2.2.1 Exemption from preparing consolidated financial statements by an intermediate parent

A parent that prepares financial statements in accordance with IFRS is exempt from presenting (i.e. need not present) consolidated financial statements if it meets all of the following conditions:

1. it is a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and all its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;
2. its debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);
3. it did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and
4. its ultimate or any intermediate parent produces financial statements that are available for public use and comply with IFRSs, in which subsidiaries are consolidated or are measured at fair value through profit or loss in accordance with IFRS 10. [IFRS 10.4(a)].

Where an entity uses this exemption, it may, but is not required to, prepare separate financial statements (see Chapter 8) as its only financial statements. [IAS 27.8]. However, if separate financial statements are prepared, they must comply with IAS 27. [IAS 27.2].

The conditions for exemption from preparing consolidated financial statements raise the following interpretation issues.

2.2.2 Employee benefit plans and employee share trusts

IFRS 10 exempts post-employment benefit plans or other long-term employee benefit plans to which IAS 19 applies. [IFRS 10.4A]. However, it is not clear whether this means that an employee benefit plan that controls an investee is not required to consolidate that investee in its financial statements, or whether an investor that controls an employee benefit plan need not consolidate the plan itself.

In our view, the latter was intended: a sponsor of an employee benefit plan need not evaluate whether it controls that employee benefit plan, and, therefore, need not consolidate it. However, the employee benefit plan would need to apply IFRS 10 if it is preparing financial statements under IAS 26 – Accounting and Reporting by Retirement Benefit Plans. These employee benefit plans are referred to as ‘Employee benefit plan (EBP) trust’ in Figure 6.2 below.

In contrast, employee benefit trusts (or similar entities) established for employee share option plans, employee share purchase plans and other share-based payment programmes are not excluded from the scope of IFRS 10. This is because these are outside the scope of IAS 19. These trusts are referred to as ‘Employee stock ownership plan (ESOP) trust’ in Figure 6.2 below. The sponsoring entity of these trusts needs to evaluate whether it controls (and therefore consolidates) the trusts. If the trust is treated as an extension of the employer or sponsoring entity (see Chapter 30 at 12.3), its assets and liabilities will already be included in the financial statements of the employer entity that are used for preparing the consolidated financial statements of the group. If the trust is not accounted for as an extension of the employer or sponsoring entity, the parent will need to assess whether the trust, as a separate vehicle, needs to be consolidated according to the control criteria of IFRS 10.

The diagram below illustrates what is in scope and out of scope of IFRS 10.

2.2.3 Investment entity exception

As an exception to the consolidation rule, a parent that is an investment entity shall not present consolidated financial statements if it is required to measure all of its subsidiaries at fair value through profit or loss. [IFRS 10.4B]. This is discussed at 10.3 below.

2.2.4 Entity no longer a parent at the end of the reporting period

It is not clear whether IFRS 10 requires an entity to prepare consolidated financial statements only if it is a parent at the end of the reporting period or also if it was a parent at any time during the reporting period.

In our view, consolidated financial statements must be prepared by an entity that was a parent during the reporting period, even if that entity is no longer a parent at the end of the reporting period (e.g. because it disposed of all its subsidiaries). IFRS 10 requires a parent to consolidate a subsidiary until the date on which the parent ceases to control the subsidiary. [IFRS 10.20]. This means that if a parent does not prepare consolidated financial statements pursuant to a concession in local law (see 2.2.5 below), the parent may not present separate financial statements in compliance with IFRS.

Likewise, we believe that an entity that had an associate, or an interest in a joint venture, during the reporting period but no longer does so at end of the reporting period, must apply IAS 28 and/or IFRS 11 to those investments in its financial statements for the reporting period, if not otherwise exempt from doing so.

2.2.5 Interaction of IFRS 10 and EU law

For entities incorporated in the EU, there may, in some cases, be a subtle interaction between the requirements to prepare consolidated financial statements in accordance with IFRS as issued by IASB and IFRS as adopted by the EU. The determination of whether or not consolidated financial statements are required is made under the relevant national legislation based on the EU Accounting Directive, and not IFRS 10.¹ In the majority of cases, this is a technicality with little practical effect. In some cases, however, there will be differences because IAS 27 states that an entity may present separate financial statements as its sole financial statements only if it is exempt from preparing consolidated financial statements in accordance with paragraph 4(a) of IFRS 10. [IAS 27.8].

In contrast, in November 2006, the European Commission stated that in its opinion ‘a parent company always has to prepare annual accounts as defined by the 4th Directive. Where, under the 7th Company Law Directive, a parent company is exempted from preparing consolidated accounts, but chooses or is required to prepare its annual accounts in accordance with IFRS as adopted by the EU, those provisions in [IFRS 10] setting out the requirement to prepare consolidated financial statements do not apply. Such annual accounts (i.e. the separate financial statements) are described as having been prepared in accordance with IFRS as adopted by the EU’² (the 4th and 7th Directives have now been replaced by a single EU Accounting Directive 2013/34/EU³).

Applying the above discussions, when an entity is not explicitly required to prepare consolidated financial statements under national legislation based on the EU Accounting Directive, even though IFRS 10 would oblige it to do so, it will not meet the criterion for exemption under paragraph 4(a) of IFRS 10. Consequently, when that entity presents separate financial statements, such financial statements must be described as having been prepared in accordance with ‘IFRS as adopted by the EU’ rather than ‘IFRS as issued by the IASB’. An example of this situation would be an entity that has an investment in an entity that is not a ‘subsidiary undertaking’ under the EU Accounting Directive 2013/34/EU, but is a subsidiary under IFRS 10.

2.2.6 Combined and carve-out financial statements

Combined or carve-out financial statements are sometimes prepared under IFRS for a ‘reporting entity’ that does not comprise a group under IFRS 10. Although some GAAPs draw a distinction between combined and carve-out financial statements, in our view, the determination of whether these financial statements are permitted to be prepared in accordance with IFRS is the same. Accordingly, where the term ‘combined’ financial statements is used below, the views apply equally to carve-out financial statements. Examples of when combined or carve-out financial statements might be requested include the following:

• two or more legal entities under common control of the same individual or group of individuals (e.g. ‘horizontal’ groups); or
• a group of business units that are intended to become a group in the future (e.g. following an initial public offering or demerger), which may or may not be separate legal entities.

In 2009, the Interpretations Committee received a request for guidance on whether a reporting entity may, in accordance with IFRS, present financial statements that include a selection of entities that are under common control, rather than being restricted to a parent/subsidiary relationship as defined by IFRS. The Interpretations Committee noted that the ability to include entities within a set of IFRS financial statements depends on the interpretation of ‘reporting entity’ in the context of common control. The Interpretations Committee decided not to add these issues on to its agenda.⁴

In our view, there are limited circumstances in which such combined financial statements can give a true and fair view in accordance with IFRS and be presented as ‘general-purpose’ financial statements. As a minimum, there must be both of the following:

• common control for the full or a portion of the reporting period (see 2.2.6.A below); and
• a clear purpose for which the combined financial statements will be used by clearly identified intended users (see 2.2.6.B below).

In addition, the preparer must be able to coherently describe the various legal entities, segments, reportable segments, branches, divisions, geographical jurisdictions, or other ‘units’ that will be included in the combined financial statements. Careful consideration is required when concluding that it is appropriate to exclude any ‘units’ from the combined financial statements (such as unprofitable operations) that are similar to the ‘units’ that are being included in the combined financial statements. Such exclusion must be appropriate when considered in the context of the purpose of the financial statements, the intended users, and the terms and conditions of any relevant agreements (e.g. acquisitions, spin-offs). Other practical considerations related to the preparation of combined financial statements are noted in 2.2.6.C below.

