IFRS10 Problem With Control

WARWICK BUSINESS SCHOOL

IB Advanced Financial Reporting

IFRS 10 Consolidations & Problem of Control

Thanh Vu (ID 1132968)

Professor Rob Bryer

C2.15 WBS

30 April 2012

Word Count: 3,236

Thanh Vu 2012 BSc Candidate Email: [email protected] Tel: +44 (0)7939597579

Hans Hoogervorst 30 Cannon Street London EC4M 6XH United Kingdom Dear Chairman Hans Hoogervorst:

Comment letter – ED 2009/10 Consolidations

It is with gladness that I am writing this letter to you. After decades of tremendous effort toward

reforming consolidated accounting, I am thrilled that the Board has elevated the priority of this

project and is committed toward forming a single control model as a basis for consolidation.

Consolidated accounting is an area that has troubled users, preparers and regulators alike. It poses

as a challenge with no easy answer. I agree with commentators on the ED10 that there has yet been

a clear definition of power. The introduction of effective control has changed the foundation under

which power was defined under IAS27. Although I welcomed the Board’s decision to move away

from the risks and rewards model, I do not think that the Board should dismiss the commentators’

demand for stewardship perspective in assessing control.

To battle against the abuse of structured entities, I do not think that it is appropriate to pursue the

decision-relevance theory which is heavily influenced by the American accounting practice.

Considering how the decision-relevance theory has underserved the US accounting system time and

time again, I urge the Board to embrace the stewardship approach and to consider rewriting IFRS10

under such perspective.

I hope you find my comments intriguing.

Yours sincerely,

Contents

I. Introduction and Purpose of the Letter: .............................................................................................. 3

II. Enron & The ‘08 Financial Crisis – The Drive Behind IFRS10 ............................................................... 3

III. Key Criticisms, Response and Areas of Impacts: ................................................................................ 4

Effective Control & Definition of Power ............................................................................................. 4

Power without a majority of voting rights ...................................................................................... 5

Potential Voting Rights.................................................................................................................... 7

Structured Entities ........................................................................................................................ 11

Conclusion ............................................................................................................................................. 13

References ........................................................................................................................................ 14

I. Introduction and Purpose of the Letter:

In 2009, the Board released the Exposure Draft 10 in hope of achieving a better approach to

consolidations for the global financial accounting and reporting system. The project’s importance

was elevated after the 2008 financial crisis and it was vital that IFRS10 would present a coherent

consolidation model to reporting entities, accounting professionals and users. In place of ISAB 27

and SIC 12, IFRS 10’s main purpose is to introduce a single consolidation model that would reduce

diversity, improve comparability and most importantly, enforce management accountability in

practice. However, the Board has not fulfilled this objective and failed to address top commentators’

concerns over a poorly articulated principle of control in ED10 and the consequent IFRS10.

This letter will first reiterate the compelling needs of a clear and applicable standard on

consolidation, demonstrated by the case of Enron and the recent financial crisis. It will then point

out the Board’s failure in responding to key criticisms voiced by top commentators regarding its

application of effective control as the base for consolidation and its definition of power, one of the

three components of control. The impacts of these two key criticisms will also be discussed in

context of areas that will be impacted in practice. The Board’s adherence to effective control and its

inconsistent approach to defining power will produce subjective judgement when considering

reporting entity’s substantive rights. This will result in significant changes in practice now that

entities with less than majority of voting rights can have control. Furthermore, with the new ‘power

to direct’ model, the Board has not limited the use-and-abuse of structured entities, which was the

focal point of this project. Finally, the letter will lead to the conclusion that the Board’s pursuit of a

single control model in order to improve the current system can only be achieved if it seeks a

consistent approach via the stewardship perspective.

