New standards on joint venture accounting and consolidation
Three new IFRSs are expected imminently. They could significantly change consolidation and joint venture accounting for many entities. IFRS 10 Consolidated financial statements, IFRS 11 Joint arrangements and IFRS 12 Disclosure of interests in other entities are not expected to be effective until 2013, but companies are encouraged to act now to understand their requirements and be able to analyse their implications before they become effective. We anticipate that applying the new standards will require a more detailed analysis of consolidation decisions than before with the IASB’s apparent goal being for more entities to be consolidated.
As this Update goes to press, we are expecting the publication of three new accounting standards which could significantly change consolidation and joint venture accounting for many entities. In some cases investors may be required to consolidate entities which have previously been treated as investments. In others, investors may be required to equity account for joint arrangements that have previously been proportionately consolidated. The new standards include more detailed guidance and will require a more detailed analysis of consolidation decisions than before: the apparent goal of the IASB is for more entities to be consolidated. Companies that are party to complex arrangements should act now to understand the requirements of the standards to be ready to apply them when they become effective.
IFRS 10 Consolidated financial statements
IFRS 10 will introduce a new set of requirements for assessing control, replacing IAS 27 Consolidated and separate financial statements and SIC 12 Consolidation – Special purpose entities. Whilst the new definition of control will retain the three key elements of the existing definition (power to direct activities, variability in returns and a link between power and returns) it will make significant changes in several key areas. Entities will need to re-assess judgemental consolidation decisions, particularly where they have the ability to control but only a minority holding (known as de facto control), potential voting rights, agency relationships (for example fund managers) or other trading relationships with entities in which they hold a stake. In addition, by replacing SIC 12, IFRS 10 will change significantly the way that control of SPEs is assessed.
Power to direct activities
IFRS 10 is expected to state that an investor has control and will consolidate when it has de facto control. This will result in consolidation of additional subsidiaries for groups which have de facto control but currently apply a policy of consolidation based on legal or contractual power to govern.
For example, suppose that an investor owns 47 per cent of the voting rights of an entity. Previously it has not consolidated based on a legal definition of power because it does not have the majority of the voting rights. If the remaining voting rights are held in two 10 per cent blocks and a four per cent block with the remainder dispersed amongst many shareholders, the investor will be required to consolidate under IFRS 10 based on its having de facto control. This is because, on the basis of the absolute size of its holding and relative size and dispersion of the other shareholders, the investor has a sufficiently dominant voting interest to meet the power criterion.
IFRS 10 will also change when an entity takes into account potential voting rights in assessing control. Entities that have voting rights that are not currently exercisable (e.g., options exercisable at a future date) do not take them into account in assessing control under IAS 27. Under IFRS 10, entities will need to consider whether such potential voting rights are substantive in determining whether they give rise to control.
Variability in returns
IAS 27 defines control with reference to obtaining benefits from activities; IFRS 10 will refer to variable returns. Benefits are not defined in IAS 27 but have been taken as being those that arise from a residual or ownership interest. We anticipate that ‘variable returns’ will include more than IAS 27 ‘benefits’. In some cases, it may be difficult to separate variable returns that arise from an entity’s investment and returns that arise from ordinary business activities.
Link between power and returns
As with IAS 27, the IFRS 10 definition of control requires a link between power and returns. However, IFRS 10 makes a number of changes, including an explicit concept of agency. If a party has power to direct activities in a capacity as an agent, the power is attributed to the principal (or principals). Whilst the new guidance appears to be directed at fund managers who may act as an investor’s agent, it is not clear whether they will lead to significant changes in the entities which are consolidated in practice. Further changes are likely to address the interaction between kick-out rights (whereby investors are able to remove a fund manager) and assessing whether a fund manager is acting as an agent.
Assessing control often involves significant analysis and judgement. Many of the requirements of IFRS 10 are likely to be detailed and include factors and indicators that are not present in the existing standards. We anticipate that determining how to apply the requirements of the new standard may take a significant amount of time and urge entities to study the new requirements when they are published so that they are able to analyse the implications of any complex arrangements to which they are party before the requirements become effective.
IFRS 11 Joint arrangements
IFRS 11 addresses situations in which an entity has joint control over an arrangement, and will replace IAS 31 Interests in joint ventures. Put simply, IFRS 11 does two things. First, it carves out of IAS 31’s jointly controlled entities those cases where, although there is a separate vehicle, that separation is ineffective (in certain ways); those cases it treats like the IAS 31 jointly controlled assets/operations, now called 'joint operations'. Second, what is left of IAS 31’s jointly controlled entities, now called 'joint ventures', are stripped of the free choice of equity accounting and proportionate consolidation; they must now always use equity accounting.
IFRS 11 defines joint operations as those joint arrangements of which investors have rights to the assets and obligations for the liabilities. Joint ventures arise when the investors have rights to the net assets. Under IAS 31, if a jointly controlled arrangement is a separate legal entity, then it is a jointly controlled entity. Instead of basing the assessment solely on legal form, IFRS 11 includes different and potentially complex guidance on how to classify such arrangements, which may look through the legal form. Entities will therefore need to consider carefully how they classify joint arrangements under the new standard.
This classification is important because it determines the accounting for the arrangement. IAS 31 allowed a choice between equity accounting and proportionate consolidation for jointly controlled entities. IFRS 11 will mandate equity accounting for joint ventures, whilst requiring assets and liabilities in respect of joint operations to be recognised directly, on a line-by-line basis, by the investor. IFRS 11 is therefore likely to have a significant effect on entities that have previously used proportionate consolidation to account for jointly controlled entities. It is also likely to change significantly the accounting for entities that were classified as jointly controlled entities under IAS 31 based on their legal form but which are classified as joint operations under IFRS 11.
IFRS 12 Disclosure of interests in other entities will be issued alongside IFRS 10 and IFRS 11, and is set to introduce new and potentially onerous disclosure requirements in respect of entities that are consolidated and of unconsolidated entities in which the investor has an interest.
In addition, IAS 28 Investments in associates will be amended to make it consistent in certain respects with IFRSs 10 to 12. However, the IASB has chosen not to address many of the inconsistencies between IAS 28 Investments in associates and other standards. For example, it has not addressed the inconsistency between the IAS 27 requirement to recognise any retained interest in a former subsidiary at fair value and the IAS 28 / SIC 13 requirement that only the portion of any gain or loss that is attributable to the interests of the other venturers is recognised. In some cases, for example, in respect of potential voting rights, new inconsistencies between IAS 28 and other standards will be introduced.
The new standards are expected to be effective from 2013. The IASB has stated that a publication plan will be placed on its web site so that entities can see the likely publication date.
The IASB is also expected to publish in the second quarter of 2011 an exposure draft proposing exemptions from the requirement to consolidate certain defined investment entities.
KPMG's International Financial Reporting Group will publish a full analysis of the new requirements in its publication, First Impressions once they have been issued by the IASB. First Impressions can be obtained from your usual KPMG contact or via KPMG’s Global IFRS Institute website here.