ifrs 10 consolidated financial statements consolidation for fund managers

IFRS 10 Consolidated Financial Statements

Consolidation for Fund Managers

IFRS 10 Consolidated Financial Statements Consolidation for Fund Managers

Today’s agenda

► Background and objectives► New definition of control► Consolidation for fund managers► Application under the local laws► Investment entities► Continuous assessment► Transition► Current issues / challenges


Background and objectives


Background and objectives

► Background► Changes – WHO consolidates; no change in – HOW to

consolidate ► Tension between the control model in IAS 27 and the risks

and rewards approach in SIC-12 ► Divergent application of IAS 27 and SIC-12 in practice► Global financial crisis – off-balance sheet entities► Convergence with US GAAP (in part)

► Objectives► Develop single control model applicable to all entities► Improve disclosures – basis of judgments


New definition of control



► Control of an investee requires an investor to possess all three essential elements:► Power over the investee;► Exposure, or rights, to variable returns from its involvement

with the investee; and► Ability to use its power over the investee to affect the

amount of the investor’s returns

An investor controls an investee when it 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



Activities

Identify which activities of the investee are considered to be the relevant activities, i.e., those that significantly affect the investee‘s returns

Iden

tify

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act

ivit

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Power

Determine which party, if any, has power, that is, having existing rights that give it the current ability to direct the relevant activities

Eva

luat

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po

wer

Returns

Assess whether the investor is exposed, or has rights, to variable returns from its involvement with the investee

Ass

essi

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ret

urn

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Understand purpose and design


Relevant activities are those that significantly affect the investee‘s returns

New definition of controlIdentifying relevant activities

► Examples:► Establishing operating, capital and financing policies► Appointing, remunerating, and terminating employment of

service providers or key management personnel

► Understand purpose and design of the investee► If two investors direct different relevant activities

► Identify which investor can direct the activities that most significantly affect returns


New definition of controlEvaluating power

► Main aspects of power:► Arises from rights► Need not be exercised (includes potential voting rights)► Does not arise from protective rights► Can exist even if others participate in directing the relevant

activities (e.g., they have significant influence)

► Evidence that an investor directed activities in the past is an indicator of power, but is not conclusive

Power is having existing rights that give an investor the current ability to direct the relevant activities


New definition of controlAssessing returns

► Examples:► