HKICPA Webinar: IFRS 10 Consolidated Financial Statements. Yin Toa Lee, Partner 13 August 2013

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1 HKICPA Webinar: IFRS 10 Consolidated Financial Statements Yin Toa Lee, Partner 13 August 2013

2 Disclaimer The materials of this seminar / workshop / conference are intended to provide general information and guidance on the subject concerned. Examples and other materials in this seminar / workshop / conference are only for illustrative purposes and should not be relied upon for technical answers. The Hong Kong Institute of Certified Public Accountants (The Institute), the speaker(s) and the firm(s) that the speaker(s) is representing take no responsibility for any errors or omissions in, or for the loss incurred by individuals or companies due to the use of, the materials of this seminar / workshop / conference. No claims, action or legal proceedings in connection with this seminar/workshop/conference brought by any individuals or companies having reference to the materials on this seminar / workshop / conference will be entertained by the Institute, the speaker(s) and the firm(s) that the speaker(s) is representing. Page 2

3 Today s agenda Background and objectives of IFRS 10 New definition of control Power Relationships with other parties Power over specified assets Continuous assessment Transition Disclosure requirements Resources Page 3

4 Background and objectives of IFRS 10 Background Tension between the control model in IAS 27 and the risks and rewards approach in SIC-12 Divergent application of IAS 27 and SIC-12 in practice Global financial crisis put emphasis on the project Convergence with US GAAP Objectives Develop single control model applicable to all entities Improve disclosures Page 4

5 New definition of control 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 Control of an investee requires an investor to possess all three essential elements: Power over the investee; Exposure, or rights, to variable returns from its involvement with the investee; and Ability to use its power over the investee to affect the amount of the investor s returns Page 5

6 Identifying activities Evaluating power Assessing returns New definition of control Activities Identify which activities of the investee are considered to be the relevant activities, i.e., those that significantly affect the investee s returns Power Determine which party, if any, has power, that is, having existing rights that give it the current ability to direct the relevant activities Returns Assess whether the investor is exposed, or has rights, to variable returns from its involvement with the investee Understand purpose and design Page 6

7 New definition of control Identifying relevant activities Relevant activities are those that significantly affect the investee s returns Examples: Establishing operating, capital and financing policies Appointing, remunerating, and terminating employment of service providers or key management personnel Understand purpose and design of the investee If two investors direct different relevant activities Identify which investor can direct the activities that most significantly affect returns Page 7

8 New definition of control Identifying relevant activities Example 1 Two investors form an investee to develop and market a medical product One investor is responsible for developing and obtaining regulatory approval Other investor is responsible for manufacturing and marketing Determine which activity most significantly affects returns Purpose and design of the investee Factors that affect profit margin, revenue, etc. Effect on returns from each decision-maker s authority Investors exposure to variability of returns Page 8

9 New definition of control Identifying relevant activities Example 2 Entity holds receivables only activities: Purchase receivables and service on daily basis Collection of principal and interest payments Passing through payments to investors in entity Upon default, receivable is put back to investor Relevant activity = managing defaults Only activity that significantly affects returns Investor who manages defaults has power Would control, if other two criteria are also met Page 9

10 New definition of control Evaluating power Power is having existing rights that give an investor the current ability to direct the relevant activities Main aspects of power: Arises from rights Need not be exercised Does not arise from protective rights Can exist even if others participate in directing the relevant activities (e.g., they have significant influence) Evidence that an investor directed activities in the past is an indicator of power, but is not conclusive Page 10

11 New definition of control Assessing returns Returns can be only positive, only negative or positive and negative, but must have the potential to vary as a result of the investee s performance Examples: Dividends, distributions of economic benefits, changes in the value of an investment Remuneration, fees, residual interests, tax benefits, exposure from providing support Synergies, cost savings, economies of scale, scarce resources, proprietary knowledge Page 11

12 New definition of control What changed or is more explicit? Protective rights De facto control Potential voting rights Delegated rights (principal-agency relationships) Relationships with other parties ( de facto agents ) Control of specified assets ( silos ) Increased use of judgement Continuous assessment Who s affected? Fund and asset managers Entities that have been delegated power (e.g., operators ) Financial services structured entities Holders of significant (but not majority) interests or options Page 12

13 Power Protective rights Protective rights do not give power When are rights merely protective rights? Fundamental changes in the activities of an investee Only apply in exceptional circumstances Examples of protective rights include the right to: Restrict an investee from undertaking activities that could significantly change the credit risk of the investee Approve an investee s capital expenditures (greater than the amount spent in the ordinary business) Protective rights do not prevent another investor from having control Page 13

14 Power Protective rights Franchises A franchise agreement often gives the franchisor rights, which generally: Are designed to protect the brand Do not have a significant effect on franchisee s returns Assess whether rights give franchisor power: Who benefits from activities of franchisee? What are the relevant activities? How was the franchisee established and structured? How does the franchisor support the franchisee? What is franchisor s exposure to variability of returns? Page 14

