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IND-AS: Consolidation – A Paradigm Shift!

Published on Mon, Apr 20,2015 | 21:12, Updated at Mon, Apr 20 at 21:12Source : 


By: Santosh Maller, EY member firm

Consolidated financial statements are those where a parent company presents its financial statements as those of entities controlled by it as single economic entity. With the application of the Companies Act, 2013 from the financial years beginning 1 April 2014, most Indian companies having one or more subsidiaries are required to prepare and present consolidated financial statements (CFS). Ind-AS, which takes effect for listed and non-listed companies having a net worth of Rs.500 crore and above (phase I) from 1 April 2016, contains significantly different requirements concerning preparation of CFS. Though Ind-AS 110 Consolidated Financial Statements contain a few exemptions from preparation of CFS, they are not in sync with the Companies Act, 2013. Consequently, the stricter of two requirements will apply and most Indian companies having subsidiaries/ associates/ joint ventures will need to prepare CFS. Also, Ind-AS 110 contains significantly different requirements to assess existence of control / joint control, thereby will potentially affect a group’s consolidated financial statements. In this article we discuss a few key new aspects of consolidation under Ind-AS along with key practical implications.

Under Indian GAAP, AS 21 defines control as ownership of majority voting rights and/ or power to control of the composition of the board of directors.

Ind-AS 110 Consolidated Financial Statements contains much broader and substance-based on definition of control. It identifies the principles of control, determines how to identify whether an investor controls an investee and therefore must consolidate the investee, and sets out the principles for the preparation of consolidated financial statements. In accordance with Ind-AS 110, 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). Such rights can either be straightforward (e.g. through voting rights) or be complex (e.g. embedded in contractual arrangements). An investor holding only protective rights cannot have power over an investee.
. exposure, or rights, to variable returns from its involvement with 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.
. the ability to use its power over the investee to affect the amount of the investor's returns. 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.
Application of this definition would require identification of the entity that in substance controls another entity. This can give significantly different results vis-à-vis that under Indian GAAP.

Voting Power vs. Board Control
Consider a scenario, wherein the 51% equity shares an entity C is held by entity A and 49% is held by entity B. Entity A has a right to appoint 2 directors on the board of entity C while entity B has a right to appoint 3 directors. Under Indian GAAP, both A and B would be consolidating C, based on majority voting rights and right to appoint majority directors, respectively. Upon transition to Ind-AS, entities shall be required to identify the entity that, in substance, controls C. Based on definition given, only one entity may be identified as controlling entity C. If the substance of the arrangement is that both A and B have joint control over C, none of the two will be able to use full consolidation for C.

De-facto Control
Ind-AS 110 states an investor might have control over an investee even when it has less than a majority of the voting rights of that investee. The control exists if the investor has the practical ability to direct the relevant activities of the investee unilaterally (a concept known as 'de facto control'). When assessing whether an investor's voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:

(a) the size of the investor's holding of voting rights relative to the size and dispersion of holdings of the other vote holders

(b) potential voting rights held by the investor, other vote holders or other parties;

(c) rights arising from other contractual arrangements; and

(d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders' meetings.

Consider an example.-Entity A holds 48% of the voting rights of entity B; the remaining 52% of B is widely held by thousands of shareholders (none of whom holds more than 1% of the voting rights). A has power over B, because A has a dominant voting interest (based on the absolute size of its holding, and relative to other shareholders), and a large number of shareholders would have to agree to outvote A.

The concept of de-facto control does not exist under Indian GAAP.

Options And Convertible Instruments
Under Indian GAAP, option and warrants are generally not considered in determination of control. Ind-AS 110 requires that a reporting entity should assess whether its power to obtain voting rights achieved from holding options or convertible instruments gives it the power to direct the activities of another entity. For example, an option or conversion agreement may give the reporting entity particular rights relating to the strategic operating and financing policies. If these rights enable the reporting entity to have the power to direct the activities of the entity, it will need to consolidate another entity. On the other hand, if convertible instruments are held by some other investor, the entity will need de-consolidate the entity which it had consolidated under Indian GAAP.

Delegated Power – Principal Or Agent
Ind-AS 110 introduces a new concept of delegated power.  An investor may delegate decision-making authority to an agent on some specific issues or on all relevant activities, but, ultimately, the investor as principal retains the power. An agent is a party engaged to act on behalf of another party (principal), but which does not have control over the investee. Accordingly, a decision maker that is not an agent is a principal. It is necessary to assess whether the decision maker is acting as a principal or an agent, to determine whether the decision maker is deemed to have control.