Although IFRS is unclear on this issue, we believe that the fact that IFRS for Small and Medium-sized Entities specifically permits the preparation of combined financial statements, and the fact that the revised Conceptual Framework for Financial Reporting (‘revised Conceptual Framework’) refers to combined financial statements (see 11.1 below), together provide a basis for preparing combined financial statements in appropriate circumstances.

4.1.1 More than one relevant activity

In many cases, more than one activity will significantly affect an investee's returns.

Under IFRS 10, if two or more unrelated investors each have existing rights that give them the unilateral ability to direct different relevant activities, the investor that has the current ability to direct the activities that most significantly affect the returns of the investee has power over the investee. [IFRS 10.13].

In some situations, activities that occur both before and after a particular set of circumstances or events may be relevant activities. When two or more investors have the current ability to direct relevant activities and those activities occur at different times, the investors determine which investor is able to direct the activities that most significantly affect those returns consistently with the treatment of concurrent decision-making rights. The investors reconsider this assessment over time if relevant facts or circumstances change. [IFRS 10.B13].

Therefore, when there is more than one activity that significantly affects an investee's returns, and these activities are directed by different investors, it is important to determine which activities most significantly affect the investee's returns. This is illustrated in Example 6.4 below, which is from IFRS 10. [IFRS 10.B13 Example 1].

In this example, IFRS 10 does not conclude which of the activities is the most relevant activity (i.e. the activity that most significantly affects the investee's returns). If it were concluded that the most relevant activity is:

• developing and obtaining regulatory approval of the medical product – then the investor that has the power to direct that activity would have power from the date of entering into the arrangement; or
• manufacturing and marketing the medical product – then the investor that has the power to direct that activity would have power from the date of entering into the arrangement.

To determine whether either investor controls the arrangement, the investors would also need to assess whether they have exposure to variable returns from their involvement with the investee (see 5 below) and the ability to use their power over the investee to affect the amount of the investor's returns (see 6 below). [IFRS 10.7, B2]. The investors are required to reconsider this assessment over time if relevant facts or circumstances change. [IFRS 10.8].

Example 6.4 above illustrates a situation when two different activities that significantly affect an investee's returns are directed by different investors. Thus, it is important to identify the activity that most significantly affects returns, as part of assessing which investor, if any, has power. This differs from joint control, defined as the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. [IFRS 11 Appendix A]. Joint control is discussed in more detail in Chapter 12 at 4.

Another example provided by IFRS 10, [IFRS 10.B13 Example 2], is reproduced in Example 6.5 below.

Example 6.6 below illustrates a structured entity in which there is more than one activity that affects the investee's returns.

When there are multiple activities that significantly affect an investee's returns, but those activities are all directed by the same investor(s) (which is frequently the case when those activities are directed by voting rights), it is not necessary to determine which activity most significantly affects the investee's returns because the power assessment would be the same in each case.

4.1.2 No relevant activities

We believe that structured entities for which there is no substantive decision making are rare. That is, we believe virtually all structured entities have some level of decision-making and few, if any, are on ‘autopilot’. Even if a structured entity operates on ‘autopilot’, there may be decisions outside the predetermined parameters that may need to be taken if an expected return fails to materialise which could significantly affect the returns of the entity and therefore be relevant activities.

In practice, many entities that may initially have few if any relevant activities can be terminated by at least one of the parties involved in the structure. In this case, the choice of whether to terminate may often be viewed as the relevant activity. IFRS 10 would most likely result in such entities being consolidated by an investor that has the power to dissolve the entity, if this power would affect its variable returns. See 4.6 below for additional guidance on evaluating relevant activities for structured entities and 6.3.2 below for additional guidance on liquidation and redemption rights.

However, if a structured entity truly has no decision-making, then no investor controls that structured entity. This is because no investor has power over the structured entity, that is, no investor has the current ability to direct the activities that significantly affect the structured entity's returns if there are no relevant activities after inception significantly affecting those returns. As discussed above, we believe that such situations where there is no substantive decision-making are rare. An example of a structured entity over which no investor had power was included in the IASB's publication, Effect analysis: IFRS 10 – Consolidated Financial Statements and IFRS 12 – Disclosure of Interests in Other Entities. However, this example caused controversy and the Effect Analysis was re-issued in 2013 with the example deleted.⁵

4.1.3 Single asset, single lessee vehicles

Some structured entities are single asset, single lease vehicles created to lease a single asset to a single lessee. Between November 2014 and May 2015, the Interpretations Committee discussed requests for clarification about the interaction of IFRS 10 and IAS 17 – Leases – in two situations which involved the establishment of a structured entity to lease a single asset to a single lessee.

In the first situation, the lease between the structured entity and the lessee was an operating lease and the question was whether the lessee should consolidate the structured entity. In the second situation, the lease between the structured entity and the lessee was a finance lease and the question was whether the junior lender of the structured entity should consolidate the structured entity. In both situations, the consolidation decision would be based on an assessment of whether the entity controls the structured entity. The Interpretations Committee was asked whether the lessee's use of the leased asset was a relevant activity of the structured entity when assessing power over the structured entity.

The Interpretations Committee was of the view that the lessee's right to use the asset for a period of time would not, in isolation, typically give the lessee decision-making rights over the relevant activities of the structured entity and hence would not typically be a relevant activity of the structured entity. This is because on entering into a lease, regardless of whether it is a finance lease or an operating lease, the structured entity (lessor) would have two rights – a right to receive lease payments and a right to the residual value of the leased asset at the end of the lease. Consequently, the activities that would affect the structured entity's returns would relate to managing the returns derived from those rights; for example, managing the credit risk associated with the lease payments or managing the leased asset at the end of the lease term (for example, managing its sale or re-leasing). How the decision-making relating to those activities would significantly affect the structured entity's returns would depend on the particular facts and circumstances.

The Interpretations Committee noted that its conclusion does not mean that a lessee can never control the lessor. For example, a parent that controls another entity for other reasons can lease an asset from that entity. Further, in assessing control, an entity would consider all of the rights that it has in relation to the investee to determine whether it has power over that investee. This would include rights in contractual arrangements other than the lease contract, such as contractual arrangements for loans made to the lessor, as well as rights included within the lease contract, including those that go beyond simply providing the lessee with the right to use the asset.

As a result, the Interpretations Committee concluded that the principles and guidance within IFRS 10 would enable a determination of control to be made based on the relevant facts and circumstances of the scenario and it is not its practice to give case-by-case advice on individual fact patterns. Consequently, the Interpretations Committee concluded that neither an Interpretation nor an amendment to a Standard was required and decided not to add these issues to its agenda.⁶

We believe the discussions above also apply to leases as defined in IFRS 16 – Leases.

4.1.4 Management of assets in the event of default

The management of defaults on assets held by a structured entity will frequently be a relevant activity for that entity (see Example 6.5 at 4.1.1 above). However, in practice, if the assets held by the structured entity are bonds, the activities of a decision-maker that is contracted to manage any defaults may be limited to voting at creditors’ meetings, as an independent administrator would be appointed to manage the bond default on behalf of all bond holders. Whether the decision-maker has power (i.e. the current ability to direct the management of defaults) or not will probably depend on the size of the structured entity's holding in the individual bonds that have defaulted. The greater the holding, the more likely the decision-maker may be able to control decision-making in a creditors’ meeting.

