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.
THE CASE – Assessing control with put and call options
Entity G set up entity I, a malt producer. Entity G initially owned 100% of entity I. Thereafter, entity G sold 50% to entity C and at the same time:
- entered into a put and call over entity D’s 50% interest; and
- entered into a series of agreements that stipulate the terms set out in the rest of this case study.
The purpose of this transaction was to allow entity G to bring in entity C, an expert in agriculture, to advise entity G and assist entity G in managing production costs, and also to provide a more consistent supply of raw materials.
Further information on entity I:
- Entity G appoints the CEO; entity C appoints the plant manager (second-in-command).
- Entity I is contractually required to produce and sell sufficient malt to meet entity G’s needs, although it is also allowed to sell malt to entity C or to other customers nominated by entity C if entity I has excess capacity.
- Selling price to entity G is based on a formula that takes all costs incurred by entity I and adds a margin that is calculated to give I a 10% gross margin on costs incurred.
- Agreements require entity C to provide entity I with market intelligence and advice, and develop and execute supply chain plans to help entity I to acquire raw materials.
- Entity C receives fees that are commensurate with the services provided.
- The contracts with entity C are automatically terminated with no penalties if either of the options is exercised.
Some of entity I’s relevant activities are controlled by contract (for example, customer selection and the sale price of malt). However, operational decisions (for example, capital, repairs and maintenance expenditure, choice of suppliers, employee hiring and firing, etc) are made at shareholders’ and/or directors’ meetings. Unanimous consent is required for both shareholder and board decisions.
Terms of put and call
- Call held by entity G allows entity G to buy 50% of entity I from entity C at fair value. Similarly, the put held by entity C allows entity C to sell 50% of entity I to entity G at fair value. Upon exercise of either the put or the call, entity G regains control of entity I, and the contracts with entity C are terminated.
- Both puts and calls are exercisable only upon any of the following events:
- The options are designed to allow entity C to exit at fair value when the above unanticipated events, or a decision deadlock, makes such an exit necessary, so that entity G regains control of entity I.
- As the options’ exercise price is at fair value, they are always at the money, including at inception of the options and at the reporting date.
- In the event of a decision deadlock, it will be beneficial for entity G to exercise the call option to regain control of entity I, as the call option will be at the money (as strike price is at fair value), due to the synergies between entity G and entity I.
The question is does entity G control entity I?
Some of the relevant activities are controlled by contract, and these appear to be fixed and cannot be changed. Unless there is excess capacity, entity I must sell to entity G at the designated price. Control with put and call options
However, an assessment must be made of all of the contracts and other arrangements (for example, shareholdings and board representation) that give rights over the relevant activities of I to determine whether each investor has rights sufficient to give it power over entity I. Control with put and call options
Purpose and design
Arguably, the purpose and design of the entire transaction, including the options, was to ensure that entity G retains control of entity I [IFRS 10 B48], as follows:
- Entity I was set up to supply malt to entity G, while entity C supplies expertise. This suggests that entity I is likely to be set up on behalf of entity G, while entity C’s involvement is mainly advisory. Control with put and call options Control with put and call options
- The strike prices of the options are at fair value, which ensure that the strike price does not pose an economic barrier for either party to exercise the option.
Parties involved in the design of entity I
Entity I was established by entity G when it was wholly-owned; however, both entity G and entity C were involved in setting up the above contractual arrangements.
The put and call arrangements allow entity G to take control of all decisions in the event of a decision deadlock. If either option is exercised, the other agreements also terminate, allowing entity G to regain control of the critical factors such as customer selection and selling price of malt. Although the options are only exercisable in limited situations such as a decision deadlock, they are substantive. A decision deadlock is the main event that necessitates the power to decide on the direction of relevant activities [IFRS 10 B24]. Control with put and call options
Parties that have a commitment to ensure that entity I operates as designed
Entity G has a greater interest to ensure that entity I operates as designed as entity G is taking malt output from entity I. The put and call arrangement that provides entity C with an exit plan also seems to suggest that entity G has the greatest commitment in this respect. Control with put and call options
Other factors [IFRS 10 B18-B20]
The activities of entity I appear to be conducted on behalf of entity G (for example, to ensure the malt supply). Control with put and call options
Control with put and call options Control with put and call options
Entity G appears to satisfy the power criterion in relation to entity I. Entity G also has exposure to the variability of entity I through its 50% interest, and nothing in the facts suggest that entity G is not a principal. Entity G therefore controls entity I.