The requirements of IFRS 10 and the interaction between the ‘Investment Entities’ amendments and the Seventh Directive
Part 1 – IFRS 10: The Requirements
The financial crisis that has left its indelible mark on recent history may have brought to the fore certain weaknesses in a number of standards which, unfortunately have been criticised for various reasons amongst which their complexity, inconsistent application and their conduciveness to lack of transparency. The infamous list included IAS 27 Consolidated and Separate Financial Statements and SIC-12 Consolidation – Special Purpose Entities.
The global financial crisis highlighted the lack of transparency about the risks to which investors were exposed from their involvement with ‘off balance sheet vehicles’ (such as securitisation vehicles)1, as a result of which the G20 leaders and the Financial Stability Board asked the International Accounting Standards Board (IASB) to review the accounting and disclosure requirements for such ‘off balance sheet vehicles’.
In response, the IASB issued IFRS 10 Consolidated Financial Statements in May 2011 as part of its comprehensive review of standards dealing with consolidation (and the determination of control in a parent – subsidiary relationship), joint arrangements and disclosure in relation to an investor’s interest in other entities. The aim of this article is to explore and discuss the more intricate aspects of IFRS 10 and its interaction with the EU Accounting directives.
The control formula
One of the major changes that IFRS 10 brings to the table when compared to IAS 27 is its definition (and determination) of control. Whereas the latter’s primary focus was on whether an investor owned, directly or indirectly, more than half of the voting power in another entity (a subsidiary) IFRS 10’s primary focus is on whether an investor has the power to direct an investee’s relevant activities so as to affect its variable returns.
Under IAS 27, an investor controlled an investee if it owned 50% or more of the voting rights in the investee. The standard contemplated other ways in which control could have been manifested, for instance by virtue of an investor’s agreement with other investors, an investor’s ability to appoint or remove the majority of the members of the investee’s governing body, and so forth.
Under IFRS 10, 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. Determining whether an investor controls an investee therefore requires consideration of the following matters:
Understanding which are the investee’s relevant activities.
Assessing whether an investor has power to direct those relevant activities.
Determining an investor’s exposure to variable returns.
Ascertaining the link between an investor’s power and the variability of returns.
Understanding the investee and its relevant activities
This first step in the control assessment may require judgement and will greatly depend on the design and purpose of an investee. Relevant activities could include:
Selling and purchasing of goods and services.
Managing financial assets during their life.
Selecting, acquiring or disposing of assets.
Researching or developing new products or processes.
Determining a funding structure or obtaining funding.2
These and many others are activities that take place within various organisations. However, only those that significantly affect an investee’s returns are ‘relevant activities’ for the purpose of IFRS 10.
For example, say that an entity “franchisor A” decides to expand its business using franchises and participates, by virtue of a 20% equity holding, in an entity “structured entity Z”. The other 80% equity of Z is held by “financial institution B”. Z is nominally capitalised and is primarily funded by debt from B, which Z in turn uses to assist potential franchisees willing to take up an entity A franchise. The determination of whether a prospective franchisee is given the franchise and subsequently the necessary funding to start operating is determined by A. Financial institution B services the loans on a day-to-day basis.
It is likely that, under SIC-12, B would have consolidated entity Z in view of the fact that it retained the majority of the risks and benefits given its funding of the loan program. The determination of control under IFRS 10 takes a different angle and, in determining which of A or B can direct the relevant activities, it is possible that A (subject to satisfaction of the three elements of control) may be the controlling entity. This is due to the fact that entity A determines who is eligible to participate in the loan program (i.e. who gets to be a franchisee) and that is the activity that most significantly affects Z’s returns.
Assessing whether an investor has power to direct an investee’s relevant activities
Under IFRS 10, to have power over an investee an investor must have existing rights that give it the current ability to direct the relevant activities. Therefore, after having identified an investee’s relevant activities one must determine who has the power (i.e. the current ability) to direct those activities. In this determination one must first distinguish between substantive rights, which are considered in the determination of control, and protective rights which are not relevant for that purpose.
