A structured entity is “an entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements”.

Identifying structured entities

IFRS 12 outlines some common characteristics of structured entities; normally, they have some or all of the following features:

• Restricted activities.

• A narrow and well-defined objective, such as:
• to effect a specific structure (for example, a tax-efficient lease);
• to perform research and development activities; or
• to provide a source of capital or funding to an entity or to provide investment opportunities for investors by passing risks and rewards associated with the assets of the structured entity to investors.
• Thin capitalization (that is, the proportion of ‘real’ equity is too small to support the structured entity’s overall activities without subordinated financial support).

• Financing in the form of multiple contractually linked instruments to investors that create concentrations of credit risk or other risks (tranches).

Common indicators of a structured entity The following characteristics are common indicators of a structured entity: ·        Use of professional directors, trustees or partners. ·        Absence of an apparent profit-making motive, such that the structured entity is engineered to pay out all profits in the form of interest or fees. ·        Domicile in ‘offshore’ tax havens. ·        A specified life. ·        Existence for the purpose of achieving a specific financial objective. For example, an institutional investor might approach a bank, wanting to obtain investments of a particular risk profile; the bank might set up a structured entity to aid such a transaction.

When assessing whether an entity is a structured entity, a crucial factor to consider is the dominance of voting or similar rights. These rights should carry significant decision-making powers, or there should be contractual terms in place that prescribe substantive powers, such as a ‘autopilot’ arrangement. If voting rights are the primary determinant of decision-making powers within an entity, then that entity is not considered a structured entity.

Employees as de facto agents Employees of the reporting entity may assume management positions in an investee. Do employees in key management personnel (KMP) roles act as representatives of a reporting entity when it comes to the reporting entity’s investees? Entity X is responsible for managing and making all decisions regarding a fund. Entity X provides performance-based awards to its key management personnel, who are eligible to receive shares in the managed funds upon meeting specific conditions. Entity X also mandates that a portion of the KMP’s cash bonuses must be invested directly in the funds. Additionally, the KMP has the option to invest their own funds. Entity X does not have any direct stake in the fund. Given that entity X does not have any direct stake in the fund, apart from a management fee, it could indicate that entity X has limited exposure to fluctuating returns. However, it is possible that the KMP is actually holding their shares on behalf of entity X. Investing in the funds could potentially serve as a form of compensation, thereby indirectly benefiting entity X. This will have an effect on both the criterion for exposure to variable returns and the analysis of control between principal and agent. Question Do KMP act as de facto agents of entity X? Solution Judgement is required to assess whether: ·        the KMP might use their investments on behalf of X; or ·        the investments are the personal assets of the KMP, over which the reporting entity has no power. This judgement should be made, based on facts and circumstances, such as: ·        the position of the KMP within the company; ·        the reason why the KMP are holding those investments; ·        whether those shares have vested (and whether the KMP could resign and retain their investments); ·        whether the shares were granted by entity X or purchased using the KMP’s own resources; ·        any restrictions on transfers of those shares by the KMP without entity X’s approval; and ·        how the KMP vote on those investments in practice. If the KMP are de facto agents, their shareholdings will be attributed to entity X when deciding whether entity X controls and should consolidate the fund.

Some examples of structured entities are:

• Securitization vehicles.

• Asset-backed financings.

• Some investment funds.

Form of structured entities A structured entity can be a business, a trust, a partnership, an unincorporated entity, or a structure with more than one user, like a protected cell company. It can also be a separate part of a bigger thing, which is sometimes called a “silo.” The investor who set up the structured entity often gives assets to it, gets permission to use assets owned by it, or does work for it, while third parties provide it with money, like in a securitization arrangement.

Can a change in facts and circumstances cause an entity previously considered to be a structured entity to no longer meet those criteria? OpCo used to be thought of as a structured organization. There was a contract that controlled the actions that had the biggest impact on returns. Voting rights were not the main thing that investors used to choose who owned OpCo. The things that OpCo does that have the most impact on returns have changed because of a change in facts and circumstances. These things are controlled by the right to vote. Question  Would OpCo cease to be considered a structured entity? Solution Yes. IFRS 10 says that control needs to be looked at again if events and circumstances show that one or more of the three parts of control have changed. If facts and circumstances change, it could affect an entity’s actions or, if it has more than one activity, it could affect how important each activity is. There may also be changes to the types of rights that owners have. People with voting rights that they couldn’t use before could now use them to make decisions about important things. IFRS 12 defines a structured entity as: “An entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements.” If voting rights decide what an entity does after the facts and circumstances have changed, then the arrangement is no longer what is called a structured entity. IFRS 12 says that interests in unconsolidated structured companies must be made public. If a reporting company has a stake in an unconsolidated entity that is not a structured entity, it does not have to follow these rules for disclosure.

Consolidation criteria for structured entities

Legal ownership is not the only thing that determines consolidation. The most important thing to know about whether an investor should merge a structured company is whether the investor owns that entity. IFRS 10 states that “an investor controls an investee when the investor 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” .

This description works for all entities, even structured entities. Structured entities are different because the investee is not always managed by the normal substantive powers, like voting rights. Contracts, on the other hand, guide relevant actions. These contracts may seem to leave no one with power over the structured body at first glance if they are very specific. Because of this, more research is needed to find out who owns the structured entity.

IFRS 10 uses the same approach to figure out who controls a structured entity as it does for all other entities. Things to think about are:

• The purpose and design of the structured entity.
• What the relevant activities are. How decisions about those 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.
• Whether the investor has the ability to use its power over the investee to affect the amount of the investor’s returns.

Other considerations include:

• Whether the decision maker is a de facto agent of someone else.
• Whether there are any silos that should be separately considered for consolidation.

This section focuses on the application of the control framework to the unique characteristics of structured entities.

Purpose and design of the investee

An investee’s purpose and design can have a significant impact on how its relevant activities are assessed, the decision-making process surrounding those activities, and who has the authority to direct them.

By carefully examining an entity’s purpose and design, it becomes evident whether the entity is under the control of voting rights, potential voting rights, or other rights granted through a contractual arrangement.

When evaluating a structured entity’s purpose and design, it is important to take the following factors into consideration:

• 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 or arrangement.
• Whether the investor is exposed to those risks and upside potential.

Relevant activities and ability to direct those activities

The following matters need to be considered when assessing who has the power to direct a structured entity’s relevant activities:

• Involvement in, and decisions made at, the structured entity’s inception as part of its design.

• Contractual arrangements established at the structured entity’s inception.
• Rights to direct the structured entity’s relevant activities that are only activated when certain events occur.

• Commitment to ensure that the structured entity operates as designed.

When assessing control over a structured entity, should the assessment of power and exposure to variability be based on the accounting assets, the legal assets or the economic exposures of the structured entity? A structured entity (SE) borrows money from a bank to buy an asset (like a house or an airplane) and get legal title to it. Then, it rents the asset to Y, who will use it in its business every day. In the eyes of the law, the SE owns the asset. Under accounting rules, if the lease is a finance lease, the SE records a finance lease receivable. If it is a running lease, the SE records a tangible asset. At the end of the lease time, the SE is entitled to the asset’s residual value and the cash flows that come from the lease. Question Should the assessment of power and exposure to variability be based on the legal asset (the building or aircraft), the accounting asset (the finance lease receivable or tangible asset) or the SE’s economic exposures? Solution When evaluating power and exposure to variability, it is important to consider the SE’s economic exposures rather than focusing solely on the accounting treatment or legal form of the transaction. This approach emphasizes the SE’s entitlement to cash flows and other advantages (such as tax benefits), as well as the control over activities related to those entitlements and the potential for fluctuating returns.