II. Enron & The ‘08 Financial Crisis – The Drive Behind IFRS10

The issues of consolidation and the definition of control are not recent issues created by Enron or

the 2008 financial crisis. The two events were merely the necessary push for regulators to deal with

the aching problems quickly. The cause of Enron’s bankruptcy in 2001 or the banks’ credit crunch in

2008 was not their failure to comply with accounting, with the exception of the technical breach of

the “3% rule” with Chewco and JEDI (Bryer, Consolidation II, p. 46). The reason was the exact

opposite. The control requirement under consolidated accounting was vague enough to give those

entities room to manage their balance sheets, hide debts and appear less leveraged by exploiting the

use of SPEs. In the 1990s, the FASB wasted valuable time on choosing between the stewardship and

decision-relevance theories (Bryer, Consolidation II, p. 38) despite the fact the its Emerging Issues

Task Force (which comprised of most major accounting firms) had already permitted non-

consolidation of SPEs under the notion of effective economic control. It could be argued that Enron

and banks were compliant with the letter of the law although its business practices were ethically

questionable. In a way, the FASB indirectly gave way to Enron and banks to create infuriating woes in

the financial markets. Hence, if there is a lesson to learn from history and the FASB in particular, it is

to abandon the US-influenced decision-relevance theory. The Board should remove the risks and

rewards model in its approach to determine control. It was an ironic and unfortunate occurrence

that the EITF’s reform of SPEs accounting created an opportunity for Enron’s exploitation of off-

balance sheet items. It is crucial that the new IFRS10 standard will not repeat such embarrassing

mistake that may lead to another major accounting failure in the near future.

III. Key Criticisms, Response and Areas of Impacts:

The Board has not been successful in moving away from the influence of the US accounting

framework in regard to the risks and rewards model. It refused to embrace the stewardship view

which was more appropriate for IFRS10. Although many commentators requested the use of risks

and rewards model as fall back test, it was the Boards’ confusing adoption of effective control and

assessment of power criteria that necessitated such remedy.

In IFRS10, the risks and rewards model provides indicators of power when control could not be

clearly assessed. Such results prove that the Board’s attempt at introducing a better framework for

IFRS10 can be deemed unsuccessful. It seems that Einstein’s famous saying, “If you can’t explain it

simply, you don’t understand it well enough” sums up the work that the Board has been doing with

IFRS10. Many important commentators urged the Board to produce a single definition for control

but it confused itself as it went back and forth between the legal control and effective control.

Introducing a complex (or confusing and contradictory) standard would result in entities developing

their own interpretation of the accounting requirements and producing unintended consequences.

The aftermath of such practice can cause even bigger problem than the original issues that IFRS10

has set out to solve. Although the Board published an Effective Analysis document to provide

further guidance and specific examples, the standard still left many important criticisms from ED10

unanswered and the application of assessing control as convoluted as ever.

A lack of understanding toward complex structured financing even among professionals led to the

financial crisis and disastrous result. A similar situation can transpire if the application of IFRS10’s

unclear principles leads to divergence in consolidation practice and further abuses of the reporting

system.

With IFRS10 and related documents, the Board has yet addressed the critical issues raised by

important commentators following ED10:

Effective Control & Definition of Power

Although the majority of the commentators agreed that control is an appropriate basis of

consolidation, the Board’s lack of clarity in defining control and power confused many. The problem

started with the principles underlying the consolidation model. Commentators including E&Y, KPMG,

Morgan Stanley and others agreed with Deloitte that the consolidation model and guidance

provided in ED10 was “ ambiguous and inconsistent in a number of fundamental areas, not least of

which is the failure to distinguish between ‘power to control’ and ‘ability to control’. Without a clear

definition of control, the resulting Standard will be difficult to interpret and apply on a consistent

basis” (Deloitte, Comment Letter, p. 1). Similarly, the London Investment Banking Association (LIBA)

voiced its concern (Comment Letter, p. 4) when the Board deemed both de facto and legal control as

overriding.

Our principal concern, as highlighted in our summary comments above, is that it is unclear whether the ED is focusing on current/de facto control or on legal control. Paragraph 28 suggests that de facto control is key, even in a case where other shareholders may have the technical ability to override a large shareholder. Paragraph 23, on the other

hand, states that a shareholder has “power” if they have “the power to appoint or remove (board members)”, even if that power has not been exercised; this suggests that legal control should be paramount.

In IFRS10, the Board moved further away from contractual or legal control to adopt effective control

as the foundation for its definition of control. Since the basis of effective control was supervision,

such view required a link between power and returns in order to achieve control. It was rather

absurd to see that the risks and rewards model could be eliminated somehow when the link

between power and returns must exist. Therefore, although it wanted to eliminate the use of risks

and rewards model in ED10, many commentators pointed out that the Board still implicitly retained

the risks and rewards elements in its approach to assessing control. As a result, the Board agreed

with the commentators to use the model as a fall back test in IFRS10, which meant it did not arrive

at a single definition of control.

