1. IFRS 10 Consolidated Financial Statements
Presenter: Kerry-Ann Richards
February 2017

2. Background Issued in May 2011
Effective for annual periods beginning on or after 1 January 2013
Further amendments in 2012:
- Provide clarification on transition guidance
- Define investment entity and introduce exception to consolidating particular subsidiaries of investment entities

3. Background
Divergence in practice when applying IAS 27 and SIC 12
Lack of transparency – “off balance sheet vehicles”
Single consolidation model for all entities – control principle
Criticisms – limited application guidance on various scenarios, perceived difference of emphasis, focus on bright lines rather than principles
Divergence in practice – interpretations and applications to situations involving de facto control and agency relationships, perceived conflict of emphasis – power to govern (IAS 27) vs. exposure to risks (SIC 12)
Supersedes IAS 27 – Consolidated and Separate Financial Statements and SIC 12 – Consolidated – Special Purpose Entities
Builds on concepts in IAS 27 and SIC 12 and combines them into a single consolidation model, based on principle of control
IFRS 10 clearly articulates how the control principle is to be applied and provides extensive application guidance. This was not included in IAS 27 and SIC 12

4. Exposure or rights to variable returns Link between power and returns
Control Principle
Power over investee
Existing rights that give current ability to direct relevant activities
Exposure or rights to variable returns
Exposed to or has rights to variable returns from involvement with investee
Link between power and returns
Ability to use power to affect the amount of the investor’s returns

5. Control Principle
Determine whether investor can use power over investee to influence returns
Determine exposure or rights to variable returns
Identify how decisions about the relevant activities are made
Identify the investee’s relevant activities
Identify the investee and consider its purpose and design

6. Power over Investee Power arises from existing rights:
Substantive vs. protective rights
Voting rights or potential voting rights
- De Facto control
Contractual arrangements
Ability to appoint, reassign or remove key management personnel of the investee
Ability to direct the investee to enter into or veto any changes to transactions for the benefit of the investor

7. Power over Investee
Ability to direct the relevant activities of an investee. What are relevant activities? ………“activities of the investee that significantly affect the investee’s returns”……. Activities that matter!

8. Power over Investee Distribution company Commercial bank
Examples of relevant activities
Distribution company
Commercial bank
Pharmaceutical company
Investment management
Sales and purchases of goods
Lending activities
Research and development of new medicine
Managing financial assets

9. Power over Investee Substantive Rights
Practical ability to exercise the right
Barriers to exercising the right
Rights will be exercised under favourable terms
Rights are exercisable when it matters – when decision about the relevant activities need to be made
Constitutes power
Protective Rights
Designed to protect the interests of parties holding these rights
Address fundamental changes in the investee’s activities
Apply in exceptional circumstances
Does not constitute power – cannot prevent another party from directing relevant activities
Consider barriers to exercising rights –
Financial penalties and incentives that would prevent (or deter) the holder from exercising its rights
An exercise or conversion price that creates a financial barrier that would prevent (or deter) the holder from exercising the rights
Conditions that narrowly limit the timing of their exercise
Legal or regulatory requirements that prevent the holder from exercising its rights (e.g.. A foreign investor is prohibited from exercising its rights)

10. Example - Substantive vs. Protective Rights
The Board of Directors of Caribbean Inc. have decided to dispose of a major subsidiary that accounts for a significant portion of their revenues and assets as they have decided to restructure the entity. For the decision to be passed, it will require the approval of 75% voting rights held by shareholders. One of the subsidiaries, Kingston Inc. holds a 15% stake in the group and has the deciding vote. Kingston Inc. is unhappy with the proposed transaction.
Substantive or Protective Rights?
Protective – Kingston Inc. can block the transaction but it cannot make an alternate suggestion

11. Power over Investee Power with majority of voting rights
- Relevant activities are directed via vote
Potential voting rights
- Only considered if substantive (exercisable under favourable terms and when decisions regarding relevant activities need to be made)
- Could arise from convertible instruments, options or forward contracts
Power without majority of voting rights
- Contractual arrangements with other vote holders
- Rights from other contractual arrangements
- The investor’s voting rights – e.g. De Facto Control

12. Example – Potential Voting Rights
Background The investee has annual shareholder meetings at which decisions to direct the relevant activities are made. The next scheduled shareholders’ meeting is in 8 months. However, shareholders that individually or collectively hold 5% of the voting rights can call a special meeting to change the existing policies over the relevant activities, but a requirement to give notice to the other shareholders means that such a meeting cannot be held for at least 30 days. Policies over the relevant activities can be changed only at special or scheduled meetings.

