Definition of control

The definition of control is not based solely on legal ownership. IFRS 10 explains that “an investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee” .

IFRS 10’s definition of control provides a link between power and returns, on the one hand, and an investor’s ability to affect those returns, on the other.

Control encompasses three distinct principles which, if present, identify the existence of control by an investor over an investee, hence forming a parent-subsidiary relationship:

• 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 amount of the investor’s returns.

All three factors must be taken into account together by an investor when assessing control over an investee. It is not sufficient for only one or two of these factors to be present; all three must be present for the investor to determine that it has control. If any of the conditions mentioned above are not fulfilled, the investor does not have control over the investee. When an investor lacks control over an investee, it must assess whether its interest in the investee falls under the category of a joint arrangement, an associate, a financial instrument, or is covered by other relevant IFRSs.

Framework for assessment of control

When evaluating control over an investee, it is important for investors to take into account various factors:

• 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.

Assessment of purpose and design of the investee

When evaluating control, it’s important for an investor to take into account the purpose and design of the investee. When making financial decisions, it is important for an investor to take into account the following questions:

• What are the relevant activities of the investee?
• How are decisions about those relevant activities made?
• Who has the current ability to direct those activities?
• Who receives returns from those activities?

At times, it becomes evident that a company is being controlled through equity instruments that grant the holder voting rights in proportion to their ownership, like a regular share in the company. In situations like this, where no other agreements are in place to change decision-making, the evaluation of control centres around determining which party, if any, has the ability to exercise enough voting rights to guide the relevant activities of the investee. Whoever holds the majority of voting rights has control over the investee, assuming no other factors are at play.

When faced with complex situations, an investor may need to take into account various factors outlined in IFRS 10.

Voting rights may not have a significant impact on the activities or returns of an investee. The investee may operate on a predetermined or contractually directed basis, similar to how an accountant meticulously plans and organises financial activities. Examining the purpose and design of such an investee can assist in determining who has control. When evaluating an entity’s purpose and design, it is important to consider the following:

• Downside risks and upside potential that the investee was designed to create.
• Downside risks and upside potential that the investee was designed to pass on to other parties in the transaction.
• Whether the investor is exposed to those risks and upside potential.

Considering an entity’s purpose and design might make it clear that the entity is controlled by voting rights, potential voting rights or a contractual arrangement.

Decisions made when an entity is formed A structured entity (SE) was established by a sponsoring bank to invest in bonds. The bond selection process is a crucial factor that impacts the returns of the SE. The bonds were chosen during the establishment of the SE by the sponsoring bank, and the incorporation documents specify that no additional bonds can be acquired. Once the SE is set up, there is no need to make any additional bond selection decisions. Question Does the sponsoring bank have power over the SE solely by virtue of its power to select the bonds in which the SE invests? Solution Finding the right assets alone won’t necessarily give the sponsoring bank an advantage in this situation. The bonds cannot be replaced, so the ability to choose bonds (the relevant activity) ended when the SE was established. Nevertheless, the sponsoring bank’s significant role in the design of the SE suggests that the bank had the chance to exert influence. It is crucial to thoroughly evaluate all contractual arrangements and relevant facts and circumstances to ascertain whether the bank possesses authority over the SE. Power can stem from rights that depend on future events.

Relevant activities

Defining relevant activities

An entity assesses whether it has the power to direct the ‘relevant activities’ of an investee. IFRS 10 defines relevant activities as “activities of the investee that significantly affect the investee’s returns” .

Identifying relevant activities

An investor should find out what an investee’s important activities are. This will help the investor figure out if it is involved in making decisions that have a big impact on those activities. Some activities that are important are, but are not limited to, the ones below: Setting budgets and important choices about things that matter. Getting and selling things and services. Take care of financial goods throughout their life, even when they’re not being paid for. picking out, buying, or getting rid of possessions. looking into and making new goods or methods. Choosing or managing cash and getting money. Choosing who to hire, firing, and paying key management staff.

People and businesses should think about whether their participation in the investee’s important activities will have a big enough effect on the investor’s returns. This is because the investee’s returns may be affected by more than one important activity. But not all relevant actions will have a big effect on the returns of an investor. IFRS 10 doesn’t say anything about what “significantly” means. In the end, this is up to you and may be different for each investment.

Identification of relevant activities Investors get loan notes from Entity A in pounds sterling, but it buys financial assets in euros and US dollars. Currency and interest rate swaps help it protect against changes in cash flow. The following are some of Entity A’s related activities: ·        Selling and purchasing assets. ·        Managing financial assets during their life (including on default). ·        Determining a funding structure and obtaining funding for its activities. ·        Hedging the currency and interest rate risks arising from its activities. These activities are likely to most significantly affect entity A’s returns.

