by Tan Liong Tong
The coming Year 2012 will yet again mark a new milestone to the financial reporting in Malaysia. The Financial Reporting Foundation (FRF) and the Malaysian Accounting Standards (MASB) have announced and expect full convergence with the IFRSs of the International Accounting Standards Board (IASB) by 1 January 2012 [see MASB ED 75, IFRS-compliant Financial Reporting Standards]. It is therefore imperative that reporting entities in Malaysia prepare in advance for the full convergence.
In May 2011, the IASB simultaneously issued six IFRSs, five of which relate to consolidation and one on fair value measurement. These are:
IFRS 10, Consolidated Financial Statements;
IFRS 11, Joint Arrangements;
IFRS 12, Disclosures of Interests in Other Entities;
IFRS 13, Fair Value Measurement;
IAS 27(r), Separate Financial Statements; and
IAS 28(r), Investments in Associates and Joint Ventures.
IFRS 10 replaces the consolidation part of the former IAS 27. IAS 27(r) deals only with accounting for investments in subsidiaries, joint ventures and associates in the separate financial statements of an investor (retains the part on separate financial statements in the former IAS 27). IFRS 11 supersedes the former IAS 31 on accounting for joint arrangements. Disclosure requirements on subsidiaries, joint arrangements, associates and involvement in unconsolidated structured entities are prescribed in IFRS 12. The Appendix to this article provides guidance on the application of the various IFRSs for a reporting entity’s involvement with other entities. IFRS 13 conceptualises the meaning of fair value and provides a framework on how to measure fair value of assets, liabilities and equity required or permitted by other IFRSs.
This article examines the history, rationale and reasons for the new IFRSs, explains the salient features and draws some implications on practice. It aims to assist preparers and other users understand better the requirements of the new IFRSs and prepare for application when they become effective in Malaysia.
1. IFRS 10, Consolidated Financial Statements
1.1 Reasons for issuing IFRS 10
The former IFRSs dealing with consolidation were IAS 27, Consolidated and Separate Financial Standards, and SIC 12, Consolidation – Special Purpose Entities. The first version of former IAS 27 was issued by the then IASC in April 1989, subsequently revised by the IASB in December 2003 and a second revision in January 2008. In between those dates, there were also amendments for improvements, the last before the current IAS 27(r) was made in July 2010. The former SIC 12 was first issued in November 1998 by the then SIC and was subsequently amended by IFRIC in November 2004.
There were some inconsistencies and conflicts when applying those two Standards. In the former IAS 27, control was defined as “the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities”. However, the Standard did not elaborate on the meaning of power and benefits and did not explain how those two components have to be linked to constitute control. Also, the criterion of “to obtain benefits” tended to be interpreted as positive returns and related to ownership interest only.
SIC 12, although referring to IAS 27, used a “risks and rewards” model to identify indicators of control in deciding whether a special purpose entity (SPE) shall be consolidated. Those indicators did not necessarily identify a control relationship. Also, SIC 12 appeared to focus primarily on vehicles that were structured to operate on “auto-pilot” mechanism for specific purpose.
Conceptually, each of the two former IFRSs was based on a different model and this gave rise to structuring opportunities, inconsistencies and diversity in practice. The potential conflict was when an investor in applying IAS 27 might consolidate an investee that would not be consolidated in accordance with SIC 12 or not consolidate an investee that would be consolidated in accordance with SIC 12. The IASB noted the divergence in practice in the application of the former IAS 27’s control concept, for example, in the following circumstances:
- when an investor controls an investee but the investor has less than a majority of the voting rights of the investee (and voting rights are clearly the basis for control);
- involving special purpose entities (where the notion of “economic substance” in SIC 12 applied);
- involving agency relationships; and
- involving protective rights.
The global financial crisis which started in 2007 saw the emergence of newer entities that do not take the conventional form. Assets and liabilities of reporting entities are transferred to, or securitised in, special purpose vehicles. Troubled debts of financial institutions are restructured and sold to structured entities but a transferor-entity continues to be involved in those structured entities. Some reporting entities also provide social and financial support to troubled entities during the financial crisis although the reporting entities do not have a legal or constructive obligation to do so (they may have a reputation at stake i.e. a reputational risk rather than a financial risk). Involvement in those non-conventional entities exposes a reporting entity to risks, whether financial or reputational.
The former IAS 27 and SIC 12 were unable to provide sufficient guidance on the accounting for these newer entities, resulting in many resources (assets) and claims (liabilities and equity) being unrecognised (off-balance sheet). Users, particularly existing and potential investors and lenders, have expressed concern that it has become increasingly difficult to analyse properly an entity’s returns and exposure to risks when those assets and liabilities were parked in separate vehicles. This created the need for the IASB to respond to the changing business phenomenon of structured entities.
In response to the impact of the global financial crisis, the IASB was also asked to consider reputational risk as a basis in deciding whether an investor should consolidate a special purpose or structured entity which the investor has sponsored or provided financial and other support, and whether the consolidation requirements of the then current standards (IAS 27 and SIC 12) were sufficient for structured entities, as many such newer entities emerged in the current global financial crisis to cater for financial reorganisation or reengineering of troubled entities.
The rationale of the single control model for consolidation in IFRS 10 is based on the view that all assets and liabilities under the control of an investor shall be consolidated regardless of how those assets and liabilities have been structured in other entities. This change in approach is necessary to reflect properly a group’s financial position (particularly its financial structure in terms of gearing) and financial performance. It would provide more useful information to users of financial statements in making economic decisions.
The project on consolidation was initiated by the IASB in April 2002, the exposure draft ED 10, Consolidated Financial Statements, was issued in December 2008, and the current IFRS 10 Consolidated Financial Statements, was published in May 2011.
1.2 The Salient Features of IFRS 10
IFRS 10 requires an investor, regardless of the nature of its involvement with an entity (the investee), shall determine whether it is a parent by assessing whether it controls the investee [IFRS 10.5]. In this new Standard, the nature of involvement need not necessarily require an investment in the investee. It may be an involvement by sponsorship, by providing financial support, including providing guarantees, or social support to another entity.
