Assessing de facto control for an operating entity the right 1 best way

IFRS 10 Assessing de facto control

– for an operating entity is a case which is important to understand when assessing who is in control in certain cases and under which conditions. This is one of the significant changes introduces by IFRS 10 – the standard includes guidance on de facto control for the first time.

An investor with less than a (simple) majority of the voting rights might hold the largest block of voting rights, with the remaining voting rights widely dispersed. The investor might have the power to unilaterally direct the investee unless a sufficient number of the remaining dispersed investors act in concert to oppose the influential investor. However, such concerted action might be hard to organise if it requires the collective action of a large number of unrelated investors.

In summary:

Assessing de facto control

Example case

Following is a case on the assessment whether certain stakeholders in a transaction/structure have obtained control over a certain entity in the transaction in line with the requirements of IFRS 10 Consolidated financial statements. Only one stakeholder can be in control! [IFRS 10 B16] Or no stakeholder is in control. Or one stakeholder is in control and has to consolidate the investigated entity  in its consolidated financial statements. Here is the case. Assessing de facto control for an operating entity

An investor  is a large owner of Entity D with other investors holding significantly lower percentages of ownership. The ‘normal’ assessment of control ‘checklist’ is:

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: Assessing de facto control for an operating entity

  1. the purpose and design of the investee; Assessing de facto control for an operating entity
  2. 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; Assessing de facto control for an operating entity
  3. the effect on the investee’s returns resulting from each investor’s decision-making authority with respect to the factors in b); and
  4. investors’ exposure to variability of returns. Assessing de facto control for an operating entity

Assessing de facto control


All these criteria can be negative and still there is an entity de facto in control or not!! Let’s see how such an assessment is made…

– Entity D manufactures and sells glass bottles to investor G at market price. The majority of sales (95%) are made to investor G; however, entity D can also sell to other customers without additional cost.

– Entity D was established to allow investor G to gain a steady supply of glass bottles.

Entity D issues two classes of shares. investor G holds Class A shares. The 17 other investors hold Class B shares. Both classes have equal voting rights.

The 6 largest Class B investors hold 14%, 8%, 7%, 6%, 5% and 4% respectively. All other investors hold less than 3% each.

Something else -   IFRS 10 Special control approach

The Class B investors have, in the past, participated actively in shareholders meetings and, on occasion, rejected resolutions put forward by investor G.

Strategic decisions are made at shareholders’ meetings, and operational decisions are made at directors’ meetings. Daily operations are handled by a Manager, based on powers granted by the shareholders and directors.

Does investor G have control of entity D?


Analysis

The involvement of investor G has to be assessed based on contractual and non-contractual involvement (or absence thereof) that exposes this investor to variability of returns from the performance of entity D.

Investor G does not seem to control entity D in this circumstance.

This is based on the following assessment:

  • Power over entity D is exercised mainly through shareholders’ and directors’ meetings. investor G does not have majority representation in both meetings. IFRS 10 B41 indicates that an investor with less than a majority of the voting rights may have de facto control if considering all facts and circumstances the (less than majority) investor has the current ability to direct the relevant activities of Entity D (see the criteria in IFRS 10 B42 – B46), other potential evidence is analysed below.
  • However, de facto control does not seem to exist. A minimum of six Class B investors could collaborate and outvote investor G. Similarly, six directors (out of the seven directors not appointed by G) could collaborate to outvote the five directors appointed by investor G.
  • Under IFRS 10 B44 example 6, de facto control did not exist where only two other investors needed to collaborate. Under see IFRS B45 example 7, the situation was unclear where 11 other shareholders needed to collaborate.
  • Collaboration by six investors falls in between. However, the remaining 17 investors have participated actively in past meetings and, on occasion, outvoted investor G. This suggests that investor G does not have de facto control of entity D [IFRS 10 B45].
  • IFRS 10 B46 indicates that if the situation is unclear after considering all factors, there is no de facto control, investor G does not seem to meet the ‘clear’ evidence of de facto required by the standard. The standard states that economic dependence alone does not lead to the investor having power over the investee [IFRS 10 B40].
Something else -   Significant influence

Point of consideration

As this exercise shows assessing control based on IFRS 10 has become much more of a ‘substance over form’ process, what has really happened in the past and what does this mean for the current situation at hand, it is not an accident that clear is in brackets in the conclusion.

Disclosure requirements de Facto control

In ‘Critical accounting estimates and judgements‘ the assessment of de facto control is required to be mentioned being a significant judgement with a reference to for example the discussion on ‘Subsidiaries’  and the ‘Basis for consolidation‘.

Note on ‘Subsidiaries

(3) Taco Bingo Limited is consolidated despite the group owning less than 50% of the voting rights in the general meeting of shareholders. This is due to the group having the practical ability to unilaterally direct relevant activities of Taco Bingo.

Judgement

De facto control exists when the size of an entity’s own voting right relative to the size and dispersion of other shareholders, give the entity the practical ability to unilaterally direct the relevant activities of the entity.

The group holds 47% of the voting rights in Taco Bingo Limited, with the remaining 53% of the voting rights being held by numerous unrelated individual shareholders, each with less that 1% holding. The group has determined that the group has the practical ability to unilaterally direct the relevant activities of Taco Bingo Limited, and has consolidated the entity as a subsidiary with a 53% non-controlling interest.

Note on ‘Basis for consolidation

Something else -   Whether the investor currently directs the activities

Where the group has control over an investee, it is classified as a subsidiary. The group controls an investee if all three of the following elements are present: power over the investee, exposure to variable returns from the investee, and the ability of the investor to use its power to affect those variable returns. Control is reassessed whenever facts and circumstances indicate that the may be a change in any of these elements of control over an investee.

De facto control exists in situations where the group has the practical ability to direct the relevant activities of the investee without holding the majority of the voting rights in the the general meeting of shareholders. In determining whether de facto control exists the group considers all relevant facts and circumstances, including:

  • The size of the group’s voting rights relative to both the size and dispersion of other parties who hold voting right,
  • Substantial potential voting rights held by the group and by other parties,
  • Other contractual arrangements,
  • Historic patterns in voting attendance.

…….

See also: de Facto control Test

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Assessing de facto control

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Something else -   IFRS 10 Special control approach

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