Instruments to Establish Control over a Subsidiary
Introduction
A standard financial reporting procedure allows actors across all levels of management in a business to make an informed decision. The International Accounting Standards Boards (IASB) adopted an International Financial Reporting Standards that aims to provide consistent and transparent financial information that indicates an accurate and fair status of a business entity. IASB establishes standards that address various accounting aspects of a business as it seeks to streamline accounting reporting procedures. These standards are a set of rules and guidelines for use in the preparation and reporting of financial information. For instance, IFRS 10 provides a set of regulations on the development and presentation of the consolidated financial statements (Australian Accounting Standards Board, 2016). This paper aims at analyzing the instruments used by investors and situations upon which they exercise control over an investee. The article also seeks to examine the implications that the use of such standards has on the capital markets and various stakeholders in a business entity. Additionally, it describes the attributes associated with IFRS 10 standards and its use.
Furthermore, this paper aims at analyzing aspects that constitute the IFRS 10 standards. Considering that IFRS 10 standards are principles-based, necessitating those involved in any business engagement to exercise professional judgement, the paper would examine the danger that may be associated with such a system. Since business entities can quickly adopt principles than rules, IFRS easily appeals to many business entities as many countries in the developing nations are angling to embrace such a system. Moreover, full acceptance and use of IFRS have been realized through its attendant benefits, such as attaining informational symmetry. The IASB expects to remove barriers that businesses face in their operation, increase accessibility to capital, and remove cross border hindrances to investment. Practer (2017) opines that IFRS implementation is associated with “enhanced access to capital, improved liquidity in the financial markets and comparability of financial information (p. 32).” The users of the financial information can make well-informed decisions; lending to firms that apply the standards is a natural choice since lenders’ confidence is upped by the inclusion of loss-making entities in the consolidated financial statements. And the financial information is useful when it meets both the predictive and confirmatory threshold. Data captured in financial statements is used by the management, investors, and key stakeholders in making decisions that affect the operation. Pacter (2019) further asserts that “markets allocate funds more efficiently, and firms can achieve a lower cost of capital (p. 32).”
International Financial Reporting Standards 10
The International Financial Reporting Standards (IFRS) are reporting guidelines set forth by the International Accounting Standards Boards that imputes consistency and transparency in the financial reporting and transactions undertaken by publicly accountable companies (Australian Accounting Standards Board, 2016). IFRS 10 is one of the standards which require a parent entity to prepare and present a consolidated financial statement for its subsidiaries. IFRS 10 provides that the financial information submitted by the companies is transparent for investors and can allow comparability of businesses across the market. Despite IFRS’s extensive usage, the U.S. and Canada still use Generally Accepted Accounting Principles; other countries too are yet to adopt the IFRS standards. In making a single definition of control in IFRS 10, IASB has made the control concept easy for business entities (The World Bank, 2017). The U.S. uses GAAP, a rule-based system that does not require much professional judgement but on accounting rules (Practical guide to IFRS Consolidated financial statements: redefining control, 2011). Even though the U.S. uses GAAP, it compares with IFRS standards to achieve convergence and uniformity in the global market. Implementation of IFRS 10 should bring congruence in the information which facilitates actors in capital markets can use for decision making.
The need for economic integration necessitated the development of a common accounting standard during the post-world war. The IASB, in its formation in 1973, envisaged an economically integrated market operated by a common set of guidelines and standards accepted globally (Panagiotis, 2017). Through frequent accounting reporting, IFRS standards aim at addressing cross-border barriers to investments, reducing the cost of attaining capital and improving the quality of the financial information among the member countries ( Ionascu et al., 2018). Since quality and symmetric financial information guide investors in making better decisions, the standards themselves have conditions required for their adoption and application even though the terms pertain to principles rather than rules (Van zijil & Maroun, 2017).
