benefit of the investor;
• the investor can dominate either the nominations process for electing members
of the investee’s governing body, or obtaining proxies from other holders of
voting rights;
• the investee’s key management personnel are related parties of the investor (for
example, the chief executive officer of the investee and the chief executive officer
of the investor are the same person); or
• the majority of the members of the investee’s governing body are related parties of
the investor. [IFRS 10.B18].
When the above factors and the indicators set out below are considered together with
an investor’s rights, IFRS 10 requires that greater weight is given to the evidence of
power described above. [IFRS 10.B21]. Sometimes, there will be indications that an
investor has a special relationship with the investee, which suggests that the investor
has more than a passive interest in the investee. The existence of any individual
indicator, or a particular combination of indicators, does not necessarily mean that the
power criterion is met. However, having more than a passive interest in an investee may
indicate that the investor has other rights that give it power over the investee or provide
evidence of existing power over the investee. For example, IFRS 10 states that this
might be the case when the investee:
Consolidated financial statements 409
• is directed by key management personnel who are current or previous employees
of the investor;
• has significant:
• obligations that are guaranteed by the investor; or
• activities that either involve or are conducted on behalf of the investor;
• depends on the investor for:
• funds for a significant portion of its operations;
• licenses, trademarks, services, technology, supplies or raw materials that are
critical to the investee’s operations; or
• key management personnel, such as when the investor’s personnel have
specialised knowledge of the investee’s operations; or
• the investor’s exposure, or rights, to returns from its involvement with the investee
is disproportionately greater than its voting or other similar rights. For example,
there may be a situation in which an investor is entitled, or exposed, to more than
half of the returns of the investee but holds less than half of the voting rights of the
investee. [IFRS 10.B19].
As noted at 4.2.3 above, the greater an investor’s exposure, or rights, to variability of
returns from its involvement with an investee, the greater is 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 does not, in itself, determine whether an investor has
power over the investee. [IFRS 10.B20].
4.6
Determining whether sponsoring (designing) a structured entity
gives power
IFRS 10 discusses whether sponsoring (that is, designing) a structured entity gives an
investor power over the structured entity.
In assessing the purpose and design of an investee, an investor considers the
involvement and decisions made at the investee’s inception as part of its design and
evaluate whether the transaction terms and features of the involvement provide the
investor with rights that are sufficient to give it power. Being involved in the design of
an investee alone is not sufficient to give an investor control. However, involvement in
the design may indicate that the investor had the opportunity to obtain rights that are
sufficient to give it power over the investee. [IFRS 10.B51].
An investor’s involvement in the design of an investee does not mean that the investor
necessarily has control, even if that involvement was significant. Rather, an investor has
control of an investee when all three criteria of control are met (see 3.1 above),
considering the purpose and design of the investee. Thus, an investor’s involvement in
the design of an investee is part of the context when concluding if it controls the
investee, but is not determinative.
In our view, there are relatively few structured entities that have no substantive
decision-making. That is, virtually all structured entities have some level of decision-
making and few, if any, are on ‘autopilot’ (see 4.1.2 above). In such cases, if that decision-
410 Chapter
6
making can significantly affect the returns of the structured entity, the investor with the
rights to make those decisions would have power. This is because IFRS 10 clarifies that
an investor has power when it has existing rights that give it the current ability to direct
the relevant activities, even if those relevant activities only occur when particular
circumstances arise or specific events occur (see 4.1.1 above).
However, a structured entity with limited decision-making requires additional scrutiny
to determine which investor, if any, has power (and possibly control) over the structured
entity, particularly for the investors that have a potentially significant explicit or implicit
exposure to variable returns. Careful consideration is required regarding the purpose
and design of the structured entity.
In addition, the evaluation of power may require an analysis of the decisions made at
inception of the structured entity, including a review of the structured entity’s governing
documents, because the decisions made at formation may affect which investor, if any,
has power.