4.2.1 Evaluating whether rights are substantive

For a right to convey power, it must provide the current ability to direct the relevant activities. An investor, in assessing whether it has power, considers only substantive rights relating to the investee (held by the investor and others). For a right to be substantive, the holder must have the practical ability to exercise the right. [IFRS 10.B22]. An investor that holds only protective rights (see 4.2.2 below) does not have power over an investee, and consequently does not control the investee. [IFRS 10.14]. Whether rights are substantive depends on facts and circumstances. The table below (although not exhaustive) describes the factors that should be considered. [IFRS 10.B23].

To be substantive, rights also need to be exercisable when decisions about the direction of the relevant activities need to be made. Usually, to be substantive, the rights need to be currently exercisable. However, sometimes rights can be substantive, even though the rights are not currently exercisable. [IFRS 10.B24]. This is illustrated by IFRS 10, [IFRS 10.B24 Example 3‑3D], as reflected in Example 6.7 below.

This example illustrates that an investor with the current ability to direct the relevant activities has power even if its rights to direct have yet to be exercised. Evidence that the investor has been directing relevant activities can help determine whether the investor has power, but such evidence is not, in itself, conclusive in determining whether the investor has power over an investee. [IFRS 10.12].

It should be noted that an investor in assessing whether it has power needs to consider substantive rights held by other parties. Substantive rights exercisable by other parties can prevent an investor from controlling the investee to which those rights relate. Such substantive rights do not require the holders to have the ability to initiate decisions. As long as the rights are not merely protective (see 4.2.2 below), substantive rights held by other parties may prevent the investor from controlling the investee even if the rights give the holders only the current ability to approve or block decisions that relate to the relevant activities. [IFRS 10.B25].

It is important to remember that the purpose and design of an investee is critical when assessing whether a right is substantive. For example, the following should be considered when evaluating whether an investor's rights are substantive:

• Why were the rights granted?
• What compensation was given (or received) for the right? Does that compensation reflect fair value?
• Did other investors also receive this right? If not, why?

These questions should be considered both when a right is first granted, but also if an existing right is modified.

To be substantive and convey power, a right must give the investor the ‘current ability’ to direct the investee's relevant activities. However, ‘current ability’ does not always mean ‘able to be exercised this instant’. The concept of ‘current ability’ is discussed more in the context of potential voting rights at 4.3.4 below.

4.2.2 Evaluating whether rights are protective

In evaluating whether rights give an investor power over an investee, the investor has to assess whether its rights, and rights held by others, are protective rights. [IFRS 10.B26].

Under IFRS 10, protective rights are defined as ‘rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate’. [IFRS 10 Appendix A].

Since power is an essential element of control, protective rights do not provide the investor control over the investee. [IFRS 10.14]. In addition, holding protective rights cannot prevent another investor from having power over an investee. [IFRS 10.B27].

Protective rights are typically held to prohibit fundamental changes in the activities of an investee that the holder does not agree with and usually only apply in exceptional circumstances (i.e. upon a contingent event). However, the fact that the right to make decisions is contingent upon an event occurring does not mean that the right is always a protective right. [IFRS 10.B26].

Examples of protective rights include (but are not limited to) the right to:

• restrict an investee from undertaking activities that could significantly change the credit risk of the investee to the detriment of the investor;
• approve an investee's capital expenditures (greater than the amount spent in the ordinary course of business);
• approve an investee's issuance of equity or debt instruments;
• seize assets if an investee fails to meet specified loan repayment conditions; [IFRS 10.B28] and
• veto transactions between the investee and a related party.

In some cases, a right might be deemed protective, such as the ability to sell assets of the investee if an investee defaults on a loan, because default is considered an exceptional circumstance. However, in the event that the investee defaults on a loan (or, say, breaches a covenant), the investor holding that right will need to reassess whether that right has become a substantive right that gives the holder power (rather than merely a protective right), based on the change in facts and circumstances. This issue has been raised with the Interpretations Committee which, in September 2013, concluded that reassessment of control is required when facts and circumstances change in such a way that rights, previously determined to be protective, change (for example upon the breach of a covenant in a borrowing arrangement that causes the borrower to be in default). The Interpretations Committee observed that it did not expect significant diversity in practice to develop on this matter and decided not to add the issue to its agenda. In making its conclusion, the Interpretations Committee observed that:

• paragraph 8 of IFRS 10 requires an investor to reassess whether it controls an investee if facts and circumstances indicate that there are changes to one or more of the three elements of control;
• a breach of a covenant that results in rights becoming exercisable constitutes such a change;
• IFRS 10 does not include an exemption for any rights from this need for reassessment; and
• the IASB's redeliberations of this topic during the development of IFRS 10 concluded that rights initially determined to be protective should be included in a reassessment of control whenever facts and circumstances indicate that there are changes to one or more of the three elements of control.⁷

4.2.3 Incentives to obtain power

There are many incentives to obtain rights that convey power; generally, the more exposure to variable returns (whether positive or negative), the greater that incentive. IFRS 10 notes this in two contexts:

• the greater an investor's exposure, or rights, to variability of returns from its involvement with an investee, the greater the incentive for the investor to obtain rights sufficient to give it power. Therefore, having a large exposure to variability of returns is an indicator that the investor may have power. However, the extent of the investor's exposure is not determinative regarding whether an investor has power over the investee; [IFRS 10.B20] and
• an investor may have an explicit or implicit commitment to ensure that an investee continues to operate as designed. Such a commitment may increase the investor's exposure to variability of returns and thus increase the incentive for the investor to obtain rights sufficient to provide it with power. Therefore, a commitment to ensure that an investee operates as designed may be an indicator that the investor has power, but does not, by itself, give an investor power, nor does it prevent another party from having power. [IFRS 10.B54].

Thus, even though there may be an incentive to obtain rights that convey power when there is an exposure to variable returns, that incentive, by itself, does not represent power. Rather, the investor must analyse whether it actually does have power through existing rights, which might be in the form of voting rights, or rights through a contractual agreement, as discussed at 4.3 and 4.4 below, respectively.

4.3.1 Power with a majority of the voting rights

In many cases, the legal environment or corporate structure dictate that the relevant activities are directed by the agreement of shareholders who hold more than half of the voting rights of the investee. Alternatively, a governing body, e.g. a Board of Directors, might make decisions regarding the investee and that Board might be appointed by whoever has the majority of the voting rights to direct an investee's relevant activities. In both cases, when one investor has more than half the voting rights, it has power, assuming that no other facts and circumstances are relevant. [IFRS 10.B35].

However, there may be other facts and circumstances that are relevant, as discussed at 4.3.2 below. In addition, any potential voting rights need to be considered (see 4.3.4 below).

4.3.2 A majority of voting rights without power

In some cases, voting rights do not provide the holder the power to direct the relevant activities. This might be the case, when:

• relevant activities are directed by another party with existing rights under a contract, and that party is not an agent of the investor (see 4.4 below); [IFRS 10.B36]
• voting rights are not substantive (see 4.2.1 above). For example, if the relevant activities are directed by government, judiciary, administrator, receiver, liquidator, or regulator (see 4.3.2.A below); [IFRS 10.B37]
• voting rights have been delegated to a decision-maker, which then holds the voting rights as an agent (see 6 below); or
• voting rights are held as a de facto agent of another investor (see 7 below).

4.3.3 Power without a majority of voting rights (de facto control)

An investor might have control over an investee even when it has less than a majority of the voting rights of that investee if its rights are sufficient to give it power, because such rights give the investor the practical ability to direct the relevant activities unilaterally (a concept known as ‘de facto control’). [IFRS 10.B41].