13. Example – Potential Voting Rights
Scenario A An investor is a party to a forward contract to acquire the majority of shares in the investee. The forward contract’s settlement date is in 25 days. Question: Are these potential voting rights substantive? Answer: Yes – existing shareholders are unable to change policies before forward contract is settled.

14. Example – Potential Voting Rights
Scenario B An investor is a party to a forward contract to acquire the majority of shares in the investee with no other related rights over the investee. The forward contract’s settlement date is in 6 months. Question: Are these potential voting rights substantive? Answer: No – existing shareholders are able to change policies before forward contract is settled.

15. Example – Potential Voting Rights
Investors X and Y own 30% and 70% respectively of a manufacturing company (‘Investee’).Investee is controlled by voting rights, manufactures a specific product for which the patent is owned by investor Y, and is currently managed by investor Y. Investor X has an out-of-the money call option over the shares held by investor Y. The patent used by Investee will revert to investor Y if the call option is exercised, unless (a) there is a change in control of investor Y, (b) investor Y breaches the terms of the contract between the parties, or (c) investor Y enters bankruptcy. Investee cannot manufacture the product without investor Y’s patent, which is not replaceable. Neither party expects the call option to be exercised. The purpose of the call option is to allow investor X to take control of Investee in exceptional situations. Question: Are these potential voting rights substantive? Answer: Unlikely to be substantive – substantial operational barriers exist to the exercise of the call option

16. Example – De Facto Control
Entity P holds 48% of voting rights in entity Q. Entity Q is a listed company, controlled by voting rights, and no other shareholder owns more than 5% of its equity shares. The other shareholders have not formed any group that might vote collectively for their combined 52% shareholding. Other shareholder representation at general meetings, in person or by proxy, has not been more than 30% of the total voting rights for many years. Entity P nominates a majority of directors and, due to its presence at general meetings, these nominations are approved. Question: Does Entity P have De – Facto control? Answer: Yes – Entity P is able to control majority of votes cast at general meetings

17. Example – De Facto Control
Entity P holds 45% of voting rights in entity Q. Entity Q is a private company, and 11 other shareholders own 5% each of Q’s equity shares. The other shareholders have not formed any group that might vote collectively for their combined 55% shareholding. Question: Does Entity P have De – Facto control? Answer: Further consideration required – - Arrangement between 11 shareholders to vote together - Past voting patterns of 11 shareholders - Any other rights of Entity P arising from contractual arrangements

18. Principal vs. Agent Scope of decision making authority
Rights held by other parties
Remuneration
Decision maker’s returns from other interests in investee
Scope of decision making authority – discretion available to decision maker, level of involvement the decision maker had in the design of investee, activities permitted under agreements or by law
Rights held by others – when a single party holds removal rights (can remove without cause), this is sufficient to conclude the decision maker is an agent, substantive rights which restrict activities of decision maker
Remuneration – greater the variability associated with decision maker’s remuneration in relation to the total returns expected, the more likely the decision maker is a principal. Decision maker cannot be an agent unless the following conditions are present (1) The remuneration is commensurate with the services provided (2) The remuneration includes only terms, conditions or amounts that are customarily present for similar services and negotiated on an arm’s length basis
Returns from other interests – greater the magnitude and variability associated with its economic interests, the more likely that the decision maker is a principal
Single party holds substantive rights to remove decision maker without cause – Decision Maker is an Agent

19. Principal vs. Agent Application is complex!
Decision maker involved in setting governing rules
Some decision making authority
Exposure to variable returns (for e.g. asset management fees which vary with performance of fund)

20. Example – Principal vs. Agent
The fund manager must make decisions in the best interests of all investors and in accordance with the fund’s governing agreements.
Despite this, the fund manager has extensive decision making authority to direct the fund’s relevant activities.
The investors can remove the fund manager by a simple majority vote, but only for breach of contract.
A market-based fee of:
1% of assets under management; and
20% of profits, if a specified profit level is achieved.
Fees are commensurate with services provided, and the remuneration agreement includes only terms, conditions and amounts that are customarily present in arm’s length arrangements for similar services. The remuneration is intended to align the interests of the fund manager with those of the other investors.
The fund manager does not have any obligation to fund losses beyond its 2% investment.
The fund manager is an agent:
The 2% investment, together with its remuneration, does not create sufficient exposure for the fund manager to be a principal.
The other investors’ rights to remove the fund manager are protective, because they are exercisable only for breach of contract.
The fund manager’s decision-making authority is restricted to the parameters set out in the fund’s governing agreements.
AGENT

