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CPD technical article
Graham Holt examines three recently issued standards - IFRS 10, 11 and 12 - that complete improvements made by the IASB in response to the financial crisis
This article was first published in the July 2010 edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) has recently issued three standards: IFRS 10, Consolidated Financial Statements, IFRS 11, Joint Arrangements and IFRS 12, Disclosure of Interests in Other Entities. The issuance of these standards completes IASB’s improvements to the accounting requirements for off balance sheet activities and joint arrangements.
The standards bring into broad alignment the accounting treatment for off balance sheet activities in International Financial Reporting Standards (IFRSs) and US generally accepted accounting principles (GAAP), and are the IASB’s response to the financial crisis.
IFRS 10 replaces all of the consolidation guidance in IAS 27, Consolidated and Separate Financial Statements, and SIC 12, Consolidation – Special Purpose Entities, although the portion of IAS 27 that deals with separate financial statements remains. The old standard has been renamed IAS 27, Separate Financial Statements.
IFRS 11 replaces IAS 31, Interests in Joint Ventures, and SIC 13, Jointly Controlled Entities – Non-Monetary Contributions by Venturers. And IFRS 12 replaces the disclosure requirements that used to be found in IAS 28, Investments in Associates and Joint Ventures.
IFRS 10: control and power
IFRS 10 makes the concept of control the determining factor in whether an entity should be included within the consolidated financial statements of the parent company, thus building on existing principles. Guidance has been added to the standard to determine the nature of control in cases where assessment is difficult.
IFRS 10 introduces a single consolidation model for all entities based on control, irrespective of the nature of the investee. Control is based on whether an investor has power over the investee; exposure, or rights, to variable returns from its involvement with the investee; and the ability to use its power over the investee to affect the amount of the returns. Thus the definition focuses on the need to have both ‘power’ and ‘variable returns’ for control to be present.
Control is assessed on a continuous basis as facts and circumstances change. A change in market conditions brings about a reassessment of control only if it changes one of the elements of control. The revised definition of control replaces not only the definition and guidance in IAS 27 but also the four indicators of control in SIC 12. The accounting requirements for consolidated financial statements have been transferred from IAS 27 to IFRS 10.
Power is the current ability to direct the activities that significantly influence returns, which can be positive, negative or both. The determination of power is based on current facts and circumstances, is continuously assessed and is a two-step process.
First, the investor considers all the facts and circumstances of the case, including the size of its holding and the dispersion of holdings.
Second, the investor considers whether other shareholders are passive by nature and if the investee is controlled by rights other than voting power, which are the facts normally used to assess power.
If after this latter step there is no clear conclusion, then the investor does not control the entity. An investor with more than 50% of the voting rights would meet the power criteria if there were no restrictions, but even if it held less than the majority of the voting rights an investor could still have power in certain cases.
In the latter case, such things as agreements with other vote holders, other contractual agreements, potential voting rights and de facto power would have to be considered. IFRS 10 provides guidance on participating and protective rights, and brings the notion of de facto control firmly within the guidance.
To have control, an investor needs to have the ability to use its power to affect returns for the investor’s benefit.
The standard also requires an investor with decision-making rights to determine if it is acting as a ‘principal’ or an ‘agent’. Such factors as whether any remuneration is at arm’s length have to be considered. If an investor acts as an agent, it would not have the requisite power, so the entity would not be consolidated.
Because the new standards may change which entities are included in consolidated financial statements, deal structures may also change. Significant judgment may be required to determine whether another entity is controlled, and data may have to be gathered about other shareholders and past voting patterns. Private equity funds, asset managers and some insurance companies will have to assess whether they are principals or agents and therefore whether they have to consolidate their investments.
An entity holding options to acquire additional voting interests or which owns a minority of voting rights will also need to consider the new rules.