When assessing whether an investor's voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:

1. the size of the investor's holding of voting rights relative to the size and dispersion of holdings of the other vote holders, noting that:
   1. the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
   2. the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities; and
   3. the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;
2. potential voting rights held by the investor, other vote holders or other parties;
3. rights arising from other contractual arrangements; and
4. any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings. [IFRS 10.B42].

In addition, IFRS 10 states that if it is not clear that the investor has power, having considered the factors above, then the investor does not control the investee. [IFRS 10.B46].

Whether an investor should include voting rights held by related parties not controlled by the investor (e.g. shareholdings held by its parent, sister companies, associates or shareholdings held by key management personnel or other individuals who are related parties) would depend on the specific facts and circumstances (i.e. whether the related parties are de facto agents of the investor). See 7 below.

Potential voting rights and rights arising from other contractual arrangements are discussed at 4.3.4 to 4.3.6 below, respectively. De facto control is discussed in more detail below.

IFRS 10 includes several examples illustrating the assessment of power when an investor has less than a majority of voting rights. Some of these are summarised in Examples 6.9 to 6.12 below. Our variation on the examples provided in IFRS 10 is introduced in Example 6.13 below. In each of the examples, it is assumed that, after understanding the purpose and design of the investee:

• voting rights give an investor the ability to direct activities that most significantly affect the investee's returns (i.e. voting rights give power);
• none of the shareholders has arrangements to consult any of the other shareholders or make collective decisions;
• decisions require the approval of a majority of votes cast at the shareholders’ meeting; and
• no other facts or circumstances are relevant.

When the direction of relevant activities is determined by majority vote and an investor holds significantly more voting rights than any other party, and the other shareholdings are widely dispersed, it may be clear, after considering the factors listed in (a)-(c) above alone, that the investor has power over the investee. [IFRS 10.B43]. This is illustrated in Example 6.9 below (although factors (b) and (c) are not applicable).

In other situations, it may be clear after considering the factors listed in (a)‑(c) above alone that an investor does not have power. [IFRS 10.B44]. This is illustrated in Example 6.10 below (although factors (b) and (c) are not applicable).

However, the factors listed in (a)-(c) above alone may not be conclusive. If an investor, having considered those factors, is unclear whether it has power, it considers additional facts and circumstances, such as whether other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. [IFRS 10.B45].

When evaluating past voting patterns, significant judgement will be required to determine how far back to review. Judgement will also be required to determine whether past voting patterns may have been influenced by conditions that existed at a point in time, such as how well the entity was operating during the periods reviewed. For example, if an entity was profitable and operating smoothly, other shareholders may have been less motivated to exercise their voting rights. The fewer voting rights the investor holds, and the fewer parties that would need to act together to outvote the investor, the more reliance would be placed on the additional facts and circumstances to assess whether the investor's rights are sufficient to give it power. [IFRS 10.B45].

Consideration of additional facts and circumstances, referred to in paragraph B45 of the standard, includes the assessment of the factors that provide evidence of the practical ability to direct the relevant activities of the investee (paragraph B18), and the indicators that the investor may have power as a result of any special relationship with the investee (paragraph B19) or due to the extent of its exposure to variability of returns (paragraph B20), which are discussed at 4.5 below. When the facts and circumstances in paragraphs B18-B20 are considered together with the investor's rights, greater weight shall be given to the evidence of power in paragraph B18 than to the indicators of power in paragraphs B19 and B20. [IFRS 10.B45].

Example 6.11 below illustrates a situation where the factors in (a)-(c) above alone are not conclusive, and therefore facts and circumstances would need to be considered.

Comparing Examples 6.10 and 6.11 above illustrates the judgement that will need to be applied in determining whether an investor has power. The IASB considers that it may be easy for two other shareholders to act together to outvote an investor (as in Example 6.10 above), but that it may be more difficult for 11 other shareholders to act together to outvote an investor (as in Example 6.11 above). Where is the line between these two situations?

Example 6.12 below illustrates a situation where additional facts and circumstances need to be considered. For example, this may include whether other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings.

In Example 6.12 above, G cannot have power because it does not have, at a minimum, more than half the votes of shareholders that have turned up at recent meetings. That is, since 75% have turned up at recent meetings, G would need a minimum of 37.5% to have power. A variation of the above scenario is shown in Example 6.13 below.

There are diverse views regarding the conclusion on this fact pattern, and judgement will need to be applied in practice. Some believe that J has power, because it has more than half the voting rights of those who have turned up at recent shareholder meetings. (J has more than half the voting rights, because J holds 38%, which is more than 37.5%, or half of 75%). Others believe that it is inconclusive whether J has power, because, while J has more than half the voting rights of those who have turned up at recent shareholder meetings, this is just barely the case. Contrast this fact pattern with Example 6.9 above, where IFRS 10 concludes that, after all relevant facts and circumstances have been considered, holding 48% in combination with remaining ownership that is widely dispersed results in an entity (A) having power.

Applying the concept of de facto control in the absence of ‘bright lines’ will require significant judgement of the facts and circumstances. For example:

• How large does an investor's interest need to be relative to others?
• How widely dispersed are the other investors? Could three shareholders easily act together?
• Are past voting patterns expected to be indicative of future voting patterns? How much history would be needed to make an assessment?
• Are there other relevant agreements between shareholders?

Generally, the lower the percentage held by one investor (the dominant shareholder, in Examples 6.9 to 6.13 above), the less likely that investor has de facto control.

Although perhaps rare, an investor could find itself in control of an investee simply because of circumstances that exist at a point in time, rather than because of deliberate action (see 9.3 below). In addition, while it may be easy to use hindsight to determine whether an investor had (or has) control, it might be difficult to apply this principle on a real-time basis. Information will need to be gathered and analysed (e.g. how widely dispersed are the other shareholders), so that management can reach a timely conclusion. It will also be necessary to monitor the changes in the profile of the other shareholders as this could mean that the investor has gained or lost power over the investee (see 9.3 below).

The following extract illustrates the disclosure of the significant judgements used in determining the existence of de facto control.

4.3.4 Potential voting rights

When assessing whether it has power over an investee, an investor also considers the potential voting rights that it holds, as well as potential voting rights held by others. Common examples of potential voting rights include options, forward contracts, and conversion features of a convertible instrument. Those potential voting rights are considered only if the rights are substantive (see 4.2.1 above). [IFRS 10.B47]. In the remainder of this section, reference is made to ‘options’, but the concepts apply to all potential voting rights.

When considering potential voting rights, an investor considers the purpose and design of the entity, including the rights associated with the instrument, as well as those arising from any other involvement the investor has with the investee. This includes an assessment of the various terms and conditions of the instrument as well as the investor's apparent expectations, motives and reasons for agreeing to those terms and conditions. [IFRS 10.B48].

If the investor also has voting or other decision-making rights relating to the investee's activities, the investor assesses whether those rights, in combination with potential voting rights, give the investor power. [IFRS 10.B49].

Substantive potential voting rights alone, or in combination with other rights, may provide an investor the current ability to direct the relevant activities. [IFRS 10.B50]. For example, if an investor has less than a majority of voting rights, but holds a substantive option that, if exercised, would give the investor a majority of voting rights, that investor would likely have power. [IFRS 10.B42, B50]. Example 6.14 below illustrates when holding an option would likely give an investor power.

The opposite is also true. If an investor holds a majority of the voting rights, but those voting rights are subject to a substantive option held by another investor, the majority shareholder would likely not have power.

Another example provided by IFRS 10 of a situation where substantive potential voting rights, in combination with other rights, can give an investor the current ability to direct the relevant activities is reflected in Example 6.15 below.

