TOPIC 3 Introduction to Group Accounts

Learning Outcomes: MFRS 3, 10, 12 &127 Compare MFRS 127 and MFRS 10 in determining parent-subsidiary relationships Know definition of control provided by MFRS 10 Differentiated types of a group structure Know the regulatory framework for consolidation TOPIC 3Introduction to Group Accounts

Group consists of a parent and its subsidiaries A parent is an entity controls one or more entities Concept of Group

A subsidiary is an entity including an incorporated entity such as a partnership that is controlled by another entity (parent) Wholly owned subsidiary Partly owned subsidiary The part of the subsidiary shares not owned by the parent is owned by other investors called Non Controlling Interest (NCI) Test of existence of a parent-subsidiary relationship rests on control Cont.

Reasons for consolidated FSs • Supply of relevant information – to investors (impossible for investors to collate information from each entity • Comparable information – for investors to make comparison between entities • Accountability – management accountability extent to subsidiaries • Reporting of risk and benefits – CFSs allow assessment of risks and benefits

MFRS 127 “Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control.” (para 13) Cont.

Control VS Ownership interest • Control • If control exists, gives rise to a group structure • Ownership interests • Relevant when preparing group accounts. i.e. the net assets of partly–owned subsidiaries are allocated between the parent and the NCI based on their respective ownership interests.

Ownership interest MORE than half • i.e. 50% plus one more share of the subsidiary. • It can be direct or indirect interests through subsidiaries. • Here, control is presumed to exist unless clearly demonstrated such ownership does not constitute control. • #Refer examples (ownership int > half)

Ownership interest HALF or LESS Control exists: • under a statute or law. • E.g. Government owns “golden” share • by virtue of an agreement with other investors. • E.g. an entity owned 40% of OS and has an agreement to exercise the voting rights of an 11% held by other investor • “de facto” control • E.g. an entity holds a 40% stake and all the remaining equity shares are thinly spread out among the investing public investors and chances of them acting together to prevent the parent from controlling is remote.

Ownership more than HALF but no CONTROL Do not have unilateral control • E.g. a local investor entered into a joint venture agreement with foreign partner and set up a joint venture entity, but the agreement provides for a joint control. Thus, the JV company is not a subsidiary for the local company because it does not have unilateral control though the local company holds more than half ownership interest.

MFRS 127 (para 4) “… is the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities.” MFRS 10 (Appendix A) “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.” Control of an investee

Control (IAS 27 – former) Control • Unilateral – i.e parent can direct or make financial and operating policy decisions of subsi without its consent • Obtain benefits – may implied as positive returns only and related to substantial equity investments Issue • Difficult to apply this concept to assess control of SPE where the creator holds little or none of the equity instruments in the SPE (SPE is a vehicle structured to operate for special purpose) Result • Issued SIC 12 – Special Purpose Entities – to provide guidance to assess control of SPE (risks and rewards approach)

MFRS 127 (para 4) “… is the power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities.” MFRS 10 (Appendix A) “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.” Control of an investee

Salient feature of IFRS 10 MFRS 10.5 • Requires investor, regardless of the nature of involvement with in an entity (the investee), shall determine whether is a parent by assessing whether it controls the investee • Nature of involvement – investment in investee or involvement by sponsorship, by providing financial support (loan – protective rights), including guarantees, or social support to another entity

The new control model MFRS 10 • The main criterion for consolidation is the existence of control - judgment • Need to consider all available facts and circumstances • Control is an exclusionary power (cannot be shared)

Three elements of control (MFRS 10, Para 7) Power over the investee (the POWER) Exposure, or rights, to variable returns from its involvement with the investee (the RETURNS) The ability to use its power over the investee to affect the amount of the investors’ returns ( the LINK between power and returns) Cont.

i.e. not legal or contractual rights but ability to direct relevant activities unilaterally Not based on risk and rewards (quantitative model) but based on power, returns and link between those two (qualitative model) Cont.

What is power? existing rights that give current ability to direct the relevant activities that significantly affect the investee’s returns Can arise from voting rights or contractual arrangements or combination of both 1) ASSESS WHETHER INVESTOR HAS POWER

Examples in MFRS 10 Examples of RIGHTS, but not limited to: (a) rights in the form of voting rights (or potential voting rights) of an investee (see paragraphs B34–B50); (b) rights to appoint, reassign or remove members of an investee’s key management personnel who have the ability to direct the relevant activities; (c) rights to appoint or remove another entity that directs the relevant activities; (d) rights to direct the investee to enter into, or veto any changes to, transactions for the benefit of the investor; and (e) other rights (such as decision-making rights specified in a management contract) that give the holder the ability to direct the relevant activities.

Examples in MFRS 10 Examples of RELEVANT ACTIVITIES, but not limited to: (a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding.

Substantive rights • Consider on substantive rights of investor and other parties • Substantive rights: • Rights are exercisable when decisions about the relevant activities of an investee need to be made; and • Holder has a practical ability to exercise the rights Factors to consider whether the rights are substantive

PROTECTIVE RIGHTS Protective rights – do not give investor control over investee

SUBSTANTIVE RIGHTS EXAMPLE 1 Y has option to purchase further 20% voting rights in Coffee Co from Java Group. The option is currently excercisable and the option is currently out of money. Question: Who should consolidate Coffee Co? (MFRS127 vs MFRS 10)

SUBSTANTIVE RIGHTS EXAMPLE 2 Y has option to purchase further 20% voting rights in Coffee Co from Java Group. The option is currently excercisable and the option is currently in the money. If Y exercises option, it must sell its 40% in another entity, Bean Ltd (unrelated to Java Group) due to anti-competition rules. Bean Ltd provides 3x return on investment compared to Coffee Co. Question: Who should consolidate Coffee Co? (MFRS127 vs MFRS 10) Rights (see appendix)

2) ASSESS WHETHER INVESTOR IS EXPOSED TO VARIABILITY OR RETURNS WHAT ARE RETURNS? An investor is exposed to variable returns from its involvement with investee when… investor’s returns from its involvement may vary as a result of investee’s performance Note: Not only positive returns (i.e. to obtain benefits – in former IAS 27) but also negative returns

EXAMPLES OF EXPOSURES TO VARIABLE RETURNS • Examples: • An investor may transfer a “loan receivable” to a structured entity and receives a servicing fee for managing the loan receivable. • A property developer may transfer a land to a SPV and receives income from the land development even though it may hold little or no equity interest in the SPV.