IFRS 10 introduces a new single control model to identify a parent-subsidiary relationship by specifying that “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” [IFRS 10.6].
The Control Model
In this new control model, an investor controls an investee if and only if the investor has all of the following three elements:
- power over the investee (the Power);
- exposure, or rights, to variable returns from its involvement with the investee (the Returns); and
- the ability to use its power over the investee to affect the amount of the investor’s returns (the Link between Power and Returns)”. [FRS 10.7]
The diagram below depicts the new control model.
In this single control model, power is not defined as legal or contractual right to direct relevant activities but is based on the ability to direct relevant activities unilaterally. The consolidation model is not a quantitative model (based on risks and rewards) but a qualitative model (based on power, returns and a link between the two elements). The control model is built on the principles (of three elements) rather than on bright lines. As such, the application of this model will require judgements by considering the relevant facts and circumstances in making consolidation decisions. In the IASB view, this consolidation model will better reflect the economic substance of relationships with other entities.
The Power Element
An investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities, i.e. the activities that significantly affect the investee’s returns [IFRS10.10]. Power can arise from voting rights (such as by holding equity instruments) or contractual arrangements or a combination of both. An investor can have the power even if its rights to direct have yet to be exercised (a passive parent). Similarly, an investor can have the power even if other parties have existing rights to participate in the direction of the relevant activities or hold protective rights, including special rights to veto certain decisions. Protective rights held by other parties may restrict but do not preclude an investor from having the power to direct.
The Returns Element
The IFRS clarifies that an investor must be exposed, or have rights, to variable returns from its involvement with an investee to control the investee. The former IAS 27 used the term “to obtain benefits from its activities”, which might imply only positive returns. In this IFRS, the returns must have the potential to vary as a result of the investee’s performance and can be only positive, only negative, or wholly positive and negative [IFRS10.15]. Thus, returns include not only dividends and other distributions from holding equity instruments in the investee, but may also include upfront fees, access to cash, servicing fee, returns not available to non-controlling interest, cost savings, etc.
For example, an investor may transfer a “loan receivable” to a structured entity and receives a servicing fee for managing the loan receivable. Similarly, a property developer may transfer a land to a special purpose vehicle and receives income from the land development even though it may hold little or no equity interest in the special purpose vehicle.
The Link Element
An investor must not only have power over an investee and exposure or rights to variable returns from its involvement with the investee. It must also have the ability to use its power over the investee to affect its return from its involvement with the investee [IFRS10.17]. In other words, there must be a link between the two components of power and returns. For example, if an investor is the majority shareholder of an investee, it receives the most dividends (returns) but if the investor does not have the power to direct the relevant activities (for example, due to a contractual arrangement), the investee is not a subsidiary of the investor. Similarly, an entity may have decision-making rights delegated to it when acting as an agent, but it does not have exposure or rights to variable returns, and accordingly, it does not control the investee. For example, a fund manager of a unit trust fund may have decision-making rights with respect to investments of the fund but it does not have the ability to direct the relevant activities (buying or selling investments) unilaterally and it is neither exposed nor have rights to variable returns. It receives a fee acting as an agent of the unit holders of the fund.
Application of the Control Model
The IFRS sets out the requirements on how to apply this control model in:
- circumstances when voting rights or similar rights give an investor power, including situations where the investor holds less than a majority of the voting rights and in circumstances involving potential voting rights;
- circumstances when an investee is designed so that voting rights are not the dominant factor in deciding who controls the investee, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements (for example, in determining control of a structured entity);
- in circumstances involving agency relationships; and
- in circumstances when the investor has control over specified assets (a silo) of an investee.
Control by Voting Rights
If the relevant activities of an investee are directed through voting rights, an investor considers whether it has the current ability, through voting or similar rights, to direct the relevant activities. IFRS 10 retains the presumption in the former IAS 27 that an investor who can exercise more than a majority of the voting rights has control of the investee (unless circumstances indicate otherwise). The “more than a majority” criterion can be attained by holding, directly or indirectly, more than half the voting equity instruments of an investee or by holding voting equity instruments and having contractual arrangements with other investors. For example, an investor owns 40% equity shares of an investee. It enters into an arrangement with another shareholder of the investee to have the power to exercise the other shareholder’s 11% voting rights. In this case, the investor’s own shareholdings and the arrangement with the other shareholder give it the current ability to exercise more than a majority of the voting rights in the investee.
When no party holds a majority of the voting rights in an investee, and voting rights are clearly the only basis for assessment (in the absence of any additional arrangements altering decision-making), the assessment of control will focus on which party, if any, is able to exercise voting rights sufficient to direct the relevant activities of the investee unilaterally [IFRS10.B41]. When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances, such as: (a) the size of its holding of voting rights relative to the size and dispersion of holdings of other vote holders; (b) potential voting rights, regardless of whether they are currently exercisable or not (the former IAS 27 required that the potential voting rights must be currently exercisable); and (c) rights from contractual arrangements.
The IFRS clarifies that when the direction of the relevant activities is determined by a majority vote and an investor holds significantly more voting rights than any other vote holders or organised group of vote holders, and the other shareholdings are widely dispersed, it may be clear, after considering the relevant facts and circumstances alone, that the investor has power over the investee [IFRS10.B43].
For example, an investor can have the power to direct the relevant activities of a public listed company if the investor is the dominant shareholder who holds voting rights and all the other shareholders with voting rights are widely dispersed and are not organised in such a way that they actively co-operate when they exercise their votes so as to have more voting power than the investor. In such a case, the investor, being the dominant shareholder, is said to have “de facto” control over the investee. This dominant shareholder concept was implicit in the former IAS 27.
Control by Contractual Arrangements
When an investee is designed or structured in a manner that voting rights relate to administrative tasks only but the relevant activities are directed by contractual arrangements, the assessment of control would need to consider those contractual arrangements to decide who is able to direct the relevant activities.