How decisions about relevant activities are made

Once the identification of an investee’s relevant activities has been taken into account, it becomes crucial to grasp the decision-making process behind these activities. Evaluating this decision-making process will help an investor determine if they have control over an investee.

An investor has the power to make decisions regarding an investee’s activities through voting rights, which are obtained through equity instruments.

In the dynamic partnership between an investor and investee, the decision-making process is not solely determined by voting rights. Instead, voting rights may be limited to administrative tasks, while the direction of the investee’s activities is guided by contractual agreements.

When multiple investors have the authority to influence the activities of an investee, it can be difficult to determine which investor truly has control. This determination often requires careful judgement and analysis. It is crucial to evaluate which activity has the greatest impact on an investee’s returns. Take into account the overall returns that an investee generates and determine which investor is driving the activity that has the most significant impact on those returns.

The relevant activities of an investee can change, which would trigger a re-assessment of control.

Assessing which activity most significantly affects returns Two investors collaborate to establish a venture aimed at developing and promoting a medical product. One investor has the sole authority to make decisions regarding product development and regulatory approval. After receiving approval from the regulator, the other investor takes on the responsibility and has the sole authority to make decisions regarding manufacturing and marketing. Here is a summary of the factors that need to be considered in determining which investor has power over the investee. The crucial question is which investor possesses the capacity to oversee the activity or activities that have the greatest impact on returns. It is important to think about the goal and design of the investee, as well as the factors that affect its profit margin, revenue, and value. The medical product’s value is also important to think about. These things will have an effect on the investee’s returns because each owner has the power to make decisions and is exposed to different return levels. Given that this is a subjective question that will depend on each case, it might be hard to say which investor has the biggest impact on profits. The answer might depend on the plan of the investee and the party that has the most power over it. Take the case of a low-cost maker of a commodity product and a high-end manufacturer of a branded product as an example. For the first manufacturer, low-cost production might be the most important thing. For the second manufacturer, good marketing might be the most important thing. Factors to consider, in assessing which activity or activities most significantly affect returns, include: ·        The investee’s purpose and design. ·        The factors that determine the investee’s profit margin, revenue and value, as well as the value of the medical product. ·        The effect on the investee’s returns resulting from each investor’s decision-making authority. ·        The investors’ exposure to variability of returns. ·        The uncertainty and effort required in obtaining regulatory approval (considering the investor’s record of successfully developing and obtaining regulatory approval of medical products). ·         Which investor controls the medical product once the development phase is successful. The decision will be highly judgmental in practice. It can be difficult to identify which activity has more effect on returns.

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Ownership of less than 50% of voting rights with dispersed public shareholding Entity P has a significant 48% stake in entity Q, giving it considerable voting power. Entity Q is a publicly traded company, with voting rights controlled by its shareholders. No single shareholder holds more than 5% of its equity shares. No group has been formed by the other shareholders to collectively vote for their combined 52% shareholding. For several years now, the presence of other shareholders at general meetings, whether in person or by proxy, has consistently remained below 30% of the total voting rights. Entity P has the power to nominate a majority of directors, and their nominations are typically approved at general meetings. According to IFRS 10, entity P exercises de facto control over entity Q. Entity P has the power to influence the outcome of general meetings by controlling the majority of votes. As a result, it can also select and appoint most of the board members.

An investor possesses significant control over an investee when the investor holds established rights that grant it the present capacity to guide the relevant activities of the investee.

Assessing power where different investors control relevant activities in different periods When an investor possesses certain rights that allow them to actively influence the activities of an investee, they hold significant power over the investee. Is it possible for an investor to hold power at present, even if their decision-making authority pertains to a future activity? Entities X and Y have collaborated to establish a brand new company with the purpose of constructing and operating a toll road. Entity X is in charge of overseeing the construction of the toll road, with an estimated completion time of two years. From that point forward, entity Y holds the power and responsibility for all aspects concerning the operation of the toll road. Question Is it possible for entity Y to have power over the company during the construction phase, even though entity X is responsible for construction and has authority to make decisions that need to be made during the construction phase? Solution Entity Y may possess authority during the construction phase, despite not being able to currently exercise its decision-making privileges. If an investor has the authority to influence the activities that have the greatest impact on the returns of the investee, they hold significant power over the investee. It is important to apply the criteria outlined in example 1 of IFRS 10, which involves considering the following: ·        the purpose and design of the investee; ·      the factors that determine profit margin, revenue and value of the investee. For example, the construction of the road might be under the supervision of the national roads’ authority. Entity X is contracted to build the road under government supervision and, subject to government audit, will recover its costs plus a specified percentage of margin. That margin will be returned through adjustment of the number of tolls that will flow to entity X, so that entity X has first call on the cash flows generated by tolls. Entity Y will manage the toll road operations, including maintenance, and will be able to claim a management fee equivalent to any residual cash in the entity after all operating expenses have been paid, including payments to entity X. Entity Y has the ability to set tolls. Alternatively, the arrangement could set out that the government regulates the tolls that can be charged, with little variation in expected revenue, but gives the investee more discretion over how the toll road is constructed, with entities X and Y sharing equally in the net cash flows of the investee; ·        the effect on the investee’s returns resulting from each investor’s decision-making authority with respect to the factors in (b); and ·        the investors’ exposure to variability of returns.