Protective rights are designed to protect the interests of their holder without giving that party power over the investee to which those rights relate. Such rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances. An example of a protective right is a lender’s right to restrict a borrower from undertaking activities that could significantly change the credit risk of the borrower to the detriment of the lender.
If an investor holds only protective rights, it cannot have power or prevent another party from having power over an investee. The discussion on whether an investor has power to direct the relevant activities of an investee must therefore revolve around substantive rights. In the most straightforward of cases, if:
an investor has the majority of voting rights in an investee,
the relevant activities of that investee are directed through voting rights, and
there are no rights held by other parties that preclude the investor from exercising that control,
the analysis is very simple and it is easy to conclude that the investor has the current ability to direct the investee’s relevant activities. However, when less than a majority of the voting rights is held, one must look to contracts (including potential voting rights) and the dominance of rights held by an investor in proportion to other investors (de facto control) in determining whether that investor has power. An investor can have power even if it holds less than a majority of the voting rights of an investee.
Potential voting rights
Potential voting rights are rights to obtain voting rights of an investee, such as those arising from call options and convertible debt instruments. When assessing control, an investor also considers its potential voting rights as well as potential voting rights held by other parties. Such rights are relevant in the determination of control only if they are substantive, that is:
there are no barriers that prevent the holder from exercising those rights;
no other parties need to agree to the exercise of those rights;
the holder would benefit from the exercise of those rights; and
the holder can exercise those rights when decisions about the direction of the relevant activities need to be made.
For example, say that an entity “ABC” owns 40% of the voting rights of entity “XYZ”, with the other 60% owned by a third party. ABC has also a call option over a further 30% of the shares (hence voting rights) in XYZ, which option can be exercised immediately without notice. The conversion price is not expected to be out of the money. In this case, the potential voting rights are deemed to be substantive and, therefore, by virtue of its 40% actual voting rights and 30% potential voting rights ABC can control XYZ.
Continuing from the previous example, say that ABC is required to give 90 days’ notice in order to exercise the call option. The fact that the call option requires 90 days’ notice to exercise is a potential barrier to exercise. Determining whether the call option is substantive requires an understanding of the investee’s decision-making process:
If a shareholders’ meeting can be held by giving 30 days’ notice, then the call option is not substantive because ABC cannot exercise the call option in time to exercise power at the meeting.
However, if a shareholders’ meeting can only be held by giving 120 days’ notice, then the call option is substantive because ABC can exercise the call option in time to exercise power at the meeting.
Adding on to the original scenario, say that due to anti-competition rules ABC will be required to sell its stake in DEF upon acquiring XYZ. The fact that there are consequences to exercising the potential voting rights is relevant. Such consequences must be analysed to determine whether they constitute a significant barrier to exercise:
If DEF provides 5x the return on investment compared to XYZ, and ABC must sell DEF in a very short time frame (i.e. akin to a “fire sale”), there is an indication that the potential voting rights are deeply out of the money and may not be substantive.
If DEF provides the same return on investment compared to XYZ, and ABC has sufficient time to allow it to sell DEF at fair value, it would seem that the requirement to sell DEF is not a significant economic barrier to exercise.
De facto control
When assessing control, one also considers the dominance of rights held by an investor in proportion to other investors. The following are noteworthy indicators:
the more voting rights held by an investor, the more likely that investor is able to direct the relevant activities;
the more voting rights held by an investor relative to other vote holders, the more likely that investor is able to direct the relevant activities;
the more parties that would need to act together to outvote the investor, the more likely that investor is able to direct the relevant activities.
For example, say that an entity “ABC” owns 45% of the voting rights of entity “XYZ”, with the other 55% owned by third party investors.
Scenario 1: the 55% voting rights are held by many others and, typically, 60% of these ‘other’ investors attend meetings at which decisions about the relevant activities are made (e.g. shareholders’ meetings). IFRS 10 requires consideration of the number of shareholders that typically come to the meetings to vote (i.e. the usual quorum in shareholders’ meetings) and not how the other shareholders vote. Therefore, in view of the fact that the other shareholders are quite passive, as demonstrated by voting patterns ate previous shareholders’ meetings, it would seem that ABC has dominance of rights relative to other vote holders and, subject to other considerations, one may conclude that ABC has the ability to direct the relevant activities of XYZ.
