RESOURCE

STUDY NOTES

Paper F2
Financial
Management
Under the new international financial
reporting standard that covers consolidated
financial statements, its possible for a
shareholder to control an entity even if it has
far fewer than half of the current voting rights
By Eric Leung
IFRS 10, Consolidated financial statements, has
introduced a new control framework as the basis for the
preparation of consolidated financial statements. F2
candidates are expected to demonstrate their grasp of the
meaning of control and how group financial statements are
prepared. Here I will highlight some of the new elements
in IFRS 10 concerning the concept of control, particularly
in cases where the investor has potential voting rights or
where there is de facto control. Note that I will be going
into a high level of detail that the F2 paper wont examine.
Basic concepts of control
Assessing whether an investor controls another entity
ie, the investee is a crucial step when you are preparing
consolidated financial statements. If control exists
between the investor and the investee, the investee needs
to be included (or consolidated) as part of the group.

STUDY NOTES

The control framework was previously governed by

IAS 27, Consolidated and separate financial statements.
This older standard defines control relatively simply,
stating that it exists if the investor has the ability to govern
financial and operating policies of another entity and to
obtain benefits from its activities. It also presumes that the
investor controls the investee if it owns more than half of
the voting power.
IFRS 10 revises the definition of control by incorporating
three elements. Control exists under this standard only if
the investor has all of the following:
Power over the investee.
Exposure, or rights, to variable returns from its
involvement with the investee.
The ability to use its power over the investee to affect
the investors returns.
Before considering the three elements of control, the
investor should first identify the investee, which is normally
a legal entity. But, under IFRS 10, the investee can be part
of a separate entity if the investor has power over only
specified assets and liabilities of an entity. That portion,
termed by IFRS 10 as a silo, is then deemed to be the
separate entity that qualifies as the investee.
The investor then needs to determine the investees
relevant activities ie, those significantly affecting returns.
Normally, a range of financing and operating activities,
such as the sale of goods, are considered relevant.
This stage is crucial, because power exists if a party is
able to direct the investees relevant activities. The next
step is to identify how decisions about such activities are
made. An investee is normally controlled by means of
voting rights, so the investor owning most of the shares
can direct all relevant activities. But IFRS 10 states that
the investee can be controlled by rights other than voting
rights. These can take the form of contractual arrangements
or rights to appoint some of the investees directors.

STUDY NOTES

Power over the investee

The first element of control under the new framework
power is defined as existing rights that give the investor
the current ability to direct the activities that significantly
affect the investees returns ie, the relevant activities.
Such rights come in forms such as current voting rights,
potential voting rights or rights to appoint or remove
members of the investees senior management. No matter
what form they take, such rights must be substantive.
The rights have to be exercisable when decisions
concerning the relevant activities need to be made. For
instance, when someone holds shares, they have current
voting rights at shareholders meetings. The shareholder
can exercise these to make decisions about the entitys
relevant activities. The holder also needs to have a
practical ability to exercise those rights and not encounter
financial or operational barriers that would hinder them
from doing so. Normally, the party holding the rights
should be able to benefit from exercising them.
The most straightforward case illustrating power over
the investee is where decision-making in the investee is
controlled by means of voting rights and the investor holds
more than half of the total. Note that, even where the
investor holds no more than half of the voting rights, power
may still exist in instances where the investor has potential
voting rights or where there is de facto control.
Potential voting rights
Certain financial instruments, such as warrants and
options, carry potential voting rights that entitle (but dont
oblige) the holder to convert them into shares. These
instruments may give the holder additional voting power if
they are converted. The decision to include such potential
voting rights in the assessment of total voting rights hinges
on how substantive they are. The table on the next page
sets out some of the key factors to consider.

STUDY NOTES

Key factors to consider when determining the substantiveness of potential voting rights
Factors

Remarks

Examples

Exercise price
or conversion
price relative to
market terms

Consider whether the entity

holding the rights will benefit from
the exercise. If it can benefit, its
likely that the instrument will be
converted into shares.

If the option is currently in the money eg, if

the exercise price is 2 while the share price
is 10 the holder will probably exercise it.
The potential voting right arising from this option
is therefore substantive.

Ability to obtain
financing

Consider whether the investor has

the financial resources to pay the
exercise price.

If sufficient cash or financing is readily available,

the holder can exercise the option without difficulty.
The potential voting right arising from this option is
therefore substantive.

Exercise period

Consider whether, at the time

when decisions are to be made,
the holder can convert the
instrument into shares.