For more complex cases of contractual arrangements (for example, when assessing control of structured entities or special purpose entities), it may be necessary to consider many or all of the following factors to determine whether an investor controls an investee:
- what the relevant activities are and how decisions about those activities are made;
- whether the rights of the investor give it the current ability to direct those activities;
- whether the investor is exposed, or has rights, to variable returns from its involvement with the investee; and
- whether the investor has the ability to use its power over the investee to affect the amount of the investor’s returns.
This assessment should include the consideration of risks that the investee was designed to create, the risks it was designed to pass on to the parties involved in the transaction and whether the investor is exposed to some or all of those risks. The investor should consider the decisions made at the investee’s inception as part of its design, including call rights, put rights or liquidation rights. If these contractual arrangements involve activities that are closely related to the investee, then they are, in substance, an integral part of the investee’s relevant activities.
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 are thus considered as relevant activities.
Being involved in the design of an investee, although not sufficient, may indicate that the investor had the opportunity to obtain rights that are sufficient to give it power over the investee. Similarly, an investor’s explicit or implicit commitment to ensure that an investee continues to operate as designed may increase the investor’s exposure to the variability of returns and thus the likelihood that it has power. The commitment alone, however, neither give an investor power nor does it prevents another party from having power.
An investor needs to assess whether its relationship with other parties is such that those other parties are acting on the investor’s behalf i.e. they are “de facto agents”. A party is a de facto agent when the investor has, or those that direct the activities of the investee have, the ability to direct that party to act on the investor’s behalf. Thus, an investor can control an investee by appointing agents to act on its behalf. But if the investor is acting only as an agent, it does not control the investee.
The IFRS provides examples of such other parties that, by the nature of their relationship, may act as de facto agents of the investor, and these include the investor’s related parties, a party that received its interest in the investee as a contribution or loan from the investor; a party that cannot finance its operations without subordinated financial support from the investor; an investee for which the majority of the members of its governing body or for which its key management personnel is the same at that of the investor; and a party that has a close business relationship with the investor, such as the relationship between a professional service provider and one of its significant clients.
Control over Specified Assets (A Silo)
Sometimes, an investor may only have power over specified assets (or over a portion) of an investee. In such cases, the IFRS requires that the investor shall treat the portion of that investee as a separate entity if and only if the following condition is satisfied:
“Specified assets of the investee (and related credit enhancements, if any) are the only source of payments for specified liabilities of, or specified other interests in, the investee. Parties other than those with the specified liabilities do not have rights or obligations related to the specified assets or to residual cash flows from those assets. In substance, none of the returns from the specified assets can be used by the remaining investee and none of the liabilities of the deemed separate entity are payable from the assets of the remaining investee. Thus, in substance all of the assets, liabilities and equity of that deemed separate entity are economically ringed-fenced from the overall investee. Such a deemed separate entity is often called a “silo”.
If an investor controls a “silo” in an investee, it consolidates a portion of an investee as a separate entity. Other parties exclude that portion of the investee when assessing control of and in consolidating the investee.
Reassessment of Control
The IFRS requires that an investor shall reassess whether it controls an investee only if facts and circumstances indicate that there are changes to one or more of the three elements of control.
A change in power over an investee can occur when there are changes to decision-making rights, for example, when the relevant activities are no longer directed through voting rights, but instead by other agreements, such as a contract, that give another party or parties the current ability to direct the relevant activities.
An investor may also gain or lose power over an investee without the investor being involved in that event. For example, an investor can gain power over an investee because decision-making rights held by another party or parties that previously prevented the investor from controlling an investee have lapsed.
Changes to exposure, or rights, to variable returns from its involvement may also cause an investor to lose control of an investee, for example when the investor ceases to be entitled to receive returns or to be exposed to obligations, such as when a contract to receive performance-related fees is terminated.
Other Requirements of IFRS 10
The requirements for consolidation and the consolidation procedures of the former IAS 27 remain unchanged in IFRS 10. The disclosure requirements of the former IAS 27 are dealt with in the new IFRS 12.
1.3 Implications of IFRS 10 on Practice
IFRS 10 may bring about fundamental changes to the current practice of some reporting entities. It is not just about learning and understanding the IFRS as the new requirements may require changes in the accounting processes and procedures of a reporting entity.
Contractual arrangements with other parties would need to be reassessed to determine whether voting rights are transferred to an investor, whether an investor holds special right by statute (such as when a golden share owned by a government is passed to the investor for control of an investee), or whether an investor controls an investee by a contract with a major shareholder.
A reporting entity would also need to reassess its involvement with all other entities, regardless of whether they are the conventional type or the structured type, and determine the nature of the relationship. Applying the new control model might result in some subsidiaries consolidated under the former IAS 27 failing the control test, and thus requiring deconsolidation.
The new control model would more probably result in some investees not consolidated under the former IAS 27 meeting the control test, and henceforth shall be consolidated. For example, the requirements on the dominant shareholder concept may result in some investees previously treated as associates becoming subsidiaries under the new control model. Even if a reporting entity is a passive investor (i.e. have yet to exercise its voting rights) in such investee, the investor would still need to test whether it would have that “current and practical ability” to direct the relevant activities of the investee if it wants to do so.
A reporting entity would also need to reassess its involvement in structured entities (SEs) as the scope is wider than the guidance on special purpose entities (SPEs) in SIC 12. The conditions for SPEs in SIC 12 were narrowly focussed on vehicles established for specific purposes. The requirement on SEs in IFRS 10 applies to any entity that is not managed by the traditional means. These may include vehicles created for transfers of assets and liabilities, entities that an investor sponsors or provides financial (including guarantees) and other support, and involvement in clubs, trusts and non-profit organisations.
Although the control model is premised on the three elements of power, returns and link between power and returns, a reporting entity needs to consider all relevant facts and circumstances. Significant judgements are required in deciding whether a reporting entity has the power to direct and generate returns when the voting rights held are less than a majority, or when the power to direct the relevant activities are based on contractual arrangements.