IFRS 10 is silent on whether the intention of the holder (i.e. whether the holder intends to exercise the option or not) is considered in the assessment of potential voting rights. However, IFRS 10 is clear that power arises from rights per se and the ability those rights give the investor to direct the relevant activities. [IFRS 10.B14]. Therefore, an option is only considered in the assessment of power if it is substantive (i.e. the holder has the practical ability to exercise the option when decisions about the direction of relevant activities need to be made). [IFRS 10.B22, B24, B47]. As discussed at 4.2.1 above, whether an option is substantive depends on facts and circumstances. Common factors to consider when evaluating whether an option is substantive include:

• exercise price or conversion price, relative to market terms;
• ability to obtain financing; and
• timing and length of exercise period.

These factors are each discussed in more detail below, and their implications are indicated in the table below. The evaluation of whether an option is substantive should consider all the factors discussed at 4.2.1 above, rather than limited to only one of the factors.

4.3.5 Contractual arrangement with other vote holders

A contractual arrangement between an investor and other vote holders can give the investor the right to exercise voting rights sufficient to give the investor power, even if the investor does not have voting rights sufficient to give it power without the contractual arrangement. However, a contractual arrangement might ensure that the investor can direct enough other vote holders on how to vote to enable the investor to make decisions about the relevant activities. [IFRS 10.B39].

It should be noted that the contractual arrangement has to ensure that investor can direct the other party to vote as required. Where the arrangement is merely that the parties agree to vote the same way, that would only represent joint control; defined as the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. [IFRS 11 Appendix A]. Joint control is discussed in more detail in Chapter 12 at 4.

In some jurisdictions, investors holding a certain number of issued shares of a public company may be able to obtain proxy votes from other shareholders by public request or other means for voting at shareholder meetings. The question as to whether the investor has the ability to obtain a majority of votes (and hence power over an investee) through control of proxy votes will depend on the specific facts and circumstances of the process such as, for example, the investor's freedom to use the proxy vote and whether any statements of voting intent must be provided by the investor as a condition of obtaining the proxy vote. A situation where, for example, proxies must be requested each year would make it more difficult to demonstrate that the investor had power as a result of its ability to obtain proxy votes.

4.3.6 Additional rights from other contractual arrangements

Other decision-making rights, in combination with voting rights, can give an investor the current ability to direct the relevant activities. For example, the rights specified in a contractual arrangement in combination with voting rights may be sufficient to give an investor the current ability to direct the manufacturing processes of an investee or to direct other operating or financing activities of an investee that significantly affect the investee's returns. However, in the absence of any other rights, economic dependence of an investee on the investor (such as relations of a supplier with its main customer) does not lead to the investor having power over the investee. [IFRS 10.B40].

Example 6.18 below reflects an example from IFRS 10 of a situation where an investor with less than a majority of the voting rights is considered to have power of the investee, taking into account rights under a contractual arrangement. [IFRS 10.B43 Example 5].

4.4.1 Structured entities

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. [IFRS 12 Appendix A]. Therefore, an entity that is controlled by voting rights is not a structured entity. Accordingly, although it might be thought that an entity that receives funding from third parties following a restructuring is a structured entity, this would not be the case, if that entity continues to be controlled by voting rights after the restructuring. [IFRS 12.B24].

A structured entity often has some or all of the following features:

• restricted activities;
• a narrow and well-defined objective, such as:
  • holding a tax-efficient lease;
  • carrying out research and development activities;
  • funding an entity; or
  • providing investment opportunities for investors by passing on risks and rewards associated with assets to investors;
• insufficient equity to finance its activities without subordinated financial support; and
• financing in the form of multiple contractually-linked instruments to investors that create concentrations of credit or other risks (tranches). [IFRS 12.B22].

Examples of structured entities include:

• securitisation vehicles;
• asset-backed financings; and
• some investment funds. [IFRS 12.B23].

Management needs to evaluate whether it controls a structured entity using the same approach as for ‘traditional entities’ (those that are controlled through voting rights). That is, management evaluates whether an investor has power over the relevant activities, exposure to variable returns and the ability to affect those returns through its power over the structured entity, as shown in the diagram at 3.1 above. Frequently, as discussed above, the relevant activities of a structured entity are directed by contractual arrangement.

For some investees, relevant activities occur only when particular circumstances arise or events occur. The investee may be designed so that the direction of its activities and its returns are predetermined unless and until those particular circumstances arise or events occur. In this case, only the decisions about the investee's activities when those circumstances or events occur can significantly affect its returns and thus be relevant activities. The circumstances or events need not have occurred for an investor with the ability to make those decisions to have power. The fact that the right to make decisions is contingent on circumstances arising or an event occurring does not, in itself, make those rights protective. [IFRS 10.B53].

This is illustrated in Example 6.19 below, which is summarised from an example included in IFRS 10. [IFRS 10.B53 Example 11].

IFRS 10 also includes a much simpler example where the only assets of an investee are receivables and when the purpose and design of the investee are considered, it is determined that the only relevant activity is managing the receivables upon default. In this situation, the party that has the ability to manage the defaulting receivables has power over the investee, irrespective of whether any of the borrowers have defaulted. [IFRS 10.B53 Example 12].

An investor may have an explicit or implicit commitment to ensure that an investee continues to operate as designed. Such a commitment may increase the investor's exposure to variability of returns and thus increase the incentive for the investor to obtain rights sufficient to give it power. Therefore, a commitment to ensure that an investee operates as designed may be an indicator that the investor has power, but does not, by itself, give an investor power, nor does it prevent another party from having power. [IFRS 10.B54].

Notwithstanding the fact that the same approach is used to evaluate control for structured entities and traditional entities, it is still important to identify which entities are structured entities. This is because certain disclosure requirements of IFRS 12 apply only to structured entities, as discussed in Chapter 13.

5.3.1 Plain vanilla foreign exchange swaps and interest rate swaps

It is important to consider the purpose and design of the entity when evaluating whether a plain vanilla foreign exchange or interest rate swap should be considered a creator or absorber of variable returns. It is our view that an exposure to variable returns generally absorbs the variability created by the investee's assets, liabilities or other contracts, and the risks the investee was designed to pass along to its investors. Therefore, if a derivative is entered into to reduce the variability of a structured entity's cash flows (such as might arise from movements in foreign currency or interest rates), it is not intended to absorb the cash flows of the entity. Instead, the derivative is entered into to align the cash flows of the assets of the structured entity with those of the investors and so reduce the risks to which the investors in the structured entity are exposed. Accordingly, the counterparty would not have an exposure to a variable return.

Meanwhile, a counterparty to a foreign exchange or interest rate swap typically has a senior claim on any cash flows due under the swap relative to any note holders. Consequently, it is unlikely to be exposed to the credit risk of the assets held by the structured entity, or else that risk will be deemed to be insignificant (i.e. losses on the assets would need to be so large that there would be insufficient funds in the structured entity to settle the derivatives).

However, if payments on a swap were subordinate to the rights of note holders, or contractually referenced to the performance of the underlying assets in the structured entity, the counterparty is exposed to the risk associated with the performance of the underlying assets (i.e. the risk that the structured entity may be unable to fulfil its obligations under the swap). In that case, if the swap counterparty had power over the structured entity because it has the ability to manage its assets, it is likely that it would be deemed to have the ability to affect its variable returns and so would control the structured entity.

The above principles are illustrated in Example 6.21 below.

5.3.2 Total return swaps

The principles discussed at 5.3.1 above are also relevant where a structured entity enters into a total return swap, since the swap creates an equal, but opposite risk to each party, as illustrated in Example 6.22 below.