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Re-assessment of power X and Y have established a brand new company with the purpose of building and managing a toll road. Entity X has been entrusted with the task of overseeing the construction of the toll road, which is projected to be completed within a span of two years.After that, entity Y is in charge of all issues pertaining to the operation of toll roads. Even though it was not yet able to exercise its decision-making rights, Entity Y was nevertheless seen to have authority since it could steer the pertinent operations that would have the biggest impact on the company’s profits. After two years, the toll road is finished being built. Entity X took over management of the toll road operations after Entity Y filed for bankruptcy. To continue managing such activities, entity X is in talks with the National Roads Authority. Question Should entity X re-assess whether it has control of the investee in this situation? Solution Yes, entity X should make a re-assessment, because there has been a change that affects the power criterion.

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Level of involvement in relevant activities The level of involvement in relevant activities can be different. For example, managing the investee’s relevant activities on a daily basis could be a strong sign that the investor has a large amount of input. On the other hand, taking part in important activities might not be as clear-cut as day-to-day management. Instead, it could be set out in a contract that tells the investee how to invest. In turn, contractual deals could have a big effect on the investor’s returns.

Rights that give an investor the ability to direct relevant activities

When evaluating its control over an investee, an investor should focus solely on the substantive rights and disregard any protective rights.

Investors have the power to influence the activities of the investee through various rights.

These rights encompass various privileges such as the ability to vote or potentially vote, the authority to appoint or dismiss decision makers (including key management), the power to veto decisions, and other contractual entitlements.

In cases where the investee is involved in various activities that necessitate ongoing substantial decision-making, having voting or similar rights will grant the necessary authority.

In certain situations where voting rights have minimal impact on returns and are primarily related to administrative tasks, it is necessary to explore alternative contractual arrangements.

When determining how the relevant activities of the investee are directed and what rights convey power, it is important to take into account the purpose and design of the investee.

There are two types of rights an investor can have over an investee: substantive and protective. An investor carefully considers the substantive rights when evaluating its control over an investee. According to the guidance provided in IFRS 10 paragraph B22. The number is 26.48. If an investor only holds protective rights over an investee, they do not possess any control or authority over that investee. Protective rights are typically reserved for significant alterations to an investee’s operations or are only invoked in extraordinary situations.

Substantive rights

Substantive rights refer to the rights that an investor possesses, which allow them to actively guide or restrict the activities of the investee. When evaluating an investment, it’s important to take into account various factors that determine the extent of an investor’s rights over an investee. Decisions must be made when there is ambiguity regarding the rights that grant control over an investee. This section highlights several important factors that can help determine the substantive nature of a right.

Substantive rights can be derived from a variety of factors. Considerations such as ownership of a majority of voting rights can grant an investor significant power. However, it is important for the majority owner to also take into account various factors such as statutes, contractual agreements, board control, rights held by other parties, and the practical ability to direct the investee’s relevant activities. These additional factors may indicate that another investor holds significant influence. Considering the rights held by other parties involved with the investee is crucial as it directly affects an investor’s evaluation of control. Other parties’ substantive rights can hinder an investor’s control, even if they cannot initiate decisions.

Evidence that a right could be substantive

The following factors might provide evidence that an investor has rights that are substantive and provide power over an investee:

• The ability to appoint and remove the investee’s key management personnel who have the ability to direct the relevant activities and affect the investee’s returns.
• The ability to direct the investee to enter into significant transactions that affect an investor’s returns, or to veto such transactions.
• The ability to dominate the nomination of members to the investee’s governing body, or to obtain proxies from other vote holders.
• If the investee’s key management or majority of its governing body are related parties of the investor.
• The ability to appoint or remove another entity that directs the investee’s relevant activities.
• Other rights (such as decision-making rights within a management contract) that give the holder the ability to direct relevant activities of the investee.