The changes in accounting will probably be in the following four situations:
- some current subsidiaries may fail the control test and thus requiring deconsolidation;
- some current investees may meet the control test and thus requiring consolidation;
- structured entities that an investor controls shall henceforth be consolidated; and
- “silos” (ringed-fenced assets, liabilities and equity) that an investor controls shall henceforth be consolidated.
2. IFRS 11, Joint Arrangements
2.1 Reasons for Issuing IFRS 11
Accounting for interest in joint ventures and strategic alliances through joint control was previously covered in the former IAS 31, Interests in Joint Ventures. The first version of the former IAS 31 was issued by the then IASC in December 1990, a revised version was issued by the IASB in December 2003 and in between then and the current IFRS 11, there were amendments made for improvements.
A conceptual weakness in the former IAS was that the accounting for joint ventures was primarily driven by the structure of an arrangement i.e. the form of the structure was the only determinant of the accounting, not the substance of the arrangement.
For joint ventures that were structured through legal entities, the former IAS gave a choice of accounting, either using the equity method or the proportionate consolidation. Outreach activities and research work done by the IASB reveal that about half the preparers with an interest in a jointly controlled entity apply the equity method, with the other half applying the proportionate consolidation method. This diversity in practice could potentially compromise the enhancing qualitative characteristic of comparability.
The IASB has for several years made known its intention to abandon the proportionate consolidation for arrangements under joint control. The project to replace the former IAS 31 was initiated by the IASB in November 2004 and the exposure draft ED 9, Joint Arrangements, was issued in September 2007. This was eventually put in place with the issuance of IFRS 11, Joint Arrangements in May 2011.
The rationale of IFRS 11 is based on the view that if an entity has rights to assets and obligations incurred in a joint arrangement, it shall account for those rights and obligations directly. In contrast, if an entity has rights only to the net assets of a joint arrangement, it shall account for its share of the net assets directly (implying the use of the equity method in this latter case). The change in approach is necessary to reflect more accurately the substance of an entity’s involvement in joint arrangements.
2.2 The Salient Features of IFRS 11
Joint arrangements can be structured in various forms, ranging from jointly controlled assets, jointly controlled operations, joint venture entities (legal entities or otherwise) and strategic alliances of businesses. A key feature of IFRS 11 is that the accounting for joint arrangements focuses on the economic substance of an arrangement. It uses a rights and obligations approach in which parties to an arrangement recognise their rights and obligations arising from the arrangement. It is thus a principle-based standard that provides for consistency in the accounting that would enhance comparability of financial statements.
The criteria of joint control remain largely the same as the former IAS but with added clarification that the sharing of control is based on decisions about the relevant activities (relying on those developed in IFRS 10).
IFRS 11 distinguishes two types of joint arrangements i.e. either joint venture or joint operation. A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to thenet assets of the arrangement. A party having joint control in such an arrangement is known as a joint venturer. In contrast, a joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for liabilities, relating to the arrangement. A party having joint control in such an arrangement is known as a joint operator.
If the arrangement is a joint operation, a joint operator accounts for the assets, liabilities, revenues and expenses related to its interest in the joint operation in accordance with the IFRSs applicable to the particular assets, liabilities, revenues and expenses [IFRS 11.20]. These may include share of any assets held jointly and share of any liabilities incurred jointly.
If the arrangement is a joint venture, a joint venturer recognises its interest in the joint venture as an investment and accounts for that investment using the equity method (referenced to the revised IAS 28) [IFRS 11.24]. The proportionate consolidation is disallowed in such joint arrangement.
The accounting treatment would thus depend on the classification of the joint arrangement i.e. whether it is a joint operation or a joint venture. This classification is determined by assessing the rights and obligations of the parties arising from the particular arrangement [see IFRS 11.14].
A separate vehicle may be created in a joint arrangement. The Standard defines a separate vehicle as a separately identifiable financial structure, including separate legal entities or entities recognised by statute, regardless of whether those entities have a legal personality.
Typically, if a joint arrangement is not structured through a separate vehicle, it would be classified as a joint operation in this IFRS. A joint operator accounts directly for the assets, liabilities, revenues and expenses related to the joint operation.
However, if a joint arrangement is structured through a separate vehicle, a reporting entity needs to consider the legal form and the terms of the contractual arrangement, and if relevant, other facts and circumstances to determine whether the arrangement is a joint operation or a joint venture [IFRS 11.17].
This requirement means that even if the arrangement takes the form of a legal separate entity (such as a registered company), it is not necessarily classified as a joint venture. If the assessment determines that the arrangement through a separate vehicle is a joint operation, the operator would still need to account for its share of the respective assets, liabilities, revenues and expenses (based on its rights and obligations) in the separate vehicle. In this respect, the accounting treatment is similar to the proportionate consolidation of the former IAS 31, albeit on a slightly different basis. When applying the proportionate consolidation, the former IAS required a line-by-line constant per cent addition of the line items in the financial statements. This new IFRS requires addition of each line item in the financial statements based on the operator’s rights to an asset item or obligation incurred on a liability item.
2.3 Implications of IFRS 11 on Practice
Operations that were termed as jointly controlled assets and jointly controlled operations under the former IAS 31 would most likely be classified as joint operations in this new IFRS. There will be no change to the accounting for such joint arrangements.
In a straightforward case of joint ventures, where joint venturers share the results and net assets based on equity interest held or agreed percentages, joint venturers who currently use the proportionate consolidation shall henceforth apply the equity method. This is likely to be the most significant change resulting from the adoption of IFRS 11.
However, some separate vehicles, classified as joint ventures under the former IAS 31 may be classified as joint operations under IFRS 11. This is not just a semantic change, as it would require that these separate vehicles be accounted for under a method similar to proportionate consolidation. However, the IASB acknowledges that the percentage share of each asset, liability, revenue and expense recognised in the financial statements could differ from the percentage interest that would have been used for proportionate consolidation.
Entities which do not have a legal personality along with some entities which only manufacture for the parties to the joint arrangement in specified proportions should now be classified as joint operations. In contrast, autonomous legal entities which bear their own risks and which have their own customers would be classified as joint ventures.
