There
are numerous situations where, concluding whether an investor exercises
significant influence over the investee and consequently whether the investee
is an associate of the investor, requires considerable judgement to be
exercised. When there is no significant influence, and an entity incorrectly
interprets the relationship to be that of significant influence, it will end up
wrongly consolidating (using the equity method) the entity in the consolidated
financial statements, rather than measuring it in accordance with Ind AS 109 – Financial
Instruments and vice versa.
In this
article, we discuss two examples. But before we do that, it is important to
understand the following key provisions in Ind AS 28 – Investments in
Associates and Joint Ventures which is reproduced below.
Paragraph
3 defines the following terms:
‘An associate is an entity over which the investor has significant
influence.’
‘Significant influence is the power to participate in the financial and
operating policy decisions of the investee but is not control or joint control
of those policies.’
Paragraph
5:
‘If an entity holds, directly or indirectly (e.g.
through subsidiaries), 20 per cent or more of the voting power of the investee,
it is presumed that the entity has significant influence, unless it can be
clearly demonstrated that this is not the case. Conversely, if the entity
holds, directly or indirectly (e.g., through subsidiaries), less than 20 per
cent of the voting power of the investee, it is presumed that the entity does not
have significant influence, unless such influence can be clearly demonstrated.
A substantial or majority ownership by another investor does not necessarily
preclude an entity from having significant influence.’
Paragraph
6:
‘The existence of significant influence by an entity is usually evidenced
in one or more of the following ways:
a) representation on the board of
directors or equivalent governing body of the investee;
b) participation in policy-making
processes, including participation in decisions about dividends or other
distributions;
c) material transactions between the
entity and its investee;
d) interchange of managerial
personnel; or
e) provision of essential technical
information.’
Example 1A – Significant influence in a group structure
Fact Pattern
The
parent has two subsidiaries, Sub 1 and Sub 2. Sub 1 has a 16% ownership
interest in Sub 2. The group structure is as follows:
The
parent has appointed two executives of Sub 1 as Directors to the Board of Sub
2. Thanks to the number of Directors on the Board, the two Directors are able
to have an impact on Sub 2’s Board. The parent has the right to remove the two
executives from the Board at any time. Sub 1 has also been directed to manage
Sub 2 in a way that maximises the return for the parent, rather than for Sub 1.
The parent can amend this directive at any time. Whether Sub 1 has significant
influence over Sub 2?
Response
Ind AS
28:5 indicates that ‘[a] substantial or majority ownership by another investor
does not necessarily preclude an entity from having significant influence’. In
this fact pattern, however, Sub 1 does not have significant influence over Sub
2, because although Sub 1 can participate in policy-making decisions, the
parent can remove Sub 1’s executives from Sub 2’s Board at any time. Therefore,
Sub 1’s apparent position of significant influence over Sub 2 can be removed by
the parent and Sub 1 does not have the power to exercise significant influence
over Sub 2. Since Sub 1 does not have significant influence over Sub 2, Sub 2
is not an associate of Sub 1. It is actually the parent that has 100% control
over Sub 2, directly and indirectly through Sub 1.
Example 1B – Board
participation alone does not provide significant influence
Fact pattern
Internet
Ltd.’s Board is the ultimate decision-making authority and has ten Directors.
The shareholder analysis of Internet Ltd. shows the following shareholders.
Other shares are widely held by the public.
|
|
Shareholding
|
Board
representation
|
|
Viz Ltd.
|
38%
|
4
|
|
Fiz Ltd.
|
36%
|
4
|
|
Ke Ltd.
|
9%
|
1
|
|
Individual M (Managing Director of Internet Ltd.)
appointed by Viz Ltd.
|
6%
|
1
|
|
Others – widely held
|
11%
|
none
|
|
|
100%
|
10
|
Board
decisions are passed by a 70% majority of voting Directors. Is a 9%
shareholding and representation of one Director on the Board enough to provide
Ke Ltd. with significant influence?
Response
Whether
Ke Ltd. has significant influence is a matter of judgement. Ke Ltd. has only
one Director out of the ten. The Board is dominated by Viz and Fiz who can make
decisions without the agreement of the other Board members. Under Ind AS 28,
the Board representation is an indicator of significant influence. However, it
does not provide any further guidance on
how to evaluate the representation in the context of the size of the Board,
voting patterns, significant transactions, exchange of managerial personnel and
the like. Ke Ltd. only has 10% of the Board seats and believes this is not
enough to exercise significant influence, given the presence of the two major
investors and the Managing Director on the Board. Although Ke Ltd. participates
in the policy-making processes and decisions, that alone does not enable it to significantly
influence those decisions as suggested under Ind AS 28.
Having a
representation on the Board of Directors is an indicator of significant
influence. It is not an automatic confirmation. Additional analysis would be
required and relevant facts and circumstances will need to be considered. Ke
Ltd., in this scenario, holds far less than 20% shareholding threshold
indicated in the standard. It therefore does not have significant influence
over Internet Ltd.
CONCLUSION
The
determination of significant influence is a matter of considerable judgement
and needs careful evaluation of all the details, the facts and circumstances of
the case.
