IFRS 10 – Consolidated Financial Statements is effective for annual periods beginning on or after 1st January 2013. It builds on the control guidance that existed in IAS 27 and SIC 12 and adds additional context, explanations and application guidance that is consistent with the definition of control. IFRS 10 applies a single control model to determine whether an investee should be consolidated.
De-facto control is explicitly included in the model.
IFRS 10 states that ‘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’. IFRS 10 requires an investor to assess whether it has power over the relevant activities of the investee. Only substantive rights of the investor are relevant for this purpose and voting and other rights needs to be considered for this assessment. There are additional considerations for assessment of power in the instance of the investor holding less than a majority of the voting rights.
De-facto control is one such consideration. De-facto control is said to exist when an investor’s current voting rights may be sufficient to give it power even though it has less than half of the voting rights. Assessing whether an investor has de-facto control over an investee is a two-step process:
• In the first step, the investor considers all facts and circumstances including the size of its holding of voting rights relative to the size and dispersion of the holdings of other vote holders. Even without potential voting rights or other contractual rights, when the investor holds significantly more voting rights than any other vote holder or organised group of vote holders, this may be sufficient evidence ofpower. In other situations, these factors may provide sufficient evidence that the investor does not have power – e.g. when there is a concentration of other voting interests among a small group of vote holders. In some cases, these factors may not be conclusive and the investor needs to proceed to the second step
• In the second step, the investor considers whether the other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. The investor also considers the factors normally used to assess power when the investee is controlled by rights other than voting rights.
An investor with less than a majority of the voting rights has rights that are sufficient to give it power when the investor has the practical ability to direct the relevant activities unilaterally. When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:
a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders, noting that:
• the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
• the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
• the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
b) potential voting rights held by the investor, other vote holders or other parties
c) rights arising from other contractual arrangements; and
d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings.
When the direction of relevant activities is determined by majority vote and an investor holds significantly more voting rights than any other vote holder or organised group of vote holders, and the other shareholdings are widely dispersed, it may be clear, after considering the factors listed above, that the investor has power over the investee.
Determining whether an investor has de-facto control over an investee is usually highly judgmental: it includes determining the point at which an investor’s shareholding in an investee is sufficient and the point at which other shareholdings’ interests are sufficiently dispersed. It would also be difficult for a dominant shareholder to know whether a voting agreement amongst other shareholders exists.
Applying the above principles poses various challenges. There may be situations in which the dominant shareholder does not know whether arrangements exist among other shareholders, or whether it is easy for other shareholders to consult with each other. The investor should have processes in place to allow it to capture publicly available information about other shareholder concentrations and agreements.
The smaller the size of the investor’s holding of voting rights and the less the dispersion of the holding of other vote holders, the more reliance is placed on the additional factors in Step 2 of the analysis; within these, a greater weighting is placed on the evidence of power.
The ‘voting patterns at previous shareholders’ meetings’ 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 (i.e. whether they usually vote the same way as the investor). However, how far back should one look for assessing the past trend is a question of judgment. Also, for start-up companies this will particularly be a challenge.
Determining the date on which an investor has de-facto control over an investee may in practice be a challenging issue. In some situations, it may lead to a conclusion that control is obtained at some point after the initial acquisition of voting interests. At the date that an investor initially acquires less than a majority of voting rights in an investee, the investor may assess that it does not have de-facto control over the investee if it does not know how other shareholders are likely to behave. As time passes, the investor obtains more information about other shareholders, gains experience from shareholders’ meetings and may ultimately assess that it does have de-facto control over the investee. Determining the point at which this happens may require significant judgment.
In the backdrop of companies getting capital infusion from private equity investors the assessment of de-facto control will be very challenging. While the investors may not have majority voting rights, they do obtain various rights that include appointment of key managerial personnel, guaranteed return on their investments, right to approve the annual operating plans/ budgets, etc. Such cases will need to be closely looked into for determining whether the investor has a de-facto control on the investee.
Let us consider an example: Company A acquired 45% in Company B (which is a listed company and balance shareholding is widely dispersed). Company B has 6 directors who are appointed by shareholders in their general meeting based on simple majority. Whether Company A needs to consolidate Company B as a subsidiary.
Analysis under AS-21 under Indian GAAP: Under Indian GAAP an investor consolidates the investee company only if it ‘controls’ the investee. Control is defined as
(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or
(b) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.
Based on the aforesaid definition of control, in this example Company A does not have control of Company B (either majority voting power or control composition of Board), thus it cannot consolidate Company B as a subsidiary.
Analysis under IFRS: Under IFRS 10, Company A will need to determine whether it has control over Company B. As discussed earlier, the control definition under IFRS is wider and includes de-facto control as well. In the instant case, Company A is the largest shareholder of Company B and it is given that the balance shareholding is widely dispersed. Company A will need to evaluate the following:
(a) Number of shareholders that own the next 45 % shareholding: The higher the number, the greater are the chances that Company A will need to consolidate Company B, for example if the next 45% is held by around 5 shareholders it will be difficult to demonstrate de-facto control as 5 shareholders can get together and vote against Company A. However if the next 45% shareholding is owned by 1,000 shareholders (widely dispersed public shareholding), it can be demonstrated that Company A in effect would control the functioning of Company B as the probability of 1,000 shareholders coming together and vote against Company A will be remote.
(b) History of voting in the past general meetings: Company A will need to evaluate the number of shareholders actively attending the general meetings and participating in the decisions of shareholders. It is important to assess the number of shareholders that attend general meetings and not how they vote. Thus, in case past history reflects that all 100% shareholders attend the general meeting and cast their votes it may be difficult to demonstrate de-facto control, no matter that the balance shareholders voted for decisions in favour of Company A. However, if the total number of shareholders casting their votes in the general meeting are always less than 80%, then it can be demonstrated that de-facto control exists, since Company A has more than 50% voting power of effective votes cast in the general meetings.
(c) Rights of other shareholders: Before concluding whether Company has de-facto control of Company B, it will need to be assessed in any special rights are available to other shareholders or shareholder groups such as their consent is required prior to approving annual business plan or appointment and removal of key managerial personnel. Presence of such rights will impact the ability of Company A to consolidate Company B as a subsidiary.
After considering the above factors, under IFRS Company A may need to consolidate Company B as a subsidiary though it only holds 45% of the voting power in Company B. Under the earlier consolidation standard under IFRS IAS 27- application of de-facto control approach was an accounting policy choice, however under IFRS 10, consideration of de -facto control is mandatory for assessing control.
The requirement to assess control is continuous. De-facto control relies, at least in part, on the actions or inactions of other investors. Therefore, the requirement to assess control on a continuous basis may mean that the investor who is assessing whether it has de-facto control may need to have processes in place that allow it to consider who the other investors are, what their interests are and what actions they may or may not take with respect to the investee on an ongoing basis.
This is an important change for companies, as currently under Indian GAAP, consolidation is more rule driven based on the definition of control under AS -21. Under IFRS 10, companies will need to closely monitor aforesaid factors on a regular basis to determine control over entities and preparation of its consolidated financial statements.
