The hype today around IFRS 9 and 15 is, at times, reminiscent of how IFRS 10 was received when it went live five years ago. One might hope that the hype fades in proportion to how clear and comfortable the new standard becomes—but what is real state of IFRS 10 in terms of its challenges, changes, and complexity?
Given that IFRS 10 was a "fresh" standard, i.e. not a revision of an older one, certain difficulties have persisted. Plus, the standard requires issuers to exercise a high degree of judgement, which makes it a tricky one.
The issues often arise because business parties, when deciding who has rights to what, rarely consider the accounting aspect of the deal (i.e. who will consolidate the entity at the end of the day). In practice, there are so many kinds of agreements between shareholders and other stakeholders that it's often hard to decide which entity controls the investee. While naturally there are similarities, one rarely finds the same terms and conditions in two different contracts.
If it's unclear whether an entity needs to be consolidated or not, careful analysis must be carried out. Many grey areas can arise: for example, even if the entity has 100% voting rights, control can be still with another party, meaning that that party needs to consolidate the entity.
The best way to check whether the investee needs to be consolidated or not is to follow a logical order during the analysis.
Such an order would be as follows.
Step one
Firstly, one needs to understand the investee: what is its purpose and design? What are its relevant activities? This latter question is particularly important as IFRS 10 states that control over the investee exists if, in addition to meeting two other criteria, the investor has power over the investee—in other words if the investor has rights that grant him/her the ability to direct relevant activities.
Under IFRS 10, "relevant" activities are those that significantly affect the investee's return. For example, suppose a current owner assumes the research and development costs for a new drug, and plans to sell the whole investee, which owns the license for the drug at a fixed price, to a third party. The current owner makes the decisions related to the development, but the development activities are already predetermined. What would the relevant activities be?
A first thought might be to consider the development as relevant, as it's the current activity of the investee. However, a careful look at the definition shows that the relevant activity must affect the investee's return, which is not true for development activities. In fact, the investee will get returns from the license of the drug, so the sale of the license to pharmaceutical companies is what's relevant. The answer may differ if the sale were not fixed. As you can see, with IFRS 10, the devil is in the details.
Step two
Secondly, after identifying the relevant activities, one must analyse who has power over them. Note that this is specifically about who has existing rights to exercise that power, even if those rights won't be exercised yet. In our example it is the third party who has the existing rights over the sale of the license of the drug, even though the sale hasn't happened yet.
Step three
Thirdly, check for exposure to variability of return.
Step four
And lastly, analyse the link between power and return.
In conclusion
In the above example, steps 1 and 2 need careful analysis, whereas steps 3 and 4 are more straightforward. The conclusion: the third party is exposed to the return from the sale of the license, and has the power to manage that activity.
If your company has bought a new entity, or if special arrangements are signed with an entity as in the example above, it is worth carrying out an IFRS 10 analysis immediately to avoid surprises during year-end reporting, especially given how much work it takes to consolidate an entity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
