Consolidated Accounts - A Changing Story
Among the concerns highlighted by the turmoil and financial crisis experienced in recent years has been the need to strengthen the accounting model for consolidated accounts, and the related disclosures. Specific concerns include off-balance sheet accounting where securitisation vehicles, asset-backed financing and other such arrangements were prevalent in the banking and related sectors. Additionally, there were instances where financial institutions provided funding or other support to such vehicles because they established or promoted them, and could not afford the reputational risk if they were to fail. The question of whether this represented control and hence the requirement for consolidation of those vehicles was one of the many factors which led to increased focus on developing a more robust consolidated accounts model.
The package of five
In response to the growing needs, the IASB published in May its 'package of five' new and revised standards addressing accounting for consolidations, involvements in joint arrangements and disclosure of investments with other entities. Each of the five standards has an effective date for annual periods beginning on or after 1 January 2013, with earlier application permitted. Special provisions apply which permit entities to early adopt all or elements of the disclosure standard, without having to early adopt all of it or the other standards.
Two key elements of the new standards are:-
- To have a single basis of consolidation for all entities, regardless of the nature of the investee, and that basis is control
- To establish disclosure objectives and specify minimum disclosures that an entity must provide to meet those objectives
These elements are the cornerstones on which the new standards are built with an overall objective of enabling users to understand the overall financial position and to help users understand the nature of and risks associated with interests in other entities.
Control is key factor
The new standard uses control as the basis for consolidation, irrespective of the nature of the investee, eliminating the risks and rewards approach which is the basis of many 'special purpose arrangements', and which may enable them to be excluded from consolidation under current standards. A number of other areas of current divergence have been addressed by the new standard, including control with less than majority voting rights, and the concept of 'de facto control'. The new standard identifies the following three elements of control, all of which must exist:
- Power over the investee
- Exposure, or rights, to variable returns from involvement with the investee
- The ability to use power over the investee to affect the amount of the investor's returns
The standard defines that power exists when the investor has existing rights that give it the current ability to direct the activities that significantly affect the investee's returns - the 'relevant activities'. Rights to direct relevant activities do not need to be exercised for them to provide an investor with power, and this gives rise to anomalies e.g. where two or more investors have the right to direct relevant activities. A number of factors may need to be taken into account when determining whether an investor has power over an investee and these may vary significantly depending on circumstances. A careful analysis of the investor's contractual and non-contractual rights as well as its related party relationships is necessary. The rights held need to be substantive in nature, rather than being restricted to protective rights.
The second criterion in the consolidation assessment uses the term 'returns' rather than 'benefits' to clarify that the economic exposure to an investee may be either positive, negative or both. This criterion is a support to the 'power over the investee', as multiple investors may share in the returns of the investee but only one investor will control an entity.
The third pillar of control, the ability to use power to affect returns, is also key to achieving control and binds together the first two criteria.
The standard requires a continuous assessment of control of an investee to consider changes in the underlying facts or circumstances relating to all three criteria comprised in control. That assessment would be carried out during each reporting period.
Disclosure - informing investors' needs
The new standard on disclosure is intended to integrate the requirements on interests in other entities, currently included in several standards and also adds additional requirements in a number of areas.
An entity should disclose information about significant judgements and assumptions it has made in determining whether it has control, joint control or significant influence over another entity. An entity should also provide these disclosures when changes in facts and circumstances affect the entity's conclusion during the reporting period.
Overall, the disclosures standard requires more information to be given by a parent regarding its subsidiary entities with particular emphasis on changing underlying circumstances, risks inherent in investments and those subsidiaries where there are non-controlling interests (NCI), including summarised financial information about each subsidiary with material NCI.
A major feature of the new standard is its requirements in relation to disclosure of interests in unconsolidated structured entities. The standard 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". The standard requires extensive disclosures to help users understand the nature and extent of an entity's interests in and risks associated with such vehicles, including:-
- The nature purpose, size and activities of the structured entity
- How the structured entity is financed
- The carrying amounts of assets and liabilities relating to interests in unconsolidated structured entities and how they compare to the maximum exposure to loss from those entities; and
- Any support provided to an unconsolidated structured entity when there is no contractual obligation to do so (including the reasons for providing such support)
Detailed information is required in a number of areas but the standard aims to strike a balance and avoid excessive detail which may not be helpful to users. Some aggregation of information is permitted.
Completing the 'package of five' are a new standard on 'Joint Arrangements' and revised standards on 'Separate Financial Statements' and 'Investments in Associates and Joint Ventures', with revisions being minimal on the first, and on the second in line with the new proposals on consolidated accounts. One of the major changes on joint arrangements is to remove the option to apply the proportional consolidation method, with equity accounting being required in all circumstances.
The IASB has made substantial progress in the area of consolidated accounts, and equity accounting. The more robust nature of the new accounting and disclosure requirements should address shortcomings which were highlighted during the financial crisis, with the overall objective being to provide improved information to investors and other stakeholders. This should assist with stakeholder protection and the ability to make well-informed investment and other economic decisions.
First published in Finance Dublin Online.