IFRS 10, in particular, defines the relationship that exists between an investor and investee. The standard provides guidelines for the presentation of consolidated financial statements by a parent entity (“Illustrative IFRS Consolidated Financial Statements 2019- PwC”, 2019). Consolidation entails an act of combing assets, liabilities, expenses and cash-flows of a parent entity and a subsidiary (). Before IFRS 10 adoption, the IAS 27 provided guidance on the accounting for subsidiaries on consolidation (Australian Accounting Standards Board, 2016). The change sought to enable convergence with the U.S. GAAP, which promotes its use and allows comparability with other standards. The standard is built on a consolidation model that outlines how control is affected and which the parent entity should control entities. Further, using power as a basis for consolidation, the standard lays out scenarios where consolidation is not applicable. According to Australian Accounting Standards Board (2016), an exemption to consolidation is laid out in IFRS 10, which includes when the “parent entity is a partially or wholly-owned subsidiary, and owners are not opposed to its non-consolidation. Furthermore, when the parent entity’s debt or equity is not traded publicly, or the parent entity did not file and is not filing its financial statements to issues publicly traded instruments, the parent is exempted from consolidating the financial statements of a subsidiary. the intermediate parent of the parent entity produces IFRS consolidated financial statements for public use (p. 8).”
Implementation of the new standards requires a process that users should be ready to undertake. Firstly, acceptability hinges on the effectiveness of an accounting system to address the accounting needs of an entity. Just as laws and rules create order, accounting standards should also create a harmonious understanding of procedures and guidelines that consider diverse business activities and the evolving nature of business. Before the adoption of IFRS 10, 11 and 12, the European Commission set up a study under the European Financial Reporting Advisory Group (EFRAG) to ascertain the reliability, relevance, comparability, and understandability of the new standards where the results of the study confirmed the attributes. The study concluded that adopting the IFRS standards outweighs the cost for implementation (EFRAG 2012, as cited in Pacter, 2017). And making adoption of the standard mandatory has led to wide acceptability. From the outlook, a country’s approval of the standards requires adjustments for which not only are costs attached but also take time to streamline (“IAS Plus — IFRS, global financial reporting and accounting resource,” n.d). The study conducted by EFRAG further notes that implementation depends on some salient features not limited to the number of investees, nature of ownership held by investee, and other structured entities run by the investee (EFRAG 2012, as cited in Pacter, 2017).
Since it is a requirement for a parent entity to present a consolidated financial statement, IFRS 10 also gives guidelines when a parent is no longer required to present the statement when it loses control of the subsidiary. Loss of control arise from arrangements that a parent and subsidiary may enter into to achieve a commercial effect when they operate as a single entity, when such an arrangement to operate as a single entity is economically feasible when considered with other future arrangements, and when such an arrangement is informed by the occurrence of other future events. The i
Application of IFRS 10 is exempted in the circumstances where a parent entity is also a subsidiary of an intermediate parent. This also applies to a case where the shares of the parent entity are not publicly traded, employee benefit plan entities, and for investment entities for which each subsidiary should present a fair view based on their profit and loss statements (Grant Thornton, 2017). Apart from these exemptions, a wider application of IFRS 10 is subject to the social, economic and political condition prevailing in a region. For countries that have adopted the standards, the uses of the standards are enforced by the legal requirements, where in some cases, presenting the consolidated financial statements allows a bottom-up approach to financing business entities.
Control in Consolidation
The concept of control is expressed by a control model. Control is the basis for consolidation; by not consolidating financial statements of a subsidiary that it does not control, a parent entity gives its true and fair view. According to Gluzova (2016), the concept of control was first captured in ISA 27 which predicated control on the voting rights whereas IFRS 10 consider control as, “the power to oversee the investee, the exposure to variable returns from the investee, and the ability to use power to affect returns (p. 19).” An investor’s power over investee is manifested through ownership of substantive rights. Such an investor can influence activities pertaining to investee’s returns. Determining existence of control involves identifying relevant activities executed by the investee, the decision-making process, and finding out the purpose and design of an investee (“IAS Plus — IFRS, global financial reporting and accounting resources,” n.d). As outline in a control model, holding of majority voting rights
Instruments used for control
- Through the use of other parties, de facto agents
An investor can exercise control through delegating its decision-making role and exposure to a de facto agent. A party may stand in the place of the another party when the party assuming the role is a recipient of interest in the entity as a contribution from an investor, furthermore, a party acting as a de facto agent when such party solely relies on the investor to fund their operations (KPMG- Consolidation: a new single control model, 2011). Again, a party with close link with an investor may act as a de facto agent. An investor may assume de facto control when it enters into a contractual agreement with other vote holders upon which such an agreement can impart voting rights to the investor. Assessing whether control is exercised through de facto agents is not easily possible as it may prove difficult determining substantive rights and ownership interests.
