IFRS 10: Consolidated Financial Statement
Power Over An Investee
The first criterion to have control relates to power. An investor has power when it has existing rights that give it the current ability to direct the relevant activities. [IFRS 10.10, B9]. Therefore, when assessing whether an investor has power, there are two critical concepts:
- Relevant activities
- Existing rights.
Power may be achieved through voting rights or through rights arising from contractual arrangements.
An investor can have power over an investee even if other entities have existing rights that give them the current ability to participate in the direction of the relevant activities, for example when another entity has significant influence, [IFRS 10.14], the power to participate in the financial and operating policy decisions of the investee but not control or joint control over those policies. [IAS 28.3 (2011)].
In many cases, it is clear that control of an investee is held through voting rights. However, when it is not clear that control of an investee is held through voting rights, a crucial step in assessing control is identifying the relevant activities of the investee, and the way decisions about such activities are made. [IFRS 10.B10]. Relevant activities are the activities of the investee that significantly affect the investee's returns. [IFRS 10.10].
For many investees, a range of operating and financing activities significantly affect their returns. Examples of relevant activities, and decisions about them, include, but are not limited to: [IFRS 10.B11-B12].
- Determining or changing operating and financing policies (which might include the items below)
- Selling and purchasing goods and services
- Managing financial assets during their life (and/or upon default)
- Selecting, acquiring or disposing of assets
- Researching and developing new products or processes
- Determining a funding structure or obtaining funding
- Establishing operating and capital decisions of the investee, including budgets
- Appointing, remunerating or terminating the employment of an investee's service providers or key management personnel.
In many cases, more than one activity will significantly affect an investee's returns.
Under IFRS 10, if two or more unrelated investors each have existing rights that give them the unilateral ability to direct different relevant activities, the investor that has the current ability to direct the activities that most significantly affect the returns of the investee has power over the investee. [IFRS 10.13].
In some situations, activities both before and after a particular set of circumstances arises or event occurs may be relevant activities. When two or more investors have the current ability to direct relevant activities and those activities occur at different times, the investors determine which investor is able to direct the activities that most significantly affect those returns consistently with the treatment of concurrent decision-making rights. The investors reconsider this assessment over time if relevant facts or circumstances change. [IFRS 10.B13].
When there is more than one activity that significantly affects an investee's returns, and these activities are directed by different investors, it is important to determine which of the activities most significantly affect the investee's returns. For example, one activity might be directed by voting rights, which are held by one investor, whereas the other activity is directed through a contract by a different investor. This is illustrated in Example 7.3 below, which is from IFRS 10. [IFRS 10.B13, Example 1].
Example 7.3: Identifying relevant activities in life sciences arrangements
Two investors form an investee to develop and market a medical product. One investor is responsible for developing and obtaining regulatory approval of the medical product - that responsibility includes having the unilateral ability to make all decisions relating to the development of the product and to obtaining regulatory approval. Once the regulator has approved the product, the other investor will manufacture and market it - this investor has the unilateral ability to make all decisions about the manufacture and marketing of the project. If all the activities - developing and obtaining regulatory approval as well as manufacturing and marketing of the medical product - are relevant activities, each investor needs to determine whether it is able to direct the activities that most significantly affect the investee's returns. Accordingly, each investor needs to consider whether developing and obtaining regulatory approval or the manufacturing and marketing of the medical product is the activity that most significantly affects the investee's returns and whether it is able to direct that activity. In determining which investor has power, the investors would consider:
- the purpose and design of the investee;
- the factors that determine the profit margin, revenue and value of the investee as well as the value of the medical product;
- the effect on the investee's returns resulting from each investor's decision-making authority with respect to the factors in (b); and
- the investors' exposure to variability of returns.
- In this particular example, the investors would also consider:
- the uncertainty of, and effort required in, obtaining regulatory approval (considering the investor's record of successfully developing and obtaining regulatory approval of medical products); and
- which investor controls the medical product once the development phase is successful.
In this example, IFRS 10 does not conclude which of these activities would be deemed the most relevant activity (i.e. the activity that most significantly affects the investee's returns). If it were concluded that the most relevant activity is:
Developing and obtaining regulatory approval of the medical product - then the investor that has the power to direct that activity would have power from the date of entering into the arrangement
Manufacturing and marketing the medical product - then the investor that has the power to direct that activity would have power from the date of entering into the arrangement.
To determine whether either investor controls the arrangement, the investors would also need to assess whether they have exposure to variable returns from their involvement with the investee and the ability to use their power over the investee to affect the amount of the investor's returns. [IFRS 10.7, B2].
Example 7.3 above illustrates a situation when two different activities that significantly affect an investee's returns are directed by different investors. Thus, it is important to identify the activity that most significantly affects returns, as part of assessing which investor, if any, has power. This differs from joint control, defined as the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. [IFRS 11 Appendix]. Joint control is discussed in more detail in Chapter 14 at 4.
Another example provided by IFRS 10, [IFRS 10.B13, Example 2], is reproduced in Example 7.4 below.
An investment vehicle (the investee) is created and financed with a debt instrument held by an investor (the debt investor) and equity instruments held by a number of other investors. The equity tranche is designed to absorb the first losses and to receive any residual return from the investee. One of the equity investors who holds 30 per cent of the equity is also the asset manager. The investee uses its proceeds to purchase a portfolio of financial assets, exposing the investee to the credit risk associated with the possible default of principal and interest payments of the assets. The transaction is marketed to the debt investor as an investment with minimal exposure to the credit risk associated with the possible default of the assets in the portfolio because of the nature of these assets and because the equity tranche is designed to absorb the first losses of the investee. The returns of the investee are significantly affected by the management of the investee's asset portfolio, which includes decisions about the selection, acquisition and disposal of the assets within portfolio guidelines and the management upon default of any portfolio assets. All those activities are managed by the asset manager until defaults reach a specified proportion of the portfolio value (i.e. when the value of the portfolio is such that the equity tranche of the investee has been consumed). From that time, a third-party trustee manages the assets according to the instructions of the debt investor. Managing the investee's asset portfolio is the relevant activity of the investee. The asset manager has the ability to direct the relevant activities until defaulted assets reach the specified proportion of the portfolio value; the debt investor has the ability to direct the relevant activities when the value of defaulted assets surpasses that specified proportion of the portfolio value. The asset manager and the debt investor each need to determine whether they are able to direct the activities that most significantly affect the investee's returns, including considering the purpose and design of the investee as well as each party's exposure to variability of returns.
Example 7.5 below illustrates a structured entity in which there is more than one activity that affects the investee's returns.
A structured entity buys dollar-denominated assets, issues euro-denominated notes, and hedges the cash flow differences through currency and interest rate swaps. The activities that affect the structured entity's returns include:
- Sourcing the assets from the market
- Determining the types of assets that are purchased
- Deciding how the structure is hedged
- Managing the assets in the event of default.
If each of these activities is managed by different investors (e.g. one investor manages the assets in the event of default, but a different investor determines the types of assets that are purchased), it is necessary to determine which activity most significantly affects the structured entity's returns.
When there are multiple activities that significantly affect an investee's returns, but those activities are all directed by the same investor(s) (which is frequently the case when those activities are directed by voting rights), it does not matter which activity most significantly affects the investee's returns because the power assessment would be the same in each case.