IFRS10 Consolidated Financial Statements
This article will consider how the accounting standard IFRS10 Consolidated Financial Statements (IFRS10) addresses the definition of a subsidiary. Where an investment is identified as a subsidiary then consolidated financial statements are prepared where the financial statements of a group parent and its subsidiaries are presented as those of a single economic entity.
But what exactly is a subsidiary?
Well the standard takes a principles based approach and in simple terms defines a subsidiary in terms of control. It should be noted that the definition of a subsidiary is not a number rather it is based on the principle of control.
This principles based approach is important as creative accountants adopting a legalistic approach may wish to try and argue that an investment is not a subsidiary, on the basis that the investor’s shareholding is less than 50% and so the entity should not be consolidated. These arguments are often used where the investment is highly geared. What the creative accountant is trying to do is take the investment’s liabilities off the group balance sheet as if the investment is defined as a subsidiary their liabilities are aggregated in full in the consolidated accounts. It is always important to consider substance of the relationship with an investment and not just the size of the shareholding. If an investment is in fact controlled then it is a subsidiary and its income expenses assets and liabilities should be consolidated in order that there is transparency and accountability.
Control is though normally, but not exclusively, evidenced by the investor holding a majority (50% +) of the voting rights.
Definition of control
According to IFRS10, an investor controls an investee if and only if the investor has all of the following elements:
- power over the investee, i.e. the investor has existing rights that give it the ability to direct the relevant activities (the activities that significantly affect the investee’s returns)
- exposure, or rights, to variable returns from its involvement with the investee
- the ability to use its power over the investee to affect the amount of the investor’s returns.
Importantly though an investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.
Power arises from rights. Such rights can be straightforward (e.g. through voting rights) or be complex (e.g. embedded in contractual arrangements).
An investor must be exposed, or have rights, to variable returns from its involvement with an investee to control the investee. Such returns must have the potential to vary as a result of the investee’s performance and can be positive, negative, or both.
A parent must not only have power over an investee and exposure or rights to variable returns from its involvement with the investee, a parent must also have the ability to use its power over the investee to affect its returns from its involvement with the investee.
Let’s explore the issue of control through a couple of examples!
Q Singapore & Flyer
Singapore has recently acquired 40% of the equity capital and voting rights of Flyer.The other 60% of Flyer’s shares are held by a wide variety of investors, none of whom owns more than 0·5% individually. None of the other shareholders has any arrangements to consult any of the others or make collective decisions. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Flyer.
Required:
Discuss how the purchase of the shareholding in Flyer should be accounted for in the consolidated financial statements of Singapore.
A Singapore & Flyer
On a first review, Singapore does not have the power to control Flyer simply on account of its the absolute size of the investor’s holding. The relative size of the other shareholdings alone are not conclusive in determining whether the investor has rights sufficient to give it power.
An investor controls an investee if and only if the investor has all of the following elements:
- power over the investee, i.e. the investor has existing rights that give it the ability to direct the relevant activities (the activities that significantly affect the investee’s returns)
- exposure, or rights, to variable returns from its involvement with the investee
- the ability to use its power over the investee to affect the amount of the investor’s returns.
An investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.
So when we consider the relevant facts that none of the other shareholders has any arrangements to consult any of the others or make collective decisions and that since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Flyer we can conclude that Flyer is controlled.
In conclusion Flyer is therefore a subsidiary of Singapore.
Q Singapore & Airways
Singapore has just purchased 25% of the equity and voting shares in Airways. In addition Singapore has purchased a substantial number of warrants (options) issued by Airways which are currently exercisable. If these warrants are exercised, they will result in Singapore owning 60% of the voting shares of Airways. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Airways.
Required:
Discuss how the purchase of the shareholding in Airways should be accounted for in the consolidated financial statements of Singapore.
A. Singapore & Airways
On a first review, Singapore does not have the power to control Airways simply on account of its absolute size of the investor’s holding, but this is not conclusive in determining whether the investor has rights sufficient to give it power to control.
An investor controls an investee if and only if the investor has all of the following elements:
- power over the investee, i.e. the investor has existing rights that give it the ability to direct the relevant activities (the activities that significantly affect the investee’s returns)
- exposure, or rights, to variable returns from its involvement with the investee
- the ability to use its power over the investee to affect the amount of the investor’s returns.
An investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.
So when we consider the relevant facts we note that it is investor Singapore that has warrants that are exercisable and if they were then it would have a majority of the voting rights. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Airways. On this basis this is sufficient to conclude that it has power over the investee which it is using.
In conclusion Airways is a subsidiary of Singapore.
Tom Clendon FCCA is a lecturer with FTMS based in Singapore. He is the author of “A student’s guide to group accounts” published by Kaplan which is now in its second edition.
stephdeladem says
very useful. thanks a lot
danhash says
it looks fine ,
but this will stope craetive accounting?
jaw123 says
I like the example and discussion, it shed more light on my understanding of control by an investor, thank you
pshc says
Does this site as audio?
MikeLittle says
There is audio on the lectures, yes
(They wouldn’t be very good as lectures if there were no audio!)
akinlajadamilare says
what dose it mean when its stated that goodwill on consolidation should be measured on full goodwill method or proportionate goodwill
MikeLittle says
full goodwill method is where the nci are valued at an amount greater than their share of the fair valued net assets – so the value attributed to them includes their fair share of goodwill
Proportionate valuation of the nci means that the parent company directors say that the nci value is equal to their proportionate share of the fair valued subsidiary identifiable net assets so NO goodwill is attributed to the nci
ok?
teresae says
Very interesting approach, however if the control is the result of management control rather that investment, lets say, the acquisition is 40% the consolidation will be based in this percentage 40% and will be very odd consolidation. If somebody can help me with a wide explanation will be great! Many thanks!
MikeLittle says
When you get to P2 (assuming that you’re not there yet!) you’ll find that we consollidate subsidiaries where the interest of the parent is less than 50%
If a parent has a 60% subsidiary and the subsidiary owns 55% of a sub-subsidiary, the parent will consolidate all three companies even though the parent’s interest in the sub-subsidiary is only 33%
shaidgunner says
My apologise, it does say that the warranty are currently exercisable. You are very correct. What if the date of excercise was still far into the future Will Signgapore still be able to exercise control? Just asking to be clear, because I think it can’t.
MikeLittle says
I would agree – Tom’s article clearly states that it’s a current situation. (investor has EXISTING rights)
shaidgunner says
Thanks
MikeLittle says
You’re welcome
MikeLittle says
Am I not correct that the article says that the warrants are exercisable at any time?
If the other 75% do get together and vote in a way that Singapore objects to, then Singapore will exercise their options and gain control. That would then put them in a position to determine whether they wished to carry on down the route that the former 75% holders had voted for
Does that answer your question?
shaidgunner says
In the example of Singapore and airways. How does the ownership of exercisable warrants translate to give control right now to Singapore, if the the right to control must be existing as in condition 1. That Singapore will exercise the warrants surely is not a fact. Should the transfer of control not be at the point where the warrants are exercised? Could Singapore not be said to have very significant influence at the least? At the moment 75% of the shares of airways are owned by other entities or individuals can they not have control if they agree to put their shares together? Is the speculation that Singapore will have control in the future sufficent to exercise contol today? If so, what time frame is relevant to exercising the warrants is relevant for Singapore to treat airways as a subsidiary?