Consolidation – redefining control and reflecting true net worth Part-2

Continuing with the topic of consolidation, in this article we will cover certain implementation issues and other differences which will have a significant impact on Indian companies.

Key differences and  implications:

Concept  of de facto  control:

In the earlier article we discussed that 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 of control under IFRS gives rise to another perspective, which is the’ defacto’ control model. De facto control arises when an entity holding a significant minority interest can control another entity without legal arrangements that would give it majority voting power. De facto control exists if the balance of holdings in an entity with other shareholders is dispersed and the other shareholders have not organised their interests in such a way that they commonly exercise more votes than the significant minority shareholder.

Under a de facto control model the power to govern an entity through a majority of the voting rights or other legal means is not essential for consolidation. Rather, the ability in practice to control (e.g., by casting a majority of the votes actually cast) in the absence of legal control may be sufficient if no other party has the power to govern. Under this approach, de facto control is evaluated based on all evidence available. Presence of de facto control can result in consolidation by the significant minority shareholder.

Both the ‘power to govern’ and ‘de facto’ control models meet the principles of control under IAS 27 – Consolidated financial statements. Accordingly, an entity has an accounting policy choice on assessing control and consolidation i.e. whether to assess as per the power to govern model or the de facto control model. This policy choice needs to be followed consistently and disclosed in the financial statements.

Accounting for joint ventures:

Currently,  accounting for joint ventures under  IFRS is not very different from accounting under Indian GAAP i.e. AS 27 – ‘Financial reporting of interests in joint ventures’. However, IAS 31- ‘Reporting interests in joint ventures’ gives the venturer a choice to account for a jointly controlled entity using either the proportionate consolidation method or the equity method in its consolidated financial statements. Interestingly, as part of the IASB/FASB convergence project, the exposure draft ED-9 on ‘Joint Arrangements’ issued by the IASB in September 2007 proposes to prohibit the proportionate consolidation method. Hence, once this ED becomes an effective IFRS, venturers would account for jointly controlled entities only as per the equity method of accounting in their consolidated financial statements.

The basis for such a change has been stated by the IASB as follows – ‘When a party to an arrangement has joint control of an entity, it shares control of the activities of the entity. It does not, however, control each asset nor does it have a present obligation for each liability of the jointly controlled entity. Rather, each party has control over its investment in the entity. Recognising a proportionate share of each asset and liability of an entity is not consistent with the Framework, which defines assets in terms of exclusive control and liabilities in terms of present obligations.’ Hence the equity method of accounting is more representative of the interests of a venturer in the joint venture. Going forward, this change would most impact the reported consolidated revenue of such venturers.

Accounting for  associates:

The principles of accounting for associate entities in the consolidated financial statements of an investor under IFRS are the same as under Indian CAAP. Unlike Indian CAAP, IFRS considers potential voting rights that currently are exercisable in assessing significant influence, for example convertible debentures held by the investor.

Deferred taxes on consolidation:

Under Indian CAAP, deferred taxes in the consolidated financial statements are quite simply the summation of deferred taxes in each of the individual group companies. Unlike IFRS, the Indian CAAP accounting framework does not require any adjustments to be made to deferred taxes on consolidation. Under IFRS, the important adjustments that are required to be made to arrive at the consolidated deferred taxes and resultant profit after tax are as below:

Elimination of deferred taxes on inter company transactions/stock reserves:

In determining tax expense in consolidated financial statements, temporary differences arising from elimination of unrealised profits and losses resulting from intra-group transactions should be considered. Consider an example: Parent company sells goods to its subsidiary company worth Rs. 1000. Parent company’s profit on this transaction is Rs. 100. At the year end, these goods remain unsold by the subsidiary and are hence lying in its inventory. On consolidation an adjustment to eliminate the unrealised profit of Rs. 100 is made in the consolidated financial statements of the Parent company. Hence the accounting base of the inventory in the consolidated books has now become Rs.900 whereas the tax base of the same inventory still remains Rs. 1000. This gives rise to deductible temporary difference which should be recognised as a deferred tax asset in the consolidated financial statements.

Now the question that arises is at what tax rate should this deferred tax asset be recognised – at the seller’s (parent company’s tax rate) or the buyer’s (subsidiary company’s tax rate). IAS 12 states that an entity recognises deferred tax assets only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised/Since the reversal of the difference would result in lower current taxes in the buyer’s books, the recognition of this deferred tax asset is made on the buyer’s rate keeping into consideration whether the buyer would have sufficient taxable profits in the future to utilise this deferred tax asset.

Recognition of deferred taxes on undistributed profits of joint ventures and associates:

Currently under Indian CAAP, profits of subsidiaries, branches, associates and joint ventures (‘investee companies’) are included in consolidated profits of the Parent company. The consolidated performance results and net worth are accordingly reported to the shareholders of the Parent under Indian CAAP. However one important aspect that is not reported is the impact of tax leakage when the profit earned by the investee companies will be transferred to the Parent. Accordingly the consolidated profit and the net worth reported under Indian CAAP is over-stated to that extent, since the overall tax impact on the consolidated profit available to the Parent company is not completely recorded in the books of account. Such deferred tax impact is accounted for in the consolidated financial statements under IFRS.

