United Kingdom
Changes to Consolidation

Changes to consolidation? - Stephen Hubbard:

SH Thank you, David. Good afternoon everyone.


As David said, I’m here today to talk to you about consolidation, and specifically changes to consolidation and IFRS 10.

Many of you will, hopefully, be thinking about IFRS 10 now, being that it will apply for December year-ends, so for non-SEC entities to December year-end, so at the end of this calendar year. So, firstly what we'll do is I'll touch on a brief recap on what IFRS 10 requires.


The first thing I notice is it's huge. It's long. It's a long read. It's gone from 144 paragraphs to 539 paragraphs, but what that means is there's a lot more guidance in it, a lot more detail, so a lot more help in some of those subjective judgemental areas.



The key change with IFRS 10 is the definition of control, so, current UK GAAP we're looking at the power to govern the operating and financial policies, there, on the left, in order to obtain benefits, and what we're moving to, on the right hand side there, is a three-legged test: the power to direct the relevant activities; having exposure to variable returns; and then lastly, check to see if there's a link between the power and the exposure. I'm going to concentrate today on the first test there, the power, but before I do that I just want a quick recap as to the second and third test.


So, the linkage test solely exists for fund managers. So fund managers have two hats. On the one hand I'm a service provider. I manage the fund. I receive a fee; often I receive a performance fee, and on the other hand, in my other hat, I own units, potentially. I'm an investor. I'm an owner. And the question here is principally, my role, is it as a service provider, as an agent, or is it as the owner? If I'm principally acting as owner, then I'm consolidating. If I'm principally acting as an agent, then I'm not into the consolidation.


The second test there, exposure to variable returns, is very wide. This can be anything. Clearly, shares will give you a variable return. But the standard also talks about a fixed interest. So a fixed interest can give you a variable return. So if you have a loan to an investee, and it's a fixed rate of return, that can give you a variable return because of credit risk. You might not get paid. There is variability there.



And then this tends to, also talks about synergies. So if I've got an arrangement, I have synergies, so I'm getting benefit synergies, again, that's a variable return that I'm achieving, so could get variable returns without even a shareholding or without even an interest.

Before we get on to power to direct, what I want to talk to you about is clearly we have, as David said, people adopting the standard at the end of this year, but we have had experience with a number of banks, a number of SEC registrants adopting it this year. I know it has been very, you know, extremely hard work looking at, you know, in banking scenarios we'll probably have a lot more vehicles, a lot more special purpose entities, a lot more arrangements, which are maybe a bit more judgemental. Corporates may well have some, and therefore we do have to look at those. You do have to look at those, but we can pick and choose which one you're going to have your time and effort looking at.


Other entities, investment entities: some investment entities will have adopted it, IFRS 10, early, because of the investment entity amendment enabled them to get a good answer in terms of consolidation, not consolidating in terms of fair valuing their investments in entities, their investments.



Moving on, so now we're on to talking about the power to direct the relevant activity. So this is my power line here. On the one hand, I have absolute power, so I have 100% shareholding. On the extreme left hand side I have no shares and no interest. Maybe I've got one share in Rolls Royce. It doesn’t really give me any influence whatsoever. Meeting in the middle, we're getting towards… so from no influence we're getting into associate, significant influence, then we're getting into joint control, and then we're moving towards having, sort of, 60, 70, 80% interest.


So where are the issues? So, at the absolute power end, nothing’s really going to change there. If I have 70%, 80% control of the voting rights I'm still going to consolidate. And again, at the other end of the spectrum, if I have, you know, two, three, four, five associate type accounting, maybe not so much change there.


It's the middle area, so the whole subjective entities that we looked at in previous years, so if in last year we had a consolidation question, we had a judgement to make, should we consolidate? Should we not? That's something that we need to revisit under IFRS 10. Also we need to revisit some of our associates, some of our joint ventures, some of our SPEs. It really depends on the nature of those operations. I'm going to touch on those three: special purpose entities, joint ventures and associates.



Special purpose entities. Under UK GAAP, under existing GAAP, we've effectively assessed whether we control an SPE through, by looking at SIC-12, so we're looking at whether we have the majority of the risks and benefits, whether we have the majority of the variability in the risks and benefits. SIC-12 says if you have the majority of the risks and benefits, then you consolidate; you control the SPE.


IFRS 10, as you know, looks at the power to direct the relevant activities, so the first question here we have to ask is, what is the relevant activity of my SPE, sometimes a pretty tough question to ask. I mean, it’s an SPE. It's on autopilot. What is it actually doing? What does it exist for? Why is it there? We have to look at those things. We have to find out what that is, decide what the relevant activity is, what the principal relevant activity is, and then determine who has the power over that relevant activity.


So the question, at this point, for SPE, is, previously I had the majority of the risks and rewards. Do I have power over the relevant activities? If yes, consider if that answer is consistent, then no change. If, however, it's inconsistent, then we're leading into going to either cease to consolidate, or we’re going to start to consolidate.


Joint ventures. Simple example there for you: I have X and Y each holding, owning 50% of the shares in Z. They have equal votes, equal seats on the board, and all decisions are unanimous. It's not an uncommon joint venture arrangement. Then we get into if there's deadlock; if there's deadlock then there are certain actions that need to be followed. We've got to try to resolve the issue, and then, on the last sentence here, this one says, if we can't resolve the issue, then X can buy Y’s investment for fair value.