When a structured entity leases out an asset, what are its relevant activities? Structured entities secure funding from banks to acquire and gain legal ownership of assets, such as buildings or aircraft. It subsequently leases the asset to another party, Y, who will handle its day-to-day operations as part of their business. Legally speaking, the asset is owned by the SE. From an accounting perspective, the SE acknowledges a finance lease receivable when the lease meets the criteria for a finance lease, and a tangible asset when the lease meets the criteria for an operating lease. From a financial standpoint, the SE has the entitlement to cash flows during the lease and to the residual value of the asset once the lease term concludes. Question  Are the activities associated with operating the asset and managed by the lessee (such as using the asset to generate cash flows and incurring associated costs) relevant in assessing control of the SE? Solution These activities are unlikely to be relevant in the control assessment in this particular situation, which aligns with the purpose and design of the SE. The lessee has taken on the responsibilities, advantages, and potential drawbacks of operating the asset. These factors do not impact the SE’s returns. Even though the SE legally owns the asset, leasing it to another party has changed the nature of the asset held by the SE to: ·        a lease receivable , where the relevant activity is the management of the associated credit risk; or ·        a residual value at the end of the lease term, where the relevant activity is realizing the value either through the re-lease or the sale of the asset. The relative importance of the two activities in the control assessment will be affected by the term of the lease and the credit risk of the lessee: ·        The longer the lease term in relation to the useful life of an asset or the higher the credit risk of the lessee, the more likely the lease receivable would most significantly affect the SE’s returns. The activity of managing the lease receivable is likely to be more important in assessing who has control. ·        The shorter the lease term in relation to the useful life of the asset or the lower the credit risk of the lessee, the more likely the residual value would most significantly affect the SE’s returns. The activity of releasing or selling the asset is likely to be more important in assessing who has control.

Does an option to purchase an asset at the end of the lease term provide control over a structured entity? Structured entities secure funding from banks to acquire and gain legal ownership of assets, such as buildings or aircraft. It subsequently leases the asset to another party, Y, who will handle its day-to-day operations as part of their business. Legally speaking, the asset belongs to the SE. From an accounting perspective, the SE acknowledges a finance lease receivable when the lease meets the criteria for a finance lease, and a tangible asset when the lease meets the criteria for an operating lease. From a financial standpoint, the SE has entitlement to cash flows during the lease and to the residual value of the asset at the lease’s conclusion. Entity Y has the opportunity to buy the asset at the end of the lease term for its market value. Question  Would the purchase option convey control over the SE? Solution No, the option wouldn’t give you power over the SE by itself. The SE needs to be able to manage the asset’s residual value, and having the choice to buy the asset at fair value would give them control over this task. But it wouldn’t be thought to change the results because it wouldn’t move variability into or out of the SE. One of the three requirements for control in IFRS 10 is exposure to variable returns. Having the choice to buy the asset at market value would not give you control by itself. But if the choice to buy had been at a fixed price, entity Y would have been able to handle the SE’s changes, which could show that it had control. In cases where the asset’s residual value is high compared to the exercise price, company Y would take on the risk that comes with the returns without complaining. So, being able to change the returns in this way would be a good sign of having control over the SE. As part of the control review, you should also look at the credit risk that comes with the lease receivable and any other factors that cause the SE’s returns to change. Because of this, the option would probably not give power over the SE if the asset’s residual value was small and didn’t change much compared to the cash flows from the lease receivable.

Does an option to extend a lease provide control over a structured entity? A structured entity (SE) borrows money from a bank to buy an asset (like a house or an airplane) and get legal title to it. Then, it rents the asset to Y, who will use it in its business every day. In the eyes of the law, the SE owns the asset. Under accounting rules, if the lease is a finance lease, the SE records a finance lease receivable. If it is a running lease, the SE records a tangible asset. At the end of the lease time, the SE is entitled to the asset’s residual value and the cash flows that come from the lease. Entity Y can choose to extend the lease for a set fee. Question  Would the extension option convey control over the SE? Solution This choice could give you power over the SE. Managing an asset’s leftover value is a task that can be used to figure out who has power over the SE. Entity Y would be able to make decisions about an important activity and SE would have to deal with the changes in the residual value if they had the choice to extend the lease at a fixed price. Even though the option might give you power on its own, you should also think about the lessee’s credit risk. It’s likely that the renter would be seen as controlling the SE if the credit risk is low and the residual value is thought to have a bigger impact on the size and range of returns on the SE than the lease receivable. It wouldn’t move risk into or out of the SE if the opportunity to extend the lease was at market value, though. It also wouldn’t give control by itself.

Involvement in, and decisions made at, the structured entity’s inception

An important part of figuring out control is seeing how many people were involved in creating the structured organization in the first place. It’s not enough for involvement to be enough to prove power, even if the involvement was big. Participants who are active in the design, on the other hand, might be able to get rights that give them power. The choices that were made when the structured body was first created need to be looked at to see if they give any of the participants rights that are strong enough to be called power.

Can a structured entity have no relevant activities? It is possible for a structured entity to be set up in a manner where no further decisions are required, leaving no relevant activities for investors to have control over. In such cases, when no party involved with the entity possesses power, the structured entity would not be consolidated by any party. Nevertheless, it is anticipated that such entities will be uncommon. Prior to reaching this conclusion, investors must carefully consider the criteria outlined in Appendix B to IFRS 10. Only when an investor thoroughly evaluates these factors and determines that the structured entity lacks any significant activities, can it be potentially concluded that no one holds power. Activities closely related to the structured entity may be involved in the contractual arrangements established at an entity’s inception. These activities are considered relevant. It remains true, even if the activities take place in a different entity rather than within the entity itself. The contractual arrangements may involve various rights, such as call rights, put rights, liquidation rights, or rights to manage assets. These contracts could potentially give investors control over the relevant activities.

Assessing control for a debt restructuring structured entity with limited activities Background and purpose An organization (called “the Corporate”) wants to borrow money for long-term loans with an interest rate that isn’t the usual one. For example, the Corporate wants to borrow money with a coupon that changes based on an underlying index, like an inflation or stock index. This could be done to protect the company’s finances (for example, if some or all of its income changes with inflation) or as part of a larger organized deal (for example, to get tax breaks). Even so, the market for this kind of non-vanilla debt is not very flexible. The following details describe a deal that the Corporate makes with a structured entity (SE). Facts ·        The Corporate, in conjunction with a Bank, sets up an SE. Corporate issues the desired non-vanilla notes (the ‘Structured Notes’) to the SE. The returns on the Structured Notes are linked to returns on a specified index (for example, inflation or equity index). ·        The SE’s shares are held by an independent third party − in this case, a charitable trust. However, the share capital is negligible, and the voting rights confer no substantive rights, as all these have been specified by contractual arrangements. ·        The Bank enters into a swap (‘the Swap’) with the SE to exchange the index-linked rate on the notes issued for a fixed coupon using a derivative. Payments under the Swap are made on a net basis and are made quarterly to match the coupon payment dates on the ‘Plain Notes’ (see below). If, in any period (including on maturity or liquidation), a net payment is due from the SE under the Swap, that payment ranks senior to all other amounts payable by the SE. ·        The SE issues vanilla fixed-rate notes (‘the Plain Notes’) to noteholders. ·        The note-holders are a dispersed group of numerous investors who do not represent a reporting entity. No individual note-holder owns more than 5% of the notes. They are represented by a trustee (‘the Trustee’). The Trustee can be removed by a majority vote of the note-holders without cause, receives fixed remuneration and has been assessed to act as an agent for the note-holders under IFRS 10. The Trustee is not a related party of the Corporate, the Bank or the note-holders. This example does not consider the agent/principal requirements in IFRS 10. ·        As long as the Corporate and the Bank perform under the Structured Notes and the Swap respectively, there is no need (or permission required) for any party to direct the SE’s activities. The SE will use the cash receipts from the Structured Notes, net of the cash paid or received under the Swap, to service the Plain Notes issued to the market. The SE does not require other activities. ·        The Plain Notes are not guaranteed by either the Bank or the Corporate. However, if the Plain Notes default, the Trustee appointed by the noteholders could seize the assets of the SE and seek payment from the Corporate on the underlying Structured Notes to recover the monies due on the Plain Notes. If the Swap is in a net receivable position from the SE, the Bank can also seek to recover its net receivable position from the assets of the SE. In such a case, the Bank’s claim ranks senior to that of the note-holders. ·        If the Bank defaults while the swap is in a payable position to the SE, the Trustee of the note-holders also has the ability to claim from the Bank on behalf of the note-holders. ·        The Structured Notes give rise to both credit risk (the risk that the Corporate, and hence the SE, will default) and variability due to the structured coupon. Assume, for the purposes of this example, that both are significant. Analysis under IFRS 10  Does the SE have relevant activities? As soon as the SE is set up, no choices will be made unless the Corporate changes its mind. The SE will default on the Plain Notes if the Corporate fails to pay on the Structured Notes. In this case, the Trustee of the note-holders can take the SE’s assets and decide how to get money back from the Corporate. This choice is dependent on something that might happen, but that doesn’t mean it’s not important. If the worse case scenario happens, this choice could have a big impact on the SE’s profits. The SE therefore has relevant activities. Who controls the SE? There are several things that need to be looked at to figure out which party rules the SE and, by extension, brings it together. We looked at each side individually below, using the three things that IFRS 10 says are needed for control: power, exposure to variable returns, and the ability to use power to change returns. In this case, the Trustee is seen as working as an agent, and they have not been looked at any further in the control analysis.