21. Example – Principal vs. Agent
The fund manager must make decisions in the best interests of all investors and in accordance with the fund’s governing agreements.
Despite this, the fund manager has extensive decision making authority to direct the fund’s relevant activities.
The fund has a board of directors comprised of directors that are independent of the fund manager.
The board appoints the fund manager annually.
The services performed by the fund manager could be performed by other fund managers.
A market-based fee of:
1% of assets under management; and
20% of profits, if a specified profit level is achieved.
Fees are commensurate with services provided, and the remuneration agreement includes only terms, conditions and amounts that are customarily present in arm’s length arrangements for similar services. The remuneration is intended to align the interests of the fund manager with those of the other investors.
The fund manager has a 20% investment in the fund.
The fund manager does not have any obligation to fund losses beyond its 20% investment.
The fund manager is an agent:
The investors have substantive rights to remove the fund manager, and the board of directors provides a mechanism to exercise these rights.
AGENT

22. Example – Principal vs. Agent
Investors A, B and C invest 15%, 30% and 55% respectively in a fund that is managed by an external fund manager. The fund manager has wide powers to make investment decisions, and the investors cannot direct or veto these decisions. The fund manager can be removed only by a unanimous vote from all three investors and has been assessed to be an agent under IFRS 10. Question: Should investor A, B or C consolidate the fund? Answer: No. None controls the entity.
However, although an agent “is a party primarily engaged to act on behalf of and for the benefit of another party or parties (the principal(s))”, this does not necessarily mean that one of the principals controls the entity.

23. Structured Entities Entity designed so that:
Voting rights are not the dominant factor in determining control.
Relevant activities often directed via contractual arrangements.
Examples:
Securitisation vehicles
Some investment funds
In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off-balance sheet securitizations also played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.
Consolidation is not decided solely by legal ownership. The key to determining whether an investor should consolidate a structured entity is whether the investor controls that structured entity. IFRS 10 states that “an investor controls an investee when the investor 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 definition applies to all entities, including structured entities. The difference with structured entities is that, often, the normal substantive powers (such as voting rights) are not the means by which the investee is controlled. Rather, relevant activities are directed by means of contracts. If those
contracts are tightly drawn, it might initially appear that none of the parties has power over the structured entity. As a result, additional analysis is required to ascertain which party controls the structured entity.

24. Example – Structured Entities
In a securitisation arrangement, a seller has transferred legal title to $100M of long-term interest-bearing mortgage receivables into a structured entity (SE) in exchange for $93M of cash. The SE funds the purchase of the receivables by issuing long-term notes to investors of $93M. The SE will use interest received on the mortgage receivables to pay the interest due on the notes issued to investors. The seller will continue to manage the underlying receivables. It has been assessed that the seller acts as principal in the servicing of the receivables (that is, the seller is not an agent of the investors). Any amount recovered above $93M will be paid to the seller – so, if $97M was recovered, the seller would receive an additional $4M. Expected losses on the receivables are $3M.
Question: Does the seller control the structured entity?
Answer: Yes.
Seller has power to manage receivables and therefore direct the relevant activities
Seller has exposure to variability of returns
Because the expected loss is only $3M, the other investors have minimal exposure to variability of returns

25. Investment Entities Typical characteristics
Has more than one investment
Has more than one investor
Investors are not related parties of the entity
Entity has ownership interests in the form of equity or similar interests
Consolidation Exemption
Not required to consolidate its subsidiaries, but rather measure an investment in subsidiary at fair value through profit or loss unless
The subsidiary is not an investment entity, and provides services that relate to the investment entity’s activities e.g. investment advisory services, investment management and investment support.
An investment entity is an entity that:
 Obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services;
 Commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both; and
 Measures and evaluates the performance of substantially all of its investments on a fair value basis.

26. Investment Entities Parent Entity Investment Entity Entity A Entity B
Parent entity shall consolidate all entities that it controls, including those controlled through the investment entity subsidiary. Therefore Parent entity will consolidate Entity A and Entity B.
Investment entity will not consolidate Entity A nor Entity B but will account for them at fair value through profit or loss in accordance with IFRS 9.
If Entity A provided investment advisory services to the Investment Entity and is not itself an Investment Entity, then the Investment Entity parent will consolidate Entity A.

27. Summary No new consolidation requirements.
Builds on control guidance that existed in IAS 27 and SIC 12 (additional explanations and application guidance consistent with definition of control).
Do away with bright lines – more principles based.
More appropriate consolidation – including structured entities which were previously unconsolidated.
Changes likely to occur in more complex areas, most consolidation decisions expected to be unaffected.

28. Questions?