Control via the right to appoint a majority of the board Entity A possesses a 45% ownership stake in entity B. However, according to the shareholders’ agreement, Entity A has the authority to determine the members of entity B’s board of directors by having the ability to appoint or dismiss the majority of directors. According to entity B’s articles of incorporation, any acquisitions or disposals of assets that exceed 50% of the fair worth of entity B’s total assets, as well as the decision to liquidate entity B, must be voted on by the shareholders. Only majority approval by the directors is required for any other decisions on the relevant activity. Entity A’s ability to influence the makeup of entity B’s board results in entity A having control over entity B. While entity A only has 45% of the votes, certain decisions that require a shareholder vote appear to be aimed at protecting the interests of the company. Specifically, these provisions pertain solely to significant alterations in the operations of the entity being invested in or are applicable only in extraordinary situations (see to the instructions in paragraph 26.80 about protective rights). Entity A has control over entity B because it has the ability to direct entity B’s “relevant activities” and hence has the ability to influence its results. Entity B would be seen as a subsidiary of entity A in this scenario.

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Control via the power to direct the board’s votes If an entity has the authority to nominate a director who has the power to break a tie in board decisions, and as a result, it possesses more than 50% of the voting power on the board, then it will have effective control over the board since it can influence the outcome of board decisions. Entity A possesses a 50% stake in the voting shares of entity B. There are eight members on the board of directors. Entity A designates four directors, while two other investors each choose two directors. One of the directors appointed by entity A consistently acts as the chairman of entity B’s board and possesses the decisive vote during board sessions. Voting decisions are determined by a straightforward majority on all pertinent activities. Entity A possesses the authority to cast the deciding vote during board meetings in the event that the directors are unable to achieve a consensus. This grants entity A authority over board decisions, thereby giving them influence over entity B’s pertinent actions. Therefore, entity B is a subordinate company of entity A and will be included in entity A’s combined financial statements.

An investor may also have the authority to make decisions regarding an entity’s relevant activities, such as setting budgets. It may be necessary to exercise judgement when determining whether those rights are substantive or protective.

Assessing whether approval rights over budgets are substantive Shareholder agreements occasionally contain approval rights over budgets. This might occur in some specialised sectors, like gaming or insurance, where one shareholder would operate as the entity’s operator and manager and possess the necessary industry knowledge. Then, in order to comply with regulations or obtain funds, a third party must have an ownership interest in the organisation. This third party may also be granted certain budget approval privileges. Determining whether budget approval rights are substantive or protective may involve considering the following factors: The degree of specificity in the budget that needs to be authorised. Such rights are more likely to be substantive the more specific they are. How often the budget is prepared, how long it covers, and how often it is reviewed. If there have been challenges to prior budgets, what was the workable process for resolving them? Such rights would be more substantial in nature if there was prior evidence of substantive challenge, with settlement of such challenge occurring before budget approval was necessary. Repercussions if spending targets are not met. The operator/manager would be removed in such a case, indicating that the rights are more substantial in character. The extent to which other returns, such management fees, are available to investors. The likelihood of substantive rights leading to power increases with exposure to a wider range of rewards. Profits that are not in line with the contractual shareholding. For instance, if the other party and the operator/manager own 51% and 49% of the entity’s shares, respectively, but the entity’s returns are split 75% and 25%, this could suggest that the approval powers are not meant to be significant. The nature of the counterparty and how it really contributes to the business. If the operator/manager possesses the necessary specialised knowledge and the company works in a specialised industry, this suggests that the operator/manager is delivering essential services and may therefore have control over the investee. The presence of any additional rights, such as the authority to designate or dismiss important members of the management team. If the investor has power over the investee’s governing body, like its board, that is an important part of the power study. Most of the time, the governing body will be able to tell the entity what “relevant activities” to do. Members of that governing body will usually have equal voting rights at meetings. This means that the power to choose the majority of the governing body’s members will give the entity “relevant activities” power. At meetings, there are times when some people may have more votes than others. An investor might not have power over the investee if the governing body has control over the activities in question and the investor chooses a majority of that body’s members, but those members do not have enough votes at meetings to make decisions on their own.

