“New consolidation standard redefines ‘control’” by Editha Viray-Estacio (December 19, 2011)

SUITS THE C-SUITE By Editha Viray-Estacio

Business World (12/19/2011)

The International Accounting Standards Board (IASB) recently issued three new standards: IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements, and IFRS 12 Disclosure of Interests in Other Entities. These standards aim to increase the consistency, transparency and comparability of accounting for and disclosure of relationships between entities.

The new standards also intend to better reflect the substance of these arrangements, rather than solely focusing on legal form. The IASB made these changes partly in response to the recent global financial crisis as accounting rules allowed investors to account for certain investees’ off-balance sheet. This article specifically focuses on IFRS 10, notably the revised definition of “control,” the entities most likely to be affected by the new standard, and its business implications.

Control redefined
IFRS 10 does not change consolidation procedures, i.e, how to consolidate an entity. The changes introduced by IFRS 10 primarily relate to identifying the consolidating entity and whether there is a need to consolidate another entity. Under the new standard, 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.

Having power would demonstrate control if an investor is able to affect those returns using that power. Consequently, an investor is determined to have control over an investee, if the investor possesses all of the following: (a) power over the investee; (b) exposure, or rights, to variable returns from its involvement with the investee; and (c) ability to use its power over the investee to affect the amount of the investor’s returns.

Under this revised definition of control, an investor may still have power over an investee even when the investor does not have a majority of the voting rights in that investee. Entities or arrangements that may fall under the control model include securitization vehicles and structured entities or special purpose entities, control through lease arrangements or operations and maintenance agreements, and principal or agency relationships for asset managers, among others.

Business impact
Structure of transactions and arrangements. Management needs to consider the requirements of IFRS 10 when negotiating new contracts or modifying current arrangements. Arrangements may have previously been structured in a manner that achieved a particular accounting treatment. Management will need to consider the impact of IFRS 10 and whether the same results are achieved under the new standard.

Management judgment. In addition to accounting personnel, a company’s leadership will need to exercise considerable judgment when the entity adopts IFRS 10. Management should be closely involved in this assessment. In certain cases, Audit Committees and independent auditors may need to be involved as well in the discussions on material areas of judgment.

Compliance. Bank covenants and regulatory requirements should be considered. The change in financial measures resulting from implementation of the new standards could affect compliance with loan covenants and regulatory requirements such as the single borrower’s limit imposed by the Bangko Sentral ng Pilipinas.

Disclosure and information requirements. Since one of the objectives of the IASB is to increase the transparency of financial reporting, management has to disclose the information that it allowed it to determine that, as an investor, it does not control an investee. The new disclosures will make management’s judgment more transparent and help users of the financial statements to make their own assessment of the financial impact had management made a different decision.

Compared to current requirements, these new disclosures are most significant when applied towards unconsolidated structured entities. Historically, these entities were off-balance sheet and did not require any disclosure. An investor is now required to disclose the information about the relationship and the kind of business and activities carried out by the structured entity, to better understand the involvement of the investor in the structured entity.

Effective date and transition
The new standards are effective for annual periods beginning on or after Jan. 1, 2013. IFRS 10 may be adopted early, but must be adopted together with IFRS 11 and IFRS 12.

The new standards are effective retrospectively, meaning when application results in consolidating an investee that was previously not consolidated, the investor applies acquisition accounting from the date on which it obtained control. However, if this is impracticable, the investor accounts for the transaction at the beginning of the earliest period practicable, which may be the current period.

Even though IFRS 10 is not effective until Jan. 1, 2013, investors are required to disclose the impact of adopting issued IFRSs even before they become effective. Because of the extent of information that needs to be gathered to make informed judgments and to actually consolidate entities that were previously not consolidated, management should not put off planning for adoption of the said standards.

Editha Viray-Estacio is a Partner of SGV & Co.

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.