Consolidation — redefining control and reflecting true net worth

    Consolidated financial statements in India have traditionally been a reporting requirement only for listed companies. Companies not listed on stock exchanges are not required to prepare or present consolidated financial statements.

    The fundamental change under IFRS is that IFRS recognises consolidated financial statements as the primary set of financial statements for any entity that has subsidiaries or joint ventures or associates. The only exception for an entity not to report consolidated financial statements is if it meets all the following conditions :

    (a) the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;

    (b) the parent’s debt or equity instruments are not traded in a public market;

    (c) the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and

    (d) the ultimate or any intermediate parent of the parent produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.

    In this article we shall discuss the differences in principles of consolidation as laid down in IAS 27 ‘Consolidated and separate financial statements’ under IFRS and AS-21 ‘Consolidated financial statements’ under Indian GAAP. We will cover some of the implementation challenges and impact of the subtle differences in the consolidation standard between Indian GAAP and IFRS in our next article.

Key differences and implication :

Definition of control :

    Under the IFRS framework, consolidation is based on the power to control (i.e., the ability of one entity to control another). Hence, understanding what constitutes ‘control’ is of utmost importance. Control is defined as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. This definition is not unlike what is stated under AS-21 in Indian GAAP. However, where Indian GAAP takes a narrow view and assumes that holding a majority of the voting interest of an entity automatically results in controlling the entity, IFRS treats the same as a rebuttable presumption. Thus, IFRS provides that control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity, unless in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control.

    The implication of the control principles under IFRS is that companies cannot consolidate an entity only based on holding of current voting interests. Since consolidation is based only on control, only one holding entity will practically be able to demonstrate such control and hence there will never be a scenario where the same entity is being consolidated by two separate holding entities as a subsidiary. As a result of the transition to IFRS, the holding in the entity will need to be re-looked for assessment of potential voting rights held and more importantly an evaluation of the nature of any veto rights held by other shareholders, which are discussed below.

Potential voting rights :

    In assessing control, the impact of potential voting rights that currently are exercisable should be considered. Such potential voting rights may take many forms, including call options, warrants, convertible shares, and contractual arrangements to acquire shares. This is because the potential voting rights give the holders the power to control the entity because they can step in and acquire control at any time if they wish to.

    For example, X owns 40% of the voting power in A, Y owns 25% and Z owns the other 35%. Further, X holds a call option to acquire from Y an additional 20% of the voting power in A; the call option can be exercised at any time. Accordingly, it is X that has the power to govern A. Therefore X consolidates A, but reflects 60% as non controlling interest.

Participative rights with other shareholders :

    The presumption of control may be rebutted in exceptional circumstances if it can be demonstrated clearly that such ownership does not constitute control. To ascertain whether ownership constitutes control, the rights of minority interests need to be analysed. In many cases minorities have certain rights even if another party owns the majority of the voting power in an entity. Sometimes these rights are derived from law, and other times from the entity’s constitution.

    IFRSs do not address the issue of minority rights but as discussed above it is necessary to consider the nature and extent of the rights of minority in determining control, including the distinction between participating rights that allow minority to block significant decisions that would be expected to be made in the ordinary course of business, and rights that are protective in nature. Since IFRS does not have specific literature on minority rights, guidance is drawn from EITF 96-16 under US GAAP to determine if certain rights are participative and hence demonstrate absence of control with the majority shareholder. Examples of participative rights are :

•      Approval from minority shareholders for selecting, terminating, and setting the compensation of management responsible for implementing the investee’s policies and procedures.

•      Approval from minority shareholders for establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

For example, two companies A and B come together to form a company X in which company A holds 75% with 3 directors on the board of company X and company B holds 25% with 2 directors on the board of company X. By virtue of majority holding, company A consolidates company X as a subsidiary under Indian GAAP. The Articles of Association of company X state that for certain decisions, a unanimous approval of the board of directors is required. These decisions include approving the annual and semi-annual budgets of the company and selection and appointment of senior management personnel. In such a case, Under IFRS, company A does not control company X, instead it shares joint control over it along with company B. Hence it shall not consolidate company X as a subsidiary but account for it as a joint venture arrangement.

Indirect holding:

Indirect holding mayor may not result in one entity having control over another. Although the total ownership interest may exceed 50%, this may not mean that the entity has control.

For example, entity L owns 35% of the voting power in entity N, and 40% of the voting power in entity M. M owns 60% of the voting power in N. There-fore, L has, directly and indirectly, a 59% [35% + (60% x 40%)] ownership interest in N.

Minority interests are referred as non-controlling interests (‘NCI’) under the revised IAS 27 standard and are presented as a part of consolidated equity. It is defined as ‘the equity in a subsidiary not attributable, directly or indirectly, to a parent’. This is unlike Indian GAAP, where minority interests are reflected outside consolidated equity (generally, as a liability).

Losses applicable to NCI are allocated irrespective of whether the NCI has a contractual obligation to make good such losses to the parent, even if doing so causes the NCI to be in a deficit position. Once again, this is unlike the treatment of excess losses under Indian GAAP.