For a structured entity with a limited range of activities, such as certain securitisation
entities, power is assessed based on which activities, if any, significantly affect the
structured entity’s returns, and if so, which investor, if any, has existing rights that give
it the current ability to direct those activities. The following considerations may also be
relevant when determining which investor, if any, has power (and possibly control):
• an investor’s ability to direct the activities of a structured entity only when specific
circumstances arise or events occur may constitute power if that ability relates to the
activities that most significantly affect the structured entity’s returns (see 4.1.1 above);
• an investor does not have to actively exercise its power to have power over a
structured entity (see 4.2.1 above); or
• an investor is more incentivised to obtain power over a structured entity the
greater its obligation to absorb losses or its right to receive benefits from the
structured entity (see 4.2.3 above).
5
EXPOSURE TO VARIABLE RETURNS
The second criterion for assessing whether an investor has control of an investee is
determining whether the investor has an exposure, or has rights, to variable returns from
its involvement with the investee. [IFRS 10.B55]. An investor is exposed, or has rights, to
variable returns from its involvement with the investee when the investor’s returns from
its involvement have the potential to vary as a result of the investee’s performance.
Returns can be positive, negative or both. [IFRS 10.15].
Although only one invest
or can control an investee, more than one party can share in
the returns of an investee. For example, holders of non-controlling interests can share
in the profits or distributions of an investee. [IFRS 10.16].
Variable returns are returns that are not fixed and have the potential to vary as a result
of the performance of an investee. As discussed at 5.2 below, returns that appear fixed
can be variable. [IFRS 10.B56].
Examples of exposures to variable returns include:
Consolidated financial statements 411
• dividends, fixed interest on debt securities that expose the investor to the credit risk
of the issuer (see 5.2 below), variable interest on debt securities, other distributions
of economic benefits and changes in the value of an investment in an investee;
• remuneration for servicing an investee’s assets or liabilities, fees and exposure to
loss from providing credit or liquidity support, residual interests in the investee’s
assets and liabilities on liquidation of that investee, tax benefits and access to future
liquidity that an investor has from its involvement with the investee; and
• economies of scale, cost savings, scarce products, proprietary knowledge,
synergies, or other exposures to variable returns that are not available to other
investors. [IFRS 10.B57].
Simply having an exposure to variable returns from its involvement with an investee
does not mean that the investor has control. To control the investee, the investor would
also need to have power over the investee, and the ability to use its power over the
investee to affect the amount of the investor’s returns. [IFRS 10.7]. For example, it is
common for a lender to have an exposure to variable returns from a borrower through
interest payments that it receives from the borrower, that are subject to credit risk.
However, the lender would not control the borrower if it does not have the ability to
affect those interest payments (which is frequently the case).
It should be emphasised that with respect to this criterion, the focus is on the existence
of an exposure to variable returns, not the amount of the exposure to variable returns.
5.1
Exposure to variable returns can be an indicator of power
Exposure to variable returns can be an indicator of power by the investor. This is
because the greater an investor’s exposure to the variability of returns from its
involvement with an investee, the greater the incentive for the investor to obtain rights
that give the investor power. However, the magnitude of the exposure to variable
returns is not determinative of whether the investor holds power. [IFRS 10.B20].
When an investor’s exposure, or rights, to variable returns from its involvement with
the investee are disproportionately greater than its voting or other similar rights, this
might be an indicator that the investor has power over the investee when considered
with other rights. [IFRS 10.B19, B20].
5.2
Returns that appear fixed can be variable
An investor assesses whether exposures to returns from an investee are variable, based
on the substance of the arrangement (regardless of the legal form of the returns). Even
a return that appears fixed may actually be variable.
IFRS 10 gives the example of an investor that holds a bond with fixed interest payments.
The fixed interest payments are considered an exposure to variable returns, because they
are subject to default risk and they expose the investor to the credit risk of the issuer of the
bond. How variable those returns are depends on the credit risk of the bond. The same
logic would extend to the investor’s ability to recover the principal of the bond. [IFRS 10.B56].
Similarly, IFRS 10 also explains that fixed performance fees earned for managing an
investee’s assets are considered an exposure to variable returns, because they expose
the investor to the performance risk of the investee. That is, the amount of variability
412 Chapter
6
depends on the investee’s ability to generate sufficient income to pay the fee.
