Blaise Jenner, Partner, Accounting Structuring, PwC
In a number of circumstances the accounting assessment of control can be complex. In such situations it will be important to consider your accounting objectives at an early stage of your transaction and look to understand what potential structuring options can help you meet your accounting objectives. Failure to do this can result in an accounting surprise following transaction close – by which point it is potentially too late to readily address. Whilst transaction structures can be designed to achieve specific accounting objectives, in all cases there has to be clear substance to the arrangement – an artificial structure created solely to achieve a specific accounting answer will be open to challenge. Additionally, where control resides with a minority shareholder, this will also mean that any majority shareholder has sacrificed their own ability to control the group – a situation, which whilst technically possible under the IFRS framework, can often be commercially challenging to achieve.
Across the region, it is common to see economic ownership of legal entities shared between two or more investors. Such arrangements may be entered into for a variety of reasons – an international corporate may join up with a local shareholder to gain access to that local market or two groups with complementary activities may form a joint venture entity in order to effectively deliver a single contract.
In such shared ownership structures, we often see that one party’s desire to consolidate or not consolidate the relevant investee is a key transaction structuring driver. Typically we see that this is driven by one of the following four factors:
1. Accounting consolidation ordinarily follows the underlying ‘control’ of an entity, which means that the party consolidating is in the driving seat; or
2. Consolidating an acquired target business may assist a group to establish and demonstrate sufficient size and scale in order to facilitate a future transaction – this is often seen with groups looking to grow their underlying asset base and revenues in advance of an envisaged Initial Public Offering or external investment; or
3. A group may have existing leverage, capital ratios, covenants and financing agreements that could be improved by not-consolidating an existing business; or
4. A start up target entity may demonstrate strong growth potential, but consolidating its current trading losses may negatively impact an investor’s short term financial results.
Where the accounting consolidation structure is deal critical we often see this leading to a delicate balancing of the contractual, governance and economic relationship between the parties in order to achieve the desired accounting outcome.
Accounting consolidation – an overview
Where an investor is acquiring 100 percent of an investee, the accounting analysis is generally straight-forward. But where there is risk sharing with another party, this can become more complex. International Financial Reporting Standards guidance for consolidation – ‘IFRS 10’ – follows a control-based framework – where an investor controls an investee, consolidation is appropriate.
The requirement to consolidate an investee can have a fundamental impact on an investor’s balance sheet and results in:
• Impact of consolidation – where an investor consolidates, it brings into its group financial statements the gross assets, liabilities, revenues and expenses of the investee on a line-by-line basis. As previously noted, this treatment may be beneficial where the investee has material net assets, revenues and net profits.
• Impact of not consolidating – where the investor has a significant economic interest, but not control, it will typically result in ‘equity accounting’. Here the investor records its share of assets, liabilities, revenues and expenses as single line items in its group balance sheet and income statement. Such treatment may be preferred by an investor where the investee has material external liabilities that may impact the investor’s existing loan ratios and covenants.
How do you ascertain which party has accounting control?
Consolidation will be triggered where an investor controls an investee. IFRS 10 requires each of the following attributes to be present to support control:
1. The investor has power over the investee. This will be present when the investor has substantive rights that provide the current ability to direct the relevant activities of the investee.
2. The investor has exposure, or rights, to variable returns from its involvement with the investee. IFRS 10 identifies a wide range of possible returns – from traditional dividends and interest to servicing fees, changes in the fair value of an investment, exposures arising from credit or liquidity support, tax benefits, access to liquidity, economies of scale, cost savings, and gaining proprietary knowledge; and
3. The investor has the ability to use its power over the investee to affect the amount of its returns. IFRS 10 considers the concept of delegated power when assessing whether a decision-maker is acting as an agent on behalf of others or acting as principal on its own behalf.
What are the structuring considerations for investors and deal makers?
Where the accounting impact of a transaction is critical, it is possible to design structures under the IFRS framework that meet specific parties’ accounting objectives, such as enabling an investor with less than 50 percent equity in an investee to consolidate – this may be achieved through:
• Designing a governance structure where voting rights are not aligned to economic interest – for example enabling an investor to control the investee board of directors despite holding less than 50 percent equity interests;
• Arrangements with other vote holders – for example a contract that enables an investor to control sufficient votes held by other investors to provide itself with power over the investee;
• Rights arising from other arrangements – for example a contract that allows the investor to directly control certain investee’s key activities such as manufacturing or marketing. If these are relevant activities, this may trigger control for the investor;
• Potential voting rights – for example immediately exercisable options over other investors’ shares;
• ‘De facto control’ through the ownership of the largest block of voting rights where the remaining rights are widely dispersed; or a combination of the above.
– Avoiding the requirement for a shareholder with greater than 50 percent equity to consolidate – applying similar principles to the above, where the majority investor does not have the current ability to exercise control;
– Enabling a party to manage the day-to-day operations of an investee, whilst not being required to consolidate it – as noted above this may be possible where the manager is only enacting the strategy of other parties and can immediately be removed from its position;
– Maximising protection for non-controlling shareholders – this may be achieved through the use of a variety of ‘protective rights’ that enable veto rights over certain events or monetary thresholds that may be considered outside the ‘normal course of business’;
– Enabling different activities of an investee to be controlled by different parties – for an investor to have control over an investee it is not necessary to have control over all aspects of the investee – for example, one investor may have the final decision over use of a brand whilst another investor may make decisions regarding distribution of a product. Whilst a highly subjective area of IFRS 10, where an investor can have control over the activity that will most significantly affect returns, it is possible to construct an argument for having overall control. As previously noted, however, only one party can be deemed to control an investee; and
– Restricting the time period for which one party controls and consolidates an investee – the determination of control is based on current facts and circumstances and is continuously assessed. As a result, time limits may be placed on key investor rights, casting votes, and/ or any call options used to impact any future control assessment.
