There are certain contractual arrangements which actually drive overall activities of an entity comparing to its voting structure where it does not has any power/ significance. These kind of activities if covers/ satisfies the definition of control over relevant activities then it will required to be consolidated in its contractually established party.
Let’s have an understanding about this concept by referring relevant extracts from Accounting Standards–
Ind-As 110 – Consolidated Financial Statements
Para -B8– An investee may be designed so that voting rights are not the dominant factor in deciding who controls the investee, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements. In such cases, an investor’s consideration of the purpose and design of the investee shall also include consideration of the risks to which the investee was designed to be exposed, the risks it was designed to pass on to the parties involved with the investee and whether the investor is exposed to some or all of those risks. Consideration of the risks includes not only the downside risk, but also the potential for upside.
Para -B2– To determine whether it controls an investee an investor shall assess whether it has all the following:
(a) power over the investee;
(b) exposure, or rights, to variable returns from its involvement with the investee; and
(c) the ability to use its power over the investee to affect the amount of the investor’s returns.
Ind-As 112 – Disclosures of Interests in Other entities
Para- B21– A structured entity is an entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements.
Para-B22– A structured entity often has some or all of the following features or attributes:
(a) restricted activities.
(b) a narrow and well-defined objective, such as to effect a tax-efficient lease, carry out research and development activities, provide a source of capital or funding to an entity or provide investment opportunities for investors by passing on risks and rewards associated with the assets of the structured entity to investors.
(c) insufficient equity to permit the structured entity to finance its activities without subordinated financial support.
(d) financing in the form of multiple contractually linked instruments to investors that create concentrations of credit or other risks (tranches).
Let’s take an example to understand what exactly the standard is trying to highlight-
Company A has transferred some debt securities to Z (a trust). Entity Z is not controlled through any voting rights. The purpose of making this trust is to market these transferred securities and then sell to the individuals as per the direction of Company A. All marketing activities are being managed by the Company A and debt securities which have been transferred will have a direction from Company A about its investments. In the market material it is clearly mentioned that Company A will be funding all such shortfalls while fulfilling any commitment related to these Investment products.
Here the relevant activities (as defined under Ind-As) are to invest those securities which have been received from Company A and market these securities to identify potential investors and making sure its sustainability.
Since the trust Z is not being governed by any share capital/ voting rights, however Company A is controlling all its relevant activities and expose towards variability in returns from entity Z, hence Company A will be controlling Z and it will be classified under “structured entity” defined by Ind-As 110 & 112 and will be consolidated accordingly.
There could be many more such examples like- Special Purpose Vehicles, Asset Backed Securities or a Trust which would have been created to fulfill share based payments etc.
After the applicability of Ind-As, these kind of structured entities need to be scrutinized in order to establish a pattern if there are control (as defined in Ind-As -110) which exist by using a CONTRACTUAL arrangement (even non-contractually also it is possible) and then possibly it will be consolidated into the investor ‘s Financial Statements.
As per Ind-As-112, there are extensive disclosure requirements (e.g. Nature of such control and exposure etc) in case of those structured entities which are consolidated and those which are not consolidated. Now, one can ask under what circumstances even if an entity is indentified as structured but still not been consolidated? ….The answer is e.g. Separate Financial Statements where all such subsidiaries/ structured entities are not consolidated however as per Ind-As -112, such structured entities will be required its extensive disclosures.
There are certain Investment Entities which are allowed to value all its subsidiaries or other investments through PL and hence in these cases “Unconsolidated structured entities” related disclosure will be applied.
At the conclusive part, it is a responsibility of the Management and the Auditors to indentify/ establishes a proper documentation in case any structured entity exists or if not then on what basis it was concluded. These structured entities can be found by reading minutes of meeting of the Board, contractual agreements with counterparties/ suppliers etc and by reading overall structure of the entity (stream of revenues) to identify such controlled units which are being deemed controlled by using a contractual agreement and not by voting rights and accordingly disclosures will be given.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at [email protected] or Whatsapp +91-9634706933)