Concerns over the accounting for off-balance sheet arrangements and special purpose vehicles have led to the issue of new accounting standards.
In a major project the International Accounting Standards Board (IASB), in conjunction with the US Financial Accounting Standards Board (FASB) has sought to address concerns that emerged during the financial crisis in relation to offbalance sheet arrangements. The project has looked to both tighten the rules for when consolidation is required and improve transparency of all interests in other entities by requiring further disclosure.
In May the IASB published a package of three new standards which both brought its project to an end and resulted in broad alignment of IFRS and US GAAP.
- IFRS 10 'Consolidated financial statements' continues to require consolidation based upon the existence of control, but modifies the definition of control.
- IFRS 11 'Joint arrangements' covers both joint ventures and joint control.
- IFRS 12 'Disclosure of interests in other entities' sets out the disclosures for entities that have interests in subsidiaries, joint arrangements or associates.
All three standards apply for periods beginning on or after 1 January 2013. When determining whether one entity controls another, IFRS 10 requires reference to three elements of control:
- 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.
'Power' is defined by the new standard as when an investor has existing rights that give it the current ability to direct the relevant activities. A simple example would be voting rights, but the IFRS also requires consideration of the economic substance of the arrangements existing between the two parties.
Assessing control by reference to the three elements will not always be straightforward, and in more complex situations significant judgement will be required. Furthermore, if there are changes to one or more of the three elements of control after it is initially established, the IFRS requires an investor to reassess whether it has gained or retained control.
Smith & Williamson commentary
Many preparers of consolidated accounts will find that the new standard results in little or no change to their financial statements. However, other preparers, for example those with links to special purpose entities, will need to look at the nature of their relationships in the context of the new standard. It is possible that some related entities that were previously treated as associates, or not included in consolidated accounts at all, will become subsidiaries under the new standard.
IFRS 11 introduces two categories of joint arrangements – joint operations and joint ventures. The new categories provide a slightly different framework to that found under the previous standard, IAS 31 'Interests in joint ventures' with the category of joint operations broadly combining jointly controlled assets and jointly controlled operations.
The accounting requirements for joint ventures will change with the introduction of IFRS 11. Under the new standard a joint venturer is required to recognise an investment and to account for it using the equity method. The option that existed in IAS 31 to account subsequently for joint ventures using proportional consolidation will not be available under the new standard. Any change in accounting arising from adopting IFRS 11 will have to be accounted for retrospectively, giving rise to a restatement of comparative figures in the first year of adoption.
Smith & Williamson commentary
Proportional consolidation has been less widely used in the UK than in some other countries, but in certain industries it has become popular because preparers argue it better presents the way in which their joint ventures operate. Those preparers who have proportionately consolidated will need to consider how they will explain the effects of the change in presentation.
Any groups that are subject to loan covenants that are assessed on consolidated figures may find that the changes arising from IFRS 10 and 11 could cause them to breach existing covenants and should plan to discuss this with their banks as soon as possible.
IFRS 12 aims to provide users of financial statements with information about all interests the reporting company has in subsidiaries, joint arrangements, associates and unconsolidated structured entities. The disclosure requirements are wideranging and go beyond current requirements for all such entities. The new requirement will provide not just quantitative data about the effect of interests in other entities on the reported consolidated figures but also qualitative information about the nature of these interests and the risks associated with them.
Smith & Williamson commentary
IFRS 12 will provide valuable information to users who are interested in understanding the true risk exposure of a group. However, the standard will also increase the disclosure burden on preparers of consolidated accounts, and in some instances preparers' existing financial reporting systems may not capture all the information required, particularly in relation to unconsolidated entities.
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