Barriers that might prevent the investor from exercising its rights

An investor should carefully assess its ability to effectively exercise the rights it holds over an investee. This evaluation is crucial in determining the true substance of these rights. Especially when faced with obstacles that could hinder an investor from exercising their rights, it is crucial to thoroughly evaluate the impact of these barriers. Here are some examples of barriers that can hinder the exercise of rights:

• Financial penalties and incentives that prevent or deter the exercise of rights.
• Exercise/conversion prices that create a financial barrier.
• Terms and conditions that prevent the exercise of rights (for example, conditions that narrowly limit the timing of exercise).
• The lack of an explicit, reasonable mechanism through which holders can exercise their rights.
• An inability to obtain information needed to exercise rights.
• Operational barriers, such as lack of expertise to replace existing management after gaining control.
• Legal/regulatory requirements that prevent exercise (for example, where a foreign investor is prohibited from exercising its rights).

Options and risk of losing key management personnel Entity J has acquired 45% of entity X, with the opportunity to buy the remaining 55%. Entity X is a highly specialised entity that excels in developing cutting-edge technology in its industry and plays a crucial role in conducting research for the latest products. Entity J has acquired the stake in entity X in order to leverage the valuable technological research it offers, which will greatly enhance its existing operations and business. The remaining 55% of equity is held by key management personnel, who play a crucial role in overseeing a major project that entity J believes will introduce a groundbreaking product to the market. However, if entity J exercises the option, it is probable that these management personnel will depart. They possess specialised technological expertise regarding the particular product. The strike price for the option is four times the current value of entity X’s share price. The option may not be significant if entity J would not gain any economic benefit (or even lose economic benefits) from using it. The high strike price and potential departure of key management personnel suggest that the option may not be significant.

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Can an option provide power where the option holder does not have the operational ability to exercise? Investors X and Y have ownership stakes in a manufacturing company called ‘Investee’. Investor X holds 30% of the company, while Investor Y holds 70%. The investee is under the control of voting rights, producing a particular product that is patented by investor Y, and currently being managed by investor Y. Investor X possesses a call option that is currently not profitable, which pertains to the shares owned by investor Y. If the call option is exercised, the patent used by Investee will go back to investor Y. However, there are certain conditions under which this may not happen. These conditions include a change in control of investor Y, a breach of the contract between the parties by investor Y, or if investor Y enters bankruptcy. The investee is unable to produce the product without the patent held by investor Y, which is irreplaceable. Both parties do not anticipate the call option being exercised. The call option serves as a mechanism for investor X to assume control of Investee in extraordinary circumstances. Question Does the option provide investor X with power over Investee? Solution Investor X’s option is unlikely to be considered significant. There are significant operational obstacles to investor X exercising the call option, as the patent would revert back to investor Y unless certain conditions are met. In addition, the exercise of the call option will only result in benefits for investor X if one or more of the events mentioned earlier take place. The design of the call option implies that it is not meant to be exercised. In accordance with the guidance provided in IFRS 10 paragraph B48. It is highly improbable that investor X will gain any significant power from this option.

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Can an option provide power where the option holder does not have the financial ability to exercise? Investors X and Y have ownership stakes of 30% and 70% respectively in a company called ‘Investee’. The control of the company is determined by voting rights. Investor X possesses a call option that is currently exercisable and in-the-money, granting them the right to purchase the shares held by investor Y. Unfortunately, investor X is facing financial difficulties and is unable to exercise the option due to their current financial situation. The investee is generating a profit. Question Does the option provide investor X with power over Investee? Solution An option that is currently exercisable and in-the-money is expected to provide significant leverage. Investor X may need to seek financial assistance from a third party in order to exercise the option, or it could choose to exercise the option and promptly sell its stake in investor Y. If investor X were able to sell the option itself or derive economic benefits from its exercise, it would grant them control over Investee. An option that was out-of-the-money could indicate the presence of substantial obstacles that would hinder the holder from exercising it. Typically, an option is considered insignificant if the option holder cannot gain any advantage by exercising it. It is important to take into account the purpose and design of such an option.

Practical mechanisms exist to exercise rights where agreement requires more than one investor

It may be essential for multiple parties to reach an agreement for the exercise of rights. Having a proper mechanism in place is crucial for individuals to be able to exercise their rights. The absence of such a mechanism could suggest that the rights are not substantial. An independent board appointed by investors can enable a diverse group of investors to collectively exercise their rights.

The investor benefits from the exercise of the rights that it holds

A right is more likely to be meaningful if the person who has it lives better when they use it. People who spend money have a stronger desire to get rights that give them power when their returns from the investment are more likely to change. Because of this, an investor is more likely to have power over the investee if it has a reason to exercise its rights, such as because it will get something good from doing so.

Most of the time, substantive rights that give the holder the power to direct relevant actions can be used right now, but not always.