For example: Parent Company P consolidates undistributed profits of Rs. 100 crores of Subsidiary company S in its consolidated financial statements of which Rs 15 crores is post acquisition profits. P plans to draw dividends of Rs.20 crores from S in 18 months’ time; P estimates that Rs.15 crores of that amount will relate to post-acquisition earnings already recognised in the financial statements. The dividend distribution tax rate in S’s jurisdiction is 15%. In this case, P should recognise a deferred tax liability of Rs.2.25 crores (at a rate of 15% on Rs.15 crores) in its consolidated financial statements.

Thus as explained above, undistributed profits of certain investee companies result in a taxable temporary difference in the consolidated books of accounts. However, as per Para 39 of IAS 12, taxable temporary differences in respect of investments in subsidiaries, branches, associates and joint ventures are not recognised if :

•     the investor is able to control the timing of the reversal of the temporary difference; and

•     it is probable that the temporary difference will not reverse in the foreseeable future.

Since an entity controls an investment in a subsidiary or branch, the entity may be exempt for recognising deferred tax liability on undistributed profits, if it can demonstrate that it controls the timing of the reversal of a taxable temporary difference and the temporary difference will reverse in the foreseeable future. The term ‘foreseeable future’ is not defined in the standard; generally it is necessary to consider in detail a period of 12 months from the reporting date, and also to take into account any transactions that are planned for a reasonable period after that date.

Since deferred tax assets and liabilities are measured based on the expected manner of recovery (asset) or settlement (liability); deferred taxes on undistributed profits of subsidiaries, joint ventures or associates could be recognised either based on the applicable dividend distribution tax or the capital gains tax rate depending on the expected manner of recovery of such profits.

In case where the difference is assumed to be reversed though capital gains i.e. on sale of investments deferred tax liability is created on the effective capital gain tax rate on the difference between the net assets attributable to the Parent’s share less the indexed cost of acquisition.

In the above example, consider that P plans to dispose of the investment in 15 months and the capital gains tax rate applicable to it is 30%. The excess of the net assets of S over the cost of acquisition is Rs.15 crores and the indexation benefit is assumed to be 3 crores. In this case, P would recognise a deferred tax liability of Rs.3.6 crores [(15-3)*30%]in its current consolidated financial statements.

In situations where the entity does not account for the aforesaid deferred tax liability in accordance with Para 39, a disclosure to that extent is required in the financial statements reporting the amount of deferred tax liability not accounted for in the books.

An investor does not control an associate or a joint venture and therefore is not in a position to control the associate/joint venture’s dividend policy. Therefore a deferred tax liability must be recognised unless the associate/joint venture has agreed that profits will not be distributed in the foreseeable future or the Parent company’s approval is mandatory for dividend distribution (as a protective right).

Uniform accounting policies:

Para 24 of IAS 27 states that ‘consolidated financial statements shall be prepared using uniform accounting policies for like transactions and other events in similar circumstances.’ Therefore, if a subsidiary, associate or joint venture uses different accounting policies from those applied in the consolidated financial statements, then appropriate consolidation adjustments to align accounting policies should be made when preparing those consolidated financial statements. In practice, this can often pose challenges, particularly in case of associates and joint ventures, where the parent entity has no control over the accounting policies considered by the investee companies for their separate financial statements.

Impact of business combination ‘fair value’ accounting on ongoing consolidation:

In the earlier article on IFRS 3 – Business Combinations (refer BCA Journal, June 2009 edition), we discussed the purchase method of accounting for all business combinations and in particular, acquisition of a subsidiary, which results in accounting for all assets and liabilities acquired at fair values. Since there is no option of push down accounting under IFRS, the subsidiary continues to carry the same assets and liabilities at their book values (or as per the IFRS accounting policy adopted by it for each asset and liability) in its stand alone books of ac-count. Whereas in the consolidated books of accounts, the assets and liabilities at acquisition date are continued to be carried at fair values as on that date. This results in the following additional adjust-ments that are required to be carried out as part of the consolidation procedure at every reporting period:

• Restate the recognised assets and liabilities in the subsidiary’s books as on acquisition date to their fair values and accordingly make adjustments for depreciation or amortisation

• Recognise intangibles identified as on the acquisition date at their fair values and accordingly make adjustments for amortisation or impairment

• Recognise deferred taxes as on the acquisition date and accordingly make adjustments for reversals in the future periods.

Effectively, the acquired subsidiary would have to maintain two sets of financial statements:

• Separate financial statements as per IFRS book values or the accounting policies applied

• Financial statements for consolidation purposes as per the fair values on acquisition date with appropriate adjustments.

IAS 28 –    ‘Investment in associates’  requires that on acquisition of the investment the excess between the cost of the investment and the investor’s share of the net fair value of the associate’s identifiable assets and liabilities should be accounted for as goodwill and included in the carrying amount of investments or any deficit arising on the same basis should be included as income in the period in which the investment is acquired. In either case, initial accounting requires the identification of the fair value of net assets of the investee as on the acquisition date. Consequently, appropriate adjustments the investor’s share of the associate’s profits or losses after acquisition are also made to account for the subsequent measurement of these initial fair values. For example, depreciation of the assets would be based on their fair values at the acquisition date. Hence, separate set of accounts of associates would also have to be maintained for consolidation purposes.

Conclusion:

Consolidated financial statements are considered as the primary set of accounts under IFRS. The differences highlighted in the earlier and the present article have far reaching effects on the procedures of consolidation and the resultant impact on various performance matrices. The goal under IFRS is to move towards more transparent and consistent reporting that reflects the true net worth of the group.