Scenario 2: the 55% voting rights are held equally by 2 other investors. In this case, the size of ABC’s voting interest and its size relative to the other shareholdings are sufficient to conclude that ABC does not have power. Only two other investors would need to co-operate to be able to prevent ABC from directing the relevant activities of the investee.
Determining an investor’s exposure to variable returns and ascertaining the link between an investor’s power and the variability of returns.
In the final steps of the control assessment an investor is required to determine whether it is exposed, or has rights, to variable returns from its involvement with the investee and whether it is a principal or an agent.
The concept of variability under IFRS 10 is complex, but in most cases the practical application will be straightforward because the investor will hold debt or equity securities in the investee.
|Types of returns||A variable return|
|Very broad…||A source of variability for investor…|
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 the linkage element is missing.
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 primarily 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.
In determining if the decision maker is acting as principal or agent, it considers the overall relationship between itself and other parties.
Part 2 – Interaction Between IFRS 10 And The 7th Company Law Directive
On 15 July 2014 the Malta Institute of Accountants (MIA) published TECH 01/14, which is a set of guidance notes to assist MIA members in complying with the relevant requirements in European Directives and Generally Accepted Accounting Principles and Practice (GAAP), namely the requirements to be found in IFRS 10, IFRS 12, and IAS 27 (revised).
The amendments to IFRS 10
Although the IASB issued IFRS 10 in May 2011, soon after, in October 2012, the IASB published amendments to IFRS 10, IFRS 12 and IAS 27 (“the amendments”). The amendments to IFRS 10 in particular are the subject of this part of the article. These amendments:
introduce a requirement for investment entities to measure their investments in subsidiaries, that do not provide services related to the investment entity’s investment activities, at fair value through profit or loss, instead of consolidating them3; and
state that an investment entity that is required, throughout the current period and the comparative period presented, to apply the exception to consolidation for all of its subsidiaries in accordance with paragraph 31 of IFRS 10, solely presents separate financial statements4.
The amendments have been given an effective date of 1 January 2014 for the preparation of financial statements in accordance with the requirements of International Financial Reporting Standards as adopted by the European Union – unless an entity elects to early adopt these amendments.
To fall within the scope of this exception, an entity has to meet the definition of “investment entity” provided by the amendments, which is based on the three following elements5:
it obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services;
it commits to its investor(s) that its business purpose is investing funds solely for returns from capital appreciation, investment income, or both; and
it measures and evaluates the performance of substantially all of its investments on a fair value basis.
In assessing whether an entity meets this definition, it shall consider four typical characteristics of an investment entity as set out in paragraph 28 of IFRS 10. Parent entities that meet the definition of an investment entity will not consolidate any of their investments in subsidiaries that do not provide services related to the investment entity’s investment activities, and will only prepare separate financial statements according to the requirements of IAS 27. Consequently those entities, which meet the definition of an ‘investment entity’, are required to measure their investments in subsidiaries that do not provide services related to the investment entity’s investment activities, at fair value through profit and loss in accordance with the requirements of IFRS 9 (currently applied though the requirements of IAS 39).
The exception has its limitations and does not apply in the following cases:
an investment entity is still required to consolidate a subsidiary that provides services that relate to the investment entity’s investment activities as highlighted above; and
a parent of an investment entity, that is itself not an investment entity, is still required to consolidate all its investments in subsidiaries unless it avails itself of any other exemption that is available and is unrelated to the amendments.
Before considering these IFRS requirements any further, one would also need to understand that legal requirements for the preparation of annual statutory financial statements that are laid out in the Maltese Companies Act, 1995.
The Seventh Company Law Directive (83/349/EEC) lays down when consolidated financial statements should be prepared as well as the required scope of consolidation. These requirements have been transposed in Chapter X of Part V of the Companies Act. The new Accounting Directive (DIR 2013/34/EU) that will repeal and replace the Fourth and Seventh Directives, includes similar provisions. Both the current Seventh Company Law Directive and the new Accounting Directive do not (and will not) permit a treatment similar to that required by the amended IFRS 10 in respect of parent investment entities.
