Scenario C
An investor holds a substantive option to acquire the majority of shares in the investee that is exercisable
in 25 days and is deeply in the money. The same conclusion would be reached as in scenario B.
Scenario D
An investor is party to a forward contract to acquire the majority of shares in the investee, with no other
related rights over the investee. The forward contract’s settlement date is in six months. In contrast to the
scenarios A to C above, the investor does not have the current ability to direct the relevant activities. The
existing shareholders have the current ability to direct the relevant activities because they can change the
existing policies over the relevant activities before the forward contract is settled.
This example illustrates that an investor with the current ability to direct the relevant
activities has power even if its rights to direct have yet to be exercised. Evidence that
the investor has been directing relevant activities can help determine whether the
investor has power, but such evidence is not, in itself, conclusive in determining
whether the investor has power over an investee. [IFRS 10.12].
It should be noted that an investor in assessing whether it has power needs to consider
substantive rights held by other parties. Substantive rights exercisable by other parties
can prevent an investor from controlling the investee to which those rights relate. Such
substantive rights do not require the holders to have the ability to initiate decisions. As
long as the rights are not merely protective (see 4.2.2 below), substantive rights held by
other parties may prevent the investor from controlling the investee even if the rights
give the holders only the current ability to approve or block decisions that relate to the
relevant activities. [IFRS 10.B25].
It is important to remember that the purpose and design of an investee is critical when
assessing whether a right is substantive. For example, the following should be
considered when evaluating whether an investor’s rights are substantive:
• Why were the rights granted?
• What compensation was given (or received) for the right? Does that compensation
reflect fair value?
• Did other investors also receive this right? If not, why?
These questions should be considered both when a right is first granted, but also if an
existing right is modified.
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To be substantive and convey power, a right must give the investor the ‘current ability’
to direct the investee’s relevant activities. However, ‘current ability’ does not always
mean ‘able to be exercised this instant’. The concept of ‘current ability’ is discussed
more in the context of potential voting rights at 4.3.4 below.
4.2.2
Evaluating whether rights are protective
In evaluating whether rights give an investor power over an investee, the investor has
to assess whether its rights, and rights held by others, are protective rights. [IFRS 10.B26].
Under IFRS 10, protective rights are defined as ‘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’. [IFRS 10 Appendix A].
Since power is an essential element of control, protective rights do not provide the
investor control over the investee. [IFRS 10.14]. In addition, holding protective rights
cannot prevent another investor from having power over an investee. [IFRS 10.B27].
Protective rights are typically held to prohibit fundamental changes in the activities of
an investee that the holder does not agree with and usually only apply in exceptional
circumstances (i.e. upon a contingent event). However, the fact that the right to make
decisions is contingent upon an event occurring does not mean that the right is always
a protective right. [IFRS 10.B26].
Examples of protective rights include (but are not limited to) the right to:
• restrict an investee from undertaking activities that could significantly change the
credit risk of the investee to the detriment of the investor;
• approve an investee’s capital expenditures (greater than the amount spent in the
ordinary course of business);
• approve an investee’s issuance of equity or debt instruments;
• seize assets if an investee fails to meet specified loan repayment conditions;
[IFRS 10.B28] and
• veto transactions between the investee and a related party.
In some cases, a right might be deemed protective, such as the ability to sell assets of
the investee if an investee defaults on a loan, because default is considered an
exceptional circumstance. However, in the event that the investee defaults on a loan
(or, say, breaches a covenant), the investor holding that right will need to reassess
whether that right has become a substantive right that gives the holder power (rather
than merely a protective right), based on the change in facts and circumstances. This
issue has been raised with the Interpretations Committee which, in September 2013,
concluded that reassessment of control is required when facts and circumstances
change in such a way that rights, previously determined to be protective, change (for
example upon the breach of a covenant in a borrowing arrangement that causes the
borrower to be in default). The Interpretations Committee observed that it did not
expect significant diversity in practice to develop on this matter and decided not to add
the issue to its agenda. In making its conclusion, the Interpretations Committee
observed that:
Consolidated financial statements 389
• paragraph 8 of IFRS 10 requires an investor to reassess whether it controls an
investee if facts and circumstances indicate that there are changes to one or more
of the three elements of control;
• a breach of a covenant that results in rights becoming exercisable constitutes such
a change;
• IFRS 10 does not include an exemption for any rights from this need for
reassessment; and
• the IASB’s redeliberations of this topic during the development of IFRS 10
concluded that rights initially determined to be protective should be included in a
reassessment of control whenever facts and circumstances indicate that there are
changes to one or more of the three elements of control.6
4.2.2.A Veto
rights
Whether veto rights held by an investor are merely a protective right or a right that may
convey power to the veto holder will depend on the nature of the veto rights. If the veto
rights relate to changes to operating and financing policies that significantly affect the
investee’s returns, the veto right may not merely be a protective right.
