their services or employment
Therefore to have control, investor must have power over an investee. To have power, investor must have rights over the relevant activities of an investee. Ultimately, understanding the purpose and design of an investee may help identify the relevant activities, how decisions about the relevant activities are made, and thus, who has the ability to direct those activities and who receives returns from that direction.
Step 2: Evaluate power
To have power over an investee, an investor must have existing rights that give the investor the current ability to direct the relevant activities.
Examples of such rights include:
- Voting rights, including potential voting rights
- Right to appoint, reassign or remove key management
- Right to appoint or remove another entity that directs the relevant activities
- Right to direct the investee to enter into, or veto any changes to, transaction for the benefit of the investor
- Other rights, such as decision-making rights specified in a management contract that give the holder the ability to direct the relevant activities
Furthermore, sometimes a special relationship could exist between an investor and an investee, suggesting that the investor has more than a passive interest in the investee. This does not necessarily mean that power criterion is met, however having more than a passive interest in the investee may indicate that the investor has other related rights sufficient to give it power or provide evidence of existing power over an investee.
Examples of such indicators, which together with other rights may indicate power, are:
- The investee’s key management personnel who have the ability to direct the relevant activities are current or previous employees of the investor.
- The investee’s operations are dependent on the investor, e.g. in the following situations:
- The investee depends on the investor to fund a significant portion of its operations.
- The investor guarantees a significant portion of the investee’s obligations.
- The investee depends on the investor for critical services, technology, supplies or raw materials.
- The investor controls assets such as licences or trademarks that are critical to the investee’s operations.
- The investee depends on the investor for key management personnel, such as when the investor’s personnel have specialised knowledge of the investee’s operations.
- A significant portion of the investee’s activities either involve or are conducted on behalf of the investor.
- The investor’s exposure, or rights, to returns from its involvement with the investee is disproportionately greater than its voting or other similar rights. For example, there may be a situation in which an investor is entitled, or exposed, to more than half of the returns of the investee but holds less than half of the voting rights of the investee.
In assessing whether the investor has power, it only takes into account rights that are substantive, i.e. the holder of the right has the practical ability to exercise that right.
Step 3: Assess returns
To control an investee, an investor must be exposed, or have rights, to variable returns from its involvement with the investee. Returns can be positive, negative or both.
Returns, for example, include:
- Dividends, interest on debt securities and other distributions, and changes in the value of the investment in the investee,
- Remuneration for servicing an investee’s assets or liabilities; fees and exposure to loss from providing credit or liquidity support; residual interests in the investee’s assets and liabilities on liquidation of that investee; tax benefits; and access to liquidity that an investor has from its involvement with an investee,
- Returns that are not available to other investors, e.g. an investor uses its assets in combination with the assets of the investee to achieve economies of scale, save costs, source scarce products, gain access to proprietary knowledge or to enhance the value of the investor’s other assets.
An investor also evaluates whether returns are variable and how variable those returns are based on the substance of the arrangement (regardless of the legal form of the returns). Even a return that appears “fixed” may actually be variable.
- An investor that holds a bond with fixed interest payments. The fixed interest payments are considered variable returns, because the investor is exposed to the credit risk of the investee. How variable these returns are, depends on the credit risk of the bond.
- Fixed performance fees received for managing an investee’s assets are also considered variable returns as the investor is exposed to the performance risk of the investee. That is, the amount of variability depends on the investee’s ability to generate sufficient income to pay the fee.
Returns may be an indicator of control. The greater an investor’s exposure to the variability of returns, the greater the incentive for the investor to obtain rights that give the investor power.
Illustrative example - Control via the right to appoint a majority of the management board
- Investor A owns 40% of the shares in investee B.
- Based on the shareholder's agreement, investor A has power to appoint or remove the majority of investee B's management board members, thus controls the composition of investee B management board.
- Investee B's articles of association state that decisions over acquisitions and disposals of assets in an amount higher than 60% of the fair value of investee B's total assets, and the decisions to liquidate investee B, are subject to shareholder vote.
- All other decisions over the relevant activities require majority approval by the members of the management board.
Analysis and conclusion:
Investor A has power over investee B, because it has the ability to control the composition of investee B's management board. Although certain decisions require shareholders voting, and investor A has control of only 40% of the votes, such decisions seem to be protective in nature as they relate only to fundamental changes to an investee's activities or apply only in exceptional circumstances. Therefore, investor A has control because it is able to direct investee B's relevant activities via power over the management board and thus is able to affect its returns. Investee B is the subsidiary of investor A and, although having 40% ownership, investor A would consolidate investee B and allocate 60% to non-controlling interest.
Illustrative example - Determining the investor with control
- Investor X holds 60% of the voting rights of investee Z.
- Investor Y holds 40% of the voting rights of investee Z and has a fixed-price option to acquire half of X’s voting rights. The option is currently exercisable and valid for the next two years.
- Option is deeply out of the money and expected to remain so over the exercise period.
- Investor X has been exercising its votes and is actively directing the relevant activities of Z.
