Scope of IFRS 10
IFRS 10 establishes principles (IFRS 10.1-3) for the presentation and preparation of consolidated financial statements when an entity (a parent) controls at least one other entity (a subsidiary).
IFRS 10 applies to all entities that are a parent, except for those meeting the criteria for scope exemption set out in IFRS 10.4-4B. Therefore, a parent controlling a sub-group that is consolidated at higher level under IFRS, and is not publicly listed, need not prepare consolidated financial statements if all the criteria contained in IFRS 10.4a are met. There are varying views as to whether this exemption can be applied by a subsidiary whose parent prepares a consolidated financial statements under local GAAP that are identical or nearly identical to IFRS (e.g. ‘IFRS as adopted by EU’). In my opinion, this exemption can be applied provided that differences, if any, to IFRS as issued by the IASB are clearly trivial.
One of the conditions for exemption relates to non-controlling interests having been informed and not objecting to not preparing consolidated financial statements. It’s important to note, that IFRS 10 sets no time limit for non-controlling interest to raise objections, therefore, to be on safe side, it’s best to seek active approval of non-controlling interest for exemption from preparing consolidated financial statements.
Local law may require a parent to present consolidated financial statements even if IFRS 10 exemption applies.
Historically under IFRS and under certain local GAAP, noteworthy exemptions from consolidation related to subsidiaries when control was temporary, where scope of activities was substantially different from the parent and when long-term restrictions to transfer funds to the parent existed. IFRS 10 does not include those exemptions from consolidation.
Accounting for business combinations (i.e. obtaining control of one or more businesses) is covered in IFRS 3.
Exemption for investment entities
Additional exemption from consolidation (and IFRS 3 accounting) relates to investment entities that are required to measure all of its subsidiaries at fair value through profit or loss in accordance with IFRS 9 (IFRS 10.4B and IFRS 10.31-33). An investment entity is an entity that (IFRS 10.27):
- 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.
Paragraphs IFRS 10.28,B85A-W,IE1-IE15 provide guidance on determining whether an entity is an investment entity. Paragraphs IFRS 10.B100-B101 prescribe accounting for becoming and ceasing to be an investment entity.
Exemption for employee benefit plans
IFRS 10.4a states that IFRS 10 does not apply to post-employment benefit plans or other long-term employee benefit plans to which IAS 19 applies. This wording does not make it crystal clear whether this exemption relates to financial statements prepared by employee benefit plans or to employers needing to consider whether such plans need to be consolidated. It is widely accepted in practice that this exemption relates to the latter case, i.e. employers don’t need to assess whether employee benefit plans should be treated as subsidiaries and consolidated.
Subsidiaries acquired exclusively with a view to resale
There is no exemption from consolidation for subsidiaries acquired exclusively with a view to resale, however they may be classified as held for sale and discontinued operations under IFRS 5 which will provide significant relief in determination of fair value and consolidation. Namely, the acquirer would not need to measure individual assets and liabilities at fair value as all assets and liabilities will be presented in one line (one line for assets and one line for liabilities). Any breakdown of these assets/liabilities is not required (IFRS 5.39). P&L consolidation will also be made in a single line presenting discontinued operations. See Example 13 accompanying IFRS 5 that illustrates this approach. See also more discussion on classification of assets and disposal groups acquired exclusively with a view to resale under IFRS 5.
A parent is an entity that controls one on more entities. The notion of control is therefore crucial in applying IFRS 10. An investor controls another entity (investee) when it has all the following (IFRS 10.6-8):
- power over the investee
- exposure, or rights, to variable returns from its involvement with the investee
- the ability to use its power over the investee to affect the amount of the investor’s returns (principal vs. agent consideration)
Existence of control should be reassessed each time relevant facts and circumstances change (IFRS 10.8;B80-B85).
The definition of control is extensively covered in IFRS 10 so that no entities that are de facto controlled by the reporting entity remain outside its financial statements, especially if their relevant activities are not directed through voting rights. The criteria for assessing control set out above are discussed in the following sections.