It is therefore at this point in the analysis that the individual is presented with the problem – when an investment entity is required, throughout the current period and the comparative period presented, to apply the exception to consolidation for all of its subsidiaries in accordance with paragraph 31 of IFRS 10, and is required to present only separate financial statements in accordance with paragraph 8A of the amendments to IAS 27. In other words, the amendments would require such parent investment entities not to prepare consolidated financial statements while the Seventh Directive would appear to require that same entity to prepare consolidated financial statements. The latter requirement is subject to the proviso that the entity is not exempted from preparing consolidated financial statements by virtue of a provision within the Seventh Directive itself6.
The (amended) IFRS 10 exception to consolidation is a requirement, which means that the parent investment entity’s use of this exception is not discretionary but mandatory.
The IAS Regulation (EC No 1606/2002) sets out the legal context and provides the legal basis for the application of IFRS in the EU. This Regulation requires the application of IFRSs as adopted by the EU (“adopted IFRSs”) for the consolidated financial statements of European companies whose securities trade in a regulated securities markets as defined in Article 4 of that Regulation. In addition, Article 5 allows Member States to permit or require (i) the companies referred to in Article 4 to prepare their annual accounts, and (ii) companies other than those referred to in Article 4 to prepare their annual and/or consolidated accounts, in conformity with IFRS adopted under the IAS Regulation. Malta is one of the countries that have extended the application of adopted IFRS to all limited liability companies registered in Malta7 except for entities that are permitted to, and apply, the General Accounting Principles for Smaller Entities (GAPSE).
In the circumstances, the application of IFRS as adopted by the EU would lead investment entities which satisfy the specified criteria to prepare separate financial statements that follow accounting rules which are distinct from those applying to consolidated financial statements in the Seventh Directive and/or the new Accounting Directive and the following question will arise: If an investment entity solely prepares separate IFRS financial statements as required under paragraph 8A of IAS 27 (amended), as required by paragraph 31 of IFRS 10 could/should it conclude that it will not be required to “go back to National Law” and prepare consolidated financial statements?
The issue raised should only concern groups where the parent entity is an investment entity complying with the criteria. Specifically, as soon as a parent entity is not an investment entity the exception in the IFRS does not apply and investment entities in the group would have to consolidate their investment in their subsidiaries (roll-up).8 The determination of whether or not a company is required to prepare consolidated financial statements depends on the requirements of the Seventh Council Directive and will depend in the future on the new Accounting Directive. 9
The relationship between the Seventh Directive and the IAS Regulation has been clarified in the document “Comments concerning certain Articles of the Regulation (EC) No 1606/2002”, published by the Commission on November 200310. Consequently the Seventh Directive lays down when consolidated accounts should be prepared, and (where relevant) the IAS Regulation is applied. For companies in the scope of the Regulation, the rules of endorsed IFRS apply11.
Recital 3 of the IAS Regulation clarifies that the aim of the IAS Regulation is “to supplement the legal framework applicable to publicly traded companies”. To do so, the IAS Regulation introduces derogations to the common regime set by the Accounting Directives, in that it provides more specific rules regarding individual or consolidated accounts than the Accounting Directives and thus represent lex specialis in comparison with the Accounting Directives, which are considered as lex posteriori. This pattern applies when either Article 4 or Article 5 of the IAS Regulation applies12.
