IFRS 10 — Effect of protective rights on an assessment of control
In August 2012, the IFRS Interpretations Committee (‘the Interpretations Committee’) received a request for clarification about IFRS 10 Consolidated Financial Statements. IFRS 10 defines the principle of control and establishes control as the basis for determining which entities are consolidated in the consolidated financial statements. An important element of control in IFRS 10 is power. The submission related to protective rights and the effect of those rights on power over the investee.
The details of the example submitted were:
- The shares of an operating entity are all owned by one entity, the investor.
- The operating entity enters into a loan arrangement with a bank that contains several covenants. If a covenant is breached, the bank has the right to veto major business decisions (considered to be the relevant activities of the operating entity) and to call in the loan. The bank’s rights are considered to be protective. The investor continues to consolidate the operating entity.
- The entity breaches a covenant. What are the consolidation implications for the investor entity and for the bank? Who now controls the investee—the original investor or the bank?
The Staff noted that the submitter highlighted two interpretations could arise under IFRS 10:
View A: when protective rights become exercisable, there is a change in facts and circumstances and the control assessment should be reassessed in accordance with paragraph 8 of the Standard. The staff noted that they viewed this is the interpretation that the IASB intended.
View B: Protective rights can never affect an assessment of control. The Staff noted that IFRS 10 states that; (I) protective rights are designed to protect the interests of the holder without giving power and (ii) protective rights are defined in the Standard as not conferring power. This is the view that the submitter favoured and proposed.
The Staff noted that the submitter in view B argued that protective rights should never be assessed as part of the control assessment. It was noted that paragraph B27 of the standard states that protective rights are designed to protect the interests of the holder without giving power. The Staff noted that the submitter in view B noted that because the design and intention behind protective rights does not change over time then the facts and circumstances relating to protective rights, which are relevant to an assessment of power, also cannot change over time. The Staff noted that the submitter was of the view that protective rights are historical and fixed at the point of design. The Staff noted that as protective rights do not confer power to the holder, as defined in the standard, then the submitter was of the view that these rights do not need to be reassessed as facts and circumstances change. The Staff noted that the submitter’s view is that protective rights can never be relevant to an assessment of power.
The Staff noted that they did not support the view proposed by the submitter and did not think that this reflected the IASB’s intention in IFRS 10 and indeed contradicted key principles on which the standard was based. The Staff argued against the submitter on three grounds:
The need for continuous assessment
The Staff noted that the standard required that control be reassessed if facts and circumstances change (paragraph 8). The Staff noted that in the submission, the issue relates to the element of control that is power and if something changes that would affect the investor’s power to direct the investee then the power element of control should be reassessed. The Staff noted that the standard was clear that the elements of control should be reassessed in accordance with paragraph 8 of the standard when facts and circumstances change and the Basis for Conclusions (BC149-153) makes it clear that this reassessment should be continuous.
The Staff were of the view that there was no exception for protective rights from the requirement for reassessment in the Standard. The Staff view was that the breach of covenant in the example was a significant change in the facts and circumstances relating to power and therefore the rights and obligations conferred by the loan agreement should be reassessed at the time of the breach to decide who controls the investee.
Discussion of control and power in the standard
The Staff noted that one element of control is power over the investee and in IFRS 10 it states that power arises from rights and these rights can include contractual rights. The Staff noted that contractual terms such as those contained in a loan agreement could affect an assessment of power. The Staff noted that any change in the terms of the loan agreement could affect the assessment of control.
The Staff noted that only substantive rights and rights that are not protective are considered in an assessment of power in accordance with the guidance in B9. The Staff presented the view that the nature of protective rights can change over time and in the submitted example on a breach. The Staff noted that a breach could trigger the change to a substantive right or at least to a right that could affect the control decision.
The Staff highlighted that the view proposed by the submitter contradicts the IASB decision made in examples in their paper Consolidation Project: Power to Direct: Protective and Participating rights. In this paper there was an example where on breach a protective right upon contract inception became substance upon a breach which changed the control assessment. The Staff noted that this example highlighted that the IASB did not intend protective rights to be exempt from continuous assessment.
The Staff noted that the Standard is effective for annual periods beginning on or after 1 January 2013 and few outreach activities had been able to be performed. The Staff did not that most accounting firms favoured view A.
The Staff assessed the issue against the criteria of the Current Due Process Handbook. They noted that they did not recommend adding this issue to the Interpretation Committee’s agenda.
The Staff asked the Interpretations Committee whether they agreed with their recommendation not to add the topic to the Interpretation Committee’s agenda.
The Staff concluded that they did not have sufficient information about the rights of the investor, the bank or other parties to come to a conclusion about control in the submitted example and asked the Interpretations Committee whether they agreed with this.
A long discussion was held around protective and substantive rights. A number of Committee members agreed that there was interaction between protective rights and substantive rights. One Committee member noted that in paragraph B26 there were two types of protective right; those that relate to fundamental changes to the activities of an investee and those that apply in exceptional circumstances. This Committee member noted that it is the latter type of protective right that would usually be subject to some trigger event that would change the holder’s rights or would give the holder additional rights to the protective right that was held. This member noted that it was these additional rights that should be assessed in the determination of control.
One Committee member questioned why the bank’s rights were considered protective. He was of the view that the bank’s rights were not protective or substantive (at inception) but as soon as they become exercisable (i.e. upon a breach) then they become substantive. He argued that he considered that the bank’s rights had never been protective. The Staff noted that the submitter may have been applying paragraph B26 of the standard in describing these rights as protective as “fundamental changes to the activities of an investee or apply in exceptional circumstances” – i.e. they considered that the beach of covenant would be an exceptional circumstance which would be an attribute of a protective right.
The Chair attempted to summarise the issue. He noted that the assessment should be continuous. He noted that when a “trigger” occurred then this would change the basis upon which one would either include or exclude rights from the continuous assessment. He noted that this may mean that certain rights may now be included in the assessment of control that may not have previously been considered. He noted that that at this trigger point one would have to consider all of the rights as part of an assessment to determine control. The Staff noted that the key consideration was who has power and that the terms substantive right and protective right do not themselves equate to power in themselves but are components that one would consider in the reassessment. It was considered that the discussion as to whether the rights are protective or substantive was not so relevant due to the requirement for continuous assessment which may indicate that these rights have changed as a result of an “event” occurring.
The Chair brought the discussion to a close and noted that the Interpretation Committee did not have an agenda decision before them. He highlighted that this issue would need to be brought back to a future Interpretation Committee’s meeting. He suggested that the majority of Committee members tentatively agreed that reassessment was continuous and that the elements (including rights) that would be included in the reassessment would change over time. He noted that this should be the principle of the future agenda decision. He noted also that a protective right could change over time and should be considered in the reassessment of control.
No vote was held and no decisions were taken in this Interpretations Committee meeting.