Power over the investee
What is the power over the investee?
Power arises from rights that give the investor current ability to direct activities that significantly affect the investee’s returns (‘relevant activities’). Examples of relevant activities are given in IFRS 10.B11. Power usually results from voting rights attached to shares, but can result also from other sources, such as contractual arrangements (IFRS 10.10-13), especially if the critical decision making is predetermined at the incorporation of the investee (‘special purpose entities’, ‘structured entities’ or ‘variable interest entities’).
Majority of the voting rights
Holding majority of the voting rights is sufficient to give power over the investee in the following situations (IFRS 10.B35):
- the relevant activities of the investee are directed by a vote of the holder of the majority of the voting rights, or
- a majority of the members of the investee’s governing body that directs the relevant activities are appointed by a vote of the holder of the majority of the voting rights.
In fact, for traditional operating investees that are controlled through voting rights, having the majority of voting rights is sufficient for a parent to assess that it controls the investee.
However, in some circumstances, an investor with majority voting rights may have no practical ability to exercise them. Such rights are not substantive (see IFRS 10.B22-B25) and do not give the power over an investee (IFRS 10.B36-B37).
Minority of the voting rights
An investor can have power over the investee even if it does not hold majority of the voting rights (such situation is often referred to as ‘de facto control’). Power can be effected through (IFRS 10.B38-50):
- the investor’s voting rights (e.g. other vote holders are dispersed and unable to act together to outvote the investor in question)
- a contractual arrangement between the investor and other vote holders
- rights arising from other contractual arrangements
- potential voting rights
Consider the following example of Entity A having 40% interest in Entity B:
Example: Minority of the voting rights vs power over the investee
Entity B is listed on the stock exchange, there are two investors who report having more than 5%, the remaining individual shareholders are unknown.
Entity B is a privately own company with shareholding structure as follows:
Entity B is a privately own company with shareholding structure as follows:
In Scenario 1, Entity A has power over Entity B (provided that criteria of IFRS 10.B35 are met) as other shareholders are too dispersed to outvote Entity A. In contrast, in Scenario 2, Entity A does not have power over Entity B, as the other shareholders could easily cooperate and outvote Entity A. This conclusion will still hold even if Entities X,Y and Z have been passive investors so far.
It is more difficult to decide whether Entity A has power over Entity B in Scenario 3. Here, other facts and circumstances need to be assessed as set out in IFRS 12.B42(b)-(d), such as whether other shareholders actively participate at AGMs (irrespective of whether they vote in the same way as Entity A).
If, after all available evidence has been considered, the evidence is not sufficient to conclude that the investor has power, the investor should not consolidate the investee (IFRS 12.B46, BC110).
Potential voting rights
Potential voting rights are rights to obtain voting rights of an investee and can arise from convertible instruments, options, or other instruments. Such rights are taken into account for the purposes of assessing control only if they are substantive (see IFRS 10.B22-B25). Potential voting rights are covered in paragraphs IFRS 12.B47-50. It’s important to realise that potential voting rights work both ways, i.e. they can give power to a minority shareholder and they can take away power from a majority shareholder.
Multiple parties with decision-making rights
When two or more unrelated investors each have unilateral decision-making rights over different activities of an investee that significantly affect the investee’s returns, the investor that has the current ability to direct the activities of the investee that most significantly affect the investee’s returns meets the power element of the control definition. In effect, power is attributed to the party that looks most like the party that controls the investee (IFRS 10.BC85-BC92).
In situations with multiple parties with unilateral decision-making rights over different activities, it may be possible that each party controls specified assets only or ‘ring-fenced’portion of a larger entity, and that portion of an investee should be consolidated as if it was a separate entity, or ‘a silo’. Guidance can be found in IFRS 10.B76-B79.