IFRS 11: rights and obligations
IFRS 11, Joint Arrangements, provides for a more realistic reflection of joint arrangements by focusing on the rights and obligations of the arrangement, rather than its legal form. The standard addresses inconsistencies in the reporting of joint arrangements by requiring a single method to account for interests in jointly controlled entities.
A joint arrangement is one where two or more parties contractually agree to share control. Joint control exists only when the decisions about activities that significantly affect the returns of an arrangement require the unanimous consent of the parties sharing control.
All parties to a joint arrangement should recognise their rights and obligations arising from the arrangement. The structure and form of the arrangement is only one of the factors in assessing each party’s rights and obligations; the terms and conditions agreed by the parties and other relevant facts and circumstances should also be considered.
Joint arrangements are either joint operations or joint ventures. A joint operation gives the parties direct rights to the assets and the liabilities of the arrangement; those parties are called joint operators. A joint operator will recognise its interest based on its direct rights and obligations rather than on its participation interest.
A joint operator needs to recognise:
- its assets, including its share of any assets held jointly
- its liabilities, including its share of any liabilities incurred jointly
- its revenue from the sale of its share of the output of the joint operation
- its share of the revenue from the sale of the output by the joint operation, and
- its expenses, including its share of any expenses incurred jointly.
A joint venturer, on the other hand, recognises its interest as an investment and accounts for that investment using the equity method in accordance with IAS 28, Investments in Associates and Joint Ventures, unless it is exempt from applying the equity method.
A party that participates in, but does not have joint control of, a joint venture accounts for its interest in the arrangement in accordance with IFRS 9, Financial Instruments. However, if it has significant influence over the joint venture, it must account for it in accordance with IAS 28.
Accordingly, a joint venture gives the parties rights to the net assets and profit or loss of the venture. A joint venturer does not have rights to individual assets or obligations for individual liabilities of the joint venture.
Entities can no longer account for an interest in a joint venture using the proportionate consolidation method but must use the equity method. Entities will need to assess their arrangements to determine whether they have invested in a joint operation or a joint venture on adoption of the new standard.
Also, some entities that previously equity-accounted their investments may need to account for their share of assets and liabilities now that there is less focus on the structure of the arrangement.
The transition provisions of IFRS 11 require entities to apply the new rules at the start of the earliest period presented on adoption. Entities in mining, extraction, oil and gas, and real estate and construction, where joint arrangements are common, might feel the biggest impact.
IFRS 12: disclosures
FRS 12, Disclosure of Interests in Other Entities, sets out the required disclosures for entities reporting under the two new standards, IFRS 10 and IFRS 11. It replaces the disclosure requirements currently found in IAS 28. The new standard requires entities to disclose information that helps users evaluate the nature, risks and financial effects associated with the entity’s interests in subsidiaries, associates, joint arrangements and unconsolidated structured entities.
To meet this objective, disclosures are required in the following areas:
a) Significant judgments and assumptions used by the entity in determining that it controls another entity, has joint control of an arrangement or exerts significant influence over another entity, and the type of joint arrangement when the arrangement has been structured through a separate vehicle.
b) The entity’s interests in subsidiaries, in order to allow users to understand, for example, the composition of the group or to evaluate the nature and extent of significant restrictions on its ability to access or use assets, and settle liabilities, of the group.
c) The entity’s interests in joint arrangements and associates, so users can evaluate, for example, the nature, extent and financial effects of its interests in joint arrangements and associates, and the nature of, and changes in, risks associated with its interests in joint ventures and associates.
d) The entity’s interests in unconsolidated structured entities.
The objective of IFRS 12 is for an entity to disclose information that helps users of its financial statements evaluate the nature of it's involvement with other entities and the effects of that involvement on its financial position. IFRS 12 is likely to increase the amount of information in financial statements about an entity’s relationships with the other parties.
The new standards are effective for annual periods beginning on or after 1 January 2013. Earlier application is permitted if the entire package of standards is adopted at the same time.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School
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