Ind-AS 110 provides guidance for analysing control, by asking whether the decision maker, is acting as a principal, or as an agent that is acting primarily on behalf of other investors. An agent cannot have control over the investee and therefore will not consolidate the investee. In contrast, an entity that is a principal controls the investee and so will consolidate the investee. For example, in some cases, the fund manager may be regarded as acting as a principal, thus it will consolidate additional funds and consequently increase the size and complexity of its balance sheet. This may have a direct impact on systems, processes and controls, key metrics and ratios, as well as how the fund manager communicates with investors. In addition, consolidation of additional funds may place extra demands on already stressed financial reporting time-lines.

Structured Entities
Ind-AS 110 introduces a new term ‘structured entities’ (SE) which an entity whose activities are restricted to the extent that they are not directed by a governing body. The standard does not have “bright-line requirements” setting out when a reporting entity should consolidate an SE. Rather, an entity needs to consider all facts and circumstances to determine whether it has the power to direct the activities that cause the returns of the SE to vary. Following are various aspects laid down to assist in decision making:

· What is the purpose and design of the SE?

· What returns does the reporting entity earn from its involvement with the SE?

· To what extent are the activities of the SE predetermined?

· Does the reporting entity have the ability to change the restrictions or predetermined strategic policies of the SE?

· What is the effect of any related arrangements?

· Whether the entity is acting as an agent in its relationship with the SE?

Entities in sectors such as, real estate and construction, infrastructure, e-commerce and financial services, where the use of structured entities are prominent need to assess whether such entities need to be controlled under Ind-AS 110. Also special purpose entities structured and designed for tax planning, financing, strategic operational efficiency may need to be assessed. For example, many real estate companies provide advance to land aggregators (LACs) for land purchase. Under Ind-AS, these LACs may have to be consolidated as subsidiaries, due to which the potential implications under the Urban Land Ceiling Act may have to be assessed.  

Global Experience
Ind-AS 110 is based on IFRS 10 which is already effective internationally. Following are a few examples of the impact that first-time application of IFRS 10 had in the financial statements of leading international companies:

· An industrial gas group assessed that it has control  over some of its investees under IFRS 10 that were previously classified as joint ventures

· A global chemical group had to deconsolidate some of its investees and classified them as joint ventures under the new guidance. This had significant impact on the consolidated revenue and earnings before interest and tax

· A major extractive group had to consolidate an investee for the first time and had to deconsolidate other investees

This is an overview of impact of moving from IAS 27 to IFRS 10. Since Indian companies will be moving from AS 21 (which is different from IAS 27), the impact could be much more significant.

Key Impact On Indian Entities
Application of Ind-AS 110 may significantly amend the existing group structures as entities may need to consolidate new entities based on criteria such as de facto control, structured entities and potential voting rights. Also, some of the existing entities may get deconsolidated. Entities will need to update their existing group structures and start coordinating with new group entities so that they get timely information for all entities to prepare consolidated financial statements.

Changes in group structure as mentioned above alongwith other Ind-AS changes may significantly impact financial performance and financial position. It is necessary that entities start communicating such impacts to their stakeholders in advance so as to avoid sudden impact. Also, entities may need to renegotiate loan covenants based on their financial performance and financial position.

Determination of control shall become more judgmental. This is particularly relevant with regard to consideration of items as options and convertible instruments, structured entities and de facto control. Since Ind-AS 110 does not contain any bright-line test on such determination, it is important that entities consider all the facts and circumstances in comprehensive manner to arrive at an appropriate conclusion. To avoid any last minute disagreements, entities should also have early discussions with their auditors.

Ind-AS 110 requires control to be assessed on a continuous basis. This is particularly relevant in marginal cases and may have “in, out and in” situation from one period to the next. For example, in case of de facto control, a relatively small change in the shareholding pattern of an investee company may fail the control test. In subsequent periods, entity may be able to achieve de facto control again.  

Adopting Ind-AS 110 will require time, effort and the exercise of considerable judgement because of the lack of “bright lines”. Many of these judgements will require a comprehensive understanding of an entity’s business, its operations, and legal rights and obligations. These judgments will require input from sources such as operations personnel, and legal counsel. Management should be closely involved in this assessment, and entities may also wish to involve their Audit Committees and independent auditors in discussions on material areas of judgement. Key discussions and decisions should be documented.


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