Assessing control of an issuer of commercial mortgage-backed securities managed by a third-party servicer acting on behalf of investors  Background and purpose There are various reasons why commercial mortgage-backed securitizations are in place. If a bank has originated or acquired commercial mortgages, it may need funding for those assets. The bank may also consider transferring a portion of its potential losses from the mortgages. Finally, there could be a chance for the bank to develop marketable securities with a specific risk profile that would appeal to investors. This would help lower its funding costs and generate fees from its participation in the transaction. It’s important to keep in mind that there may be additional features in commercial mortgage-backed securitizations that are not shown in this illustration. Facts A bank sets up a structured entity (SE) and transfers to it commercial mortgages with a value of C100. The shares of the SE, which are held by independent third parties (a charitable trust), have no decision-making authority, due to the rigid contractual arrangements in place. The mortgages held by the SE are contractually specified and do not change over the life of the SE (a static portfolio). The historical, as well as the expected, future default rate of these mortgages is approximately 5%. The likelihood of a default rate of more than 10% is considered remote. A third-party servicer administers the mortgage portfolio in the SE under a servicing agreement that sets out servicing standards. The servicer will receive management fees of 8bps (that is, 0.08%) of the outstanding principal of loans, which are not dependent on the servicer’s performance. The SE issues two tranches of debt. A senior tranche of C80 is issued to a dispersed, unrelated group of note-holders in the market that do not constitute a reporting entity and are represented by a trustee. No individual senior debt-holder owns more than 5% of the senior notes. A junior tranche (subordinated liabilities) of C20 is held by the bank. The SE’s liability in respect of both tranches is limited to the collections from the mortgages that it holds. If the SE is not able to repay either tranche due to defaults in the underlying mortgages, this does not constitute a legal default by the SE (that is, debt holders cannot take actions against the SE, such as seizing its assets, or placing the SE under liquidation). Any residual amount in the SE, after payment of all parties, is allocated to the junior notes on termination of the SE. The servicer assumes the status of the ‘super-servicer’ in case of default on one or more of the underlying commercial mortgages. Management fees on the defaulted mortgages are increased from 8bps (0.08%) to 25 bps (0.25%) of the outstanding principal of defaulted mortgages; and a performance-related fee is paid equivalent to 1% of any collections from mortgages that have defaulted. The higher management fees are designed to cover the higher costs of managing the structure, and the performance fees are designed to incentivize the super-servicer to maximize collections. The servicer can therefore obtain a minimum fee of 0.25% of the outstanding principal of defaulted mortgages and a maximum of 1.25%. ·        The magnitude of the management fee (between 8bps and 25bps) has been assessed to be insignificant, compared to the SE’s much higher overall expected returns on its mortgage portfolio. The magnitude of the performance fee is also expected to be insignificant, as this is only 1% of collections on defaulted mortgages, which in turn are expected to comprise only 5% of the portfolio. ·        The variability of the management fee relative to the SE’s returns has also been assessed to be insignificant, because the fee is based on principal, which is relatively stable. The variability of the performance fee is assessed to be insignificant, as it is only 1% of collections on defaulted mortgages, which in turn are expected to comprise only 5% of the portfolio. The servicer’s fee ranks ahead of payments on the junior and senior notes. ·        The servicer’s fees are commensurate with the services provided, and the remuneration agreement does not include terms or conditions that are not customarily present in similar agreements. The servicer must make decisions in the best interests of all investors (that is, the bank and senior note-holders) and in accordance with the SE’s governing agreements. Nevertheless, if there is a default, the servicer has significant decision-making discretion. ·        The bank can remove the servicer if a breach of contract occurs. ‘Breach of contract’ includes a return on the senior notes of less than 20%, a condition that is met as soon as any defaults occur. The effect is, therefore, that the bank can unilaterally remove the servicer on default of the underlying receivables. No other party has kick-out rights. It is improbable that none of the mortgages will default at the reporting date. The servicer is easily replaceable. Analysis under IFRS 10 Does the SE have relevant activities? Within the SE, there are two primary functions: mortgage servicing and collection in case of default. Servicing mortgages on a daily basis is not considered a relevant activity as it has minimal impact on the SE’s returns and is typically predetermined by a contractual arrangement. Collecting receivables on default is a crucial activity as it has a significant impact on the returns of the SE. This right can be exercised only in the event of default, but that doesn’t mean it’s just a protective measure. It actually holds significant value over the relevant activity of the SE. According to IFRS 10 paragraph B53. If an investor has the authority to guide the actions of the SE after default, they could potentially wield influence over activities that are predetermined until default occurs. The SE thus engages in pertinent activities.  Who controls the SE? Several factors must be evaluated to determine which party has control over the SE and can consolidate it.