Substantive rights currently exercisable An investee makes decisions about relevant activities at special meetings and annual general meetings (AGMs). The upcoming Annual General Meeting is scheduled for eight months from now. Shareholders who individually or collectively possess a minimum of 5% of the voting rights have the authority to convene a special meeting within a period of 30 days. Modifications to policies regarding relevant activities can only be made during designated or prearranged meetings. A majority of the voting rights are held by an investor. The voting rights hold significant weight, as they allow the investor to actively participate in decision-making processes regarding relevant activities, regardless of a 30-day delay before exercising them. The power associated with these rights is present from the moment the shares are acquired.

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Substantive rights not currently exercisable: forward contract to be settled in 25 days An investee typically makes decisions regarding relevant activities during special meetings and annual general meetings (AGMs). The upcoming Annual General Meeting is scheduled to take place in eight months. Shareholders who individually or collectively possess a minimum of 5% of the voting rights have the authority to convene a special meeting within a period of 30 days. Modifications to policies regarding relevant activities can only be made during designated or prearranged meetings. An investor has a forward contract to acquire the majority of the voting rights in the investee. The settlement date for the forward contract is in 25 days. The forward contract is significant, as the current shareholders have no ability to alter the existing policies in the next 30 days. By that time, the forward contract will have been settled, and the investor will have rights similar to those of a majority shareholder. The forward contract empowers the investor, despite the pending settlement.

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Substantive rights not currently exercisable: option exercisable in 25 days An investee normally takes decisions regarding relevant activities during special meetings and annual general meetings (AGMs). The upcoming Annual General Meeting is scheduled to take place in eight months. Shareholders who individually or collectively possess a minimum of 5% of the voting rights have the authority to convene a special meeting within a period of 30 days. Modifications to policies regarding relevant activities can only be made during designated or prearranged meetings. An investor has a significant option to acquire the majority of the shares that can be exercised in 25 days. The option is significantly profitable. The option is significant, as the current shareholders have no ability to modify current policies within the next 30 days. The option can be exercised within that time frame, and the investor’s rights are essentially the same as those of a majority shareholder. The option provides the investor with authority, despite not being utilised yet.

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Substantive rights not currently exercisable: forward contract to be settled in six months An investee usually makes decisions regarding relevant activities during special meetings and annual general meetings (AGMs). The upcoming Annual General Meeting is scheduled to take place in eight months. Shareholders who individually or collectively possess a minimum of 5% of the voting rights have the authority to convene a special meeting within a period of 30 days. Revisions to pertinent activities policies can only be made during designated or prearranged meetings. An investor has a forward contract to acquire the majority of the voting rights in the investee. The settlement date for the forward contract is in six months. The forward contract lacks substance at the moment, as the current shareholders have the ability to modify existing policies regarding the relevant activities prior to the settlement of the forward contract. Thus, the investor lacks the present capacity to oversee pertinent operations. The forward contract will become effective 29 days prior to its exercisable date

Assessing control requires considering the financial status of potential voting rights, including whether they are profitable or not, and any additional advantages that can be obtained from exercising them. Voting rights that are significantly out of the money may be considered non-substantive.

Can an option provide power when it is out of the money? Investor X and Investor Y each possess a 30% and 70% stake, respectively, in a corporation called ‘Investee’. The control of Investee is determined by voting rights. Investor X currently has the right to buy shares from investor Y at a price that is higher than the current market price. Question Can the option provide investor X with power over Investee? Solution Yes, if it turns out to be real, this kind of choice can give investor X power. Based on all the facts and situations, you will have to make a decision. Here are the important things to think about. Investment X must gain something from exercising the option for it to be real. The choice has lost all of its value, which could mean that the possible voting rights are not important. However, investor X might make money by taking the option, even though it is no longer worth anything. Investor X might get other benefits from exercising the call option, like synergies or better business efficiency. In general, exercising the option might be a good idea. In that situation, the choice is going to be important.

Other factors to consider when assessing an investor’s rights

The presence of a “special relationship” could be a sign of power. There may be more to an investor’s interest in the investee than just a passive one. This could be a sign of a special bond. Here are some situations in which an investor may have more than a casual interest, which could mean they have power:

• The investee’s key management personnel are the investor’s current or ex-employees.
• The investee’s activities either involve, or are conducted on behalf of, the investor.
• The investor has a disproportionate level of exposure from involvement with the investee – for example, where an investor has less than 50% of the voting rights, yet it is exposed to greater than 50% of the returns (positive or negative).
• The investee is economically dependent on the investor. The investor provides resources that are critical to the investee’s operations, such as:
• Critical services, such as head office administrative support.
• Technology, such as IT systems, or use of a mainframe server or a help desk.
• Supplies or raw materials.
• Licenses or trademarks.
• Key management personnel.
• Specialized knowledge.
• Other critical assets.

