IFRS 10: Principles of Consolidated Financial Statements

International Financial Reporting Standard 10 (IFRS 10) provides the principles for preparing consolidated financial statements when a parent company controls one or more subsidiaries. The standard was issued to create a single, unified model for determining control, replacing previous fragmented guidance. By combining the financial data of the parent and its subsidiaries, this approach presents the group as a single economic entity. This offers a holistic view of the group’s financial position, performance, and cash flows.

The Core Principle of Control

An investor controls an investee if it possesses all three of the specified elements of control. This framework requires a comprehensive assessment of all relevant facts and circumstances, moving beyond a simple analysis of share ownership. The determination of control is not a one-time assessment and must be re-evaluated if facts and circumstances change, indicating that one or more of the control elements have been altered.

Power over the Investee

The first element of control is the investor’s possession of power over the investee. Power is defined as having existing rights that give the current ability to direct the “relevant activities” of the investee. Relevant activities are those that significantly affect the investee’s returns, such as establishing operating policies or appointing key management personnel. The assessment focuses on the current ability to direct, meaning the power must exist at the time of assessment, even if the rights have not yet been exercised.

Power arises from rights, which can be straightforward, like those from holding a majority of voting shares. In more complex situations, power can stem from contractual arrangements, such as rights to appoint or remove another entity that directs the relevant activities. If different investors have the unilateral ability to direct different relevant activities, the investor who directs the activities that most significantly impact the returns is the one deemed to have power.

Exposure, or Rights, to Variable Returns

The second element required to establish control is the investor’s exposure, or rights, to variable returns from its involvement with the investee. These returns are not fixed and must have the potential to change based on the investee’s performance. The concept of returns is broad and includes positive outcomes like dividends, negative returns, or a combination of both.

Examples of variable returns include distributions of economic benefits, changes in the value of the investment itself, and remuneration for servicing an investee’s assets or liabilities. Returns can also be less direct, such as achieving economies of scale or gaining access to proprietary knowledge by combining the operations of the investor and investee.

The Link Between Power and Returns

The final element connects power and returns. An investor must have the ability to use its power over the investee to affect the amount of its own variable returns. This linkage ensures that an entity with decision-making authority is not automatically deemed to have control if it cannot use that authority to influence its own financial outcomes. This element helps distinguish a principal, who has control, from an agent acting on behalf of others.

Key Factors in Assessing Control

A foundational aspect of assessing power is distinguishing between substantive rights and protective rights. Only substantive rights are considered when evaluating control. For a right to be substantive, the holder must have the practical ability to exercise it, with no significant barriers preventing its exercise. Factors that might render a right non-substantive include prohibitive financial penalties or an option’s exercise price that is deeply out of the money.

In contrast, protective rights are designed solely to protect the interest of the holder without giving them power over the investee. An investor who holds only protective rights cannot control an investee. Examples include a lender’s right to seize assets if a borrower defaults or a minority shareholder’s right to approve major capital expenditures outside the ordinary course of business. These rights are reactive or apply only in exceptional circumstances.

Voting Rights

In many cases, power is obtained directly from the voting rights granted by equity instruments. An investor holding more than half of the voting rights of an investee is presumed to have power, unless there is evidence to the contrary. This presumption can be overcome if the voting rights are not substantive or if another entity holds rights that allow it to direct the relevant activities.

An investor can also possess power with less than a majority of the voting rights, a situation referred to as “de facto control.” This can occur when an investor holds a significant block of voting rights while the remaining shares are widely dispersed. In this situation, the entity considers the size of its holding relative to others and any contractual arrangements that grant it additional power to determine if it has the practical ability to direct activities unilaterally.

Principal vs. Agent Relationship

A common consideration in the control assessment is determining whether a decision-maker is acting as a principal or an agent. An agent is a party engaged to act on behalf of another party, the principal. A decision-maker that is an agent does not control the investee because it is exercising delegated authority, which is critical for entities like asset managers.

Several factors are considered to determine if a decision-maker is a principal or an agent:

• The scope of the decision-maker’s authority.
• The rights held by other parties, such as the ability to remove the decision-maker without cause.
• The remuneration the decision-maker is entitled to.
• The decision-maker’s exposure to the variability of returns from any other interests it holds in the investee.

A decision-maker whose remuneration is commensurate with its services and who has little exposure to the investee’s variable returns is more likely to be an agent.

The Investment Entity Exemption

IFRS 10 includes an exception to its consolidation requirements for an investment entity. Instead of consolidating its subsidiaries, an investment entity must measure those investments at fair value through profit or loss, as detailed in IFRS 9. This exemption exists because the fair value of its investments is considered more relevant than a line-by-line consolidation.

To qualify, an entity must meet three criteria. First, it obtains funds from investors to provide them with investment management services. Second, its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both. An entity holding subsidiaries for operational synergies would not meet this condition.

Third, it measures and evaluates the performance of substantially all of its investments on a fair value basis, using this information for internal decision-making. However, if a subsidiary of an investment entity provides investment-related services to the parent, that subsidiary must be consolidated.

The Consolidation Process

The consolidation process begins on the date an investor obtains control of a subsidiary and ceases when that control is lost.

Combining Financial Statements

The first step in consolidation is to combine the financial statements of the parent and its subsidiaries on a line-by-line basis by adding together like items of assets, liabilities, equity, income, and expenses. This process requires the use of uniform accounting policies for similar transactions. If a subsidiary uses different accounting policies, its financial statements must be adjusted before they are combined.

Eliminating Intercompany Transactions and Balances

A procedure in consolidation is the full elimination of all intragroup assets, liabilities, equity, income, and expenses related to transactions between entities within the group. This step is necessary to avoid overstating the group’s assets and income and to reflect only transactions with external parties. For instance, if a parent has a loan receivable from its subsidiary, the corresponding loan payable on the subsidiary’s books is eliminated. Any profit from transactions between group members must also be eliminated in full until realized through a sale to an outside party.

Accounting for Goodwill

Goodwill is recognized in a business combination and represents the excess of the consideration transferred over the fair value of the net identifiable assets acquired. The calculation of goodwill also includes the amount of any non-controlling interest and the fair value of any previously held equity interest in the subsidiary. The detailed guidance for this calculation is provided in IFRS 3.

Recognizing Non-Controlling Interests (NCI)

When a parent company owns less than 100% of a subsidiary, the portion of the subsidiary’s equity not attributable to the parent is called the non-controlling interest (NCI). IFRS 10 requires that NCI be presented in the consolidated statement of financial position within the equity section, but separately from the equity of the parent’s owners. This presentation highlights the claim that non-controlling shareholders have on the group’s net assets. The group’s profit or loss must be attributed to both the owners of the parent and the NCI, even if this results in the NCI having a deficit balance.

Required Disclosures

The specific disclosure requirements for consolidated financial statements are detailed in IFRS 12. A primary disclosure area involves the significant judgments and assumptions made in determining control, especially when it is not straightforward. This includes explaining the reasoning when an investor with less than a majority of voting rights is judged to have control, or vice versa.

Entities must also disclose the nature and extent of any significant restrictions on their ability to access or use the assets and settle the liabilities of the group, such as statutory or contractual restrictions. Information about the risks associated with an entity’s interests in consolidated entities must also be provided.

Detailed disclosures are required for each subsidiary with a material non-controlling interest (NCI), including:

• The proportion of ownership interests held by the NCI.
• The accumulated NCI.
• The profit or loss allocated to the NCI during the reporting period.

Information is also required about the consequences of changes in a parent’s ownership interest in a subsidiary that do not result in a loss of control.