Assessing control of an issuer of credit-linked notes with limited activities and derivatives that enhance risk Background and purpose There are several reasons why a credit-linked note structure may be established, with the most common ones being: ·        to enable a bank to obtain credit protection on loans that it holds; and ·        to enable a bank to create marketable securities of a particular risk profile that are attractive to investors. The bank will earn fees from creating and marketing the structure.  Facts ·        A Bank sets up a structured entity (SE), and enters into a credit default swap (CDS) with the SE, for which it pays the SE a premium at market rates. Under the CDS, if a stipulated commercial debt security (‘the Risky Asset’) defaults, the SE will pay to the Bank the par value of that security. Any liability of the SE to the Bank in respect of the CDS has priority over all of the SE’s other liabilities. ·        Shares of the SE, which are held by independent third parties (for example, a charitable trust), have no significant decision-making rights, due to the restrictions imposed by the contractual agreements. The note-holders have limited exposure to downside variability through their holdings of senior notes. However, the extent of an investee’s exposure in itself does not necessarily result in power. There are no conclusive indications that any of the note-holders has power over the SE. Further, IFRS 10 indicates that only one investor can control an investee. As explained above, there are strong indications that the bank has power. ·        The SE invests in AAA bonds whose maturity matches that of the CDS and the notes issued by the SE (see next bullet point). In the event that the AAA bonds are downgraded below AAA, the Trustee of the charitable trust is required to sell the bonds and buy replacement bonds with an AAA rating. ·        The SE issues a single tranche of credit-linked notes (‘the Notes’) to a large number of dispersed, unrelated investors (the ‘note-holders’), which do not form a reporting entity. No individual note-holder owns more than 5% of the notes. The returns on the Notes are linked to the returns from the AAA bonds and the payments on the CDS. The noteholders are represented by a Trustee, which can be removed by a majority vote of the note-holders without cause. The Trustee receives a fixed level of remuneration that is consistent with market rates for its level of services. The Trustee has been assessed to act as an agent for the note-holders under IFRS 10. This example does not, therefore, consider the requirements for agent/principal in IFRS 10. ·        The SE’s liability in respect of the Notes is limited to the paramount adjusted for CDS receipts/payments. If the SE is not able to repay the notes in full, due to a credit event on the CDS, it does not constitute a legal default by the SE (that is, debt holders cannot take actions against the SE, such as seizing its assets or placing the SE under liquidation). ·        However, a default on the notes will arise if the SE is not able to repay the notes, due to default of the bonds. If this occurs, both the Bank (if the CDS is a net receivable from the SE) and the note-holders as a group, as represented by the Trustee, have normal powers under bankruptcy laws (for example, seizure of assets, or liquidation of the SE) to recover any amounts due from the SE. Analysis under IFRS 10 What are the SE’s relevant activities? The following relevant activities exist within the SE: ·        asset-replacement decision in the event that bonds are downgraded; and ·        asset seizure and recovery powers on a default by the SE (for example, if the bonds were to default and amounts were due to the note-holders and/or the Bank). Even though these choices depend on things that might not happen, that doesn’t mean they aren’t important. If the thing that might happen does happen, these choices could have a big effect on the SE’s returns. Accordingly, the SE does have relevant activities.  Who controls the SE? There are several things that need to be looked at to figure out which party rules the SE and, by extension, brings it together. In this case, the Trustee is seen as working as an agent, and they have not been looked at any further in the control analysis.

Rights to direct relevant activities

It is important to carefully analyze decision-making powers that are only activated when specific situations or events occur while evaluating control.

An investor possessing these rights can exert control over the structured entity, even in situations that have not yet occurred, provided that the rights grant the investor the practical capacity to oversee the necessary activities of the investee.

The authority to make such choices does not exclusively serve the purpose of protection.

Contingent power Question Can an investor have power if it can make decisions only on a contingent event but cannot make any decisions currently? Solution An investor could exert influence in this particular scenario. If an investor has the ability to control an activity that will only happen in the future when a certain event happens, that authority should be taken into account even before the event actually occurs. Contingent power is an important factor to examine when determining who has authority over organized entities in situations where decisions may be necessary or allowed when the contingent event takes place. Contingent power does not just serve a protective function.

Commitment to ensure that a structured entity operates as designed

Demonstrating a dedication to ensuring that a structured entity functions according to its intended design may lead to being exposed to fluctuations in returns and enhance the probability of the investor having influence. Nevertheless, this component alone is inadequate to substantiate authority or to hinder other entities from possessing authority.

Commitment to ensure that a structured entity operates as design Entity Z, a financial institution, transfers debt securities to entity A, a trust. Entity A is not subject to control via voting rights. Entity A has been established exclusively for the purpose of this transaction, and its relevant operations are governed by the terms of a contractual agreement between entity Z and entity A. Entity A satisfies the criteria for being classified as a structured entity. The trust’s founding documents and marketing materials provided to investors specify the minimum credit quality necessary for the assets included in the trust. The trust subsequently offers fresh securities to investors. An essential aspect of the marketing literature is that entity Z sponsors the trust and guarantees that it adheres to the guidelines outlined in the marketing literature. A trust administrator is responsible for the collection and timely distribution of payments on the securities held in the trust to the investors. Entity Z has established the trust with a specific operational framework and is dedicated to ensuring that the trust administrator effectively collects payments and administers the trust according to the established guidelines. Entity Z played a role in choosing the assets to be moved into the trust, and it also participated in creating and promoting the documents given to outside investors. These indicators suggest that entity Z possesses authority over the trust, as it has a motivation to acquire rights in order to safeguard its position. However, by themselves, these indicators are insufficient to definitively establish that entity Z has control over entity A. For instance, the investors who hold the shares may have been bestowed certain privileges that confer them with authority.

Can reputational risk give control? A bank sets a structured entity (SE) with the purpose of acquiring and retaining specific financial assets that the entity buys from traded markets. Additionally, the SE issues asset-backed securities to investors. Once the SE is established, the bank no longer has any stake or authority in its decision-making process. Nevertheless, the bank’s reputation will be negatively impacted if the SE (Security Enhancement) fails. In such situations, the bank may choose to offer financial assistance to the SE, although not being legally obligated to do so, in order to safeguard its own reputation.  Question  How does reputational risk impact the conclusion on control?  Solution In situations where there are several parties involved in decision-making, the party who has the authority to control the action that has the greatest impact on returns holds power over the investee. The Trustee has a greater ability than the Bank to influence returns by shifting more risk (and potential gains) to the Special Entity, so enhancing returns for note-holders. The bank’s reputational vulnerability may lead to an implicit obligation to ensure that the SE functions as intended. However, this alone does not serve as definitive proof of the bank’s authority. The bank was also engaged in the development and establishment of the SE; nevertheless, this factor, once again, does not offer definitive proof of authority. In the absence of any other signs of authority, it is improbable that the bank will have control over the SE. Consolidation should not be only based on reputational exposure. However, a thorough analysis of all the facts and circumstances is necessary to determine if the bank has control. Increased reputational exposure can lead to higher variability of returns for investors, motivating them to acquire sufficient rights to gain power.

Whether the investor is exposed to variable returns

IFRS 10 encompasses a wide spectrum of financial gains, including dividends, fees, tax advantages, economies of scale, and cost reductions. The analysis encompasses both financial and operational rewards and hazards. If you need additional assistance regarding variability. The following instructions pertain only to organized entities.

What creates variability in returns in a structured entity? Variability in returns from structured entities, like other entities, might result from volatility in: ·        exchange rates; ·        interest rates; ·        equity prices; ·        commodity prices; ·        credit risk; or ·        residual values. It is important to understand where the variability arises from and whether an investor in a structured entity is creating or absorbing variability.

What represents an interest in a structured entity? An interest in a structured entity, like other entities, can include any of the following: ·        A debt instruments. ·        An equity instruments. ·        A contractual arrangement. ·        A participation right. The Trustee has the following powers: ·        A residual interest. ·        A lease. ·        The provision of funding. ·        Liquidity support. ·        Credit enhancement. ·        A guarantee. However, a conventional customer-supplier relationship is not regarded as an investment in a formal organization. Certain investments offer investors a predetermined or specified rate of return, while others grant investors privileges or opportunities to benefit from the future economic advantages of the structured company. Typically, the investor who establishes the structured business generally maintains a substantial stake in the activities of the structured organization, although potentially having minimal or no ownership of the structured firm’s equity.