15 Power Current ability Does the investor have the current ability to exercise power? Rights need to be substantive (i.e. the holder must have the practical ability to exercise those rights) Factors to consider whether? Economic or other barriers exist Multiple parties have to agree to exercise right Holders would benefit from exercising the right Right is currently exercisable Current does not necessarily mean this instant Page 15

16 Power Majority of voting rights Majority of voting rights normally gives power to direct the relevant activities when: Voting rights are substantive Voting rights direct the relevant activities Holder is not an agent of the investor This might not be the case when: Other legal requirements, founding documents or other contractual arrangements restrict the ability to direct the relevant activities Activities are subject to direction by government, court, administrator, receiver, liquidator, or regulator Page 16

17 Power De facto control An investor may have the power with less than half of the voting rights Consider facts and circumstances: Contractual rights arising from other arrangements Size of the investor s holding of voting rights relative to the size and dispersion of other vote holders Voting rights (absolute amount) Voting rights relative to other vote holders Number of other vote holders that would need to act together Potential voting rights Additional facts & circumstances Voting patterns at previous shareholders meetings Page 17

18 Power De facto control Examples 1 and 2 Example 1 A has power Example 2 C does not have power 52% widely dispersed 1% 1% 1% 26% 26% A 48% B C 45% D Page 18

19 Power De facto control Examples 3 and 4 Example 3 E has power Example 4 not conclusive 12 investors at 5% each 11 investors at 5% each Contract to appoint mgmt E 40% F G 45% H Page 19

20 Power De facto control Examples 5 and 6 Example 5 J does not have power Example 5 L has power 50% widely dispersed, half turn up at AGM 5% 5% 5% 50% widely dispersed, half turn up at AGM 4% 4% 4% J 35% K L 38% M Page 20

21 Power De facto control Practical issues How should the exact date at which control is obtained (or lost) be determined? How is the exact date at which the other investors became widely dispersed determined? How large should an investor s interest be relative to other vote-holders, or how widely dispersed must they be for the investor to have power? How relevant are past voting patterns? How far should you look back? How will you gather all information? Past voting patterns Relationships between other shareholders Page 21

22 Power Potential voting rights An investor may have the power through holding potential voting rights All facts and circumstances must be considered: Substance of the rights Exercisability Barriers Benefits Purpose and design Other involvement the investor has with the investee Investor s apparent expectations, motives and reasons for agreeing the terms of the instrument Page 22

23 Power Potential voting rights Example 1 Investee s AGM is in eight months 30 days needed for shareholders to call meeting Investor holds option to acquire the majority of shares in the investee that is exercisable in 25 days and is deeply in the money Conclusion: Investor with options has power Existing shareholders are unable to direct relevant activities because a special meeting cannot be held for 30 days, when option could have been exercised Investor holding the option can direct relevant activities, even before the option is exercisable Page 23

24 Power Potential voting rights Example 2 Investor A holds 70% of the voting rights Investor B has: 30% of the voting rights of the investee Option to acquire half of investor A s voting rights Exercisable for the next two years Fixed price and deeply out of the money (expected to remain so) Investor A has power it has been actively directing the relevant activities of the investee Investor B does not have power the terms and conditions are such that the options are not considered substantive Page 24

25 Power Potential voting rights Practical issues When is the exercise/conversion price considered a barrier? Could financing be obtained? When are options deeply out of the money? What period do you consider? When are options currently exercisable? Would the holder benefit from the exercise? How will you gather information? Do other shareholders have potential voting rights, barriers, or incentives that you are unaware of? Page 25

26 Power Delegated rights Overview An agent is a party engaged to act on behalf of another party or parties (the principal(s)) A principal may delegate some or all decisionmaking authority to the agent An agent does not control an investee All facts and circumstances must be considered Principal? Agent? Page 26

27 Power Delegated rights Scope of decision-making Range of activities that are permitted by the decisionmaking agreement or by law Whether relevant activities have been delegated Discretion that the decision-maker has when making decisions about those activities Level of involvement that the decision-maker had in determining the scope of its authority Opportunity and incentive to gain power Purpose and design Risks to which the investee was designed to be exposed Risks investee was designed to pass on to investors Page 27

28 Power Delegated rights Rights held by other parties Held by a single investor decision-maker is an agent More parties that have to agree more likely that decision-maker is a principal Removal rights held by an independent board who can remove decision-maker for any reasons more likely decision-maker is an agent Investors Fund manager Fund Kick-out rights Voting rights Page 28

29 Power Delegated rights Remuneration To be an agent, remuneration must : Be commensurate with services provided AND Includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated on an arm s length basis Commensurate Market terms Conclusion Greater magnitude and variability of remuneration compared to expected returns more likely principal Not an agent Not an agent Not an agent Page 29

30 Power Delegated rights Exposure to variability through other interests Are any interests held by related parties? Greater the magnitude of, and variability associated with, its economic interests, more likely it is a principal Does exposure differ from other investors? Expected returns vs. maximum exposure Direct 20% Parent Fund manager Fund Delegated 80% Investors Delegated 80% Page 30

