Consolidations: who is really in control?

One of my favourite topics to teach financial reporting students is consolidation. Students easily grasp the principles of acquisitions and how consolidated financial statements are formed. In many acquisitions, the group structure is reasonably clear cut, with a company acquiring all of the shares and accounting for the acquired company as a subsidiary.

After introducing the topic to students, it is often time to acknowledge to them that there can be some cases where things are maybe not as clear. A huge part of this can relate to identifying the level of influence or control in a scenario.

Big impact?

The distinction of whether control exists or not can be key for financial statements, as it can have a large impact on consolidated financial statements. If control does exist, then 100% of the income, expenses, assets and liabilities of the entity are included in the consolidated financial statements.

If control is deemed to not exist in situations, entities may then examine whether there is significant influence or joint control. In these cases, the group would use the equity method. This would mean that there would be one line in the statement of financial position showing the value of the investment, and one line in the statement of profit or loss showing the group’s share of profit from that entity.

Clarity

With that in mind, the International Accounting Standards Board has produced guidance on the crossover between the varying standards dealing with consolidated financial statements. IFRS 10, Consolidated Financial Statements, often interacts with IFRS 11, Joint Arrangements, and IAS 28, Investments in Associates and Joint Ventures, as the basis of control affects all of them.

IFRS 10 states that an investor has control when it has all of the following elements:

• power over the investee
• exposure, or rights, to variable returns from its involvement with the investee
• the ability to use its power over the investee to affect the amount of the investor’s returns.

Common indicators of having power include having the ability to appoint most of the board, regardless of the number of shares owned by the entity. IFRS 10 gives a few more indicators of whether power exists, such as looking at the rights available to parties to direct activities.

At this point, most students despair at why things aren’t simpler and there isn’t an easy rule to follow. However, occasionally, a keen undergraduate really grasps the judgment and can illustrate that. This was recently noted in a report from a final-year student who analysed online grocer Ocado’s UK financial statement.

Perceived inconsistency

The issue relates to a 50:50 joint venture of Ocado Retail Limited in the UK, between Ocado and high-street retailer M&S for online grocery deliveries. Despite legally being a joint venture, where both parties hold 50% of the voting rights, the student noted that neither Ocado nor M&S account for Ocado Retail Limited as a joint venture under IFRS 11 in their consolidated financial statements.

This again comes back to the principle of control. Ocado holds an agreement giving it determinative rights in relation to the approval of Ocado Retail’s business plan and budget in addition to the appointment and removal of the CEO. On this basis, Ocado consolidates 100% of the results of Ocado Retail Limited, splitting out the 50% share of the profits (actually, losses) due to M&S at the bottom of the statement of profit or loss as a non-controlling interest.

As Ocado is deemed to have control, M&S doesn’t account for its share under the principles of IFRS 11, noting that it does not have joint control. With neither control nor joint control, it has deemed that it has significant influence. On this basis M&S has deemed the investment to be an associate and therefore accounts for its share of the investment using the equity method per IAS 28.

This situation means that despite both parties owning 50% and receiving 50% of the profits, they account for them completely differently. Ocado’s revenue, expenses, assets and liabilities contain 100% of the results of the joint venture, whereas M&S includes none of these, simply having one line representing the value of the investment in the statement of financial position and one line representing its share of profit from the associate.

The only accounting standard that Ocado and M&S both use for the investment is IFRS 12, Disclosure of Interests in Other Entities. The purpose of IFRS 12 is to inform the user of the nature and risks of the interested party, along with how they affect the financial statements.

These different accounting treatments showcase the importance of understanding the basis of control under IFRS 10. While students may not appreciate the lack of specific rules, the IASB would point to the fact that IFRS remain a principles-based set of standards.