Common IFRS 10 Pitfalls

Transcript

Shreeya: Hello, and welcome to the fourth podcast in our series “On the top shelf”, which deals with topical issues in IFRS that impact clients operating in the retail and consumer  industry. 

My name is Shreeya and I am a Senior Manager in PwC’s Accounting Consulting Services. I am joined today by Renitha Dwarika, a partner in Accounting Consulting Services. Renitha is an expert at business combinations and consolidations - which is the topic of our podcast today. Welcome! 

Renitha: Thank you Shreeya. I am glad to be here.

Shreeya: Thanks for joining us!

This year, 2021, has seen a lot of activity in the market. We’ve seen a number of business acquisitions within the retail and consumer industry. For example, earlier this year:

• The market saw Clicks make an offer for Pick n Pay's retail pharmacy business as it accelerates the expansion of its network;
• Mr. Price acquired Yuppiechef and Power Fashions; and
• Shoprite, Africa's biggest retailer, went to market to indicate that it would acquire some of Massmart's wholesale and retail chains.

The list goes on!

Naturally, this being an accounting podcast, all of these acquisitions are making us think about business combinations… but before we can get to IFRS 3 - which is the business combinations standard - there are actually some pitfalls within IFRS 10 - Consolidated Financial statements - that people can sometimes overlook.  

Renitha: Yes - although people think IFRS 10 is ‘old news’ it continues to be topical and can impact material transactions in the market. Hopefully we can unpack some common pitfalls in the podcast today. 

Shreeya: Great! I’m looking forward to our discussion. Let’s get into it - beginning with the basics.

The ‘group’ in IFRS 10 is “a parent and its subsidiaries”. The financial statements of a parent and its subsidiaries must be presented as a single economic entity - which we know as the consolidated or group accounts. To create this parent-subsidiary relationship, control is required. 

Renitha, can you give us a high level recap of what constitutes control - and what some of the common pitfalls are when assessing control?

Renitha: You are right, Shreeya, that control is central to establishing the relationship of parent and subsidiary. 

The term ‘parent’ is defined as “an entity that controls one or more entities”. A subsidiary is defined as “an entity that is controlled by another entity”.

The key principle is that control exists, and consolidation is required only if the investor possesses power over the investee, has exposure or rights to variable returns from its involvement with the investee, and has the ability to use its power over the investee to affect its returns. Control is, however, not always established through majority shareholding. 

Shreeya: How do people typically assess control?

Renitha: We could talk about control assessments all day! It’s inherently a mix of qualitative and quantitative factors that come together within the assessment. 

IFRS 10 focuses on the need to have both power and variable returns before control is present. Power is the current ability to direct the activities that significantly influence

returns. Returns must vary and can be positive, negative or both. The determination of power is based on current facts and circumstances and therefore should be reassessed should facts and circumstances change.

The factors that an investor should consider during its assessment of control over an investee are:

• The investee’s purpose and design;
• What the relevant activities are;
• How decisions about those relevant activities are made;
• Whether the rights of the investor give it the current ability to direct the relevant activities;
• Whether the investor is exposed, or has rights, to variable returns from its involvement with the investee; and
• Whether the investor has the ability to use its power over the investee to affect the amount of the investor’s returns.

Shreeya: Thank you for sharing the framework to assess control. I think that an investor with more than half the voting rights would typically meet the power criteria ... in the absence of restrictions or other circumstances. 

In practice, though, where do you see judgement coming in, when doing a control assessment? Where do the ‘grey’ areas typically exist?

Renitha: One of the grey areas are with employee trusts or charitable trusts. Sometimes companies set up special purpose vehicles in the form of a trust. They then appoint some of their employees or directors as the trustees. Often the debate of trustee independence comes in. 

One of the questions that comes to mind is whether or not employees in key management personnel roles are considered to be the de facto agents of a reporting entity. If the employees are assessed to be de-facto agents of the reporting entity then their presence on the board of trustees could be attributed to the reporting entity - leading you to tick one of the boxes on the control assessment. 

Shreeya: Good point on the independence of trustees. Moreover, I think that, even if you get to having a body of entirely independent trustees, you could still get to control if their actions are predetermined and the special purpose vehicle is on autopilot. 

For example, within a special purpose vehicle designed by an investor with a detailed trust deed that almost dictates exactly what the trust should do!

Renitha: Yes, you always need to think carefully about special purpose vehicles like trusts. If the trust runs on auto-pilot for the benefit of the founder, it could suggest that the founder controls the trust.