6.2.1 Involvement in design

IFRS 10 requires that a decision-maker considers the purpose and design of the investee, the risks to which the investee was designed to be exposed, the risks it was designed to pass on to the parties involved and the level of involvement the decision-maker had in the design of an investee. For example, if a decision-maker is significantly involved in the design of the investee (including in determining the scope of decision-making authority), that involvement may indicate that the decision-maker had the opportunity and incentive to obtain rights that result in the decision-maker having the ability to direct the relevant activities. [IFRS 10.B63].

However, a decision-maker's involvement in the design of an investee does not mean that decision-maker necessarily is a principal, even if that involvement was significant.

A decision-maker is a principal if it is not primarily engaged to act on behalf of and for the benefit of others. This determination is made in the context of considering the purpose and design of the investee, and the other factors listed at 6.1 above. While not determinative, a decision-maker's involvement in the design of an investee is part of the context when concluding if it is a principal or agent.

In our view, similar to the considerations for structured entities discussed at 4.6 above, when a decision-maker sponsors an investee and establishes certain decisions in the governing documents of the investee, there should be increased scrutiny as to whether that decision-maker is a principal or an agent with respect to the investee, particularly if the other factors are indicative of the decision-maker being a principal. However, when there are many parties involved in the design of an investee, the decisions established in the governing documents might be less relevant.

6.2.2 Assessing whether the scope of powers is narrow or broad

When evaluating whether a decision-maker is a principal or an agent, in considering the scope of its decision-making authority, it appears that a relevant factor is whether the scope of powers that have been delegated (and the discretion allotted) is narrow or broad. In an example in IFRS 10 where a decision-maker (fund manager) establishes, markets and manages a publicly traded, regulated fund according to narrowly defined parameters set out in the investment mandate, it is stated that this is a factor that indicates that the fund manager is an agent. [IFRS 10.B72 Example 13]. In another example, where the decision-maker (fund manager) has wide decision-making authority, it is implied that the extensive decision-making authority of the fund manager would be an indicator that it is a principal. [IFRS 10.B72 Example 14‑14A]. This suggests that where the scope of powers is broad, this would be an indicator that the decision-maker is a principal. However, to conclude whether a decision-maker is an agent or a principal, the scope of power needs to be evaluated with the other three factors in totality.

6.3.1 Evaluating whether a removal right is substantive

When evaluating removal rights, it is important to determine whether they are substantive, as discussed at 4.2.1 above. If the removal right is substantive, this may be an indicator that the decision-maker is an agent. [IFRS 10.B64]. On the other hand, if the removal right is not substantive, this may be an indicator that the decision-maker is a principal, but this indicator should be given less weight. The determination of whether the decision-maker is a principal needs to be based on the three other factors, i.e. scope of decision-making authority, remuneration and exposure to variability of returns through other interests.

Some of the criteria that might be more relevant when evaluating whether a removal right is substantive are shown in the diagram below. However, all of the factors noted at 4.2.1 above and IFRS 10 must be considered in this evaluation.

Evaluating whether a removal right is substantive will depend on facts and circumstances. [IFRS 10.B23].

6.3.2 Liquidation rights and redemption rights

In some cases, rights held by other parties (such as some liquidation rights and some redemption rights) may have the same effect on the decision-maker's authority as removal rights. When a liquidation right or a redemption right is in substance the same as a removal right, its consideration in the evaluation of whether a decision-maker is a principal or an agent is the same.

For example, if a limited partnership were required to be liquidated upon the withdrawal of one limited partner, that would be considered a removal right if it were substantive (as discussed at 4.2.1 and 6.3.1 above). However, such rights must be analysed carefully, based on the facts and circumstances.

6.4.1 Evaluating remuneration in the asset management industry

When evaluating whether a decision-maker is a principal or an agent, an entity is required to evaluate the magnitude and the variability of the remuneration relative to the expected returns from the investee. In examples related to the asset management industry, IFRS 10 describes three common remuneration structures:

• 1% of net assets under management; [IFRS 10.B72 Example 13]
• 1% of assets under management and performance-related fees of 10% of profits if the investee's profits exceed a specified level; [IFRS 10.B72 Example 15] and
• 1% of assets under management and 20% of all the fund's profits if a specified profit level is achieved. [IFRS 10.B72 Example 14].

In each case, the examples assume that the remuneration is commensurate with the services provided. In addition, the remuneration aligns the interests of the decision-maker with those of other investors. However, IFRS 10 concludes for each of these cases that the level of remuneration does not create an exposure to variable returns that is of such significance that, in isolation, it indicates that the fund manager is a principal. IFRS 10 does not include any examples of remuneration arrangements where the remuneration is of such significance that, in isolation, it does indicate that the fund manager is a principal. Additionally, IFRS 10 does not provide any examples of remuneration arrangements that are not market-based although this would always need to be assessed.

In our experience, in most asset management scenarios involving retail investors, management will be able to conclude that the remuneration is commensurate with services provided and only includes market terms. This is because otherwise, retail investors would take their business elsewhere.

As discussed at 6.4 above, a decision-maker cannot be an agent unless conditions (a) and (b) are met. However, meeting both criteria is not conclusive. The decision-maker must evaluate whether the magnitude and exposure to variable returns received through the remuneration, together with other factors, indicates that it is an agent or a principal.

6.4.2 Evaluating remuneration in other industries

IFRS 10 does not include any examples of principal-agency evaluations in the construction, real estate and extractive industries. In our view, in these industries, it is more common for the decision-maker to possess unique traits (see 6.3.1.A above). That might make it more difficult to assess whether the remuneration is commensurate with the skills provided, and includes only market terms.

6.5.1 Evaluating returns received via an indirect investment in another entity

In Example 6.25 above, the exposure of the investor (the parent of the fund manager) to variable returns was through a direct investment in the fund. However, what if the exposure to variable returns arises from an investor's indirect involvement with an investee, e.g. via a joint venture or an associate?

When assessing whether an investor has control of an investee, the investor determines whether it is exposed, or has rights, to variable returns from its involvement with the investee. IFRS 10 discusses ‘returns’ as a broad term, and the examples in paragraph B57 of the standard (see 5 above) suggest the exposure to variable returns encompasses both direct and indirect involvement with the investee.

The Basis for Conclusions accompanying IFRS 10 further clarifies that the IASB intended the term ‘returns’ as a broad term, stating that ‘The Board confirmed its intention to have a broad definition of “returns” that would include synergistic returns as well as more direct returns, for example, dividends or changes in the value of an investment. In practice, an investor can benefit from controlling an investee in a variety of ways. The Board concluded that to narrow the definition of returns would artificially restrict those ways of benefiting.’ [IFRS 10.BC63].

Therefore, in our view, when an investor evaluates the exposure to variable returns from its involvement with another entity, the returns received indirectly via another entity that is not under the control of that investor, are included in that assessment. This is regardless of the structure of the indirect involvement – that is, whether it is held through a joint venture, an associate, or neither influence nor joint control exists such that it is just an investment.

In the case of an indirect interest there are essentially two different ways of assessing the returns – the dividend flow and/or the change in fair value of the intermediate investment. While the dividend flow is not in the control of the investor, it still receives the returns via the change in value of its intermediate investment, and therefore these returns cannot be ignored.

8.1.1 Identifying silos in the insurance industry

For insurers, silos may arise in a structure such as a multi-cell reinsurance vehicle, which is an entity comprised of a number of ‘cells’ where the assets and liabilities are ring-fenced.

