While analyzing the control aspect on any investments made by an entity, we usually go by the definition which suggests that while evaluating such rights which provides right to variable returns from the entity in which such investment has been made.
In other words the control is usually defined to have power over the investee’s relevant activities (activities which are actually making effects on Profit & Loss account) and such rights should be substantive (currently exercisable including potential voting rights).
Control has been defined by Ind-As 110 (IFRS-10) as per the Appendix –A
Control of an investee – “An investor controls an investee when the investor is exposed, or has
rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.”
Now, it essentially focuses on control over relevant activities of investee operations in which a parent could direct in such a way so that it can have variable returns(either profit or loss) from such investments. That return could be either profit or loss.
Next question comes, how to involve in the relevant activities of the investee so that the entity who has invested into a set of activities could direct (i.e.control) the same. These rights could be voting rights or potential voting power (e.g. options which is currently in the money) where the controlling rights to direct relevant activities are vest with the investor who has been identified being controller of such investee. Relevant activities are those which eventually effect profits/ loss of the business and not those which are just an administrative powers.
Standard talks about a concept called “PROTECTIVE RIGHTS” and one has to be careful while making an analysis whether an Investor has controlling power over the relevant activities over investee. Let’s first have some references from the standard about this concept before getting into more details about the same-
Ind-As-110 (IFRS-10) Appendix A
Protective rights – “Rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate.”
Para B-9 – To have power over an investee, an investor must have existing rights that give it the current ability to direct the relevant activities. For the purpose of assessing power, only substantive rights and rights that are not protective shall be considered.
Para B-26 – In evaluating whether rights give an investor power over an investee, the investor shall assess whether its rights, and rights held by others, are protective rights. Protective rights relate to fundamental changes to the activities of an investee or apply in exceptional circumstances. However, not all rights that applies in exceptional circumstances or are contingent on events are protective.
Para B-27 – Because protective rights are designed to protect the interests of their holder without giving that party power over the investee to which those rights relate, an investor that holds only protective rights cannot have power or prevent another party from having power over an investee.
To be specific, substantive rights (voting power plus any potential rights etc) will be considered while evaluating control. In contrast any protective rights (which only protect a party without giving any controlling power to such party) will not be considered.
What exactly are protective rights and why do we need to understand carefully the concept and relevant guidance in order to evaluate controlling rights of an Investor-
1. Protective rights are certain clauses which essentially provide a safety to shareholder/ investor in order to prevent any fundamental change that could bring in,
An entity has taken some loan from a bank under which it was mentioned that the Entity can not change its business activities which are different from the existing without getting consent from the bank. Such kind of rights which bank is having shows protection against the loan which has given to the Entity and the bank should then be able to intervene in case new business activity will take place which might increase credit risk of the loan. Such rights will be under protective rights and not substantive rights. Such protective rights will protect the repayment of loan to Bank.
2. Protective rights are usually given to secure the interest of the investor without having a control over the relevant activities. In other words these rights can not direct/ influence any relevant activities of the Investee. If relevant activities can not be influenced/ directed then there is no exposure towards variable returns (which means a profit or loss of the business),
3. There are many loan agreements which provide a clause to seize the assets of the borrower in case of default in repayment of such loan will also be an example of PROETCTIVE rights which does not make any control over the direction of any relevant activities of the investee (in which investment is made).
4. This distinction between substantive rights & protective rights is very crucial to understand as the incorrect assessment would lead to a wrong conclusion. All substantial rights should be evaluated if these are just protective rights which provides a investor to protect its interest/ investment and does not PREVENT OTHER INVESTOR TO CONTROL RELEVENT ACTIVITIES of the investee,
5. Hence if an investor has certain rights which does not prevent in any way to control the relevant activities by other investors then these will be considered as protective rights,
6. There is an another indication to identify rights which could be protective is its occurrence which means these kind of protective rights are normally uses less frequently comparing to the other substantive rights. The reason for giving the protective right is to secure investment and all fundamental changes, if any, should be notified or seek consent from such protective investors,
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)