ED10 had not been able to reduce legal and de facto control to the “power to direct to generate

returns” (Bryer, Consolidation III, pg. 8) and many commentators pointed this out. IFRS10 also did

not overcome this shortcoming. ED10’s criteria of control included power, variability of returns and

the link between power and variability of returns. With effective action control, IFRS10 required a

link between power and returns because it viewed these two elements are separate. In BC56 and

BC57, the Board dictated that the link between power and returns needed not to be proportional

and contested specifying the proportion of voting rights or the proportion of returns that are

prerequisite to possession of control. Such vagueness caused a lot of confusion for commentators.

On the other hand, Paragraph 13 in ED10 stated that “power ... is generally correlated with ...

exposure to the variability of returns”. This statement is not necessary true and the Board clearly

contradicted its own assumptions.

Furthermore, the definition of power itself lacks precision. In ED10, the underlying principle of

power was not established comprehensively and commentators including Deloitte, CNC, KPMG, E&Y

and Morgan Stanley (Bryer, Consolidation III, p. 10) demanded the Board to distinguish between

“actual control” (legally enforceable power to govern, the right to control that cannot be taken

away) or “ability to control” (the current, practical ability to control that can be taken away).

Power without a majority of voting rights

Although the Board has provided a lot more guidance under IFRS10 and even specific examples,

most of commentators’ concerns were addressed with encouragement to consider “all facts and

circumstances”. There were too many aspects which required a lot of subjective judgement from

management when it came to assessing power criteria. Examining the case of power without a

majority of voting rights or de facto control will help to demonstrate the amount of ambiguity that

IFRS10 can result in practice.

In an example provided by IFRS10’s Effective Analysis, without considering the voting pattern at the

recent shareholders’ meeting, reporting entity G which had less than a majority of voting rights

would have to consolidate entity H. IFRS10’s de facto control opened the scope of assessing power

much wider by taking into considerations “all facts and circumstances”. These “additional facts and

circumstances” would cause even more diversity in practice. Reporting entities may arbitrarily

include or exclude “facts and circumstances” in their favour to avoid consolidation or to consolidate

when beneficial.

As IFRS10 eradicates the use of ‘bright lines’,

assessing control will require significant judgement which would threaten the comparability and

accountability of the financial reporting system. E&Y

raised a number of questions relevant to de facto

control that the Board left the decisions entirely to

reporting entities (E&Y Applying IFRS, 2012, p. 18). For

example, how many years of historical voting results at

AGMs can be used to discern a voting pattern? Is it

appropriate to assume that such voting pattern will

continue in the future? How large does an investor’s

interest need to be relative to others? Is it really

appropriate for a reporting entity to consolidate an

investee with as much holding as 10%? 40%? 50%? Such

concern was also raised by the London Investment

Banking Association (Comment Letter, p.9): Testing whether “the reporting entity’s exposure is more than that of any other party” may require a detailed knowledge of other shareholdings. If, for example, one shareholder has 10% with ten others holding 9% each, does the 10% shareholder qualify under this criterion? We do not believe that the level of returns held by a party that directs the activities of the entity relative to those held by others is a relevant factor when considering whether consolidation is required

Similar questions have been raised in response to ED10 and the Board has yet given adequate

answers. It is reasonable that these questions will surface again in the future when IFRS10 continues

to cause more diversity in practice. These ‘additional facts and circumstances’ can change quickly

and dramatically and therefore, the application of this principle can prove challenging in reality.

EFRAG’s report on field-test on IFRS10, IFRS11, and IFRS12 indicated that de facto control proves to

be one of the most challenging implementation areas.

Other operational difficulties: A few participants observed difficulties when (i) a structure was set up

by more than one bank and administered by several banks (since strategic decisions could only be

made by the majority of the participating bankers), (ii) financial covenants contained substantive

rights provided de facto control, and (iii) when changes in the ownership structure were not identified

on a timely basis. (EFRAG, 2012, p. 8-9)

Considering the significant impacts of de facto control and the many issues still surrounding the

concept, the Board needs to provide users and preparers with further current application guidance.

Potential Voting Rights

As the Board’s definition of control is built upon effective action control, IFRS10’s view toward to

potential voting rights also requires extensive subjective judgement. PwC commented that the Board

presented “contradictory indications in the draft IFRS as to whether control is assessed in the

present context (what an entity has the power to do today), or an expanded context that might

include what the entity will have the power to do in the future or what an entity has done in the

past” (Comment Letter, p. 3).