Insurers should evaluate whether investments made on behalf of insurance contract holders (policyholders) would be considered silos under IFRS 10. The evaluation will depend on the facts and circumstances of the particular case, and may vary by jurisdiction and by policy, given the differences in regulatory environments and types of policies offered by insurance entities.

When determining whether policies held are ring-fenced (whether a silo exists) relevant facts and circumstances, including local laws and contractual arrangements with the contract holder, must be assessed.

Where a silo exists and the shares in the silo are held by the insurance company on behalf of policyholders and all returns from the sub-funds are passed to the policyholders, the following needs to be considered:

• Does the insurance company have a contractual obligation to hold investments in the sub-funds?
• Are the investments legally ring-fenced such that they may not be used to satisfy other liabilities of the insurance company in the event of liquidation?
• Do the policyholders select the investments?
• Will other funds beyond the value of the specified assets in the silo be necessary to fulfil the obligation to the policyholders?
• Is there an exact matching of the policy to the assets held?

All of the relevant facts and circumstances would need to be considered when determining if a silo exists. As discussed at 8.2 below, if a silo exists, control is evaluated for each silo. However, if a silo does not exist, this simply means that the control evaluation is made at the entity level.

8.1.2 Identifying silos in the investment funds industry

Silos may exist in the investment fund industry. Certain investment vehicles are set up as ‘umbrella funds’ with a number of sub-funds, each with its own investment goals and strategies e.g. a sub-fund may specialise in the shares of small companies, or in a particular country, or a particular industry. An assessment will need to be made as to whether a sub-fund should be considered a silo under IFRS 10. The evaluation will depend on the facts and circumstances of the particular case as to whether the sub-funds are legally ring-fenced from each other and the investment vehicle itself, and may vary by jurisdiction, given the differences in regulatory environments and types of such investment vehicles.

10.2.1 Business purpose

The definition of an investment entity requires that the purpose of the entity is to invest solely for capital appreciation, investment income (such as dividends, interest or rental income), or both. [IFRS 10.B85B].

Documents that include a discussion of an entity's investment objectives, such as offering memoranda, publications distributed by the entity and other corporate or partnership documents, typically provide evidence of an entity's business purpose. Further evidence may include the manner in which an entity presents itself to other parties (such as potential investors or potential investees). [IFRS 10.B85B].

However, an entity that presents itself as an investor whose objective is to jointly develop, produce or market products with its investees, has a business purpose that is inconsistent with the business purpose of an investment entity. This is because the entity will earn returns from the development, production and marketing activity as well as from its investments. [IFRS 10.B85B].

10.2.2 Exit strategies

One feature that differentiates an investment entity from other entities is that an investment entity does not plan to hold its investments indefinitely; it holds them for a limited period. [IFRS 10.B85F].

For investments that have the potential to be held indefinitely (typically equity investments and non-financial asset investments), the investment entity must have a documented exit strategy. This documented exit strategy must state how the entity plans to realise capital appreciation from substantially all of these potentially indefinite life investments. An investment entity should also have an exit strategy for any debt instruments that have the potential to be held indefinitely (e.g. perpetual debt instruments). [IFRS 10.B85F].

The investment entity need not document specific exit strategies for each individual investment but should identify different potential strategies for different types or portfolios of investments, including a substantive time frame for exiting the investments. Exit mechanisms that are only put in place for default events, such as breach of contract or non-performance, are not considered exit strategies. [IFRS 10.B85F].

Exit strategies can vary by type of investment. Examples of such strategies for investments in equity securities include an initial public offering, selling the investment in a public market, a private placement, a trade sale of a business, distributions (to investors) of ownership interests in investees and sales of assets (including the sale of an investee's assets followed by a liquidation of an investee). For real estate investments, an example of an exit strategy includes the sale of the real estate through specialised property dealers or the open market. [IFRS 10.B85G].

An investment entity may have an investment in another investment entity that is formed in connection with the entity for legal, regulatory, tax or similar business reasons. In this case, the investment entity investor need not have an exit strategy for that investment, provided that the investment entity investee has appropriate exit strategies for its investments. [IFRS 10.B85H]. This is intended to prevent an entity that conducts most of its investing activities through a subsidiary that is a holding company from failing to qualify as an investment entity. [IFRS 10.BC248].

10.2.3 Earnings from investments

An investment entity must commit to its investors that its business purpose is to invest funds solely for returns from capital appreciation, investment income or both.

An entity does not meet this condition when it, or another member of the group containing the entity (i.e. the group that is controlled by the entity's ultimate parent) obtains, or has the objective of obtaining, other benefits from the entity's investments that are not available to other parties that are not related to the investee. ‘Other benefits’ means benefits in addition to capital appreciation or investment return and such benefits include:

• the acquisition, use, exchange or exploitation of the processes, assets or technology of an investee including the entity or another group member having disproportionate, or exclusive, rights to acquire assets, technology, products or services of any investee; for example, by holding an option to purchase an asset from an investee if the asset's development is deemed successful;
• joint arrangements or other agreements between the entity or another group member and an investee to develop, produce, market or provide products or services;
• financial guarantees or assets provided by an investee to serve as collateral for borrowing arrangements of the entity or another group member (however, an investment entity would still be able to use an investment in an investee as collateral for any of its borrowings);
• an option held by a related party of the entity to purchase, from that entity or another group member, an ownership interest in an investee of the entity; and
• except as described below, transactions between the entity or another group member and an investee that:
  • are on terms that are unavailable to entities that are not related parties of either the entity, another group member or the investee;
  • are not at fair value; or
  • represent a substantial portion of the investee's or the entity's business activity, including business activities of other group entities. [IFRS 10.B85I].

These requirements in respect of ‘other benefits’ are anti-avoidance provisions. As explained in the Basis for Conclusions, the Board was concerned that an entity that meets the definition of an investment entity could be inserted into a larger corporate group in order to achieve a particular accounting outcome. This concern is illustrated by an example of a parent entity using an ‘internal’ investment entity subsidiary to invest in subsidiaries that may be making losses (e.g. research and development activities on behalf of the overall group) and therefore record its investments at fair value, rather than reflecting the underlying activities of the investee. Because of these concerns, the Board has included the requirement that the investment entity, or other members of the group containing the entity, should not obtain benefits from its investees that would be unavailable to other parties that are not related to the investee. [IFRS 10.BC242].

It is also clarified that an entity should demonstrate that fair value is the primary measurement attribute used to evaluate the performance of its investments, both internally and externally. [IFRS 10.BC252].

An entity is not disqualified from being classified as an investment entity because it has investees in the same industry, market or geographical area that trade with each other. This applies where the investment entity has a strategy to invest in more than one investee in that industry, market or geographical area in order to benefit from synergies that increase the capital appreciation and investment income from those investees. [IFRS 10.B85J]. The Board decided that trading transactions or synergies that arise between the investments of an investment entity should not be prohibited because their existence does not necessarily mean that the investment entity is receiving any returns beyond solely capital appreciation, investment return, or both. [IFRS 10.BC243].

10.2.4 Fair value measurement

In order to qualify as an investment entity, a reporting entity must measure and evaluate the performance of substantially all of its investments on a fair value basis. This is because using fair value results in more relevant information than, for example, consolidation for subsidiaries or the use of the equity method for interests in associates or joint ventures. In order to demonstrate fair value measurement, an investment entity should:

1. provide investors with fair value information and measure substantially all of its investments at fair value in its financial statements whenever fair value is permitted in accordance with IFRSs; and
2. report fair value information to the entity's key management personnel who use fair value as the primary measurement attribute to evaluate the performance of substantially all of its investments and to make investment decisions. [IFRS 10.B85K].