[IFRS 10.B56]. Performance fees that vary based on the value of an investee’s assets are
also an exposure to variable returns using the same reasoning.
In contrast, a non-refundable fee received up-front (wherein the investor does not have
exposure to credit risk or performance risk) would likely be considered a fixed return.
5.3
Evaluating whether derivatives provide an exposure to variable
returns
Investors need to evaluate whether being party to a derivative gives them an exposure
to a variable return.
As indicated at 3.2 above, 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 that it was designed to pass on to the parties
involved with the investee and whether the investor is exposed to some or all of these
risks. Consideration of the risks includes not only the downside risk, but also the
potential for upside. [IFRS 10.B8].
When evaluating whether being party to a derivative is an exposure to a variable return,
it is helpful to follow these steps:
• analyse the nature of the risks in the investee – for example, assess whether the
purpose and the design of the investee exposes the investor to the following risks:
• credit risk;
• interest rate risk (including prepayment risk);
• foreign currency exchange risk;
• commodity price risk;
• equity price risk; and
• operational risk;
• determine the purpose(s) for which the investee was created – for example, obtain
an understanding of the following:
• activities of the investee;
• terms of the contracts the investee has entered into;
• nature of the investee’s interests issued;
• how the investee’s interests were negotiated with or marketed to potential
investors; and
• which investors participated significantly in the design or redesign of the
entity; and
• determine the variability that the investee is designed to create and pass along to
its interest holders – considering the nature of the risks of the investee and the
purposes for which the investee was created.
Consolidated financial statements 413
Some might argue that any derivative creates an exposure to variable returns, even if
that exposure is only a positive exposure. However, we do not believe that this was the
IASB’s intention, given the following comments made by the IASB in both the Basis for
Conclusions accompanying IFRS 10 and the Application Guidance of IFRS 12.
‘Some instruments are designed to transfer risk from a reporting entity to another
entity. During its deliberations, the Board concluded that such instruments create
variability of returns for the other entity but do not typically expose the reporting
&
nbsp; entity to variability of returns from the performance of the other entity. For
example, assume an entity (entity A) is established to provide investment
opportunities for investors who wish to have exposure to entity Z’s credit risk
(entity Z is unrelated to any other party involved in the arrangement). Entity A
obtains funding by issuing to those investors notes that are linked to entity Z’s
credit risk (credit-linked notes) and uses the proceeds to invest in a portfolio of
risk-free financial assets. Entity A obtains exposure to entity Z’s credit risk by
entering into a credit default swap (CDS) with a swap counterparty. The CDS
passes entity Z’s credit risk to entity A, in return for a fee paid by the swap
counterparty. The investors in entity A receive a higher return that reflects both
entity A’s return from its asset portfolio and the CDS fee. The swap counterparty
does not have involvement with entity A that exposes it to variability of returns
from the performance of entity A because the CDS transfers variability to entity A,
rather than absorbing variability of returns of entity A.’ [IFRS 10.BC66, IFRS 12.B9].
This principle is applied in the following example.
Example 6.20: Derivatives that create risk for an investee
A structured entity (Entity A) enters into a CDS whereby a bank passes the credit risk of a reference asset to
the structured entity and, hence, to the investors of that structured entity. In this example, if the bank has the
power to amend the referenced credit risk in the CDS, it would have power over a relevant activity. However,
as the bank, through the CDS, creates rather than absorbs risk, the bank is not exposed to a variable return.
Consequently, the bank would not be able to use its power to affect its variable returns and so would not
control the structured entity.
In our view, a derivative that introduces risk to an investee (e.g. a structured entity)
would not normally be considered an exposure to variable returns under IFRS 10. Only
a derivative that exposes a counterparty to risks that the investee was designed to create
and pass on would be considered an exposure to variable returns under IFRS 10. This
view is consistent with the IASB’s intentions.
5.3.1
Plain vanilla foreign exchange swaps and interest rate swaps
It is important to consider the purpose and design of the entity when evaluating whether
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 82