Another area of judgement with charitable trusts includes reputational risks. Sometimes the name of the trust will carry the name of the reporting entity. Reputational exposure might create an implied commitment for the entity to ensure that the trust operates as designed; however, reputational risk alone does not provide evidence that the entity has power over the trust. You’ll need to look at the trust deed and consider who set up the trust, amongst other factors.

Shreeya: Thanks for those watch-out-for items! 

I think another area commonly overlooked are special rights given to minorities at the point of acquisition. Typically if a company has acquired, say, 80% of a business - the remaining 20% is the non-controlling interest, commonly referred to as “NCI”.  

Sometimes that NCI is given special mechanisms to exit the business and put their interest to the majority shareholder. Could you maybe touch on this issue?

Renitha: Yes, it’s sometimes an area that is overlooked.

Like you’ve said, sometimes a parent might write a put option on shares in a subsidiary that are held by non-controlling interests. The put option provides the non-controlling shareholder with the right to force the parent to purchase the shares in accordance with the terms and conditions of the put option.

A purchased call option might also accompany the put option, on exactly the same (or similar) terms as the put. The call option provides the parent with the right to force the non-controlling shareholder to sell its shares to the parent in accordance with the terms and conditions of the call option.

Shreeya: I think that IFRS 10, the consolidation standard, and IFRS 3, the business combination standard, does not give guidance on how such contracts should be accounted for in a business combination. 

There is also a lack of guidance in the standard regarding when such contracts are entered into by a parent subsequent to the business combination. 

IFRS 10, and the standards on financial instruments, IAS 32 and IFRS 9, all need to be considered holistically in determining the appropriate accounting treatment. 

But I think the whole issue could be distilled into two key questions: 

• Whether or not to derecognise the non-controlling interest as a result of the put option and
• Whether subsequent changes to the put liability should be presented in profit and loss or equity

What are your thoughts there, Renitha? 

Renitha: I think it’s important to remember that the financial liability to settle the forward or put option is always recorded. This will be a function of the actual contract and how the liability will be settled. The recognition of the put liability is something to watch out for carefully.

When it comes to the recognition of non-controlling interest - there is diversity observed in practice. In our view two approaches are generally acceptable when accounting for the non-controlling interest. Preparers decide that either the principles in IFRS 10 or those in IAS 32 will take precedence and be applied when determining their accounting policy.

Shreeya: Okay, sure, so if IFRS 10 takes precedence, then the terms of the forward and option contracts should be analysed to assess whether they provide the parent or the non-controlling interest with access to the risks and rewards associated with the actual ownership of the shares. 

To stress the point you touched on a bit earlier- irrespective of the outcome of the risks and rewards analysis, a financial liability (recognised at the present value of the redemption amount) is recorded to reflect the forward or put option.The financial liability is recognised at the present value of the redemption amount.

Renitha: Yes - and if If IAS 32 takes precedence, a risks and rewards analysis is not performed and the non-controlling interest is derecognised when the forward or put option liability is recognised. The financial liability is recognised at the present value of the redemption amount.  If the forward or put option was entered into as part of a business combination, there would not be a non-controlling interest recognised.

Shreeya: So what happens to the subsequent measurement of the put liability, Renitha? 

Renitha: There’s also diversity in practice regarding the subsequent changes to the financial liability. 

This diversity likely exists due to conflicting guidance in IFRS 9 and IFRS 10. The predominant approach observed in practice has been that finance charges are recognised in the income statement which is in line with the guidance of paragraph B5.4.6 of IFRS 9.  

We have also observed in practice adjustments to the redemption liability being recorded in equity. But - in our view the application of this approach is only supportable where IFRS 10 takes precedence and further that, the risks and rewards are not transferred to the parent such that non-controlling interests are still recognised and therefore this can be viewed as a transaction with non-controlling interest. 

Shreeya: We’ve covered a lot of complexities and pitfalls to think about when it comes to acquisitions in terms of IFRS 10 thus far. We’ve considered entities running on ‘auto-pilot’ for the benefit of the founder,reputational risks as well as accounting for sometimes overlooked rights of NCI, or minorities.

Renitha: These concepts are quite complex, and I would suggest that listeners consider engaging with PwC where there are significant judgements or uncertainties.

Shreeya: I agree - it can seem a lot to keep under ‘control’ when dealing with business acquisitions. Thank you for your time today Renitha, I hope to have you back on the podcast soon!

Renitha: Thanks for having me. It was great joining in on the podcast and I hope to be back in the aisle soon - looking up at the Top Shelf!

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