This all starts with a definition:
An 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. (IFRS 10 6)
Power over the investee
Exposure, or rights, to variable returns from its involvement with investee
The ability to use its power over the investee to affect the returns
For an investor to have control it must (not only) have power over the investee
For an investor to have control it must (not only) have exposure, or rights, to variable returns from the investee.
For an investor to have control it must (not only) have the ability to use power to affect returns.
Rights confer power when they are sufficient to give the investor the current ability to direct the ‘relevant activities’ (see below) unilaterally. In this context ‘current ability’ does not necessarily require the rights to be exercisable immediately.
Instead, the key factor is whether the rights can be exercised before decisions about relevant activities need to be taken.
(see also below ‘Directing relevant activities‘)
Variable returns are returns that are not fixed and have the potential to vary as a result of the performance of an investee.
Variable returns can be only positive, only negative or both positive and negative.
Variable returns are defined very broadly and extend well beyond the ownership benefits obtained through equity shares.
An investor is able to use its power to affect its returns (sometimes referred to as ‘linkage’).
This linkage depends on whether the investor has the current ability to direct the relevant activities (decision-making rights):
Substantive and protective rights [IFRS 10 B22-B28]
In assessing whether it has power, an investor does not consider rights that it holds, or rights held by others, if those rights are:
For a right to be substantive, the holder must have the practical ability to exercise that right.
Therefore, an investor cannot have control if its only rights are non-substantive or protective.
Likewise, rights held by other parties cannot prevent an investor from having control if they are non-substantive or protective.
IFRS 10 explains that returns that are ‘fixed’ in contractual terms are nonetheless regarded as variable for the purposes of the control assessment. For example:
This link between power and returns clearly exists in a normal parent-subsidiary relationship based on majority share ownership. Accordingly, in such cases a detailed analysis is not needed.
However, this element of control is important when an investor holds decision-making rights as a result of a management contract or similar arrangement – such as a fund or asset manager.
If an investor has some or all of its decision-making rights in the capacity of agent, those rights do not count towards the assessment of whether it controls the investee. Conversely, if the investor has delegated some or all of its decision-making rights to an agent, those rights are treated as the investor’s rights for IFRS 10 purposes.
Straightforward situations of power assessment
Assessing power is straightforward for conventional investees where voting rights (normally conferred by share ownership) are the key factor [IFRS 10 11].
In such cases, ownership of a majority of the voting rights confers power and control (in the absence of other relevant factors) [IFRS 10 B6].
Relevant activities are activities of the investee that significantly affect the
IFRS 10 provides some non-exhaustive examples of possible relevant activities:
‘de facto’ agent
IFRS 10 also includes the concept of a ‘de facto’ agent, ie an entity that acts on the investor’s behalf even though there is no contractual arrangement that obliges it to do so.
The guidance on de facto agents is not intended to imply that certain parties would always act for the investor. The assessment requires judgement, including careful consideration of the nature of the relationship and the way that the parties interact with each other.
To some extent this guidance appears to be designed as an ‘anti-abuse’ provision, intended to ensure that control cannot be disguised by the informal delegation of power to other parties.
Questions sometimes arise as to whether an investee whose activities are largely pre-determined (such as some special purpose and structured entities) really has any relevant activities. However, in general it is very rare (although not impossible) that an investee has no relevant activities at all.
Assessing relevant activities is critical when an investor has the current ability to direct only some of an investee’s activities (and decisions about other activities are taken by other parties, or through shared decision-making).
If two or more investors have rights to direct different relevant activities, the investor with current ability to direct the activities that most significantly affect the returns has power. [IFRS 10 13]
More complex situations of power assessment
A more specific and detailed analysis of relevant activities is required in less straightforward situations. This will often be the case for special purpose or structured entities.
Some investees are structured such that two or more investors have the current ability to direct relevant activities but those activities occur at different times. In this situation the investors again determine which investor is able to direct the activities that most significantly affect the returns. This assessment is re-evaluated if relevant facts or circumstances change.
Directing relevant activities
Having identified an investee’s relevant activities, the next step is to determine how those activities are directed.
IFRS 10 breaks this down into the following two steps (although in practice these steps are normally combined with the identification of relevant activities):
Directing relevant activities is about making decisions in relevant activities including but not limited to:
These decisions are broad-based and relate to high level direction of the investee. For conventional investees where the relevant activities comprise a wide range of financial and operating activities, direction is generally through these broad-based decisions. In other words there is usually no need to identify relevant activities at a specific or detailed level.
In more complex situations where the relevant activities are identified at a more specific level, such as the preceding example above, direction might be through a more specific contractual right or process.
IFRS 10 envisages two types of rights that may confer ability to direct these decisions (ie power):
The control assessment will typically be more straightforward when power is conferred through voting rights. In most cases involving conventional operating entities and governance structures, power is conferred by voting rights.
For investees that would have been considered special purpose entities or structured entities however, power arises from more specific contractual rights.
In some cases voting rights might exist but, in practice, confer an ability to direct only administrative-type tasks with little or no effect on returns.
Purpose and design of investee
IFRS 10 refers to assessing the ‘purpose and design’
an investee in several different contexts.
The assessment of the investee’s ‘purpose and design’ is carried out in order to identify:
In addition purpose and design is considered in assessing:
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