The changes in accounting will thus be in one of three possibilities depending on which option the reporting entity currently uses to account for its joint ventures. These are:
- Joint ventures (as defined in IFRS 11) which are currently accounted for using the proportionate consolidation method shall henceforth be accounted for using the equity method;
- Legally separate vehicles which are classified as joint operations (as defined in IFRS 11), and currently accounted for using the equity method, shall henceforth be accounted for by recognising share of the assets, liabilities, revenues and expenses directly; and
- Legally separate entities which are classified as joint operations (as defined in IFRS 11) and which are currently accounted for using the proportionate consolidation shall henceforth be accounted for by recognising share of assets, liabilities, revenues and expenses directly (the percentage or percentages may be different from the percentage interest previously used for proportionate consolidation).
3. IFRS 12, Disclosures of Interests in Other Entities
3.1 Reasons for issuing IFRS 12
Users of financial statements have consistently expressed a need for better information about subsidiaries that are consolidated, as well as an entity’s interests in joint arrangements and associates that are not consolidated but with which the entity has special relationship. The disclosure requirements in the former standards (IAS 27, IAS 28 and IAS 31) overlapped in many areas and generally did not emphasis on the risks of an entity’s involvement.
The global financial crisis that stated in 2007 highlighted a lack of transparency about risks to which a reporting entity was exposed from its involvements with structured entities, including those that it had sponsored. In its deliberations, the IASB concluded that reputational risk from involvement in structured entities is not a sufficient basis for consolidation. Thus, if a reporting entity does not control a structured entity, the latter is classified as an unconsolidated structured entity in this IFRS. Disclosures on unconsolidated structured entities were originally proposed in the consolidation exposure draft. Many commented that the disclosure requirements for interests in unconsolidated structured entities should not be in the consolidation standard.
IFRS 12 did not start of as a separate project of the IASB but the issues of disclosures were deliberated in the projects on consolidation and joint arrangements. In January 2010, the IASB announced its decision to issue a separate disclosure standard to address a reporting entity’s involvement with other entities that are not in the scope of IAS 39 or IFRS 9.
There is generally no change to the approach for disclosures about subsidiaries, joint arrangements and associates. The only significant change is the requirement to disclose information about an entity’s involvement in consolidated and unconsolidated structured entities. The rationale of IFRS 12 is basically to have a combined disclosure standard for interests in all other entities as this would make it easier for users and preparers to understand and apply the disclosure requirements for subsidiaries, joint ventures, associates and unconsolidated structured entities.
3.2 The Salient Features of IFRS 12
IFRS 12 requires an entity to disclose information that enables users of its financial statements to evaluate: (a) the nature of, and risks associated with, its interests in other entities; and (b) the effects of those interests on its financial position, financial performance and cash flows [IFRS12.1].
A reporting entity shall disclose: (i) the significant judgements and assumptions it has made in determining the nature of its interest in another entity or arrangement; and (ii) information about its interests in subsidiaries, joint arrangements, associates and unconsolidated structured entities.
An entity discloses information about significant judgements and assumptions (and changes to those judgements and assumptions) made to determine control of an investee, joint control of an arrangement and the type of joint arrangement (whether joint operation or joint venture), and significant influence over another entity. These include judgements and assumptions in determining that an entity does not control an investee even though it holds more than half of the voting rights; controls an investee even though it holds less than half of the voting rights; it is an agent or a principal; it does not have significant influence even though it holds 20 per cent or more of the voting rights; and it has significant influence even though it holds less than 20 per cent of the voting rights.
Subsidiaries, including consolidated structured entities
The disclosure requirements prescribed for interests in subsidiaries relate to: (i) understanding the composition of the group and the interest of non-controlling interests; and (ii) evaluating restrictions on access or use of resources and claims, including protective rights held by non-controlling interests, risks associated with consolidated structured entities (such as obligations to provide financial support and obligations arising from trigger-loss events) and (iii) consequences of changes in ownership interest in a subsidiary, with or without loss of control [see IFRS 12.10].
Joint arrangements and associates
The disclosure requirements for interests in joint arrangements and associates relate to evaluation of: (i) the nature, extent and financial effects of interests in joint arrangements and associates, including the nature and effects of its contractual relationship with the other investors and restrictions on the ability of the investees to transfer funds or repay loan to the investor; and (ii) the nature of, and changes in, the risks associated with its interests in joint ventures and associates, such as commitments and contingencies relating to those interests [see IFRS 12.20].
Unconsolidated structured entities
The disclosure requirements on interests in unconsolidated structure entities relate to: (i) understanding the nature and extent of interests in unconsolidated structured entities; and (ii) evaluation of the nature of, and changes in, the risks associated with interests in unconsolidated structured entities [see IFRS 12.24].
Information on unconsolidated structured entities includes the nature, purpose, size and activities of the structured entity and how the structured entity is financed. A reporting entity also discloses how it has determined which structured entities it has sponsored, any income it receives from those structured entities and the carrying amount of all assets transferred to those structured entities.
Information on the nature of risks in involvement with unconsolidated structured entities include: (i) assets and liabilities recognised in financial statements relating to interests in unconsolidated structured entities and the line items those asses and liabilities are recognised; (ii) the amount of maximum exposure to loss from its interests in unconsolidated structured entities, including how the maximum amount is determined (if the amount cannot be quantified, an entity discloses that fact and the reasons); and comparison of the carrying amount of the assets and liabilities of the entity that relate to its interest in unconsolidated structured entities and the entity’s maximum exposure to loss from those entities.
If an entity provides financial or other support without having a contractual obligation to do so, it discloses the type and amount of support provided, including situations in which the entity has assisted the structured entity in obtaining financial support and the reasons for providing the support. The entity also discloses any current intentions to provide financial or other support, including intentions to assist the structured entity in obtaining financial support.
3.3 Implications of IFRS 12 on Practice
Most of the disclosure requirements on subsidiaries, joint ventures and associates in the former IASs are retained in IFRS 12. The additional disclosures imposed by IFRS 12 on these other entities are the judgements and assumptions applied to determine the relationships and the risks of involvement, including risks of involvement in consolidated structured entities.
