International Financial Reporting Standard (IFRS) 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements and IFRS 12 Disclosure of Interests in Other Entities (the standards) became effective for annual reporting periods beginning on or after 1 January 2013. Companies with subsidiaries and joint arrangements apply these standards when preparing their group financial statements.
In May, the Institute’s Standard Setting Department responded to the International Accounting Standards Board’s (IASB) request for information (RFI) on the standards. The RFI sought feedback from stakeholders on the application of the standards and how useful the resulting information has been. The IASB will use the feedback from the RFI to determine whether any further action is required.
This article summarizes specific areas and highlights points of our response to the RFI. The full response is available on our website.
Overall, we consider the application of the standards can be challenging and often involves significant judgement. We suggest the IASB reiterate the need for preparers to disclose clearly any significant judgements made when applying the company’s accounting policies.
Control assessment under IFRS 10
We consider the principle of control in IFRS 10 has been operating largely as intended. However, we noted from our outreach activities that respondents had the following practical difficulties:
a) Determination of whether rights are substantive or protective
We noted that challenges are often seen in the real estate and the asset management industries, and when trusts or special purpose entities (SPE) are involved. For example, diversity in practice is noted in determining whether a veto right exercisable by a lender on the investment decisions of a borrower is substantive or protective. The application guidance in IFRS 10 would imply such a right is protective. However, if the investment decisions are significant to the returns of the borrower, such a right could be viewed as substantive.
b) Assessment of de facto control
We noted that challenges in assessing control in situations without a majority of voting rights arise regularly in Hong Kong. The increasing use of sophisticated structures is making this problem worse, in addition to placing more pressure on the general control assessment.
One of the practically challenging situations identified is when an investor has de facto control over an investee, and then, due to share dilution, the percentage of shareholding held by the investor decreases over time. If there are no other changes in facts and circumstances, questions may arise as to when the investor loses control over the investee.
IFRS 10 does not provide a minimum level of voting rights needed to achieve de facto control, and requires companies to look at all facts and circumstances. Hence, we consider the application of the requirements and guidance in IFRS 10 is highly judgemental and similar fact patterns could be interpreted differently.
c) Decision-maker: principal or agent?
The assessment of whether a decision-maker is a principal or an agent can be challenging and highly judgemental, particularly in the fund and asset management industries.
IFRS 10 requires a decision-maker that holds other interest in an investee to consider its exposure to variability of returns from those interests in assessing whether it is an agent. Assessing the exposure to variability of returns inevitably involves judgement, and IFRS 10 has limited guidance on whether more emphasis should be placed on magnitude or the variability of the returns, and how the different nature of returns impacts that assessment. For example, there are cases where the absolute amount of returns is small while the variability could be substantial. Questions arise as to whether other factors should also be considered, e.g. the amount as a percentage of the total expected returns.
d) Assessment of the existence of de facto agency relationships
We generally observed that non-contractual agency relationships are common among group companies, in the asset management industry, and when SPE are involved.
We believe that the de facto agency guidance in IFRS 10 is a well-meaning piece of guidance, but it is highly judgemental to apply in practice. In particular, it is practically difficult to determine whether a de facto agency relationship exists in the absence of a contractual arrangement.
In light of the above, we recommend that the IASB develop additional non-industry specific examples to illustrate the principles in the above areas to facilitate application.
Accounting for loss of control
Diversity in practice has been observed in accounting for the partial disposal of a subsidiary that results in a loss of control, where the subsidiary does not constitute a business under IFRS 3 Business Combinations. Some companies remeasure the retained interest at fair value while others adopt a cost-based approach. Questions also arise when accounting for transactions involving single-asset entities or corporate wrappers as to the interaction between the accounting for loss of control requirement in IFRS10 and the recognition of gain or loss in other IFRSs; in particular, whether the accounting should be driven by substance or form.
Given the above, we believe that it’s important for the IASB to consider the accounting for transactions involving single-asset entities or corporate wrappers more holistically, including whether the requirements in IFRS 10 are applicable to disposals of a subsidiary when the subsidiary does not constitute a business and how that interacts with the recognition of gain or loss in other IFRSs.
Accounting for collaborative arrangements
Collaborative arrangements, which are outside the scope of IFRS 11, are relatively common in Hong Kong. It is often difficult to classify collaborative arrangements appropriately, e.g. is it a joint arrangement under IFRS 11, an associate under International Accounting Standard 28 Investments in Associates and Joint Ventures, an equity investment under IFRS 9 Financial Instruments, a debt-type loan, a supplier-customer relationship, a prepayment for future expenditure, etc.?
In some cases, these collaborative arrangements are not joint arrangements because the contractual terms imply one party has control and another has significant influence (though the arrangement is collaborative in nature); or there are other factors that affect the voting power of the arrangement. These arrangements are also often not structured through a separate legal entity which increases the challenge of classification.
There is currently a lack of guidance in this area and challenges arise in determining how to characterize and classify such arrangements, resulting in diversity in practice. Hong Kong stakeholders have also reflected that the accounting treatments used in practice do not always provide relevant or useful information for such arrangements.
Accordingly, we recommend that the IASB develop clear principles for collaborative arrangements to better reflect the substance of those arrangements.
Classifying joint arrangements
IFRS 11 requires a company to apply judgement when assessing the classification of joint arrangements by considering the structure and legal form of the arrangement, the terms of the contractual arrangement and, when relevant, “other facts and circumstances.” Respondents found that the consideration of the “other facts and circumstances” in IFRS 11 is challenging and subjective.
Classification challenges also arise when the arrangements are structured through a separate vehicle but the legal form is not clearly representative of the underlying economics. In practice it is difficult to draft appropriate contractual terms that can enable such arrangements to be accounted for as a joint operation given that the legal form of the entity confers separation of the net assets from the parties to the joint arrangement. It is also often difficult for auditors to use “other facts and circumstances” to challenge management’s classification based on the legal form and contractual terms of the arrangement.
In light of the above, we recommend that the IASB provide more detailed guidance on the application of “other facts and circumstances” in IFRS 11.
We are currently seeking comments on a number of consultation papers. Visit our website and talk to us so that we can help steer the development of accounting standards.
This article was contributed by Eky Liu CPA, Joni Kan CPA and Katherine Leung CPA, Associate Directors of the Institute’s Standard Setting Department. Visit the department’s “What’s new” webpage for our latest publications, and follow us on LinkedIn for upcoming activities.