- Treatment of portion of an investee as separate entity
A portion of an investee can be regarded as a separate entity by an investor who considers that portion as subsidiary upon which they can exercise control. Specified assets are considered separate entity when they are the sole source of payments for an investor’s interest in the investee, and it is only the investor who has the entitlement to the assets and the cash flow realized (Under Control? A practical guide to applying IFRS 10 Consolidated Financial Statements, 2017). In the event there are specified assets for which only the parties with specified liabilities have the rights to the returns from the assets and liabilities and the liabilities are not payable by other parties as they are ring-fenced from overall investee, an investor may assume control over that separate entity which is ring-fenced (Australian Accounting Standards Board, 2016).
- Acting as a principal
This instrument of control is defined through the decision-making authority that an investor exercises over an investee, the rights held by other governing bodies, the compensation an investor is titled to, and the exposure to variability of returns from other interests. As a principal, an investor bears wide decision-making privileges, in addition, the fees and percentage of investment charged as their professional fees gives an investor exposure to variability of the returns from the activities of firms, which gives an investor control over the investee (IFRS 10. B63). Also, a principal tends to have extensive interests that relates to the variability to returns. Since the principal work for its own benefits, an investor in that capacity has control to influence major decisions targeting the variable returns such as the performance-related fees.
- Investor’s involvement with the investee
When such an involvement bears a result on the investee’s performance, then the investor wields control. Involvement with the investee from the start gives an investor opportunity to craft rights that may grant it power over the investee. Likewise, The scope of the investor’s decision making authority, the magnitude of an investor’s economic interests, and rights held by other parties dictates the level of involvement and relationship with an investee. For instance, an investor’s involvement to follow up on default receivables aims at absorbing variability from the investee, and therefore exposing the investor to risks associated with the conduct of the investee.. For instance, an investor, who as well act as a decision maker is in control when there is no single that holds rights such removal rights which they can apply even without cause.
- Investor’s power over relevant activities
The substantive rights held by the investor are exercised when actions which involve a substantive decision can only be made by the investor. The ability to carry out such relevant activities which require substantive decisions gives investor control. For instance, an investor may come in to manage defaulted receivables which have a huge impact on the returns for which an investor is incapable due to the limitations of decisions. An investor with substantive rights to direct the prevailing relevant activities demonstrates that ability by stopping any attempt by other shareholders from affecting any significant impact to the operation of key tasks since there is a mechanism that disallows attempt by other shareholders to make any significant change in the operation of an entity under thirty days during which an investor exercises control over the investee.
Apart from exercising power over relevant activities through majority voting rights, an investor may direct appropriate activities through contractual rights or other rights. An investor who uses control associated with this right, s further illustrates using.
- The purpose and design of the investee and its relevant activities
The elements for engagement set out during investee’s inception spells out rights held by each party. A constitution and contract binds a structured entity to its purpose set at inception. When the terms of the contract spells out activities which relate to investee, they are relevant activities for which an investor exercises decision rights regardless of the activities happening in their structured entity or not. Still, at inception, the risks to be incurred should be determined what extent the investee can bear and what is passed to the investor and the likely impact of such risks on variable returns. An investor exercises control upon such occurrences. An investor may choose to assign itself rights that give them power during the design of the investee, in the case where majority voting rights do not apply, an investor may further determine the risks that the investee should bear and whether such risks may be passed to the investor. Similarly, when the investee is designed to have use of equity instruments such as shares as a means of control, an investor seeking to control the investee should accumulate shares that grant it majority voting rights to direct relevant activities. The purpose and design also assist in determining which activity significantly affect returns and hence the power to control when two investors collude to form an investee where each of the investor performs a relevant activity.