31 Power Delegated rights Examples Example 1 Example 2 Example 3 Scope Broad discretion Broad discretion Broad discretion Bank Rights held by others Simple majority, for cause Simple majority, for cause Independent board, for any reason Direct Invest Remuneration 1% of NAV 20% of profits if hurdle rate Other interests 2% direct interest 1% of NAV 20% of profits if hurdle rate 20% direct interest 1% of NAV 20% of profits if hurdle rate 20% direct interest Conclusion Agent Principal Agent Asset Mgr Fund Delegated rights Delegated rights Page 31

32 Relationships with other parties De facto agents Consider whether the investor has the ability to direct other parties (i.e., de facto agents ) to act on its behalf? Examples: Related parties (IAS 24) A party that cannot finance its operations without subordinated financial support from the investor A party with same Board or key management personnel Rights and returns of de facto agents are considered together with investor s own, when evaluating control Page 32

33 Control of specified assets If an investor has control of specified assets of an investee, it treats that portion ( silo ) of the investee as a separate entity if all apply Specified assets are the only source of payment for specified liabilities/other interests in the investee Parties other than those with the specified liabilities do not have rights or obligations related to the specified assets or to residual cash flows from those assets None of the returns from the specified assets can be used by the remaining investee None of the liabilities of the deemed separate entity are payable from the assets of the remaining investee In other words, is there a ring-fence? Page 33

34 Continuous assessment Reassess if facts and circumstances suggest change to one of criteria of control Examples: Changes to how activities are directed Changes in exposure to variable returns Market conditions change: If affect one of control criteria re-evaluate control If do not affect one of control criteria no re-evaluation Page 34

35 Transition Effective for annual periods beginning on or after 1 January 2013 Retrospective application As if it was always consolidated (since the date of gaining control) If not practicable to apply retrospectively, consolidate as of earliest date where practicable, which may be current period Page 35

36 Disclosure requirements Disclosures should enable users to understand: Nature of, and risks associated with, involvement with other entities Financial effects of that involvement on financial position, financial performance, and cash flows Significant judgments and assumptions (and changes thereto) made by the investor in determining whether it controls another entity For subsidiaries with material NCI interests, summarised financial information Disclosures for structured entities Page 36

37 Resources IFRS Developments Issue 1 (May 2011) Webcast Sector publications Applying IFRS 10 application issues and indepth explanations Page 37

38 Appendix: Comparison to US GAAP

39 Comparison to US GAAP Background MOU project ideally Boards hoped for converged standard FASB and IASB jointly deliberated much IFRS 10 FASB decided: Not to converge with much of IFRS 10 To propose amendments to US GAAP related to the principal/agent determination Result: Voting interest entities significant differences remain Structured entities (VIEs) Boards expect convergence Page 39

40 Comparison to US GAAP Two models Variable interest entities (VIEs) The power to direct the activities of the VIE that most significantly impact the VIE s economic performance The obligation to absorb losses of the VIE or the right to receive benefits from the VIE that potentially could be significant to the VIE Voting interest entity Holding a majority of voting rights For limited partnerships and similar entities - presumption that the general partner (or its equivalent) controls the entity, regardless of ownership percentage Page 40

41 Comparison to US GAAP US GAAP IFRS 10 De facto control Potential voting rights Principal / agency Removal rights Related parties / de facto agents Voting entities none VIEs Amendments will be proposed for VIEs to converge with IFRS Substantive if: Voting entities simple majority VIEs single party Voting entities none VIEs aggregate interests in certain cases The more parties that are required to agree to exercise the rights, the less likely that those rights are substantive Page 41

42 Comparison to US GAAP Decrease in ownership provisions (with and without loss of control) Different reporting dates of parent and subsidiary Different accounting policies of parent and subsidiary Investment entity accounting US GAAP IFRS 10 Applies to businesses and non-profit activities Excludes sales of real estate and conveyances of oil and gas rights The effects of significant events are disclosed A parent and subsidiary are not required to have the same accounting policies Investment companies (as defined) measure investments at fair value Scope applies to all subsidiaries The effects of significant events are reflected in the financial statements A parent and subsidiary are required to have the same accounting policies Currently no scope exclusion consolidation required Page 42

43 Key differences to US GAAP Likely to remain: Accounting for the acquisition of an entity that is not a business Accounting for a loss of control Accounting for decreases in ownership interests without a loss of control Requirement that parents and subsidiaries have the same reporting period end and the same accounting policies Page 43

44 Question & Answer Please drop questions into the question box. Page 44

45 Thank You Please fill in the evaluation form. Page 45

46 IFRS 10 Consolidated Financial Statements

Ind-AS 110 Consolidated Financial Statements

Ind-AS 110 Consolidated Financial Statements Hemal D. Shah The Chamber of Tax Consultants Topics Background, objectives and core principle New definition of control Assessing control Investment entities