For unconsolidated structured entities, the disclosure requirements are new. Henceforth, reporting entities with involvement in unconsolidated structured entities need to comply with all those new disclosures.
4. IFRS 13, Fair Value Measurement
4.1 Reasons for issuing IFRS 13
Various IFRSs require or permit some assets, liabilities and equity instruments to be measured at fair value. These include IAS 41, Agriculture, IAS 40, Investment Property, IAS 39, Financial Instruments: Recognition and Measurement, and IAS 16, Property, Plant and Equipment. Fair value measurement is also required in a business combination accounted for as an acquisition under IFRS 3, Business Combinations, in valuing employee share options in share-based payment transactions under IFRS 2, Share-based Payment, and in performing impairment test under IAS 36, Impairment of Assets.
Although the fair value measurement basis has been used quite extensively to date, it has been added to IFRSs piecemeal over the years. As a result, the guidance on measuring fair value was dispersed across many IFRSs and they were not always consistent. Furthermore, the former guidance was incomplete as it provided neither a clear measurement objective nor a robust measurement framework.
The project on fair value measurement was initiated by the IASB in September 2005. A discussion paper on fair value measurement was issued in November 2006. The exposure draft was issued in May 2009, re-exposed in June 2010, before it was finalised as IFRS 13, Fair Value Measurement, in May 2011.
The rationale of this IFRS is to provide guidance on how to measure fair values of assets, liabilities and equity instruments, and specify the disclosures about fair value measurements.
4.2 The Salient Features of IFRS 13
The IASB’s objective of publishing the IFRS on fair value measurement are to: (i) define fair value, (ii) sets out in a single IFRS a framework for measuring fair value; and (iii) require disclosures about fair value measurement (IFRS 13.1).
IFRS 13 explains how to measure fair value but does not require additional fair value measurements and does not change the measurement objectives in the existing IFRSs. It applies to IFRSs that require or permit fair value measurements or disclosures.
As the core principle to the fair value measurement, the Standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (IFRS 13.9). This establishes the framework, which is based on an objective to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (i.e. the notion of an exit price from the perspective of a market participant that holds the asset or owes the liability at the measurement date). The definition emphasises that fair value is a market-based measurement, not an entity-specific measurement. Thus, an entity’s intention to hold an asset or to settle a liability is not relevant when measuring fair value.
The Fair Value Measurement Framework can be portrayed by the diagram below:
The Asset or Liability
The fair value measurement in IFRS 13 is for a particular asset or liability. The asset or liability might be a stand-alone asset or liability (e.g. a financial instrument or an operating asset) or a group of assets or liabilities (e.g. a cash-generating unit or a business) depending on the unit of account prescribed by IFRSs applicable to the asset or liability or group of assets or liabilities.
The measurement shall consider the characteristics of the asset or liability (e.g. the condition and location of the asset and restrictions, if any, on its sale or use). For example, when measuring fair value of an investment property using prices of similar properties in other locations (observable market prices of similar properties), appropriate adjustments should be made to reflect the difference in price due to location. Similarly, when measuring fair value of a biological asset using market prices of similar biological assets in other locations, adjustments should be made to reflect the differences in age attribute (condition) and location (transport cost to get to the market).
A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either:
- in the principal market for the asset or liability; or
- in the absence of a principal market, in the most advantageous market for the asset or liability IFRS 13.16]
Principal market is defined in IFRS 13 as “the market with the greatest volume and level of activity for the asset or liability”. The Standard clarifies that in the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market, in the absence of a principal market, the most advantageous market. The principal market is determined from the perspective of the entity, and thus different entities with different activities might have different principal markets.
The Price in a Market
The fair value is the exit price that would be received to sell an asset or paid to transfer a liability, regardless of whether that price is directly observable or estimated using another valuation technique.
Although transaction costs are considered when determining the principal (or most advantageous) market, the price used to measure the fair value of the asset or liability shall not be adjusted for those costs. Transactions costs are not a characteristic of the asset or liability; rather, they are specific to the transaction and will differ depending on how an entity enters into a transaction for an asset or liability.
The Market Participants
The fair value of the asset or liability shall be measured using the assumptions that market participants would use in pricing the asset or liability, assuming that market participants act in their economic best interest [IFRS 13.22]. In developing those assumptions, an entity need not identify specific market participants. Rather, the entity shall identify characteristics that distinguish market participants generally, considering factors specific to: (i) the asset or liability; (ii) the principal (or most advantageous) market; and (iii) market participants with whom the reporting entity would enter into a transaction in that market.
Application of the Fair Value Measurement Framework
A fair value measurement requires an entity to determine the following:
Transaction costs do not include the costs that would be incurred to transport an asset to or from its principal or most advantageous market. If location is a characteristic of the asset (for example, in the valuation of a commodity or an agricultural produce), the price in the principal (or most advantageous) market shall be adjusted for the costs, if any, that would be incurred to transport the asset to or from that market.
- the particular asset or liability being measured;
- for a non-financial asset, the highest and best use of the asset and whether the asset is used in combination with other assets or on a stand-alone basis;
- the market in which an orderly transaction would take place for the asset or liability; and
- the appropriate valuation technique(s) to use when measuring fair value.
Application to Non-Financial Assets
The IFRS requires that a fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use (IFRS 13.27). The term “highest and best use” refers to the use of an asset by market participants that would maximise the value of the asset or group of assets and liabilities (e.g. a business) within which the asset would be used. The fair value of an asset reflects its highest and best use from the perspective of market participants, considering uses of the asset that are physically possible, legally permissible and financially feasible.
The highest and best use of a non-financial asset establishes the valuation premise used to measure the fair value of the asset, either in combination with other assets as a group or on a stand-alone basis.
Application to Liabilities and Own Equity Instruments
A fair value measurement assumes that a liability or an entity’s own equity instrument (e.g. equity interests issued as consideration in a business combination) is transferred to a market participant at the measurement date. Thus, if there is a quoted price, the fair value of the liability or equity instrument is the quoted price.