Analysis and conclusion:
Investor Y has a currently exercisable option to purchase additional voting rights, however the conditions associated with that option are such that the option is not considered substantive. Investor Y is believed to have no incentive to exercise the option as its exercise price is deeply out of the money and is expected to remain so for the two-year exercise period.
Investor X is actively directing the relevant activities of investee Z, thus indicating it has power over the investee Z. As investor A has the power to direct the relevant activities, it also has the ability to affect its returns and thus has control over investee Z. Investor X consolidates investee Z and allocates 40% to the non-controlling interest.
How to determine whether control exists under the rules of US GAAP?
Under both, IFRS and US GAAP, control is the basis for consolidation. In contrast to IFRS where single control model applies to all entities (including structured entities, i.e. variable interest entities (VIE) under the US GAAP), the latter provides for two consolidation models:
- Variable Interest Model, and
- Voting Model.
Regardless of the type of entity an investee is (corporation, partnership, limited liability company, trust), investor always starts its assessment for consolidation with the Variable Interest model, which enables the investor to determine whether the investee should be evaluated for consolidation purpose based on variable or voting interests.
Voting Model is divided into two categories:
- Consolidation of corporations, and
- Consolidation of limited partnerships and similar entities.
The first is based on a general rule that an investor holds more than 50% of the voting shares of an investee, whereas in case of the second, a single limited partner who has the ability to exercise substantive kick-out rights, will consolidate.
Under the Variable Interest Model, however, investor has control, if it has both:
- Power – i.e. power to direct the activities that most significantly impact the investee’s economic performance, and
- Benefits – i.e. investor has the obligation to absorb losses of, or the right to receive benefits from the investee that could potentially be significant to the investee.
In the evaluation of applicability of Variable Interest Model, it would be helpful to consider the below questions:
- Does a scope exception to consolidation guidance apply?
- Does a scope exception to the Variable Interest Model apply?
- If a scope exception does not apply, does the investor have a variable interest in an investee?
- If the investor has a variable interest in an investee, is the latter a VIE?
- If the investee is a VIE, does the investor have a controlling interest in the investee (i.e. the power and benefits)?
Are any entities exempt from consolidation?
IFRS 10 provides the following exemptions from consolidation:
- Intermediate parent meeting the following criteria:
- It is a wholly–owned subsidiary, or a partially–owned subsidiary of another entity and all its other owners have been informed about and agree,
- Its debt or equity instruments are not traded in a public market,
- It did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market, and
- Its ultimate or any intermediate parent prepares consolidate financial statements available for public use and in compliance with IFRSs.
- Employee benefit plans and employee share trusts – i.e. post–employment benefit plans or other long–term employee benefit plans to which IAS 19 applies
- Investment entities - shall measure investments in subsidiaries at fair value through profit or loss in accordance with IFRS 9 Financial Instruments. It should be noted that the parent of an investment entity is required to consolidate all entities that it controls, including those controlled through an investment entity subsidiary, unless the parent itself is an investment entity.
Under the US GAAP, ASC 810 provides for the following exceptions to the consolidation:
- Employee benefit plans,
- Certain investment entities (guidance for determining whether the company is an investment company differs from that provided under IFRS),
- Governmental organisations (e.g. a state or local governmental agency, airport authority),
- Money market funds which are required to comply with or operate in accordance with requirements that are similar to those included in Rule 2a-7 of the Investment Company Act of 1940.
How to account for investments if control does not exist?
As was explained in the beginning of this article, entities could, in addition to investments made into subsidiaries, also have other investees, which are not controlled by the investor. If an investor does not have control over an investee, it does not consolidate the investee but would account for such investments based on the guidance available for each individual type of investment.
These are arrangements where two or more parties have joint control, which means that decisions about relevant activities of joint arrangement are only made unanimously. Typically, joint arrangements are separated into joint operations and joint ventures. In case of joint operations, parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. In case of joint venture, parties that have joint control of the arrangement have rights to the net assets of the arrangement.
Joint ventures are accounted for using the equity method whereas in case of joint operations, investor accounts for the assets, liabilities, revenues and expenses relating to its interest in a joint operation in accordance with the applicable guidance to the particular assets, liabilities, revenues and expenses.
Refer to the guidance in IFRS 11 and IAS 28 / ASC 323 and ASC 808 for more details.
Investments in associates (entities over which investor can exercise significant influence)
Associates are entities over which an investor has significant influence, i.e. the power to participate in the financial and operating policy decisions of the investee but does not have control or joint control over those policies. It is presumed that ownership interest between 20% and 50% reflects existence of significant influence, however similarly to control assessment, the size of the ownership interest does not always demonstrate that significant influence exists.
Investments in associates are accounted for using the equity method.
Refer to the guidance in IFRS 11 and IAS 28 / ASC 323 for more details.
Other equity investments that do not fall within the criteria of the above are accounted for at fair value. US GAAP gives a measurement alternative for such investments where fair value is not readily determinable and which do not qualify for the practical expedient in ASC 820, to account for these investments at cost less any impairment.
Refer to the guidance in IFRS 9 and IAS 39 / ASC 321 for more details.
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