Other veto rights that are common, and are typically protective (because they rarely
significantly affect the investee’s returns) include veto rights over changes to:
• amendments to articles of incorporation;
• location of investee headquarters;
• name of investee;
• auditors; and
• accounting principles for separate reporting of investee operations.
4.2.2.B Franchises
Many have questioned how to consider franchi
se rights, and whether they give power
(to the franchisor), or whether they are merely protective rights. IFRS 10 notes that a
franchise agreement for which the investee is the franchisee often gives the franchisor
rights that are designed to protect the franchise brand. Franchise agreements typically
give franchisors some decision-making rights with respect to the operations of the
franchisee. [IFRS 10.B29].
The standard goes on to say that, generally, franchisors’ rights do not restrict the ability
of parties other than the franchisor to make decisions that have a significant effect on
the franchisee’s returns. Nor do the rights of the franchisor in franchise agreements
necessarily give the franchisor the current ability to direct the activities that significantly
affect the franchisee’s returns. [IFRS 10.B30].
It is necessary to distinguish between having the current ability to make decisions that
significantly affect the franchisee’s returns and having the ability to make decisions that
protect the franchise brand. The franchisor does not have power over the franchisee if
other parties have existing rights that give them the current ability to direct the relevant
activities of the franchisee. [IFRS 10.B31].
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By entering into the franchise agreement the franchisee has made a unilateral decision
to operate its business in accordance with the terms of the franchise agreement, but for
its own account. [IFRS 10.B32].
Control over such fundamental decisions as the legal form of the franchisee and its
funding structure often are not made by the franchisor and may significantly affect
the returns of the franchisee. The lower the level of financial support provided by
the franchisor and the lower the franchisor’s exposure to variability of returns from
the franchisee the more likely it is that the franchisor has only protective rights.
[IFRS 10.B33].
When analysing whether a franchisor has power over a franchisee, it is necessary
to consider the purpose and design of the franchisee. The assessment of whether a
franchisor has power hinges on the determination of the relevant activities, and
which investor (the franchisor or owner of the franchisee) has the current ability to
direct that activity through its rights. The rights held by the franchisor must be
evaluated to determine if they are substantive, (i.e. the franchisor has the practical
ability to exercise its rights when decisions of the relevant activities need to be
made so that it has the current ability to direct the relevant activities), or whether
they are merely protective rights. A determination will need to be made in each
case, based on the specific facts and circumstances. This is illustrated in
Example 6.8 below.
Example 6.8:
Rights held by franchisor
A franchisor has certain rights that are designed to protect its brand when it is being licensed by a franchisee.
Activities that significantly affect the franchisee’s returns include:
• determining or changing its operating policies;
• setting its prices for selling goods;
• selecting suppliers;
• purchasing goods and services;
• selecting, acquiring or disposing of equipment;
• appointing, remunerating or terminating the employment of key management personnel; and
• financing the franchise.
If certain of the activities above are directed by one investor (e.g. the owners of the franchisee), and other
activities are directed by another investor (e.g. the franchisor), then the investors will need to determine which
activity most significantly affects the franchisee’s returns, as discussed at 4.1 above.
4.2.2.C
Budget approval rights
Approval rights over budgets are fairly common in shareholders’ agreements and form
part of the assessment as to the level of power held by investors. If the budget approval
rights held by a shareholder (or other investee) are viewed as substantive, that might
indicate that the entity having those rights has power over an investee.
