Power in IFRS-perspective is all about the difference between structured entities (also called Special Purpose Vehicles, think of Enron!) and non-structured entities (strange name for normal (legal) entities) and what control through power means in IFRS 10 Consolidation.
Power is defined in IFRS 10 as ‘existing rights that give the current ability to direct the relevant activities’.
Just to look at an important term in IFRS from a different perspective, here are some IFRS / financial reporting topics in which power plays an important role. By reading this you get a quick understanding on all kinds of financial reporting issues.
Power and (Non-) Structured entities
Although there is no distinction between different types of entities in determining whether one entity controls another, there is a ‘gating’ question in the analysis that distinguishes between entities for which:
- voting rights are the dominant factor in assessing whether the investor has power over the investee – i.e. the investee is controlled by voting instruments; and
- voting rights are not the dominant factor in assessing whether the investor has power over the investee – i.e. the investee is controlled by means of other rights. [IFRS 10 B6]
This results in the recognition of two types of entities for IFRS:
- Non-structured entities are entities for which voting rights are the dominant factor in assessing whether the investor has power over the investee.
- Structured entities are entities for which voting rights are not the dominant factor in assessing whether the investor has power over the investee.
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. This principle applies to all investees, including structured entities. (IFRS 10 6)
Consequently, for an investor to control an investee, the investor must possess all of the following elements (the ‘power-to-direct’ model):
- Power over the investee, which is described as having existing rights that give the current ability to direct the activities of the investee that significantly affect the investee’s returns (such activities are referred to as the ‘relevant activities’) Power in IFRS-perspective
- Exposure, or rights, to variable returns from its involvement with the investee Power in IFRS-perspective
- Ability to use its power over the investee to affect the amount of the investor’s returns (IFRS 10 7)
Power and consolidation
Consolidation is based on what can be referred to as a ‘power-to-direct’ model (see above). Although there is a practical distinction between structured and non-structured entities, the same control model applies to both. Power in IFRS-perspective
Subsidiaries are entities controlled by the consolidation group (direct by the parent entity or indirect through other subsidiaries). The consolidation group ‘controls’ an entity when it is exposed to, or has rights to, variable returns from its involvement with the entity and has the ability to affect those returns through its power over the entity. The financial statements of subsidiaries are included in the consolidated financial statements from the date on which control commences until the date on which control ceases. Power in IFRS-perspective
Although a consolidation group owns less than half of entity A (45% ownership) and entity B (48% ownership) and has less than half of their voting power, management has determined that the consolidation group controls these two entities. Power in IFRS-perspective
The consolidation group controls entity A by virtue of an agreement with its other shareholders; the consolidation group has control over entity B, on a de facto power basis, because the remaining voting rights in the minority owned subsidiary are widely dispersed and there is no indication that all other shareholders exercise their votes collectively. Power in IFRS-perspective
– Structured entities
The consolidation group does not hold any ownership interests in two structured entities, entity C and entity D. However, based on the terms of agreements under which these entities were established, the consolidation group receives substantially all of the returns related to their operations and net assets (these entities perform research activities exclusively for the consolidation group) and has the current ability to direct these entities’ activities that most significantly affect these returns. (IFRS 12 7(a), IFRS 12 9(b), IFRS 12 10(b)(ii)) The owners’ interests in these structured entities are presented as liabilities of the consolidation group, and as such there are no non-controlling interest for these structured entities in the consolidation group’s equity. Power in IFRS-perspective
Power and associates
This type of investment is something less than a subsidiary, no joint venture but more than a simple investment.
The definition of an associate is based on ‘significant influence’, which is the ‘power to participate’ in the financial and operating policy decisions of an associate, but is not in ‘control’ or ‘joint control’ of those decisions. (IAS 28 Definitions) Power in IFRS-perspective
Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity. IAS 28 states that if an investor holds 20% or more of the voting power of the investee, it can be presumed that the investor has significant influence over the investee, unless it can be clearly shown that this is not the case. [IAS 28 Definitions] IFRS 10 puts an upper limit to this definition in that if an investor holds over 50% and more of the voting rights of the investee the investment is a subsidiary. Power in IFRS-perspective
Significant influence can be presumed not to exist if the investor holds less than 20% of the voting power of the investee, unless it can be demonstrated otherwise.
These presumptions may be overcome in circumstances in which an ability, or lack of ability, to exercise significant influence can be demonstrated clearly. [IAS 28 5]
An associate may also be created if the nomination or appointment power is used in conjunction with a formal or informal agreement to exercise significant influence through direct involvement in setting the associate’s financial and operating policy decisions.
The existence of significant influence is evidenced in one or more of the following ways.
- Representation on the board of directors (or equivalent) of the investee
- Participation in the policy making process Power in IFRS-perspective
- Material transactions between investor and investee Power in IFRS-perspective
- Interchange of management personnel Power in IFRS-perspective
- Provision of essential technical information Power in IFRS-perspective
Potential voting rights that are currently exercisable are considered in assessing significant influence.
Power to exercise dominant influence
Control can also exist when the parent has the power to exercise, or actually exercises, dominant influence or control over the undertaking or it and the undertaking are managed on a unified basis.
Power and potential voting rights
An entity may own share warrants, share call options, or other similar instruments that are convertible into ordinary shares in another entity. If these are exercised or converted they may give the entity voting power or reduce another party’s voting power over the financial and operating policies of the other entity (potential voting rights). The existence and effect of potential voting rights, including potential voting rights held by another entity, should be considered when assessing whether an entity has control over another entity (subsidiary, joint operation or consolidated structured entity).
