Definition of “Control” under IFRS 10
By Adil Khan
Manager Audit and Assurance Services,Mazars Abu Dhabi, UAE
This article focuses exclusively on the definition of “the Control” as defined under IFRS 10 “Consolidated Financial Statements”. The change to the definition of control in IFRS 10, have a significant effect on entities making investments in companies’ equity. Investors will apply more comprehensive guidance of IFRS 10 when determining whether they control investees’ and consequently, whether they are required to consolidate their books in their financial statements.
This article spotlight on the practical issues that required immediate attention, when applying the new definition of the control and provides a number of hypothetical examples.
“An investor, regardless of the nature of its involvement with an entity, shall determine whether it is a parent by assessing whether it controls the investee”.
As per IFRS 10, a Company controls another entity 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.
The control principle in IFRS 10 sets out the following three important elements of control:
- Power over the investee
- exposure, or rights, to variable returns from involvement with the investee; and
- the ability to use power over the investee to affect the amount of those returns.
For companies, the first two elements are relatively easy to assess and are likely to be met in most of cases. However, more judgement and critical thinking is required in reaching a conclusion on the third element “the ability to use power over the investee to affect the amount of those returns”.
As we see, it is inherent in the control definition => the requirement to understand the purpose and structure of investee and its relevant activities.
The control analysis may be relatively straightforward and simple in cases where an investee is controlled by means of equity instruments that give the holder the majority voting rights. However, in more complex situation an investee may be designed in a manner that voting rights relate only to administrative tasks and that relevant activities are directed through contractual arrangements and has nothing with the company’s main decisions though which the company can be directed in the substance. In such cases some further consideration would need to be given to the risks to which the investee was designed to be exposed, the risks it was designed to pass on to the parties involved with it and the risks to which the investor is exposed.
The first element of control focus on the POWER OVER THE INVESTEE. The current ability to direct the investee’s relevant activities arises from rights.
For the purpose of assessing power, only substantive rights (the practical ability to exercise that right) shall be considered. Protective rights (that protect the interest of the holder) should not be considered.
Elements that an investing company will need to consider in determining whether rights are substantive include the following:
- Whether there are any barriers that prevent the holders from exercising their rights.
- Whether a mechanism is in place that provides the holders with the practical ability to exercise their rights collectively.
- Whether the holders would benefit from the exercise of their rights.
After making my research, it is concluded that in order to control an investee, an investor must have the power to govern the significant activities of that investee. IAS 27 defines previously control as the power to govern the financial and operating policies of the company. Subsequent to IFRS 10, control definition is changed, as even though power is often obtained by governing the strategic operating and financing policies of an investee, that is only one of the ways in which power to direct the activities on an investee can be achieved.
Hence referring to the power to govern the financial and operating policies of an investee would not necessarily apply to investees that are not directed through voting rights. During the initial phase, many questions were raised for a clear articulation of the principal behind the term power to direct. It was told that power should relate to the significant activities of an investee, and not those activities that have little effect on the investee’s return.
Sometimes I have seen many of us is confusing power with legal or contractual power to direct the activities of the company, but according to my study it does not necessarily required the company to have the legal or contractual power to direct the activities of another company. Similarly, before IFRS 10, many were confused that company could never have the power with less than majority of the voting rights in another company.
I agree that the legal or contractual right approach point out that this approach requires less judgement than other approaches and accordingly is more likely to result in more consistent application of the definition of the control, but this is not the case anymore.
EXAMPLES on Power over the Investee:
- When other entities have the right to remove the Investment Manager/Director, but the right is exercisable only for breach of contract, then this right is not considered to be substantive.
- When the Investment Manager/Director can be removed from acting as Director by a simple majority of the fund’s investors, but a simple majority requires a large number of widely dispersed and unrelated third party investors to act together, then this right will not necessarily be considered to be substantive.
- When the holder of these rights would benefit from their exercise by realizing synergies with the investee, then these rights are likely to be substantive.
The second element of control focuses on variable returns. Variable returns are returns that are not fixed and have the potential to vary because of the performance of an investee.
Control definition uses the concept of returns in two ways: (1) In order to have the power over an investee an investor must have the current ability to direct the relevant activities (major), i-e the activities that significantly affect the investor returns. (2) The second element of control requires the investor’s involvement with the investee to provide the investor with rights, or exposure, to variable returns.
Hence, control is not synonym of power, because equating power and control would result in wrong conclusions in situation when an agent acts on behalf others.
Please remember that the definition of returns means more synergetic and more direct returns.
When assessing control, investor determines whether it is exposed, or has rights, to variable returns from its involvement with the investee. It is considered whether this criterion should refer to involvement through instruments that must absorb variability, in the sense that those instruments reduce the exposure of the investee to risks that cause variability. Remember as some instruments are designed to transfer risk from reporting entity to another. Hence, such instruments create variability of returns for the other entity but do not typically expose the reporting entity to variability of returns from the performance of the other entity. Let me explain the same with the help of below example.
Assume an entity (entity A) is incorporated to provide investment opportunities for investors who wish to have exposure to entity Z’s credit risk (entity Z is unrelated party in arrangement). Entity A obtains funding by issuing to those investors notes that are linked to entity Z’s credit risk (credit‑linked notes) and uses the proceeds to invest in a portfolio of risk‑free financial assets. Entity A obtains exposure to entity Z’s credit risk by entering into a credit default swap with a swap counterparty. This passes entity Z’s credit risk to entity A, in return for a fee paid by the swap counterparty. The investors in entity A receive a higher return that reflects both entity A’s return from its asset portfolio and the credit default swap fee. The swap counterparty does not have involvement with entity A that exposes it to variability of returns from the performance of entity A because the credit default swap transfers variability to entity A, rather than absorbing variability of returns of entity A.
Resultantly, it is not necessary referring specifically to instruments that absorb variability, although it expects that an investor will typically have rights, or be exposed, to variability of returns through such instruments.
NOTE >>> CONTROL IS NOT SHARED:
Absolute power is not required, but when two or more investors collectively control an investee when they must act together to direct the relevant activities of the companies. In such cases, because no investor can direct the activities without the co-operation of the others, no investor individually controls the investee, and each must prevent other from taking any major decision to govern the company main activities. In this case, each would account for its interest in the investee in accordance with the relevant IFRSs, such as IFRS 11 Joint Arrangements, IAS 28 Investments in Associates and Joint Ventures or IFRS 9 Financial Instruments.
It is very important to focus and understand that what if different activities significantly affect the returns.
Previously/before IFRS 10, standards did not specifically address situations in which multiple parties have decision‑making authority over the activities of an investee. May questions were raised and become confusing that how the control would be applied in such situations. It was concerned that the absence of specific guidance would create structuring opportunities to avoid the consolidation of structured entities —they asserted that, without any guidance, power could easily be disguised and divided among different parties so that it could be argued that no one would have power over the investee.
Following situations can be encounter in which multiple parties may have decision‑making authority over the activities of an investee: (a) joint control (b) shared decision‑making that is not joint control (c) multiple parties that each have unilateral decision‑making rights to direct different activities of an investee that significantly affect the investee’s returns.
It can be seen whether, for such investees, none of the parties controls the investee because the ability to direct the activities is shared. If those different activities, in fact, significantly affect the returns of the investee, many would reason that it would be artificial to force the parties involved to conclude that one activity is more important than the others.
An investor might be required to consolidate an investee when the investor would not have the power to direct all the activities of the investee.
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