On the other hand, from a stewardship theory, one can simply observe that option-holders cannot

have the power to direct activities before exercising their options. Assessing control from a legal or

contractual approach would always have more consistency and require much less subjective

judgment than the current approach that the Board is taking. Yet, the Board rejected the “future

power” under stewardship theory. Similarly, the Board stubbornly contested the apparent demand

among commentators for a stewardship approach that would be more appropriate (IASB Project

Summary and Feedback Statement, 2012, p. 16).

The Board neglected to address criticisms from CNC (Comment Letter, p. 5/15), E&Y (Comment

Letter, p.13), Deloitte (Comment Letter, pg. 7-8) and Morgan Stanley (Comment Letter, p.5-6) in

regards to the subjectivity of power vested in options. All these commentators criticised that the

assumption of option-holders’ “threat” effect on the governing body was extremely judgmental. In

addition, B13 (a) and B13 (b) provided two contradictory requirements for consolidation: effective

control and potential majority control respectively.

Morgan Stanley went on to illustrate the Board’s conflicting requirements in an example where an

entity can be consolidated by more than one party (Comment Letter, p. 6)

In IASB’s Effective Analysis, example 5 demonstrated a similar case that could address Morgan

Stanley’s question above.

In this example, IFRS10 again avoided the use of ‘bright lines’ to prevent structuring opportunities

where reporting entities abused the literal definition of ‘currently exercisability’ of potential voting

rights and avoided consolidation by excluding options exercisability near reporting period. The Board

claimed that reporting entities should take a holistic approach in determining if potential voting

rights were substantive enough to demonstrate power. This would translate to even more extensive

subjective judgement (E&Y Applying IFRS10, 2012, p. 19).

It seems that the Board deemed options and other convertible instruments as sources of power. It

did not consider commentators’ doubts toward the link between options and control. Nonetheless,

IFRS10 also ignores a very critical element in evaluating if potential voting rights are substantive

which is option-holders’ intention to exercise (E&Y Applying IFRS10, 2012, p. 20). Such omission is

fatal to the integrity of the Board’s approach.

Structured Entities

Structured entities are perhaps the most challenging areas of the application of IFRS10. Due to the

specific nature and the significance of these financial entities during the crisis, IFRS10’s impacts on

structured entities should be scrutinised. The Board agreed to use risks and rewards as indicators of

control after various commentators seriously questioned the original approach proposed by ED10, to

treat structured entities as other traditional entities.

Under IFRS10, power, variability of returns and the link between power and variability of returns

were still the mandatory requisites for consolidation of IFRS10. Proving the presence of these three

elements for the ‘investor’ of structured entities would not be easy. Although the simplistic

examples provided in IASB’s Effective Analysis might paint a deceptively straight-forward path.

Macquarie Bank correctly criticised ED10 for failing to produce a high quality standard in assessing

control for structured entities and the Board “has underestimated the challenge of assessing control

for structured entities on bases different from SIC -12 by not recognising their unique complexity”

(Comment Letter, p. 1)

ED10’s redefinition of IAS27’s ‘power to govern’ to effective action control made consolidating

entities with little or no action control like structured entities even more challenging. However,

power over structured entities’ relevant activities under specific circumstances (such as the defaults

of receivables) could still exist. The exposure or rights to variability of returns from its involvement

with the investee could also exist through any profit extraction mechanism of residual income or

excess spread. Nonetheless, the onus of proving the ability to use the investor’s power to affect the

amount of the investor’s return remained tremendous. As a result, it would not be surprising if there

would be less consolidation of structured entities under IFRS10 than under SIC12. The

implementation of IFRS10 in 2013 will probably defeat the objectives of the Board to prevent

entities from taking advantage of off-balance sheet items. It is quite ironic to see that the effort of

IASB to bring structured entities onto the balance sheets has actually produced an obstacle course

for such task.

Even the more liberal counterpart of the IASB is considering the elimination of QSPEs altogether. The

more stringent approach toward structured entities should be embraced. The implication will be,

needless to say, considerable as reporting entities will have to bring much more financial obligations

onto their balance sheet (Alloway, 2012). Therefore, it is important that IASB provides a clearly

articulated framework to prevent reporting entities from exploiting accounting loop holes.