In order to meet the requirements in (a) above, an investment entity would:

• elect to account for any investment property using the fair value model in IAS 40 – Investment Property;
• elect the exemption from applying the equity method in IAS 28 for its investments in associates and joint ventures; and
• measure its financial assets at fair value using the requirements in IFRS 9. [IFRS 10.B85L].

As described in the Basis for Conclusions, investments measured at fair value in the statement of financial position with fair value changes recognised in other comprehensive income rather than through profit or loss still satisfy the fair value measurement condition of the definition of an investment entity. [IFRS 10.BC251]. However, an investment entity should not account for more than an insignificant amount of financial assets at amortised cost under IFRS 9, nor fail to elect the fair value measurement options in IAS 28 or IAS 40. [IFRS 10.BC250].

Fair value measurement applies only to an investment entity's investments. There is no requirement to measure non-investment assets such as property, plant and equipment or liabilities such as financial liabilities at fair value. [IFRS 10.B85M].

10.2.5 Holding more than one investment

An investment entity would typically hold several investments to diversify its risk and maximise its returns. These may be held directly or indirectly, for example by holding a single investment in another investment entity that itself holds several investments. [IFRS 10.B85O].

However, holding a single investment does not necessarily prevent an entity from meeting the definition of an investment entity. Examples where an investment entity may hold only a single investment are when the entity:

• is in its start-up period and has not yet identified suitable investments and, therefore, has not yet executed its investment plan to acquire several investments;
• has not yet made other investments to replace those it has disposed of;
• is established to pool investors’ funds to invest in a single investment when that investment is unobtainable by individual investors (e.g. when the required minimum investment is too high for an individual investor); or
• is in the process of liquidation. [IFRS 10.B85P].

As holding only one investment is not a typical characteristic of an investment entity, this would require disclosure as a significant judgement (see 10.1 above).

10.2.6 Having more than one investor

An investment entity would typically have several investors who pool their funds to gain access to investment management services and investment opportunities they might not have had access to individually. In the Board's opinion, having more than one investor makes it less likely that the entity, or other members of the group containing the entity, would obtain benefits other than capital appreciation or investment income (see 10.2.3 above). [IFRS 10.B85Q].

Although the Board considers that an investment entity would typically have more than one investor, there is no conceptual reason why an investment fund with a single investor should be disqualified from being an investment entity. Therefore, the presence of more than one investor is a typical characteristic of an investment entity rather than as part of the definition of an investment entity. [IFRS 10.BC260].

An investment entity may be formed by, or for, a single investor that represents or supports the interests of a wider group of investors such as a pension fund, a government investment fund or a family trust. [IFRS 10.B85R].

The Board acknowledges that there may be times when the entity temporarily has a single investor. For example, an investment entity may have a single investor when it:

• is within its initial offering period and the entity is actively identifying suitable investors;
• has not yet identified suitable investors to replace ownership interests that have been redeemed; or
• is in the process of liquidation. [IFRS 10.B85S].

These examples are not stated to be exhaustive and there could be other reasons why an investment entity might have only one investor. Having only one investor is not a typical characteristic of an investment entity. The fact that an entity is considered to be an investment entity despite having only one investor is a significant judgement requiring disclosure (see 10.1 above).

10.2.7 Unrelated investors

An investment entity would typically have several investors that are not related parties of the entity or other members of the group containing the entity. The existence of unrelated investors makes it less likely that the entity, or other members of the group containing the entity, would obtain benefits other than capital appreciation or investment income (see 10.2.3 above). [IFRS 10.B85T].

As the definition of a related party includes an entity which has significant influence over a reporting entity, when read literally this means that, typically, an entity that is significantly influenced by one or more parties by, for example, having investors with a greater than twenty percent ownership interest (see Chapter 11 at 4), cannot be an investment entity.

However, an entity may still qualify as an investment entity even though its investors are related to the entity. To support this, an example is illustrated in which an investment entity sets up a separate ‘parallel’ fund for a group of its employees (such as key management personnel) or other related party investors, which mirrors the investment of the entity's main investment fund. It is stated that this ‘parallel’ fund may qualify as an investment entity even though all of its investors are related parties. [IFRS 10.B85U]. In this example, the key determinant in concluding that the parallel fund is an investment entity is that it is being managed for capital appreciation or investment income.

Although IFRS 10 provides only one example of a fund which qualifies as an investment entity with investors that are related parties, it is explained in the Basis for Conclusions that respondents to the Investment Entities ED provided ‘examples of entities with related investors that they believed should qualify as investment entities’. [IFRS 10.BC261].

10.2.8 Ownership interests

An investment entity is typically, but is not required to be, a separate legal entity. Ownership interests in an investment entity will usually be in the form of equity or similar interests (e.g. partnership interests), to which proportionate shares of the net assets of the investment entity are attributed. However, having different classes of investors, some of which have rights only to a specific investment or groups of investments or which have different proportionate shares of the net assets, does not preclude an entity from being an investment entity. [IFRS 10.B85V].

It is rationalised in the Basis of Conclusions that holding a proportionate share of the net assets of an investment entity explains in part why fair value is more relevant to investors of an investment entity because the value of each ownership interest is linked directly to the fair value of the entity's investments. [IFRS 10.BC263]. However, whether there is this form of ownership interest in an entity should not be a deciding factor and would inappropriately exclude certain structures from investment entity status. One example illustrated by the Basis for Conclusions is entities that do not have units of ownership interest in the form of equity or similar interests is a pension fund or sovereign wealth fund with a single direct investor which may have beneficiaries that are entitled to the net assets of the investment fund, but do not have ownership units. Another example is funds with different share classes or funds in which investors have discretion to invest in individual assets. [IFRS 10.BC264, BC266]. In both of these examples, the investors are entitled to a proportionate share of at least part of the assets of the fund although not the entire fund.

An entity that has significant ownership interests in the form of debt that does not meet the definition of equity may still qualify as an investment entity, provided that the debt holders are exposed to variable returns from changes in the fair value of the entity's net assets. [IFRS 10.B85W].

10.2.9 Investment entity illustrative examples

The following examples illustrate the application of the investment entity criteria and are based on illustrative examples contained in IFRS 10.

10.2.10 Multi-layered fund structures

Example 6.45 above illustrates a multi-layered fund structure. The reason and purpose of these is usually to accomplish one or more of the following:

• regulatory reasons to invest in certain jurisdictions; or
• risk mitigation reasons, that is, to ring fence particular investees; or
• investment-return enhancement, where the after-tax returns on an investment can be enhanced by using vehicles in certain jurisdictions.

When an investment entity has a subsidiary that is an intermediate parent that is formed in connection with the parent investment entity for legal, regulatory, tax or similar business reasons, the investment entity investor need not have an exit strategy for that subsidiary. This is on condition that the intermediate investment entity parent has appropriate exit strategies for its investments. [IFRS 10.B85H]. In addition, an entity must consider all facts and circumstances in assessing whether it is an investment entity, including its purpose and design. [IFRS 10.B85A]. Illustrative Example 4 of IFRS 10, represented by Example 6.45 above, indicates that funds formed in connection with each other for legal, regulatory, tax or similar requirements can be considered together to determine whether they display the characteristics of an investment entity. In Example 6.45 above, both Domestic Feeder and Offshore Feeder are considered to be investment entities.

10.3.1 Accounting for a change in investment entity status

A parent that either ceases to be an investment entity or becomes an investment entity shall account for its change in status prospectively from the date at which the change in status occurred. [IFRS 10.30].