How should the exposure to the variability of a structured entity which holds a financial asset be assessed? Within a securitization arrangement, the seller has relinquished legal ownership of C100 worth of mortgage receivables that accrue interest over a lengthy period of time. In return, the seller has received C93 in cash from a structured entity (SE). The Special Entity (SE) finances the acquisition of the outstanding payments by issuing extended-term promissory notes to the investors of C93. The Special Entity (SE) will utilize the income earned from the mortgage receivables to cover the interest payments owed on the notes issued to investors. The seller will maintain responsibility for overseeing the underlying receivables. It has been determined that the seller functions as the main party responsible for managing the receivables, indicating that the seller is not acting on behalf of the investors. If the amount recovered exceeds C93, the seller will receive the surplus amount. For example, if C97 is recovered, the seller will receive an additional C4. The anticipated losses on the receivables amount to C3.  Is the SE’s exposure to variable returns: ·        the gross amount of C100, of which C7 is absorbed by the seller and C93 is absorbed by the note-holders; or ·        the net amount of C93, being the amount of reduction in the previous exposure of the seller, all of which is absorbed by the note-holders? Solution The vulnerability to fluctuating returns of the SE pertains to all C100 of the receivables. The Special Entity (SE) possesses the entitlement to the cash flows generated by the entire C100 of the receivables, as well as the corresponding economic exposure to potential risks in the event that any of the receivables default on payment. The seller has assumed the risk associated with the initial C7 tranche of losses that may occur on any of the C100 receivables. The seller’s exposure pertains to all of the outstanding amounts owed to them. Furthermore, although the seller’s greatest potential loss is capped at C7, the seller assumes the initial amount of any losses and its maximum exposure of C7 is considerably higher than the anticipated losses of C3. As a result, the seller bears almost all of the fluctuations in returns. The seller possesses the authority to oversee and control the underlying receivables, so exerting influence over the relevant activities of the SE. Therefore, it is probable that the seller has authority over the SE and should merge it. On the other hand, the note-holders have only taken on the risk of the most recent C93 of losses. Although the seller’s exposure is smaller in absolute terms, it contributes only a small portion of the predicted range of returns.

Investor’s ability to use its power to affect the structured entity’s returns

Whether the investor has the capacity to utilize its authority for its own advantage, specifically if it is functioning as a principal or an agent. This is typically a crucial factor to take into account, as structured businesses often have limited senior management, a small workforce, and few or no internal processes. A structured entity has the option to delegate important services and duties, as well as the corresponding decision-making authority, to either its investors or other parties. Outsourced powers may include significant rights over relevant operations, even if these powers are used outside the legal boundaries of the organized company and are dependent on particular events. It is imperative to ascertain whether the individual with these abilities is functioning as an agent or a principal in such circumstances.

Unconsolidated structured entities

If an entity determines that it is not necessary to consolidate a structured entity, it must comply with the disclosure requirements outlined in IFRS 12. IFRS 12 mandates the provision of information that allows readers of an entity’s financial statements to comprehend the type and scope of the entity’s involvement in unconsolidated structured entities, as well as assess the risks associated with these involvements.

Subsidiaries acquired with a view to disposal

A subsidiary that is purchased and is intended to be sold, and fits the criteria of being classified as an asset held for sale, is not exempted from consolidation. However, it is quantified and recorded according to the International Financial Reporting Standards (IFRS) 5, initially at the fair value minus the costs associated with selling.

A subsidiary that is retained for selling and is recognized as a disposal group is not exempted from consolidation. The company is consolidated, but, its performance, assets, and liabilities are shown individually. The subsidiary’s results will be classified as a ceased operation and presented as a consolidated figure on the income statement, encompassing the sum of:

• The post-tax profit or loss of the discontinued operations.
• The post-tax gain or loss recognized on measuring the disposal group at fair value less costs to sell.

Continuous assessment

An investor must reevaluate its control over an investee if there are indications that any of the three criteria of control have changed.

An investor should consider any changes in the exercise of power over an investee when assessing their level of control over that investee. For instance, alterations in the process of making decisions regarding pertinent activities could result in a decrease in the significance of voting rights. Alternatively, other agreements or contracts may grant other parties the present capacity to control relevant operations.