Purpose and design of the investee
When assessing control, purpose and design of the investee need to be taken into account. An investee may be designed so that voting rights are not the dominant factor in deciding who controls the investee (IFRS 10.B5-B8;B51-B54). This criterion is most relevant in assessing control over so-called ‘special purpose entities’or ‘structured entities’, i.e. entities designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements. Structured entities often have restricted activities, a narrow and well-defined objective and need subordinated financial support (IFRS 12.B21-B22).
Rights designed to protect the interest of an investor (or other party, e.g. creditor) without giving it power over the entity (‘protective rights’) do not give power over the investee (IFRS 10.14). Examples of such protective rights are given in IFRS 10.B28. Existence of protective rights does not preclude another party to have control over an investee.
Veto rights are usually protective rights, but this is not always the case. If the veto relates to e.g. changes in relevant activities that significantly affect investee returns for the benefit of the investor, it can be deemed to give power over the investee (IFRS 10.B15d).
See also bankruptcy proceedings or breach of covenants in the following section.
Bankruptcy proceedings or breach of covenants
September 2013 IFRIC update considers a question whether the assessment of control should be reassessed when facts and circumstances change in such a way that rights, previously determined to be protective, change (for example upon the breach of a covenant in a borrowing arrangement that causes the borrower to be in default) or whether, instead, such rights are never included in the reassessment of control upon a change in facts and circumstances. As noted earlier, existence of control should be reassessed each time relevant facts and circumstances change (IFRS 10.8;B80-B85), and IFRIC noted that IFRS 10 does not include an exemption for any rights from this need for reassessment. IFRIC also observed that a breach of a covenant that results in rights becoming exercisable constitutes such a change in facts and circumstances.
Therefore, protective right can become a right giving power when it becomes exercisable. This is often linked to assessing control over entities suffering financial difficulties and entering in bankruptcy proceeding. Is such cases, creditors often have right to direct relevant activities of the entity for their own benefit (i.e. repayment of debt) which may lead to a conclusion that the control over an investee has been passed to them.
Franchise agreements are covered in paragraphs IFRS 10.B29-B33. Typically, franchisor does not have power over the franchisee as its rights are designed to protect the franchise brand, but without the ability to direct the activities that significantly affect the franchisee’s returns.
Exposure, or rights, to variable returns
An investor is exposed, or has rights, to variable returns from its involvement with the investee when the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance (IFRS 10.15). Only one investor can control an investee, but it is possible for other parties, such as holders of non-controlling interests, to benefit from investee’s returns (IFRS 10.16).
Example of variable returns include (IFRS 10.B57):
- dividends, interest and other distributions of economic benefits,
- changes in the value of the investor’s investment in an investee,
- remuneration for servicing an investee’s assets or liabilities, fees and exposure to loss from providing credit or liquidity support, residual interests in the investee’s assets and liabilities on liquidation of that investee, tax benefits, and access to future liquidity that an investor has from its involvement with an investee,
- returns that are not available to other interest holders, such as synergy benefits, sourcing scarce products, gaining access to proprietary knowledge or limiting some operations or assets, to enhance the value of the investor’s other assets.
As we can see, credit risk is also a factor when considering variable returns, therefore financing with fixed interest also constitutes exposure to variable returns.
Additionally, in paragraphs IFRS 10.BC37-BC39, the IASB confirms that it believes that reputational risk is part of an investor’s exposure to risks and rewards and is therefore a factor to consider along with other facts and circumstances.
Link between power and returns (principal vs. agent)
A parent must have the ability to use its power to affect the returns from an investee. Entities acting as agents for other parties do not control an investee (IFRS 10.17-18). Conversely, an entity controls an investee if another party with decision-making rights acts as an agent for that entity. When assessing control, the investor treats the decision-making rights delegated to its agent as if they were held by the investor directly. Principal-agent relationships are most common in asset management, real estate and construction industries.
Paragraph IFRS 10.B60 lists the following factors that are applicable in determining whether a decision maker is an agent:
- the scope and independence of decision-making authority over the investee (IFRS 10.B62-B63),
- the removal (‘kick-out’) and restrictive rights held by other parties (IFRS 10.B64-B67),
- the remuneration to which the decision maker is entitled, its magnitude and variability relative to the returns expected from the activities of the investee (IFRS 10.B68-B70),
- the decision maker’s exposure to variability of returns from other interests that it holds in the investee (IFRS 10.B71-B72).