Changes in controlling interests:

Under IFRS, changes in the  parent’s ownership interest in a subsidiary after control is obtained that do not result in a loss of control need to be accounted for as transactions with owners in their capacity as owners. As a result no gain or loss on such changes is recognised in the income statement. Also, no change in the carrying amounts of assets (including goodwill) or liabilities is recognised as a result of such transactions.

For example, Entity A owns 60% of the shares in Entity B. On 1st January 2010 Entity A acquires an additional 20% of Entity B. The consideration transferred for the additional shares of Entity B is INR 400. The carrying amount of non-controlling interest in the consolidated financial statements of Entity A on 1st January 2Q10 is INR 500.

The acquisition of the 20% interest of the non-controlling interest is recorded as follows:

Under Indian CAAP, the above acquisition of 20% additional interest would result in additional good-will for .the difference between the consideration transferred (INR 400) and the book value of the minority interest purchased.

Similarly, a reduction in equity interests from 80% to 60% due to sale of shares to minority interests (however control retained by the Company) would also have been adjusted in equity in the same manner as above, unlike Indian CAAP where a gain or loss on such sale of stake would have been rec-ognised in profit and loss e.g., : If the sale of 20% stake was made for a consideration of INR 500 (thus reducing the overall stake from 80% to 60%), and the net assets of the subsidiary were INR 1500 – Under IFRS, this transaction would result into an additional credit of INR 300 (1500*20%) to non-controlling interests and a credit of INR 200 to other equity, whereas under Indian CAAP the adjustment of INR 200 would have been recognised as a gain in the income statement.

Under IFRS, when a change in controlling interests results in loss of control (e.g., due to sale of investment in the subsidiary, due to which the investee company ceases to be a subsidiary), such a change is accounted for in two parts. Firstly, derecognise the net assets and goodwill of the subsidiary and recognise the relating gain or loss in income statement (by comparing it to the fair value of consideration received). Secondly, recognise any balance investment in the former subsidiary at fair value.

For example, Entity A owns 60% of the shares in Entity B. On 1st January 2010 Entity A disposes of a 20% interest in Entity B and loses control over Entity B. The consideration received for the sale of shares of Entity B is INR 400. At the date that Entity A disposes of a 20% interest in Entity B, the carrying amount of the net assets of Entity B is INR 1,750. The amount of non-controlling interest in the consolidated financial statements of Entity A on 1st January 2010 is INR 700. The fair value of the remaining 40% investment is determined to be INR 800.

Entity A would record the following entry to reflect its disposal of a 20% interest in Entity B at 1st January 2010 :

Assuming that the remaining interest of 40% represents an associate, the fair value of INR 800 represents the cost on initial recognition and IAS 28-Accounting for associates applies going forward.

Under Indian CAAP, the gain on sale in the above case would be recognised based on the difference between the consideration received (INR 400) and the proportionate carrying value of the investment in the subsidiary. The carrying value of the balance investment would not be revalued to the fair value
unlike  IFRS.    ‘

Special purpose entities:

Under IFRS, there is no requirement for the parent to have a shareholding in a subsidiary, and this is not a necessary pre-condition for control. Sometimes an entity is created to accomplish a narrow and well-defined objective (e.g., conduct research and development activities, securitise financial assets, or own a specified asset). Such entities are referred to as Special Purpose Entities (SPE) and SIC 12 ‘Consolidation – Special purpose entities’ lays down the guidance for consolidation of SPEs. Important to bear in mind when analysing an SPE is the requirement to account for the substance and economic reality of a transaction rather than only its legal form. Conditions where an entity controls an SPE and hence needs to apply consolidation are given below:

a) in substance, the activities of the SPE are being conducted on behalf of the entity according to its specific business needs so that the entity obtains benefits from the SPE’s operation;

    b) in substance, the entity has the decision-making powers to obtain the majority of the benefits of the activities of the SPE or, by setting up an ‘autopilot’ mechanism, the entity has delegated these decision-making powers;

    c) in substance, the entity has rights to obtain the majority of the benefits of the SPE and there-fore may be exposed to risks incidental to the activities of the SPE; or

    d) in substance, the entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities.

Using this approach, several SPE’s that have been set up by Indian companies for specific purposes (without any direct holding of voting interest or Board representation) may need to be consolidated, if the conditions of SIC 12 are met. This involves significant use of judgment and an evaluation of all the facts and circumstances of the case. Such entities are typically not consolidated under Indian CAAP. In the Indian context, some of the above parameters may get triggered in arrangements of ‘toll manufacturers’ – a practice which is fairly common in the FMCC and pharmaceuticals industry.

Conclusion:

Consolidation is an area which needs careful evaluation on convergence with IFRS. The changes due to such transition could result in a change in the group i.e., subsidiaries which were earlier part of the group may now become joint ventures or associates; and special purpose entities which were earlier not consolidated would now form part of the consolidation group. Consolidation in IFRS essentially revolves around the concept of unilateral control of the financial and operating policies of the investee company and lays importance on substance over form. It is important to note here that IASB has issued an Exposure Draft ‘ED 10 – Consolidated Financial Statements’ that under one standard now covers concepts of participative and protective rights of non-controlling interest and special purpose entities.