When should the restructuring of a loan result in consolidation by the lender? Background Banks may encounter troubled loans, leading to the need for restructuring of the lending agreements. Occasionally, debt may have been altered and/or prolonged, but the connection between the borrower and the bank still unequivocally remains that of a borrower and a lender. For instance, the bank does not acquire any ownership stake or convertible instruments and only possesses protective rights over the borrower’s underlying business. Alternatively, in certain situations, the loan may have been entirely or partially exchanged for equity instruments, such as preferred shares or convertible instruments. As a result, the lender has been more involved in overseeing the borrower’s business activities. The borrower may have also acquired the entitlement to request a substitution, even if it has not yet been executed. In certain cases, it is possible for an administrative receiver or liquidator to be appointed. The debt restructuring will prompt the bank to assess whether it has control over the borrower and if the Trustee has the right to replace assets, leading to a potential consolidation. The objective of this analysis is to delineate the elements that should be taken into account when doing this assessment, following the occurrence of a default. The main goal of the evaluation is to distinguish between situations where the bank still functions as a lender, despite changes in its rights due to a troubled lending relationship, and situations where the bank has taken control of the underlying operating business or has acquired the right to do so. Typically, the bank is unlikely to consolidate in the earlier scenarios, but likely to do so in the latter situations. In making this determination under IFRS 10, it is necessary to decide whether the bank now controls the borrower. Control is held by an investor where it has: ·        power over the investee; ·        exposure, or rights, to variable returns as a result of its involvement with the investee; and ·        the ability to use its power over the investee to affect the amount of the investor’s returns. The loan provided by a bank would expose it to fluctuating returns. An evaluation will be necessary to determine if the bank has authority over the investee and if its exposure to fluctuations in returns is significant enough to show that it is a controlling entity. If the bank has the authority to make choices on important activities and is exposed to enough unpredictability, its engagement is deemed to be a form of control, likely meant to safeguard against further losses. It is beneficial to contemplate which decisions include actively participating in the administration of the business, as opposed to decisions that are focused on protecting the firm. Protective rights encompass the power to reject spending beyond a specific threshold that is not anticipated to happen as part of regular corporate operations (for instance, if it is not mentioned in the business or operating plan created during the restructuring process). When examining control, it is important to consider both the decision-making rights over the borrower’s relevant activities and the type of the investment given by the bank, as well as its exposure. The bank’s level of exposure to the borrower’s returns variability is expected to provide additional evidence of control. As the level of risk increases, the bank is more motivated to acquire the necessary rights in order to attain power. When assessing the extent of risk, the bank will take into account the collateral replacement rights in case of a downgrade. This includes all forms of capital of the entity, such as subordinated debt, preference shares, common shares, and convertible debt. This advise largely focuses on corporate lending, namely corporate real estate credit. The following features should be taken into account while assessing these loans, as well as considerations for cases when an organization is undergoing formal liquidation. Loans extended to other structured companies, such as securitization, may include distinct characteristics that enable a lender to recoup their investment in case of financial hardship. Nevertheless, certain traits and concerns outlined below may still be relevant. The essence of the connection between the bank and the borrower is crucial in determining control, and other aspects will need to be taken into account. Each circumstance will be unique, and it is important to take into account all relevant aspects and their interplay. Certain instances may lack clear-cut solutions and necessitate the exercise of judgment. Finally, this analysis specifically examines the reevaluation of control over the formal restructuring of a lending arrangement, as well as situations where an administrative receiver or liquidator has been appointed. This advise may also apply to other scenarios in which a bank actively monitors the business activities of a borrower, potentially leading to control. Nevertheless, it is uncommon for a default to directly lead to the bank gaining control, unless the default clauses in the agreement state otherwise. Restructuring of the lending arrangements Indicators of power Examples of factors that might indicate that the restructuring resulted in the bank obtaining power over the borrower are set out below. As noted above, all relevant factors and the interaction between them should be considered in determining the substance of the relationship between the bank and the borrower. Decision-making considerations: ·        The management team is acting in the capacity of an agent for the bank. Indicators of such an agency relationship might include: o   The bank has appointed the turnaround management team (to replace the current management team), even if the turnaround management team holds the majority of the ordinary shares. o   The bank has the ability to remove, replace or veto the management team. o   The bank has guaranteed management’s compensation in the event that the entity is unable to pay. ·        Although the bank does not have a majority of the seats on the board, board decisions are subsequently submitted to the bank for consent. These decisions include decisions that are participating in nature. Participating decisions relate to operating and financial policy decisions made in the ordinary course of business (such as decisions that implement the business or operating plan established at the time of the restructuring). Examples are: o   approval of annual operating budgets; o   approval of capital expenditure, disposals, etc. that would be o   expected to be in the ordinary course of the entity’s business; o   approval/termination of management; o   approval of management compensation; and o   approval/termination of board members. In this scenario, the final decisions are not taken by the board. Therefore, the bank’s lack of a majority of board seats is not significant. If the bank does not endorse or agree with a choice, the management team is required to suggest an alternative that meets the bank’s requirements. The bank can demonstrate this authority through many means. An instance of this would be if the board or management team were to implement a decision that has been rejected by the bank. In such a case, it would be considered a default, and the bank would have the authority to demand repayment of the loan and compel the sale of assets. .        The bank possesses options, warrants, or other presently exercisable rights that grant it the ability to assume control. When assessing whether certain rights are substantial, it is important to consider factors such as the bank’s financial and operational capacity to exercise those rights. It is imperative to evaluate the conditions of a transaction to verify that they possess commercial significance. If the terms are such that it is impossible to imagine any party using the rights, then those clauses are ignored. An instance could arise when the exercise price is intentionally fixed at a non-commercial level that is deliberately high. Indicators of no power Examples of factors that might indicate that the restructuring has not resulted in the bank obtaining power over the borrower are set out below. All relevant factors and the interaction between them should be considered in determining the substance of the relationship between the bank and the borrower. Decision-making considerations: The current management team and directors continue to hold their positions and retain a significant financial stake in the business’s long-term prosperity. For instance, this situation may arise when the fundamental company strategy and management team are strong, but the borrower faces challenges due to prevailing market conditions. The bank does not have authority to approve judgments that are considered to be participatory in character. All approval rights pertain to decisions that have a protective purpose, such as granting approval for significant capital expenditures, acquisitions, or disposals that are not anticipated to happen as part of the normal business operations (as indicated by being outside the business or operating plan established during the restructuring).·If the bank can veto ‘participating’ decisions, but there is a deadlock provision such that disputes over participating decisions are resolved through independent arbitration (that is, the bank does not have the ability to enforce the ultimate decision). As part of the bank’s initial restructuring, it is requested that the current directors replace the management team. Nevertheless, the newly appointed management team is accountable to the current board of directors. The bank lacks the authority to remove or participate in decision-making any further. The board and/or the management team is functioning as an autonomous and influential majority shareholder, as demonstrated by their significant financial stake in the business’s long-term prosperity. In this scenario, although it seems that the bank lacks control, if the bank possesses the ongoing capacity to compel the board to replace the management team, the bank must assess if it possesses sufficient authority to govern the board. The bank is part of a syndicate of lenders that makes decisions collectively, and the bank does not have power over the ultimate decisions made by the syndicate. A default has occurred but the bank has entered into a ‘standstill agreement’ under which the bank (along with other creditors) has formally agreed that it will not take action against the company to enforce a claim for payment for a specified period of time. A bank will waive breaches of loan covenants as part of this standstill. The existence of a standstill might indicate that the bank is unable to exercise power over the borrower until the end of the standstill period. However, it should be evaluated if the end of this time of inactivity will happen prior to the date when judgments regarding pertinent activities must be taken. If the standstill period concludes prior to this date, the Trustee’s obligation to mitigate credit risk by exercising its recovery powers is more substantial than the credit risk faced by the Bank. The power requirement in IFRS 10 does not endorse consolidation by the Bank. It does not provide support for asset seizure and liquidation rights in case of default on the AAA bonds. As the Trustee acts on behalf of the note-holders, there is a question over whether the note-holders can be credited with the powers mentioned above. Nevertheless, because the note-holders are varied and have no connection to each other, none of them possess the authority to independently instruct the Trustee or a significant entitlement to replace the Trustee. The powers of the Trustee cannot be ascribed to any one note-holder. According to paragraph B59 of IFRS 10, if an agent represents numerous principals, each principal must still evaluate whether they have authority. The proximity to the bank may nevertheless be regarded as significant and provide influence. Occasionally, the duration of the standstill phase may be brief, lasting only two to three months, and there may not be any substantial decisions to be taken regarding pertinent activities at this time. Given the current situation, it is improbable that the standstill agreement will have any impact on the bank’s rights. However, if there is a longer period of inactivity, lasting several years, it is probable that important choices will have to be taken regarding essential activities during this period. Consequently, the bank will not have authority or control. The particular facts and circumstances will need to be assessed carefully, and significant judgement might be required. Exposure to variable returns ·        The bank might be exposed to variable returns in a number of ways, including equity interests and debt. It is the bank’s total exposure to variability of returns which should be considered, not just the exposure arising from equity interests. If a bank is concluded to have power, it is likely that it will be such a significant lender that it will also have sufficient exposure to variable returns to have control. ·        For example, the bank might have provided most or all of the current financing of the entity (both debt and equity) when considering the overall capital structure. Although the bank might hold a relatively small percentage of the common ‘voting’ stock, the common stock might not be substantive in comparison to the other tranches of capital (including preference shares or debt). ·        It should also be considered whether there are ‘swamping rights’ whereby, on an exit event, the bank’s economic interest increases significantly, such that it obtains the majority of any benefits from exit. ·        It is unlikely that a bank will have power and will not have exposure to variable returns. However, indicators that the level of exposure might not be sufficient to provide control include: ·        The bank has modified the terms of the debt instrument (for example, by deferring repayment or extending the term), but its investment remains debt before and after the transaction and it takes no significant equity stake. The bank’s return is no more than what it might demand for other high-risk loans. ·        The bank takes no significant equity stake (common or preference shares, or other convertible or optional instruments) or debt, and there is substantive equity investment from other investors. ·        There are other substantive subordinate investors (for example, the bank might provide lending in as part of a syndicate of banks). The other equity holders/management team are credible, independent holders. Current ability to exert control versus intent ·        While the aforementioned factors may suggest that the bank has no intention of exerting control over the borrower, it is crucial to verify that the bank does not possess or have the capacity to acquire any rights that would grant it authority. The definitions of ‘power’ and ‘control’ under IFRS 10 are determined by the investor’s rights, whether currently possessed or potentially obtainable, rather than the investor’s intentions. Control is determined by the bank’s ability to exercise its rights when making choices regarding the direction of relevant activities. This includes both rights that can currently be exercised and those that are not now exercisable but are regarded significant. Even if past history suggests that a bank has not actively exerted control or is unlikely to do so, the bank would still be considered to have control if it currently possesses the ability and power to do so.Administrative receivership and liquidation scenarios Administrative receivership and liquidation scenarios Where an administrative receiver or liquidator has been (or is to be) appointed following a loan default, the effect on the power held by the lender should also be considered: ·        Who has the ability to appoint and remove the administrative receiver or liquidator? Although the procedures to appoint or remove will typically involve an application to the courts, this might vary according to local legislation. The holder of a fixed or floating charge might have the power to nominate a chosen receiver or liquidator, or to order their removal and replacement. ·        Has the entity been put into formal administrative receivership or liquidation and, if so, who controls it during the period? Typically, an entity in receivership or liquidation is controlled by the courts, and the administrative receiver or liquidator will be required to act in the interests of all creditors, not just the bank. However, the process might vary by jurisdiction. The bank should understand the legal process and evaluate its rights to participate in the process (for example, through representation on a credit committee), to ensure that it does not assume control through the process as a primary creditor. If the administrative receiver or liquidator is required to clear decisions with the bank (for example, where the bank has a majority representation on the credit committee), it would be considered to be an agent of the bank, and the bank would be viewed as holding the power. ·        Another factor to consider, in determining whether the administrative receiver or liquidator is acting as an agent of the bank, is whether the bank is responsible for negotiating the fee to be charged. If the ability to negotiate this fee allows the bank to influence the administrative receiver or liquidator, this might provide the bank with power. ·        If the entity has not been put into formal administrative receivership or liquidation, has a new management team been appointed to sell off the assets? If so, have the detailed plans for sale been established by the bank at the point of renegotiation – with management acting in accordance with the established plans? Is the bank required to approve proposed sales of assets? If the bank was extensively involved in developing the plan and/or approving the disposal activities, this might be an indication of control (as described in more detail above). ·        Has the bank appointed a management team to act as an agent to sell-off the assets of the business in return for a fee, with perhaps some (although minimal) upside? If so, can the bank remove the management team? Other considerations Non-core activities refer to business operations that banks are not generally involved in and may lack the capacity or knowledge to manage. The decision to consolidate these activities depends on the bank’s actual ability to exercise control over them. Consolidation is mandatory even if the activities are non-core or unrelated to the bank’s other activities. Temporary control refers to the situation where a bank invests in enterprises without a long-term purpose and intends to exit the investment in the short term. However, it is important to note that there is no exemption from consolidation for temporary control. According to IFRS 5, a subsidiary that is purchased solely for the purpose of being sold might be classed as “held for sale” and considered a discontinued operation if:· ·        The sale is expected to be completed within one year, although the period could be extended if delay is caused by events or circumstances outside the bank’s control and the bank remains committed to sell. ·        It is highly probable that the other criteria in IFRS 5 will be met within a short period (of no more than three months) following the acquisition, including: o   available for sale in present condition; and o   sale is highly probable (that is, management has committed to a plan to sell, an active programmed to locate a buyer and complete the plan has been initiated, and the subsidiary is actively marketed at a fair value price). If these criteria are met, the balance sheet and income statement presentation could be collapsed, and some relief from a full fair value exercise could be provided. Significant influence – This examination specifically examines signs that demonstrate a bank’s level of control. Nevertheless, if the bank lacks control but possesses an equity stake in the borrower, it should evaluate whether it holds substantial influence. If the bank has a substantial influence and holds an ownership stake in a company, it would use the equity method of accounting, unless the investment is specifically classified as being at fair value through profit or loss according to IAS 28. The term “significant influence” refers to the ability to participate in the financial and operational decisions of the investee, without having control over them. Several of the identical indicators mentioned before will be applicable in determining the presence of considerable influence.