- Investor’s rights to variable returns and the ability to affect the returns
An investor controls the investee when he has power, has rights to variable returns from their involvement with the investee, and has power over the investee to affect the amount of the returns ((“IAS Plus — IFRS, global financial reporting and accounting resource,” n.d.). An investor owning rights to remove an entity that perform a relevant activity, or the rights to veto changes on the operations of the investee can do with the intention to affect returns for their benefit. The returns include te financial returns that can be realized or synergy benefit their involvement creates.
- Changes to facts and circumstances of control
Markets are subjected changes that may affect the investor’s exposure, or rights, to variable returns from their involvement with the investee (IFRS 10. B83). Changes pertaining to the position of the investor either as an agent or principal impact on the level of capability to assume control (IFRS 10. B84). Situations in the market which affect the elements of control are likely to
- Use of equity instruments
The investor can use it majority voting rights to affect investee’s operating and financing policies. Additionally, an investor may determine level of control by the risk that the investee is exposed to and through the risks that risks that an investee passes to other parties. Instruments such as ordinary shares grants holders voting rights enable them to direct decisions as is the case of governance structures (Grant Thornton, 2017).
- Contractual arrangement with other vote holders
Even in the circumstances where an investor does not hold majority rights, a contractual arrangement with enough vote holders gives an investor voting rights. For instance when Investor C has forty percent voting rights and five other shareholders each owning twelve percent voting rights, if investor C has a contractual arrangement to consult other shareholders, investor C may collude with one shareholder to attain majority voting rights, and influence major activities determined through voting rights. Existence of contractual arrangements that grants holders the ability to direct decisions on relevant activities hence power.
- Existence of a linkage between power and returns
If there is no link between power and returns, then a fund manager cannot consolidate funds under their watch due to their inability to control. A link allows a fund manager to use its power to affect returns, using the delegated power as a principal to exercise control.
- Potential voting rights
Rights arising from forward contract or convertible instruments can grant power to an investor when such rights are exercisable, and the holders can demonstrate a practical ability for their use. The relationship between the holder of potential right and the investee, the expectations arising out of the terms of the agreement as set out in design and purpose of the rights can put holder of the potential rights on the vantage position. Potential voting rights exercisable in the future can also grant control when such rights are performed at an earlier date before a major decision regarding relevant activity is undertaken (Grant Thornton, 2017).
Elements of Control
Power over an Investee
IFRS 10 defines power as “Existing rights that give the current ability to direct the relevant activities.” Owning rights bear power, although holding protective rights only seeks to protect the interest of the holder. This right is exemplified when a lender seizes control of assets owed by a borrower; holding such a right by itself does not confer power to the holder. IFRS 10 .B 15 lists rights that give its holders power such as the voting rights of an investee; right to appoint or remove crucial members within the investee’s management team who influences relevant activities; rights pertaining to removal of another entity that may control relevant activities; rights to direct an investee to enter or veto transactions that benefit an investor; and decision-making rights. The power of any of these rights is felt when a right is put into practical use
Holding a substantive right becomes effective when they the right is put in use at a point when a decision for its use is required. This provision necessitates a potential voting rights can be activated by the time voting is required to make a major decision (Thornton, 2019). Applicability of this concept is however hamstrung by a contrasting mechanism that supports it and what the right may imply before it is exercised. Despite holding substantive rights, its applicability and practicality is determined by, firstly, the existence of barriers which may impede use of these rights such penalties that restrict exercising the rights (IFRS 10. B23 (a). Secondly, the requirement of the rights to be exercised jointly or at an individual level dictates the effectiveness of such rights. This provision for the professional judgement of knowing substantive rights asserts further that the more are parties to assent to a right, the less likely it is to bear substantive qualities (IFRS 10. B23 (b). It requires more judgement to establish the practical ability of owners of potential voting rights to execute those rights (Consolidation: a new single control model, 2011). Lastly, holders of the rights are likely to put the rights into use depending on the benefits that the rights accrue to the holders. Further, an investor who holds more than fifty percent of voting rights of an investee has an automatic power. On the contrary, there is an instance when a majority of voting rights do not confer power. Still, an investor should consider the dispersion between their voting rights and those of other vote holders. An investor uses its voting rights to influence the relevant activities undertaken through a voting process. Similarly, an investor uses voting rights to determine the outcome of appointments carried out through voting (Panagiotis, 2017 ). The exemptions to these voting rights include instances when contracts or governments direct relevant activities. An investor may still demonstrate passive interest when an investor constitutes management personnel to act on their behalf.