Disclosure is required in the financial statements of the date on which the financial statements were authorised for issue and who gave such authorisation. If the shareholders have the power to amend the financial statements after issue, then the entity discloses that fact. [IAS 10 17]
Power in list of investments
In the consolidated financial statements and separate financial statements a consolidation group includes a list of significant investments in subsidiaries, jointly controlled entities and associates, including the name, country of incorporation, proportion of ownership interest and, if different, proportion of voting power held
Power of an agent
An investor that has decision-making power over an investee and exposure to variability in returns determines whether it acts as a principal or as an agent to determine whether there is a link between power and returns. If the decision maker is an agent, then the link between power and returns is absent and the decision maker’s delegated power is treated as if it were held by its principal(s).
In assessing whether an entity has joint control of an arrangement, an entity shall assess first whether all the parties, or a group of the parties, control the arrangement. When all the parties, or a group of the parties, considered collectively, are able to direct the activities that significantly affect the returns of the arrangement (ie the relevant activities), the parties control the arrangement collectively. (IFRS 11 B5 – B8)
An entity shall assess whether it has joint control of the collectively controlled arrangement. Joint control exists only when decisions about the relevant activities require the unanimous consent of the parties that collectively control the arrangement. Assessing whether the arrangement is jointly controlled by all of its parties or by a group of the parties, or controlled by one of its parties alone, can require judgement.
Sometimes the decision-making process that is agreed upon by the parties in their contractual arrangement implicitly leads to joint control. In other circumstances, the contractual arrangement requires a minimum proportion of the voting rights to make decisions about the relevant activities, as such this will not lead to joint control in a frequent manner.
THE POWER-TO-DIRECT MODEL
To control and investee the investor must possess all of the following elements:
1. Power over relevant activities
Power is based on an assessment of who directs the relevant activities of an investee, i.e. the activities that most significantly affect the investee’s returns. [IFRS 10 10]
The assessment of power over an investee includes considering the following factors:
- determining the purpose and design of the investee, including:
- the risk(s) that the investee was designed to create;
- the risk(s) that the investee was designed to pass on to parties involved with the investee); and
- the investor’s role in the purpose and design of the investee;
- identifying the population of relevant activities; and
- considering evidence that the investor has the practical ability to direct the relevant activities, special relationships, and the size of the investor’s exposure to the variability of returns of the investee (see below). [IFRS 10 B3, IFRS 10 B7–B8]
For a leasing vehicle that is a structured entity created to lease a single asset to a single lessee, the lessee’s right to use the leased asset for a period of time does not, in isolation, typically give the lessee decision-making rights over the relevant activities of the vehicle (e.g. managing the credit risk on rentals, and/or managing the leased asset at the end of the lease term) and therefore the lessee does not typically have power over the vehicle. Power in IFRS-perspective
As for non-structured entities, an investor considers both substantive rights that it holds and substantive rights held by others. To be ‘substantive’, rights need to be exercisable when decisions about the relevant activities are required to be made, and the holder needs to have a practical ability to exercise those rights. In the context of structured entities, kick-out rights are an example of rights that are potentially substantive. [IFRS 10 B22, IFRS 10 B24] Power in IFRS-perspective
Fund managers apply the general guidance for their analysis of whether there is a link between power and returns (see below #3).
Determining whether rights are substantive requires judgement, taking into account all available facts and circumstances. Factors to consider include:
- whether there are barriers that prevent the holder from exercising the rights; Power in IFRS-perspective
- how many parties need to agree for the rights to become exercisable or operational; and Power in IFRS-perspective
- whether the party holding the rights would benefit from their exercise – e.g. because the rights are in the money. [IFRS 10 B23]
2. Exposure to variability in returns
To have control over an investee, an investor needs to be exposed to (have rights to) variable returns from its involvement with the investee. Returns might be only positive, only negative, or either positive or negative. Sources of returns include:
- dividends or other economic benefits, such as interest from debt securities and changes in the value of the investor’s investment in the investee;
- remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss from providing credit or liquidity support;
- tax benefits; Power in IFRS-perspective
- residual interests in the investee’s assets and liabilities on liquidation; and/or Power in IFRS-perspective
- returns that are not available to other interest holders, such as the investor’s ability to use the investee’s assets in combination with its own to achieve economies of scale, cost savings or other synergies. [IFRS 10 15, IFRS 10 B55–B57] Power in IFRS-perspective
There is no specific guidance on fees paid to a decision maker in determining the variability of returns. Instead, guidance that is particularly relevant to fund managers is included in the assessment of the link between power and returns (see below #3). Power in IFRS-perspective
To have control, in addition to power and exposure to variable returns from its involvement with the investee, an investor needs the ability to use its power over the investee to affect its returns. If the investor is an agent, then this linkage element is missing. [IFRS 10 17]
The following is a summary. Power in IFRS-perspective
- If the decision maker has the power to direct the activities of the investee that it manages to generate returns for itself, then it is a principal.
- If the decision maker is engaged to act on behalf and for the benefit of another party or parties, then it is an agent and does not control the investee when exercising its decision-making authority. However, a decision maker is not an agent simply because other parties can benefit from the decisions that it makes. [IFRS 10 18, IFRS 10 B58]
This analysis is often particularly relevant for fund managers. In applying the guidance, two tests are determinative.
- If a single party holds substantive kick-out rights (i.e. the decision maker can be removed without cause), then the decision maker is an agent. In that case, the linkage test is failed and the decision maker does not consolidate the investee. This is regardless of the level of remuneration.
- If the decision maker’s remuneration is not commensurate with the services provided, or the terms and conditions are not on an arm’s length basis, then the decision maker is the principal. In that case, the linkage test is met and the decision maker consolidates the investee. [IFRS 10 B65, IFRS 10 B69–B70]
Power in IFRS-perspective
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