Investors should also evaluate whether there has been any alteration in the determination of whether they are acting as the main party or as an intermediary. Alterations in the connections or rights of investors and other parties can impact the determination of whether the investor is functioning as a principal or an agent.

An investor’s classification as a principle or an agent remains unaffected by market conditions, unless such factors alter the three elements of control or modify the principal-agent relationship.

Loss of control

An investor relinquishes control of an investee, specifically its subsidiary, when it no longer possesses the authority to dictate the investee’s significant actions and therefore forfeits the capability to modify its financial gains.

An investor may relinquish control of a foreign investee if it becomes subjected to the governance of a certain country’s government. In cases when a government has implemented limitations on the transfer of cash from a country to an investor, the investor may lose control over the entity they have invested in. This is because they are no longer eligible to gain any profits or benefits from their involvement with the entity.

While the loss of control may only be temporary, the parent will need to separate the investee from its financial statements starting from the date when control is lost. A parent must consistently evaluate its level of control over its investees.

Control can be altered due to external factors, such as the expiration of the investor’s decision-making authority, even without the investor’s involvement.

Accounting for loss of control

The income and costs of a subsidiary should be incorporated into the consolidated financial statements as long as the parent company maintains control over the subsidiary. When a company is no longer considered a subsidiary, its previous parent company may still hold a stake in the company and it may continue to be classified as an associate, a joint venture, or simply an investment.

When a company loses control of a subsidiary, it must report a gain or loss on the sale of the subsidiary’s equity and also revalue any remaining noncontrolling investment in the consolidated financial statements. A loss of control is an economic occurrence that is comparable to obtaining control, and so it is classified as a remeasurement event.

If a parent loses control of a subsidiary, it:

• De-recognizes any assets (including goodwill) and liabilities of the subsidiary at their carrying amounts at the date when control is lost.
• De-recognizes the carrying amount of any non-controlling interest at the date when control is lost (including any components of accumulated other comprehensive income attributable to it).
• Recognizes the fair value of the proceeds from the transaction, event or circumstances that resulted in the loss of control. Recognizes any investment retained in the former subsidiary at its fair value at the date when control is lost.
• Recognizes any distribution of shares of the subsidiary to owners in their capacity as owners.
• Reclassifies to income or transfers directly to retained earnings, if required in accordance with other standards, the amounts recognized in other comprehensive income in relation to that subsidiary.
• Recognizes any resulting difference as a gain or loss in the income statement attributable to the parent.

IFRS 12 mandates that a parent company must declare the total gain or loss resulting from the subsidiary’s loss of control, as well as the specific component of the gain or loss that is associated with the retained non-controlling investment. Therefore, it is necessary to calculate the portion of the gain or loss on the retained non-controlling investment in order to acquire the required information for disclosure.

It is crucial to recognize any delayed gains or losses in accumulated other comprehensive income that can be attributed to the subsidiary. The total amount of deferred income related to the subsidiary is realized through the disposal. Any sum that would be moved to the profit or loss category when the associated assets or liabilities are sold is transferred to profit or loss, therefore becoming a portion of the gain on disposal. This encompasses the portion of gains or losses previously acknowledged in other comprehensive income on foreign exchange differences, cash flow hedges, and other specific assets and liabilities (such as available-for-sale financial assets), which are attributable to both the parent and the non-controlling interest. The revaluation excess associated with fixed and intangible assets is transferred from reserves directly to retained profits, and it is not included in the gain or loss recorded upon sale.

If a subsidiary is partially owned before control is lost, the non-controlling interests held by third parties are not adjusted to their fair value. As the subsidiary is being separated, the value of the non-controlling interest’s share of the subsidiary’s net assets is removed from the non-controlling interest’s value, without any profit or loss. Hence, when an 80% ownership share is sold in a subsidiary, the 20% minority interest will no longer be recognized in relation to the entire net assets. As a result, only 80% of the net assets will be considered when calculating the profit or loss from the sale.

If an organization decides to adopt International Financial Reporting Standards (IFRS) for the first time and had previously accounted for goodwill as a deduction from equity under the prior Generally Accepted Accounting Principles (GAAP), it should not include that goodwill in its initial IFRS statement of financial condition. In addition, it is important not to reclassify the goodwill as profit or loss in the event of disposing of the subsidiary or if the investment in the subsidiary becomes impaired.

If the parent company anticipates selling or relinquishing control of a subsidiary, it is necessary to assess the subsidiary’s goodwill and long-lived assets for impairment, following the guidelines outlined in IAS 36 and IFRS 5. Impairment losses on goodwill or long-lived assets must be acknowledged in the income statement.

How might an investor lose control of an investee? Loss of control can occur when an interest in an investee is sold, or through other methods. Loss of control can occur even if there has been no change in the investee’s ownership interest, either in absolute terms or relative to other owners. There are several scenarios in which an investor may lose control over an investee. These may include the following:· ·        An investor sells all or part of its ownership interest in its investee, thereby losing its controlling interest in its investee. ·        A contractual agreement that gave control of the investee to the investor expires. ·        The investee issues share to investors other than the investee, thereby reducing the investor’s ownership interest in the investee so that the investor no longer has a controlling interest in the investee. ·        A power of veto is granted to a third party. ·        The investor enters into an agreement with a non-controlling interest holder that gives both parties joint control. ·        An investee becomes subject to control by a government. ·        Insolvency or administration procedures are in progress. If an investee is undergoing an insolvency procedure and authority over the entity has been transferred to a designated official, the result is that the entity will no longer be considered a subsidiary of the investor and should not be included in the consolidation. The extent to which formal insolvency procedures in a specific country result in a loss of control depends on the legislation in that jurisdiction.