The proposed amendments to FASB Statement 140 will basically get rid of the idea of

QSPEs altogether.

The rule change would bring $900bn in assets back onto balance sheets, according to

recent estimates by regulators. Individual banks like JP Morgan have said the FASB

change would require it to consolidate $145bn in off-balance sheet assets, and

Citigroup said it foresees circa $166bn coming back onto its balance sheet.

In the case of structured entities, the Board has listened to the commentators’ recommendation and

incorporate risks and rewards as indicators of power. However, the stewardship perspective would

provide a much more straight-forward solution that would not require the reinstatement the risks

and rewards model. Since structured entities are sponsored and operated under legal and

contractual agreements, legal financial results control consistent with the stewardship theory would

serve as solid foundation for consolidation. Banks’ use of structured entities can be understood as

leasing capital. The continuing use or termination of the structured entities are the investor’s

‘rewards’ and ‘punishment’ in the stewardship perspective. It is evident that the stewardship view

can provide a much simpler and more consistent approach to appropriate consolidation, especially

considering the main objective of the Board with IFRS10.

Conclusion

Revisiting the premise of the creation of IFRS10, the Board’s objective is to develop a single control

model that will increase comparability, accountability and financial reporting quality. Based on this

premise, the Board should consider adopting a more consistent approach. If the Board adopted the

stewardship perspective in assessing control and defining power, it would be able to resolve the

existing problems with effective control and power.

The Board needs to acknowledge the fundamental difference between the history of US and UK

accounting. Although IASB and FASB are working toward international convergence of accounting

standards, it is important that IASB maintains the stewardship function of the UK accounting system.

The most severe crisis in modern history of 2008 reminds us that our objective should be focused on

improving the integrity of financial reporting and holding management accountable for their

decisions. A proprietorial stewardship helps to correct the prevalent issues of moral hazards, where

corporations fail to fulfil their fiduciary duties to their shareholders. As a result, the Board’s new

IFRS10 needs to improve the accountability and comparability of financial accounting and reporting

among entities and must not leave significant amount of subjective judgement to management.

References

Accounting Standards Board (ASB), Comment letter (2009).

Alloway, Tracey. Quo Vadis QSPEs? FT Alphaville. June 8 2012.

<http://ftalphaville.ft.com/blog/2009/06/08/56710/quo-vadis-qspes/> Accessed April 23,

2012.

Bryer, Rob. Consolidated accounts II: US accounting theory caused the global financial crisis.

Advanced Financial reporting. WBS (2012).

Bryer, Rob. Consolidated accounts III: IFRS10 and the problem of control. Advanced Financial

reporting. WBS (2012).

Conseil National de la Comptabilitié, Comment letter (2009).

Deloitte, Comment letter (2008).

Deloitte, iGAAP 2012: IFRS Reporting in the UK (London: LexisNexis, 2011).

European Financial Reporting Advisory Group, EFRAG Field-test on IFRS10 (February 2012).

Ernst & Young, Comment letter.

International Accounting Standards Committee, IAS27: Consolidated Financial Statements and

Accounting for Investments in Subsidiaries (IASC, revised 1998, 2004, 2008).

International Accounting Standards Board, ED 10 Consolidated Financial Statements (December

2008).

International Accounting Standards Board, IFRS 10 Consolidated Financial Statements (May 2011).

IASB, Effect analysis: IFRS 10 Consolidated Financial Statements and IFRS 12 Disclosure of Interests in

Other Entities (January 2012).

IASB, Project Summary and Feedback Statement: IFRS 10 Consolidated Financial Statements and IFRS

12 Disclosure of Interests in Other Entities (January 2012).

IASB Staff Paper, The definition of control of an entity: activities and returns, Agenda paper 10D, July

2009a.

IASB Staff Paper, Power to direct the activities of an entity (Part 1) – Power without a majority of the

voting rights, Agenda paper 10B, July 2009b.

IASB Staff Paper, Power to direct the activities of an entity (Part 2) – Options and convertible

instruments, Agenda paper 10C, July 2009c.

KPMG IFRG Limited, Comment letter, 20th March 2009.

London Investment Banking Association, Comment letter, 19th March 2009.

Morgan Stanley & Co, Comment letter, 20th March 2009.

Macquarie Bank, Comment letter, 2009.

PricewaterhouseCooper, Comment letter, 2009.