Now, under old GAAP would we have concluded this was a joint venture? Would we have considered that last sentence? Would we have said, actually, no, that's more of a protective right? Would we have said that the option or the arrangement at the bottom there is non-substantive? It's not really going to happen and we'll resolve our differences, and even if it did happen, we wouldn't really intend to exercise this option. Again, as I've said, IFRS 10, a lot longer, a lot more guidance, it goes into these kinds of issues. It gives guidance and explanations on these kinds of issues.


Protective rights. Protective right can relate only to a fundamental change, so this, what we're talking about here, is just a, sort of, an operating decision, so this is not a protective right under IFRS. It's not something you can ignore.


Substantive rights. Again, is it something that would have exercised? Is it something in the future, which may or may not happen? How likely is it that we're going to have this deadlock arrangement and we're not going to be able to resolve it?


Again, substantive rights, because it affects a key decision then it is substantive. The question is simply, does, in this case, X, have a practical ability to exercise? Yes, they do, so we're probably ending up with control here. Would you have gone into the level of detail in your joint venture arrangements, any arrangements that you have, in order to find out what happens on deadlock? Do you know what happens on deadlock if you have joint venture arrangements, and then, moving on to protective and substantive rights.

So, I think we need to carefully consider, in joint venture arrangements, the potential voting rights. We need to carefully consider what happens on deadlock, and that may, as I say, involve going through agreements in much more detail. IFRS 10 is much more detailed in what it requires us to look for.


Moving on to associates. The slide is headed up Associates, but what we're going to talk about here really does relate equally to joint ventures and other entities, and other potential subsidiaries. So, again, by example, have a look at this one: X and Y each own interest in the company below there. Let's call it company Z. X has one seat and Y has three seats. The majority of votes, we're looking at Y consolidating that. We're looking at X having an associate. Yes, now happy with that?


Okay, let's add a twist. Let's say that X is responsible for the design, and Y is responsible for the build, so ignore the majority vote. X has sole discretion over decisions regarding design; Y has sole discretion over decisions regarding the build. What have we got now? Does one entity control it? What is the relevant principal, the relevant activity, which the principal relevant activity? Is the important activity here the design or is it the build? X controls the design; Y controls the build. It's going to involve judgement.



IFRS 10 goes on to say, in order to determine the relevant principal activity here, we're looking at which one most significantly affects the financial outcome, affects the returns, so, is the outcome of this going to be driven by the design or is it going to be driven by the build? If it's going to be driven by the design we're going to end up X consolidating here, which, you know, previous year we wouldn’t have had, so again that will be a change.


So when we're looking at an entity with two different operations controlled by two different entities, and there are two different strings being pulled by two different people, who’s got the biggest string?


Moving on, then we've got some… looking at what is called a practical ability to direct, so add another twist. So, X provides all the finance. X provides the finance. X can choose to pull the finance any time it likes. Does Y really now have the practical ability to direct? If Y wants to do something that X doesn’t want them to do, X will say, I'm going to withdraw the funding. So does Y really have that power?


So IFRS 10 effectively is telling us to look at lots of factors. We've got to look at everything around the arrangement.



This could quite easily have been provision of technology, as opposed to provision of funding. If I can pull the technology, and company Z there its operation is principally determined and driven by that technology. Again that's something that we would need to consider.


Just to recap here, what we're talking about in terms of IFRS 10, yes, we're looking at associates and joint ventures. We're not looking at the majority of associates and joint ventures that you have and that are in operation. We're looking at the ones with unusual arrangements, so the ones where you have the power of this I have the power over that, or the ones where there are, as I say, different factors involved.


If it were a normal associate without any of these other unusual transactions, other issues, then again, it will remain an associate, but as I say, if you have these bells and whistles, so to speak, then they're things that need to be looked into.

So, going back, it's, as I say, it is the power over the relevant activities. You need to determine the relevant activities and then we look to see who has the power. There will be a return, often will be a return, and as I say, linkage is something driven mainly for investment managers.


Before I pass on to Sarah, one more thing to talk about is just this final, there are lots of minor, sort of, other amendments, going through on the suite of consolidation standards, so IFRS 10, 11, 12. I'm not going to go through these in detail. It's something for you to take away.



The first one, I'll just mention briefly, joint arrangements, other facts or circumstances, the question there is if I have a joint arrangement, and the two parties have rights to take all the outputs, so we're talking about some kind of production here. The issues are, does this need to be a contractual arrangement? Then the question is, what happens if the entity itself takes up external financing? So there are other questions. So if you’ve got other questions, be aware of that.


Investment entity. I'm sure many of you will have heard about the investment entity amendment. The investment entity amendment is being amended, because it was… it didn’t meet the requirement spot on, so again, they're going to tweak it and change it again, for those kinds of things, and then there's, again, as I say, a number of other ongoing projects that they're looking at. If any of these are relevant to you, then obviously keep an eye open for them.


I now pass over to Sarah, who’s going to talk to you about new UK GAAP. Thank you.

Changes to consolidation? - Stephen Hubbard