The new Accounting Directive further clarifies in a Recital that its provisions should apply only to the extent that they are not inconsistent with, or contradicted by provisions specified elsewhere for the financial reporting of certain types of undertakings. The new Accounting Directive would therefore not restrict or hinder a company’s compliance with (or choice under) adopted IFRS further to the IAS Regulation. The Commission services analysis of November 200313 indicated a similar interpretation with respect to the current Fourth and Seventh Directives.14
Once a company was within the Seventh Directive and was listed, it is also automatically captured by the IAS Regulation. In Malta’s case, every company falls in scope of the IAS Regulation because Malta took up the Member State option in Article 5 of the Regulation. Consequently two sets of requirements would apply to a Maltese parent investment entity, one from an IAS Regulation perspective and one from an Accounting Directive’s perspective transposed at national level. Contradictions between the two have been resolved by the European Commission using concepts called lex specialis and lex posteriori, and, based on the concept of lex specialis, legislation that was deemed more specific than an Accounting Directive, the IAS Regulation (and hence adopted IFRS) would apply. Therefore whenever there is a conflict, adopted IFRS, being lex specialis, would prevail. This means that if a company is required to prepare consolidated financial statements under the Accounting Directive, but the lex specialis contains a conflicting requirement and required the same company to prepare separate financial statements, by preparing IFRS-compliant separate financial statements, a company would fulfil the National Law obligation to prepare consolidated financial statements and would also be complying with the requirement of the Accounting Directive. The following decision tree illustrates this15:
Since the application of the IAS Regulation cannot subsequently change the conditions which gave rise to this application16, such a parent entity should not be required to prepare consolidated accounts in addition to those separate financial statements. This would be the same with the new Accounting Directive17.
Unless an entity adopts GAPSE as its financial reporting framework, provided it is eligible to do so, all incorporated entities are required by Maltese law to prepare their financial statements in accordance with adopted IFRS and therefore an entity complying with the Seventh Directive is also captured within the scope of the IAS Regulation. Any contradictions between the Directive and the Regulation are resolved using the concepts of lex specialis and lex posteriori. According to the concept of lex specialis, legislation that is deemed to be more specific than the Accounting Directive, the IAS Regulation would apply.18
Based on this analysis, a parent company that meets the criteria to be classified as an investment entity and would accordingly prepare separate financial statements as a result of the requirements described within these notes, in accordance with the amendments to IFRS 10, 12 and IAS 27, shall be deemed to be compliant with the requirements of both the Seventh Directive and the IAS Regulation. Since the application of the IAS Regulation cannot subsequently change the conditions which gave rise to such application, an investment entity shall not be required to prepare consolidated accounts in addition to those separate financial statements. This would still apply with the new Accounting Directive19.
- 1 IFRS 10 Consolidated Financial Statements, paragraph IN5
- 2 IFRS 10 Consolidated Financial Statements, paragraph B11
- 3 Amendments to IFRS 10, IFRS 12 and IAS 27 Investment Entities, paragraph 31
- 4 Amendments to IFRS 10, IFRS 12 and IAS 27 Investment Entities, paragraph 8A of the amendments to IAS 27
- 5 Amendments to IFRS 10, IFRS 12 and IAS 27 Investment Entities, paragraph 27
- 6 Articles 13 to 15 of the Seventh Company Law Directive
- 7 Regulation 3(1) of SL 281.02 Accountancy Profession (Accounting and Auditing Standards)
- 8 Commission Services’ Working Paper, MARKT/F3/JPR/VDC/ga, Brussels, 06 June 2013
- 9 Ibid
- 10 http://ec.europa.eu/internal_market/accounting/docs/ias/200311-comments/ias-200311-comments_en.pdf
- 11 Agenda Paper for the meeting of the Accounting Regulatory Committee, 24 November 2006 (DOCUMENT ARC/19/2006)
- 12 Commission Services’ Working Paper, MARKT/F3/JPR/VDC/ga, Brussels, 06 June 2013
- 13 http://ec.europa.eu/internal_market/accounting/docs/ias/200311-comments/ias-200311-comments_en.pdf
- 14 Commission Services’ Working Paper, MARKT/F3/JPR/VDC/ga, Brussels, 06 June 2013
- 15 EFRAG, Interaction between the Fourth and Seventh Accounting Directives and the exception from consolidation for investment entities, Summary memorandum, 2014
- 16 The same conclusion was reached by the Commission Services in their Agenda Paper for the meeting of the Accounting Regulatory Committee, 24 November 2006 (DOCUMENT ARC/19/2006)
- 17 Ibid
- 18 MIA TECH 01/14 Interaction between the amendments to IFRS 10, IFRS 12 and IAS 27 regarding investment entities and the Seventh Directive
- 19 Ibid