3) ASSESS WHETHER INVESTOR CAN USE POWER TO AFFECT RETURNS (THE LINK) • There must be a LINK between the POWER and RETURNS • e.g. An investor is the majority shareholder and receives the most dividends (returns) BUT if the investor does not have the power to direct the relevant activities (may due to contractual agreement), the investee is NOT a subsidiary. However, to test the LINK always tested upon UNIT TRUST COMPANIES or REITs Note: Refer case page 20, TLT, 7thedn. on structured entities SPE/ SPV

Some current subsidiaries may fail the control test and thus requiring deconsolidation Some current investors may meet the control test and thus requiring consolidation Structured entities (SEs) that an investor controls shall be consolidated “silos” (ringed-fenced assets, liabilities and equity) that an investor control shall be consolidated Implications of IFRS 10 on practice

Three types of group structure: Fellow Group Structure Vertical Group Structure Mixed Group Structure Group Structure

Fellow Group Structure H Bhd 100% 75% 60% Co. 2 Co. 3 Co. 1 This types exists when a holding company acquired majority issued share capital of another company/ies.

Vertical Group Structure • It exists when a holding company acquired shares in a subsidiary and at the same time the subsidiary also invests in other company. • Besides having direct control (80%), H also has indirect interest over Co.2 for 48% (80%x60%) • Co. 2 is also considered as indirect subsidiary of H H Bhd 80% Co. 1 60% Co. 2

Mixed Group Structure • Also known as complex group structure. • H has direct interest over its subsidiary and at the same time has both direct and indirect interest over sub-subsidiary. • Direct interest 80% of Co.1 and 30% of Co.2 • Indirect interest 48% of Co.2 (80%x60%) • Thus, total control = 78% of Co.2 H Bhd 80% Co. 1 30% 60% Co. 2

Notes: If a company holds 20% to 50% of the issues capital of another company, then the company that being acquired is called as an associate company If an investor holds <20% of the equity shares, then is it know as simple investment (financial instruments) Group Structure

CFS are the combined FS of a group of legal entities under a common control. It treats the parent and its subsidiaries as a single unit. Consolidated Financial Statements

Need for group accounts: To provide useful information to shareholders and other users of the holding enterprise’s financial statements about the group as a whole Cont. 34

Who has to present CFS? Companies Act 1965: a ‘holding company’ Holding company is a corporation that owns one or more subsidiaries Cont. 35

When there is conflict between Companies Act 1965 and FRS 127 Section 166A of Companies Act 1965: FRS prevails Cont.

Not all parents present CFs A B C • Question: Will B Ltd have to present consolidated accounts? • Yes, unless…

Cont • MFRS 10 (para 4(a)) • B is wholly owned by A, or NCI in B do not object • B is not listed, • B is not in process of being listed; and • A produces consolidated accounts available for public use

Consolidated Financial Statements Views on consolidation Proprietary Concept Entity Concept combination

It stresses on the ownership interest rather than control. Assumes that the shareholders of the parent are only relevant users and that they are interested solely in the equity shares that they owned. Thus, only the proportionate interest of the parent in the assets, liabilities, revenues and expenses of partly owned subsidiaries would be added to the consolidated accounts. Proprietary Concept

It stresses on the common control regardless of ownership. It does not make a distinction between the different shareholders in the companies that comprise a group. Controlling and minority (non-controlling) shareholders are all treated as shareholders within the group Entity Concept

Stress on common control Target; no distinction between shareholders of companies in group Method; consolidate in full, 100% irrespective of % interest owned Proprietary vs Entity • Stress on ownership interest • Target; for shareholders of parent company that hold interest in subsidiary only • Method; consolidate based on the % interest owned

Two methods to record business combination: Acquisition method (extensively used in Malaysia) Merger method (see TLT Chap 8) Accounting for Business Combination

MFRS 3, “An entity shall account for each business combination by applying the acquisition method.” (para 4) Cont.

Acquisition Method The following steps are required (para 5): • Identifying the acquirer; • Determining the acquisition date • recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; and • recognising and measuring goodwill or a gain from a bargain purchase.

Cont. 1) Identifying the acquirer: • acquirer must be identified for all acquisitions. • the combining entity that obtains control of the other combining entities or businesses. • if difficult, other indications by referring to MFRS 10 para B14-B18

Cont. 2) Determining the acquisition date: • The acquirer shall identify the acquisition date, which is the date on which it obtains control of the acquiree. • Obtains control – date which the acquirer legally transfers the consideration, acquirers assets and liabilities (the closing date) • However, acquirer may obtain control at earlier or later than closing date (e.g. through written agreement).

Cont. Why the date of acquisition is important? • Determines the date that results of the subsidiary are included in the group FS. • The date on which FV of assets & liabilities acquired, including goodwill are measured. • The date on which FV of purchase consideration is measured.

Cont. • 3) Recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree • Recognition principle - As of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree. Recognition of identifiable assets acquired and liabilities assumed is subject to the conditions specified in paragraphs 11 and 12 (MFRS 3)

TOPIC 3 Introduction to Group Accounts