If the option is currently exercisable ie, it can be

converted into shares if a shareholders meeting were
to be held now the potential voting right arising from
this option is substantive.

Lets consider the following example to work through the

points in the table. Entity A holds 20 per cent of the shares
of entity B and also holds an option to acquire another
40 per cent of shares in B from an existing shareholder.
The option can be exercised in 20 days and it is deeply in
the money. Bs activities are controlled through voting
rights and key issues will be discussed in shareholders
meetings. The next such meeting is due in 10 months time,
but shareholders can convene a special meeting to change
existing policies governing relevant activities. Other
shareholders must be given 30 days notice of the meeting.
Analysing this case, we can make the following points:
Voting rights are relevant in the analysis of power.
Entity A does not own most of the shares in entity B. If we
are referring merely to current voting rights, A does not
have power over B.
The issue of whether the 40 per cent potential voting
rights should be considered or not is crucial. If such rights
are considered, A has a 60 per cent interest in total and
therefore has power over B. This in turn depends on
whether the potential voting rights are substantive.

STUDY NOTES

It requires 30 days notice to hold a special shareholders

meeting, but it takes only 20 days to convert from options
to shares, which would grant A the actual voting rights.
By the time the meeting is held, A should have converted
the options to shares and thereby gained the ability to
direct Bs relevant activities. The rights are therefore
exercisable when decisions about the relevant activities
need to be made.
The option is deeply in the money. A would benefit from
its conversion. The holder has the practical ability to
exercise such rights (assuming that it has the financial
resources to make the conversion).
From all of these points we can conclude that the
potential voting rights are substantive in nature and need
to be considered in the assessment of power. A therefore
currently has power over B.
De facto control
This is a new element in the control framework under
IFRS 10 that applies to situations where an investor
possesses no more than half of the investees shares but is
still considered as holding significantly more voting rights
than any other voting party. If de facto control exists, this
is sufficient evidence of power.
When assessing whether de facto control exists, a
two-step approach is required. In the first step the
following factors need to be considered:
Absolute size. The more voting rights an investor holds
(ie, the closer it is to owning half of the total), the more
likely it is that the party has de facto control.
Relative size. The more voting rights an investor holds
compared with those of other vote holders, the more likely
it is that the party has de facto control.
The dispersion of other vote holders. This refers to the
ease with which other parties can co-operate in order
to prevent the investor from controlling the investee.

STUDY NOTES

The more that they are required to act together in order

to outvote the investor, the more likely the investor is to
have de facto control.
If the factors considered in the first step do not make it
clear whether the investor has power over the investee,
we need to consider further circumstances, such as the
voting patterns of other parties at previous shareholders
meetings. This in turn hinges on whether they are active or
not. The more active the other shareholders are, the less
indication there is that the investor has the practical ability
to direct the investees relevant activities unilaterally.
Say, for example, that entity C holds 39 per cent of the
voting rights in entity D. Eight other investors each hold
5 per cent of the voting rights in D, while the rest are
widely dispersed, with no other party holding more than
1 per cent. No other arrangements affect decision-making.
At recent relevant shareholders meetings, 76 per cent of
the voting rights have been cast.
The factors to consider in step one are not conclusive
as to whether C has a dominant voting interest in D:
it owns only 39 per cent (not an absolutely large holding)
and it is not relatively larger than that of the other
significant shareholders, which may possibly co-operate
to outvote it. The analysis needs to enter step two in order
to consider whether the other shareholders are active or
passive. The active voting rights held by C, neglecting
those passive shareholders, is 39 76 = 51.3 per cent.
Because this is more than half, it gives us evidence
indicating that C does have de facto control over D.
Exposure to variable returns
The second element in IFRS 10s control framework
concerns whether the investor is exposed to variability
in returns from its involvement with the investee.
Typical examples of returns include dividends and
changes in the value of investment.

STUDY NOTES

The power to affect the investors returns

The last element of the control framework establishes a link
between the first two. If the investor can use its power to
obtain returns for itself (but not using delegated power to
generate returns for others), this criterion is fulfilled.
IFRS 10 has made it more complicated for us to assess
whether an entity controls an investee or not, because the
decision is no longer based simply on current voting
interests. The standards new control framework provides
additional guidance on whether potential voting rights and
de facto control need to be considered in the assessment.
Students are expected to understand such concepts
because, once control is established, consolidated financial
statements need to be prepared even in cases where the
parent owns no more than half of the shares in the investee.

Eric Leung is a lecturer

at CUHK Business
School at the Chinese
University of Hong Kong