It is important to thoroughly evaluate all relevant factors when determining if there is power. Nevertheless, it is improbable that any of the aforementioned factors, when examined individually, will be enough to determine that an investor possesses authority.

It is quite common for one company to be economically dependent on another. Nevertheless, without any additional rights, relying solely on economic dependence does not grant an investor control over an investee.

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Can economic dependence provide power? Entity P produces widgets for entity Q. The majority of entity P’s output is provided to entity Q, while the rest is distributed among several smaller customers. Entity Q has no connection to entity P other than placing orders for widgets. The contract to supply entity Q with widgets outlines the precise order quantities, quality criteria, and prices. If entity Q fails to meet the minimum order quantities, it will incur a penalty payment to entity P. Entity P is responsible for replacing any widgets that do not meet the specified quality criteria. If the number of sub-standard widgets exceeds certain specified levels, entity Q has the right to terminate the contract without any further consideration. Nevertheless, entity Q lacks the authority to make decisions regarding the production or sourcing of the widgets. The contract that entity P has with entity Q has a duration of three years and is typically renewed on an ongoing basis. If the contract is terminated prematurely by either party, there will be financial consequences for the terminating party. If the contract is not renewed, both parties have the freedom to explore alternative customers and suppliers. Entity P has its own management board that efficiently runs the business, strategically makes key decisions about the contracts it enters into, and proactively seeks out new customers. Entity P’s management consistently evaluates the equipment used for widget manufacturing and replaces machinery as needed. Based on the given circumstances, it can be concluded that entity Q does not have control over entity P, as the control criteria specified in IFRS 10 are not satisfied. Entity Q lacks authority over entity P as it is not engaged in overseeing the essential operations of entity P, such as the daily manufacturing of widgets and the pursuit of new customers. There are no indications in the contractual arrangement that suggest Entity Q has any authority over entity P. Although entity P may seem to rely on entity Q for its economic stability, this factor alone is not sufficient to determine control according to IFRS 10.

When an investor’s exposure to the variability of the investee’s returns is significant or when the investee relies heavily on the investor, it does not automatically mean that the investor has control over the investee. Other rights need to be present in order for power to be established.

When evaluating its control over an investee, an investor must take into account the level of exposure to variability of returns. Investors tend to seek greater control and influence when they have a higher level of risk associated with their investments. For instance, an investor would seek adequate rights to safeguard against potential losses and maximise potential gains.

Voting rights

Voting rights, or the possibility of voting rights, can be a sign of power. The next part talks about some important ideas related to the right to vote.

Power with a majority of the voting rights

An investor with more than half of the voting rights is considered to have power, where the following conditions are present:

• Relevant activities are directed by a majority vote, or a majority of the governing body that directs the relevant activities is appointed by majority vote.
• The voting rights provide the investor with the current ability to direct relevant activities.
• The voting rights are substantive.

What form can vote rights take? The phrase “voting rights” refers to the capacity of shareholders to exercise their rights to vote at general meetings of an organisation on all or most topics related to their shares. If the entity does not hold regular general meetings where decisions are made through voting, the term ‘power conveyed by voting rights’ can be understood as the ability to use the right granted by the entity’s constitution to influence its overall policy or change its constitution

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Voting rights of different classes of shares Voting rights provide an investor in entity B with the current ability to direct relevant activities. The rights attached to entity B’s shares are as follows: ·        Ordinary shares (wholly owned by entity A): o   100 ordinary shares. o   All dividends after payment of preference dividends. o   Right to all surplus assets on a winding up of the entity after repayment of preference shares. o   Right to vote on significant matters in relation to relevant activities for entity B. These include appointment of the board of directors (on a day-to-day basis, the relevant activities are directed by the board). ·        Preference shares (all held by entity C): o   100 C1 preference shares. o   Fixed preference dividend. o   Right, on winding up, to the repayment of par value and up to 25% of any sum standing to the credit of the share premium account. o   No rights to vote at entity meetings. The preference shares have no voting rights, while the ordinary shares do. Consequently, when considering voting rights (that is, the means of exercising power in this case), along with rights to variable returns and the ability to affect those returns, entity B is controlled by entity A.

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Voting rights for pledged shares Sometimes, an investor may use their shares as collateral by pledging them to another corporation. If the voting rights on such shares can only be exercised based on the instructions of the investor who pledged them, save in the case of default, then those shares are considered to be held by that investor. For instance, entity A provides a loan to entity B. Entity B pledges its shares in entity C as collateral for the loan. Nevertheless, entity A will not get the voting rights for the shares in entity C unless entity B fails to repay the debt. Therefore, entity B maintains authority over the voting rights in entity C (until it fails to meet its obligations), despite entity A holding the shares as collateral. Thus, entity A lacks the present capacity to oversee the pertinent operations of entity C.