When a quoted price for the transfer of an identical or a similar liability or entity’s own equity instrument is not available but the identical item is held by another party as an asset, an entity shall measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date.
If a quoted price is not available (either directly or by reference to identical asset held by another party), the fair value is determined by another valuation technique (such as an income approach or a market approach). When a valuation technique is applied, the fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk. Non-performance risk is assumed to be the same before and after the transfer of the liability.
IFRS 13 clarifies that when measuring the fair value of a liability or an entity’s own equity instrument, an entity shall not include a separate input or an adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the item. The effect of a restriction that prevents the transfer is either implicitly or explicitly included in the other inputs to the fair value measurement. It further clarifies that the fair value of a financial liability with a demand feature (e.g. a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.
IFRS 13 provides for an exception to the fair value measurement if an entity manages a group of financial assets and financial liabilities on the basis of its net exposure to either market risks or credit risks. The exception permits an entity to measure the fair value of a group of financial assets and financial liabilities on the basis of the price that would be received to sell a net long position (i.e. an asset) for a particular risk exposure or to transfer a net short position (i.e. a liability) for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions.
Fair Value at Initial Recognition
The price paid (transaction price) to acquire an asset or to assume a liability is the entry price. In many cases, the transaction price will equal the fair value of the asset or liability, for example, when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold. For example, the price paid (entry price) to acquire a quoted equity share is the fair value of the equity share on initial recognition because that is the price in which the equity share would be sold (the exit price).
However, an entry price is not necessarily the same as the exit price and an entity does not necessarily sell an asset or transfer a liability at the price paid to acquire the asset or to assume the liability. Thus, transaction price might not represent the fair value of an asset or a liability at initial recognition. If another IFRS requires or permits an entity to measure an asset or a liability initially at fair value and the transaction price differs from fair value, the entity shall recognise the resulting gain or loss in profit or loss unless that IFRS specifies otherwise. For example, the price paid to acquire a “loan & receivable” asset might be different from the fair value determined using a discounted cash flow technique on the initial recognition. IAS 39 permits an entity to choose an accounting policy for recognising this difference in profit or loss.
Valuation Techniques and Inputs
IFRS 13 requires that an entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. The Standard does not prescribe a particular technique but clarifies that the technique could be based on: (i) the market approach; (ii) the income approach; or (iii) the cost approach. Guidance is provided on estimating fair value using the present value techniques and these include the risk-adjusted discount rate method, the certainty equivalent cash flow method and the expected present value method.
The IFRS clarifies that in some cases, a single valuation technique to measure fair value will be appropriate. For example, when valuing an asset or a liability using quoted prices in an active market for identical assets or liabilities, a valuation technique using the market approach is sufficient. In other cases, multiple valuation techniques need to be applied (for example, when valuing a cash generating unit or a business). If multiple valuation techniques are applied to measure fair value, the results (i.e. the respective indications of fair value) shall be evaluated considering the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.
Inputs are the assumptions used when pricing the asset or liability, including assumptions about risk. IFRS 13 requires that the valuation techniques used to measure fair value shall maximise the use of observable inputs (market-based data) and minimise the use of unobservable inputs (developed data).
If an asset or liability has a bid price and an ask price (e.g. an input from a dealer market), the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value regardless of where the input is categorised within the fair value hierarchy. The use of bid prices for asset positions and ask prices for liability positions is permitted, but is not required. IFRS 13 does not preclude the use of mid-market pricing or other pricing conventions that are used by market participants as a practical expedient for fair value measurement within a bid-ask spread.
The Fair Value Hierarchy
The Standard establishes a fair value hierarchy that prioritises into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
The fair value hierarchy prioritises the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorised within Level 2 or Level 3, depending on the inputs that are significant to the entire measurement and the level in the fair value hierarchy within which those inputs are categorised. If observable inputs require significant adjustments using unobservable inputs, the resulting measurement is a Level 3 measurement.
For example, in measuring the fair value of an unquoted share option derivative, the observable inputs from the marketplace may include the market price of the underlying shares, the strike price, the time period to maturity, the current risk-free interest rate, the current dividend yield and a calculated volatility using past price movements of the underlying shares. The resulting valuation is a Level 2 measurement. In contract, when measuring the fair value of an oil palm crop (a biological asset) using the discounted cash flow technique, the only observable input might be the market price of the fresh fruit bunches (the agricultural produce) whilst other inputs such as costs, margins, growth, yield, etc are developed internally. The resulting valuation is a Level 3 measurement.
The fair value hierarchy to measurement of assets and liabilities shall be applied as follows:
- If there is a quoted price in an active market for an identical asset or liability, an entity uses the quoted price (Level 1 input) for the fair value measurement (Level 1 measurement);
- If there is no quoted price in an active market, an entity determines whether there are any observable inputs other than a quoted price in an active market for an identical asset or liability. If there are significant observable inputs (market-based data), the entity uses those inputs (Level 2 inputs) for the fair value measurement (Level 2 measurement).
- If significant observable inputs are not available from the marketplace, the entity uses unobservable inputs, including developing internal data and assumptions, for the fair value measurement (Level 3 measurement).
The primary focus of the disclosures in IFRS 13 is to provide information that help users of its financial statements assess both of the following:
- for assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements.
- for recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period [IFRS 13.91].
The Standard requires disclosures about the methods and inputs used to develop those measurements and, for fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period.
An entity shall determine the appropriate classes of assets and liabilities on the basis of the following:
- the nature, characteristics and risks of the asset or liability; and
- the level of the fair value hierarchy within which the fair value measurement is categorised.
The number of classes may need to be greater for Level 3 measurements because they have a greater degree of uncertainty and subjectivity.