However, the purpose and design of arrangements is key to the analysis of who has
power. Therefore, the right to approve budgets should not automatically be considered
substantive but should be based on a careful consideration of the facts and
circumstances. Factors to consider in assessing whether budget approval rights are
substantive or protective include (but are not limited to):
Consolidated financial statements 391
• the level of detail of the budget that is required to be approved;
• whether the budget covers the relevant activities of the entity;
• whether previous budgets have been challenged and if so, the practical method of
resolution;
• whether there are any consequences of budgets not being approved (e.g. may the
operator/directors be removed?);
• whether the entity operates in a specialised business for which only the
operator/directors have the specialised knowledge required to draw up the budget;
• who appoints the operator and/or key management personnel of the investee; and
• the nature of the counterparty with budget approval rights and their practical
involvement in the business.
4.2.2.D Independent
directors
In some jurisdictions, there are requirements that an entity appoints directors who are
‘independent’. The phrase ‘independent director’ has a variety of meanings in different
jurisdictions but generally means a director who is independent of a specific shareholder.
In some situations, a majority of directors of an entity may be ‘independent’.
The fact that a majority of directors of an entity are ‘independent’ does not mean that
no shareholder controls an entity. IFRS 10 requires that all facts and circumstances be
considered and in the context of an entity with independent directors it is necessary to
determine the role that those directors have in decisions about the relevant activities of
the entity. The power to appoint and remove independent directors should be
considered as part of this assessment.
Similarly, an entity may have more than one governing body and it should not be
assumed that because one body (which may consist of a majority of independent
directors) has oversight of another this means that the supervisory body is the one that
makes decisions about the relevant activities of the entity.
4.2.3
Incentives to obtain power
There are many incentives to obtain rights that convey power; generally, the more
exposure to variable returns (whether positive or negative), the greater that incentive.
IFRS 10 notes this in two contexts:
• the greater an investor’s exposure, or rights, to variability of returns from its
involvement with an investee, the greater the incentive for the investor to obtain
rights sufficient to give it power. Therefore, having a large exposure to variability
of returns is an indicator that the investor may have power. However, the extent
of the investor’s exposure is not determinative regarding whether an investor has
power over the investee; [IFRS 10.B20] and
• an investor may have an explicit or implicit commitment to ensure
that an investee
continues to operate as designed. Such a commitment may increase the investor’s
exposure to variability of returns and thus increase the incentive for the investor
to obtain rights sufficient to provide it with power. Therefore, a commitment to
ensure that an investee operates as designed may be an indicator that the investor
has power, but does not, by itself, give an investor power, nor does it prevent
another party from having power. [IFRS 10.B54].
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Thus, even though there may be an incentive to obtain rights that convey power when
there is an exposure to variable returns, that incentive, by itself, does not represent
power. Rather, the investor must analyse whether it actually does have power through
existing rights, which might be in the form of voting rights, or rights through a
contractual agreement, as discussed at 4.3 and 4.4 below respectively.
4.3 Voting
rights
Power stems from existing rights. Often an investor has the current ability, through
voting or similar rights, to direct the relevant activities. [IFRS 10.B34].
In many cases, assessing power can be straightforward. This is often the case when, after
understanding the purpose and design of the investee, it is determined that power over
an investee is obtained directly and solely from the proportionate voting rights that stem
from holding equity instruments, such as ordinary shares in the investee. In this case, in
the absence of evidence to the contrary, the assessment of control focuses on which
party, if any, is able to exercise voting rights sufficient to determine the investee’s
operating and financing policies. In the most straightforward case, the investor that
holds a majority of those voting rights, in the absence of any other factors, controls the
investee. [IFRS 10.B6].
Nevertheless, when taking into account other factors relating to voting rights, an
investor can have power even if it holds less than a majority of the voting rights of an
investee. An investor can have power with less than a majority of the voting rights of an
investee, for example, through:
(a) a contractual arrangement between the investor and other vote holders
(see 4.3.5 below);
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