Furthermore, the demonstration of power applies to relevant activities that affect the returns and is dependable on the nature of the business. For example, the purchase and sales of goods and services or an engagement in research for new products design are likely to impact the returns of an entity. The concept of relevant activities is also illustrated when an investor engages gets involved in the collection of defaulted loans, which possibly affect the returns. The ability to direct related activities gives investors a de facto control over an investee. An investor capable of exercising de facto control, on the other hand, should own majority holdings. Using the power of investee requires judgement by the investor to determine which activities are relevant and are likely to affect returns and whether such activities require an investor’s current ability or the events are dependent on some circumstances upon which the direction of the investor should be sought.
Exposure or rights to variability in returns from involvement with the investee
Some of the variable returns envisaged by the standards include the pay for servicing investee’s liability and assets, tax benefits, fees and exposure to the loss incurred in providing credit and the profits out of the cooperation between investor and investee. An investor can use their power to determine to what extent a return is variable, and further whether such variability is material on the overall returns.
The capability of an investor to use their power to affect their returns through involvement with the investee dictates the efficacy of the power they hold and the extent to which they can exert control. This capability also dictates principal – agent relationship where an investor’s ability to use power for their benefit makes them a principal. The investor’s ability to use control affects the returns on the variables. If an investor operates as a principal, an investor can use his decision-making rights to make choices likely to benefit them. In other circumstances, an investor may delegate his role to another party; this may deny the investor power. In such a scenario, the investor may not give an agent all the rights and, therefore, not capable of controlling an investee.
Ability to use power to affect returns
An investor with decision-making capacity can influence the relevant activities, consequently affecting performances. To show control, the holder of power should be able to use their power to affect returns failure to which owning power alone does not confer control.
Implications of Adopting IFRS 10
The scope of developing the IFRS 10 standards arose from the need for common accounting standards which could apply across many sectors in the market. The standard would also clarify the inconsistency in consolidation under IAS 27. Arguably, IFRS 10 is lauded for its comprehensiveness and ability to offer guidelines and principles that present a true and fair view of the business, giving investors faith and confidence that their interests are protected. Transparency in financial statements and allowance for comparability across the sector presents would-be investors in making better investment decisions. Management can make informed projections on their company’s future profit postings. Information and assist are outlining risks that a business may face in the future, where appropriate information can be taken.