Loss of control when a subsidiary declares bankruptcy Question #1 – When should a parent company, which is not in bankruptcy, deconsolidate a subsidiary that is a business that has filed for bankruptcy? A parent should deconsolidate a subsidiary that is a business as of the date the parent no longer has control of the subsidiary in accordance IFRS 10. Instances of events that lead to the deconsolidation of a subsidiary include when a subsidiary comes under the supervision of a government, court, administrator, or regulator. Typically, when a subsidiary files for bankruptcy protection, the parent company loses control over the subsidiary since the bankruptcy court must approve all major decisions. As a result, the subsidiary should be removed from the parent company’s financial statements on the date of the bankruptcy filing. Question #2 – Should a parent company, which is not in bankruptcy and has a negative investment in a subsidiary, recognize a gain upon deconsolidating a subsidiary that files for bankruptcy if that subsidiary is a business? Based on IFRS 10, a parent would take back the negative investment and figure out how much gain or loss to record on the date of filing for bankruptcy. When making this choice, the parent should think about the fair value of the investment it has kept. This means that the company has to think about whether it needs to separate any obligations that come from owning the subsidiary. If it does, it could lower the gain or raise the loss on deconsolidation (for example, if the parent company has guaranteed or the court will hold the parent company responsible for some of the subsidiary’s obligations).

Loss of control of a wholly owned subsidiary with an interest retained in an associate Entity A owns all of its subsidiaries. It sells 60% of its stake in the subsidiary for C360 million, which means it no longer controls the company. It will separate the subsidiary from its parent company and use the equity way of accounting to record the remaining 40% interest as an associate. The fair value of the remaining investment is found to be C240 million at the dates of disposal. If you take away the goodwill, the subsidiary’s known net assets are worth C440 million. Goodwill worth C60 million has been recorded for the shares in the company that were bought in the past. Before selling the company, Entity A checked to see if the goodwill and long-term assets had been damaged, but there was none. There is a credit of C4 million in the available-for-sale reserve and a credit of C10 million in the revaluation reserve for the business. The tax effects of the income have not been taken into account. The accounting entry on the disposal date for the 60% interest sold, the gain recognized on the 40% retained investment and the de-recognition of the subsidiary is as follows:   Cm Cm Dr Cash 360 Dr Investment in associate 240 Dr Available-for-sale reserve 4 Dr Revaluation reserve 10 Cr Net assets (including goodwill) 500 Cr Retained earnings 10 Cr Gain on disposal of controlling interest 104 The gain or loss on the interest sold, and on the retained investment recognized in the income statement, is calculated as follows: Cm Fair value of the consideration 360 Fair value of retained investment 240 600 Less: Carrying value of former subsidiary’s net assets (C440m + C60m) (500) Available-for-sale reserve transferred to income 4 Gain on interest sold and on retained investment 104 The consolidated financial records show the C104 million gain from selling the interest and keeping the investment. This gain is shown in the income statement. IFRS 12 also says that the part of the gain or loss that is due to recalculating the remaining non-controlling investment to its fair value must be shared. Here’s how to figure this out: Cm Fair value of retained investment 240 Percentage retained of carrying value of subsidiary ((C440m +C60m) × 40%) (200) Gain on retained investment 40

Partial disposal of a partially owned subsidiary with an interest retained in an associate Business B owns 80% of a company. It sells half of the subsidiary for $300 million and no longer has power over it. It will separate the division from its parent company and use the equity method to account for the last 30% interest as an associate. The real worth of the kept investment is found to be C180 million at the dumping date. It is worth C440 million to hold the subsidiary’s known net assets, and there is no goodwill. The 20% non-controlling interests owned by third parties before the deal were worth C88 million at the time of the deal. There is a credit of C4 million in the available-for-sale reserve and a credit of C10 million in the revaluation reserve for the business. The tax effects of the income have not been taken into account. The accounting entry recorded on the disposal date for the 50% interest sold, the gain recognized on the 30% retained investment, and the de-recognition of the subsidiary is as follows:   Cm Cm Dr Cash 300 Dr Investment in associate 180 Dr Available-for-sale reserve 4 Dr Revaluation reserve 10 Dr Non-controlling interest 88 Cr Net assets (including goodwill) 440 Cr Retained earnings 10 Cr Gain on investment 132 The gain or loss on the interest sold, and on the retained investment recognized in the income Cm Fair value of the consideration 300 Fair value of retained investment 180 180 Carrying value of the non-controlling interest 88 568 Less: Carrying value of former subsidiary’s net assets (C440m + C60m) (440) Available-for-sale reserve transferred to income 4 Gain on interest sold and on retained investment 132 There was a gain of C132 million on the sale of the interest and the holding of the investment. This is shown in both the income statement and the financial records. IFRS 12 also says that the part of the gain or loss that is due to recalculating the remaining investment to its fair value must be shared. Here’s how to figure this out: Cm Fair value of retained investment 180 Percentage retained of carrying value of subsidiary (C440m × 30%) (132) Gain on retained investment 48

Partial disposal of subsidiary with off market lease arrangement Entity A owns all of division B. Entity A rents an office building to subsidiary B for a small amount of money, which is less than the market renting rate. Entity A gives a third party that has nothing to do with it 60% of its ownership in division B. Entity A calls the lease agreement a working lease, and it stays the same after the sale. On the date of sale, entity A separates company B from itself. In order to figure out how much gain or loss there was when subsidiary B was split up, entity A needs to know what part of the buyer’s payment was for buying the 60% ownership in subsidiary B and what part was for paying entity A to keep renting to its former subsidiary B under an unfavorable lease contract. On the balance sheet, the amount that is linked to the off-market lease deal should be written down at its fair value. This lowers the value of the payment given for breaking up subsidiary B, which means that entity A recognizes less of a gain.

Multiple transactions or agreements that result in loss of control

If an entity sells more than one thing about a subsidiary, like 40% of the subsidiary and then another 20% of the subsidiary soon after, that company could lose control of the subsidiary. There are times when more than one plan needs to be recorded as a single transaction. The terms and conditions of the agreement as well as its economic effects should be taken into account when deciding whether to treat it as a single transaction.

If several transactions that lead to a loss of control are seen as different transactions, then each one should be accounted for separately based on what it is. Transactions that don’t lead to a loss of control are recorded as equity transactions. Any differences between the amount paid and the carrying value of the non-controlling interest should be recorded in equity instead of the income statement. In the financial statements of the reporting entity, the effects of these kinds of transactions on equity are shown individually.

However, if there are multiple transactions and the entity decides that they should be treated as a single transaction, which means that control has been lost, the gains and losses from all of the transactions, along with the revaluation of any investments that were kept, should be shown in the income statement.

If any of the following signs are present, it may mean that more than one arrangement should be handled as a single one:

• The arrangements are entered into at the same time or in contemplation of each other.
• The arrangements form a single transaction designed to achieve an overall commercial effect.
• The occurrence of one arrangement is dependent on the occurrence of at least one other arrangement.
• One arrangement considered on its own is not economically justified, but it is economically justified when considered together with other arrangements. An example is when one disposal of shares is priced below market and is compensated for by a subsequent disposal priced above market.

Multiple transactions or agreements that result in gaining control

A company might take over a business after making at least two purchases of the business. For example, it might buy 40% of the business and then soon after buy another 20% of the business. The same rules that were talked about above for losing control can also be used to take back control of a business in more than one situation. Companies could use the listed criteria to decide if a set of transactions that lead to taking control should be seen as a single transaction.