An entity shall disclose and consistently follow its policy for determining when transfers between levels of the fair value hierarchy are deemed to have occurred. The policy about the timing of recognising transfers shall be the same for transfers into the levels as for transfers out of the levels
For each class of assets and liabilities not measured at fair value in the statement of financial position but for which the fair value is disclosed, an entity shall disclose the level of the fair value hierarchy; for levels 2 and 3, the valuation technique(s), inputs and changes; and if highest and best use of a non-financial asset differs from its current use. However, an entity is not required to provide the quantitative disclosures about significant unobservable inputs used in the Level 3 measurements. For such assets and liabilities, an entity does not need to provide the other disclosures required by IFRS 13.
An entity shall present the quantitative discloses required by IFRS 13 in a tabular format unless another format is more appropriate.
4.3 Implications of IFRS 13 on Practice
IFRS 13 applies to any IFRSs that require or permit fair value measurements or disclosures. It does not impose new fair value measurements or change the measurement objectives in the IFRSs. It only serves as a reference point for fair value measurement in existing and future IFRSs.
The changes to the current accounting practice are likely to be in the processes and procedures of Level 3 fair value measurement. A reporting entity whose current fair value measurements are not in accordance with the fair value measurement framework needs to conform to the requirements of the Standard. The changes may include the approach, the valuation techniques and the inputs used in the valuation.
Disclosures about fair value measurements of financial instruments have already been incorporated in the Amendment to IFRS 7, Financial Instruments: Disclosures, for early application. The disclosure requirements are now extended to some other IFRSs and these include fair value measurements of:
- biological assets and agricultural produce at point of harvest (IAS 41);
- investment property (IAS 40);
- property, plant and equipment (IAS 16) and intangible assets (IAS 38) carried at revalued amount;
- assets acquired and liabilities assumed in a business combination (IFRS 3); and
- share-based payment transactions (IFRS 2).
Unlike the former IFRSs, these new IFRSs are principle-based standards, focusing on articulating the accounting and reporting principles. There are no prescribed rules or specified bright lines. As such, reporting entities in Malaysia will need to apply judgements and assumptions by considering all the relevant facts and circumstances. For example, judgement is required when applying the new control model of IFRS 10 in deciding whether a reporting entity controls a structured entity or whether it is the dominant shareholder. The control test must also be applied in deciding whether control exist if a government holds a special or golden share in a privatised public vehicle, whether that special share has veto power and to what extent that veto power can be exercised or whether that share only has protective right that would not preclude the investor from having control.
In the current FRS Regime in Malaysia, some FRSs provide for exceptions or exemptions to the fair value measurement if the fair value cannot be measured reliability. For example, unquoted equity instruments would be measured at cost in accordance with FRS 139, Financial Instruments: Recognition and Measurement, if their fair value cannot be measured reliably. Similarly, for FRS 141, Agriculture, an entity is permitted on initial recognition to rebut the presumption that the fair value of biological assets and agricultural produce at point of harvest can be measured reliably and thus avails the cost model. The exemptions may also be availed by the impracticability criterion in some other areas, such as in measuring fair value of bank license or other intellectual property in a business combination.
The fair value model has been debated, researched and found to be more relevant to the decision-making needs of the existing and potential investors, lenders and other creditors i.e. the model is consistent with the Framework’sobjective of providing useful information to users of financial statements. For example, if a unit trust fund applies a cost-based model, profit is recognised only when an investment is sold. Changes in fair value are not recognised. This may lead to “cherry-picking” opportunities to manage reported results. There is only a fine line between realised and unrealised profits for investments of unit trust funds, the difference being merely a phone call to a broker. Can that phone call be so critical so as to make a difference in reporting profit? In contrast, the fair value model would report the performance of a unit trust fund in totality and is argued as more relevant to the existing and potential investors.
Those exemptions were justifiable in the past because there were insufficient guidance about fair value measurement in the FRSs. However, with this IFRS 13 in place, such exemptions may become invalid because the Standard provides guidance on how to measure fair value. It should be noted that the IASB has removed the cost exception for unquoted equity instruments in IFRS 9, Financial Instruments.
For agriculture accounting, the fair value model is applied “across the board” to all biological assets and agricultural produce at point of harvest. There are some who hold the view that the fair value model may not be useful in the reporting of long-term bearer biological assets (such as oil palm crop). The MASB has presented a paper at the international level articulating why this model is not useful and instead proposed that bearer biological assets should be accounted for under FRS 116, Property, Plant and Equipment. Pending an outcome of a decision by the IASB on this matter, a reporting entity in Malaysia would still need to prepare for compliance with FRS 141 by 1 January 2012.
Plantation companies that currently apply the cost-based models for their plantation crops will need to change to the fair value, model unless bearer biological assets are scoped out of FRS 141 before 1 January 2012. However, for plantation companies that currently apply the capital maintenance method, a change of treatment is required by 1 January 2012 regardless of whether or not bearer biological assets are scoped out of FRS 141 by then. Accounting for bearer biological assets under FRS 116 means that if a plantation crop has a finite life, it must be depreciated in accordance with that standard. The previous notion of “permanent maintenance” does not hold in the new IFRS-compliant Reporting Framework.
- Effect Analysis – IFRS 11 Joint Arrangements and disclosures for joint arrangements included in IFRS 12, Disclosure of Interests in Other Entities, July 2011, IASB.
- IASB ED 10, Consolidated Financial Statements, December 2008, IASB.
- IASB ED/2009/5, Fair Value Measurement, May 2009, IASB.
- IFRS 10, Consolidated Financial Statements, May 2011, IASB.
- IFRS 11, Joint Arrangements, May 2011, IASB.
- IFRS 12, Disclosures of Interest in Other Entities, May 2011, IASB.
- IFRS 13, Fair Value Measurement, May 2011, IASB.
- MASB ED75, IFRS-compliant Financial Reporting Standards, July 2011, MASB.
- Project Summary and Feedback Statement – IFRS 10 and IFRS 12, May 2011, IASB.
Appendix: A Decision Flowchart for Involvement with Other Entities
Tan Liong Tong is the Project Manager of the MASB Working Group (WG) 63 on Consolidation. The views expressed in this article are those of the author and not the official views of the MASB.