If an investor possesses over 50% of the voting rights of an investee, they do not exert control over the investee if such voting rights lack significance.

Practically every organisation is subjected to some type of governmental regulation. The concepts of regulation and control, whether by the government or a third party, are distinct from one another. An investor’s authority is nullified if the operations in question are under the control of a government, court, administrator, receiver, liquidator, or regulator.

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Impact of regulation on assessment of power Government regulation is generally inadequate to prevent investors from exerting power. For instance, if an investor holds a majority of the voting rights in a regulated utility, which is subject to price restrictions imposed by a regulatory authority, they will typically have the ability to influence the utility’s relevant operations despite the presence of these price constraints. While the regulator does impact the utility company’s profits, it lacks the authority to directly influence the company’s operations and hence does not have control over it. Only the implementation of regulations that restrict investors from exerting influence over the relevant activities would effectively prevent them from exercising control. As an illustration, a legislation could mandate that the state must designate fifty percent of the board of directors of a defence contracting organisation, while granting the government the authority to break a tie if the board is unable to reach a decision. This legislation would prohibit an entity that possesses the remaining 50% of the voting rights from exerting influence over the relevant activities and, consequently, from exercising control over the investee.

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Restrictions on power due to shareholder agreements An investor’s charter or memorandum of understanding may impose limitations on its or others’ capacity to fully exercise their voting rights. The company may have the authority to select the board of directors for the individuals who own a specific type of voting share, or limit the situations in which the investor can use their voting privileges. An entity’s apparent control over an investee, due to owning more than 50% of the share capital, might be limited by an agreement with other shareholders that restricts the entity’s ability to exercise this control. One possible arrangement could involve the shareholders reaching a unanimous agreement on all significant decisions regarding the investee. This would include matters such as distributing dividends, making substantial changes to the investee’s business operations, incurring capital expenses beyond a specified threshold, altering the compensation of directors and employees, or modifying other major relevant activities. If these items were considered to be the relevant actions of the investee in this case, the investor who holds more than 50% of the share capital would not have control over the investee. Nevertheless, it might potentially retain shared authority or exert substantial influence.

Power without a majority of the voting rights

An investor with less than a majority of voting rights can also have power through:

• Contractual arrangements with other vote holders. For example, such a contract might enable the investor to control sufficient votes held by other investors to provide itself with power over the investee.
• Rights arising from other contractual arrangements. For example, such a contractual arrangement might allow the investor to direct some of an investee’s activities (for example, manufacturing). If these are the relevant activities, this could result in control by the investor.
• Ownership of the largest block of voting rights in a situation where the remaining rights are widely dispersed (‘de facto control’). Potential voting rights.
• A combination of the above. For example, a combination of 40% voting rights and 20% potential voting rights might provide power.

Contractual arrangements with other vote holders

Contractual arrangements between an investor and other vote holders might grant the investor the authority to exercise voting rights, even if the investor does not currently own those rights.

Majority of voting rights by agreement with other shareholders Entity A possesses a 45% ownership stake in the voting shares of entity B. Entity B’s pertinent activities are governed by voting rights, with a mandate for a simple majority vote on all decisions regarding those activities. Entity A has a contractual agreement with other shareholders, stipulating that they must consistently vote in alignment with Entity A for an additional 20% ownership. Entity A has authority over 65% of Entity B’s voting rights, as stipulated in the agreement with the other shareholders. Entity A exercises control over entity B, making entity B a subsidiary of entity A. As a result, entity B should be included in entity A’s consolidated financial statements.

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Reduction of ownership to below 50% of voting rights with contractual arrangement An entity called L owns 51% of a listed company called M. The people who own the other shares are spread out and don’t usually show up to meetings or choose proxies to speak for them. Since entity L owns 51% of entity M, it rules it and has been merging it with other entities. Entity M has a lot of debt and starts to lose money. Entity L sells a 2% stake in entity M to an investment bank, which lowers its stake to 49%. There is a contract between entity L and the investment bank that says entity L will continue to manage entity M’s relevant operations and keep the investment safe. Being in charge of entity M’s relevant actions is still possible thanks to the 49% interest. object L is in charge of object M. There are a lot of different shareholders in entity M, but entity L owns 49% of it. It also has a deal with the investment bank that lets it choose most of the board’s members and run the business. Entity L should keep combining with entity M.