IFRS10 Consolidated Financial Statements

This article will consider how the accounting standard IFRS10 Consolidated Financial Statements (IFRS10) addresses the definition of a subsidiary. Where an investment is identified as a subsidiary then consolidated financial statements are prepared where the financial statements of a group parent and its subsidiaries are presented as those of a single economic entity.

But what exactly is a subsidiary?

Well the standard takes a principles based approach and in simple terms defines a subsidiary in terms of control. It should be noted that the definition of a subsidiary is not a number rather it is based on the principle of control.

This principles based approach is important as creative accountants adopting a legalistic approach may wish to try and argue that an investment is not a subsidiary, on the basis that the investor’s shareholding is less than 50% and so the entity should not be consolidated. These arguments are often used where the investment is highly geared. What the creative accountant is trying to do is take the investment’s liabilities off the group balance sheet as if the investment is defined as a subsidiary their liabilities are aggregated in full in the consolidated accounts. It is always important to consider substance of the relationship with an investment and not just the size of the shareholding. If an investment is in fact controlled then it is a subsidiary and its income expenses assets and liabilities should be consolidated in order that there is transparency and accountability.

Control is though normally, but not exclusively, evidenced by the investor holding a majority (50% +) of the voting rights.

Definition of control

According to IFRS10, 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)

· exposure, or rights, to variable returns from its involvement with the investee

· the ability to use its power over the investee to affect the amount of the investor’s returns.

Importantly though an investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.

Power arises from rights. Such rights can be straightforward (e.g. through voting rights) or be complex (e.g. embedded in contractual arrangements).

An investor must be exposed, or have rights, to variable returns from its involvement with an investee to control 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.

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.

Let’s explore the issue of control through a couple of examples!

Q Singapore & Flyer

Singapore has recently acquired 40% of the equity capital and voting rights of Flyer.The other 60% of Flyer’s shares are held by a wide variety of investors, none of whom owns more than 0·5% individually. None of the other shareholders has any arrangements to consult any of the others or make collective decisions. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Flyer.

Required:

Discuss how the purchase of the shareholding in Flyer should be accounted for in the consolidated financial statements of Singapore.

A Singapore & Flyer

On a first review, Singapore does not have the power to control Flyer simply on account of its the absolute size of the investor’s holding. The relative size of the other shareholdings alone are not conclusive in determining whether the investor has rights sufficient to give it power.

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)

· exposure, or rights, to variable returns from its involvement with the investee

· the ability to use its power over the investee to affect the amount of the investor’s returns.

An investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.

So when we consider the relevant facts that none of the other shareholders has any arrangements to consult any of the others or make collective decisions and that since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Flyer we can conclude that Flyer is controlled.

In conclusion Flyer is therefore a subsidiary of Singapore.

Q Singapore & Airways

Singapore has just purchased 25% of the equity and voting shares in Airways. In addition Singapore has purchased a substantial number of warrants (options) issued by Airways which are currently exercisable. If these warrants are exercised, they will result in Singapore owning 60% of the voting shares of Airways. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Airways.

Required:

Discuss how the purchase of the shareholding in Airways should be accounted for in the consolidated financial statements of Singapore.

A. Singapore & Airways

On a first review, Singapore does not have the power to control Airways simply on account of its absolute size of the investor’s holding, but this is not conclusive in determining whether the investor has rights sufficient to give it power to control.

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)

· exposure, or rights, to variable returns from its involvement with the investee

· the ability to use its power over the investee to affect the amount of the investor’s returns.

An investor will also have to consider all relevant facts and circumstances when assessing whether it controls an investee.

So when we consider the relevant facts we note that it is investor Singapore that has warrants that are exercisable and if they were then it would have a majority of the voting rights. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of Airways. On this basis this is sufficient to conclude that it has power over the investee which it is using.

In conclusion Airways is a subsidiary of Singapore.

Tom Clendon FCCA is a lecturer with FTMS based in Singapore. He is the author of “A student’s guide to group accounts” published by Kaplan which is now in its second edition.