Among the challenges to use of IFRS 10 include its retrospective application. A lot of changes occur within the business environment that makes it cumbersome to access past information on a business entity. Applying IFRS 10 require entities to incorporate other standards, including IFRS 11on Joint Arrangements; IFRS 12 on Disclosure of Interest in Other Entities; and an amended version of IAS 28 Investments in Associates and Joint Venture. The initial cost requirement puts a strain on entities. Consolidation decisions, dependent on judgement and assumptions made by an investment manager in the absence of investors with majority voting rights, can interfere with the uniformity of a business. Additionally, control as a basis for consolidation keeps changing due to circumstances in the capital markets, necessitating the need for continuous reassessment by investor managers. For instance, when decision-making rights lapse or when an investor ceases control that may impact the variable returns
Transitioning to IFRS 10 requires business entities to build a robust infrastructure that will address internal control mechanisms necessary, conduct training to familiarize members of staff on the new accounting systems, and inform external stakeholders on the latest changes and the resultant impacts. Proper understanding of the accounting features incorporated in the new standards requires input from the auditor and preparer conversant with the new system. Still, business entities may need to reassess its adoption; a business may want to clarify what relevant activities an investor can undertake, harmonizing with what other business entities do (Lopes & Lopes, 2019). Still, there are ongoing costs that entities incur during implementation, such as audit fees and cost for monitoring the relevant activities. Adoption presents an array of benefits to a business entity. As a principle-based standard, it gives users the freedom to exercise professional judgement in decision-making.
The adoption of IFRS 10 presents a better opportunity that businesses can enjoy. An accounting standard that avails information to all the users instills a level of confidence in the users of such information.
The standards open grounds for establishing excellent communication with users through the requirements for an accurate and fair value of their businesses (Gluzová, 2015). Another implication for the use of this system presents to companies with better policies aimed at addressing misstatement scenarios of financial information. Still, the uptake and worldwide use depend upon the ability to tackle technical requirements in diverse setup.
Case study
References
Australian Accounting Standards Board. (2016). Consolidated Financial Statements (pp. 30-42). Commonwealth of Australia.
Illustrative IFRS Consolidated Financial Statements 2019- PwC. https://www.pwc.com. (2019). Retrieved 10 June 2020.
Gluzová, T. (2015). THE ADOPTION OF IFRS 10 AND ITS IMPACT ON THE SCOPE OF CONSOLIDATION. Acta Academica Karviniensia, 15(4), 18-27. https://doi.org/10.25142/aak.2015.039
Grant Thornton 5-32. (2017). Under control? A practical guide to applying IFRS 10 Consolidated Financial Statements [Ebook]. Retrieved 10 June 2020from.
IAS Plus — IFRS, global financial reporting and accounting resources. Iasplus.com. Retrieved 10 June 2020, from https://www.iasplus.com/en.
Ionascu M., Ionascu I., Sacarin M., Minu M. (2018). Benefits of global financial reporting models for developing markets: The case of Romania. PLoSONE 13(11):e0207175.https://doi.org/10.1371/journal.pone.0207175
Klimczak, K., & Krasodomska, J. (2017). The Role and Current Status of IFRS in the Completion of National Accounting Rules – Evidence from Poland. Accounting In Europe, 14(1-2), 158-163. https://doi.org/10.1080/17449480.2017.1302596
KPMG. (2011). Consolidation: a new single control model [Ebook] (14th ed.). Retrieved 10 June 2020
Lopes, A., & Lopes, M. (2019). Effects of adopting IFRS 10 and IFRS 11 on consolidated financial statements. Meditari Accountancy Research, 27(1), 91-124. https://doi.org/10.1108/medar-12-2017-0253
Panagiotis, G. (2017). A Qualitative Analysis of the Global IFRS Adoption. Trustees Perspective. Human And Social Studies, 6(2), 59-70. https://doi.org/10.1515/hssr-2017-0014
Pacter, P. (2017). Pocket Guide to IFRS Standards: the global financial reporting language [Ebook] (pp. 23-178). IFRS Foundation. Retrieved 11 June 2020,
Pricewaterhousecoopers. (2011). A practical guide to IFRS Consolidated financial statements: redefining control [Ebook]. Retrieved 10 June 2020
The World Bank. (2017). IFRS Foundation and World Bank Deepen Cooperation to Support Developing Economies in Their Use of Reporting Standards.
Van Zijl, W., & Maroun, W. (2017). Discipline and punish: Exploring the application of IFRS 10 and IFRS 12. Critical Perspectives On Accounting, 44, 42-58. https://doi.org/10.1016/j.cpa.2015.11.001