In addition relationships between parties need to be considered as well (IFRS 10.B73-B75).
When an investor has decision-making rights, but considers itself an agent, it should assess whether it has significant influence over the investee.
Consolidated financial statements
What are consolidated financial statements?
Consolidated financial statements are the financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity and with uniform accounting policies (IFRS 10.19,B86-B87). A parent should prepare consolidated financial statements, unless exemptions described in introduction to IFRS 10 apply.
Consolidation procedures are usually performed by a dedicated software where subsidiaries submit their data which is then consolidated. IFRS 10.B93 specifies that the difference between the date of the subsidiary’s financial statements and that of the consolidated financial statements should not exceed three months. In practice, even if a subsidiary has different reporting date than the parent, it prepares additional information so that there such time gap has no impact on consolidated financial statements.
Consolidation of an investee begins when control is obtained and ceases when control is lost (IFRS 10.20,B88).
Non-controlling interest (‘NCI’) should be presented within equity in the consolidated statement of financial position, separately from equity attributable to owners of the parent (IFRS 10.22). NCI constitutes existing interest in a subsidiary not attributable, directly or indirectly, to a parent. For example, when a parent has 80% of shareholding in a subsidiary, the remaining 20% is NCI. It used to be called ‘minority interest’ and you can sometimes come across this term.
A parent presenting consolidated financial statements should attribute the profit or loss and total comprehensive income to the owners of the parent and to the non-controlling interests. Non-controlling interests can have a negative balance as a result of cumulative losses attributed to them (IFRS 10.B94) even without any existing obligation to make an additional investment to cover the losses (IFRS 10.BCZ160-BCZ167). Allocation of profit or loss and total comprehensive income should be based only on existing ownership interests, i.e. without taking into account the possible exercise or conversion of potential voting rights and other derivatives (IFRS 10.B89-B90).
Changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions, i.e. without any impact on profit or loss, recognised assets (including goodwill) or liabilities (IFRS 10.23,B96). Before IFRS 10 was introduced, acquisition of non-controlling interest often resulted in additional goodwill recognised by the parent (not allowed under IFRS 10). Consider the following example:
Example: acquisition of non-controlling interest
The starting point here is an example presented in IFRS 3 for calculation of goodwill. As a result of the acquisition of the Target Company (TC), Acquirer Company (AC) recognised $16.8m of non-controlling interest (NCI). Let’s assume that after one year, AC acquires the remaining 20% shareholding in TC for $30m (paid fully in cash). For simplicity, let’s assume that the value of NCI remains unchanged (it can change as a result of dividend payments, profit generated by TC etc.).
Entries made in consolidated financial statements of TC are as follows:
As we can see, there is no impact on profit or loss even though AC paid more than the amount of NCI in the consolidated statement of financial position.
Loss of control
If a parent loses control of a subsidiary, paragraphs IFRS 10.25,B98-B99 prescribe the accounting approach:
- derecognise all assets (including goodwill) and liabilities of the former subsidiary at their carrying amount,
- derecognise carrying amount of any non-controlling interests,
- the fair value of the consideration received,
- recognise any investment retained in the former subsidiary at fair value,
- recognise any resulting difference as a gain or loss in profit or loss attributable to the parent
Additionally, when a parent loses control of a subsidiary, all amounts previously recognised in other comprehensive income in relation to that subsidiary should be accounted for on the same basis as would be required if the parent had directly disposed of the related assets or liabilities, i.e. transferred to P/L as a reclassification adjustment (e.g. foreign currency translation) or directly to retained earnings (IFRS 10.B99).
See also the discussion on accounting for a former subsidiary becoming a joint operation under IFRS 11.
IFRS 12 is a comprehensive standard that covers all disclosure requirements relating to interests in other entities.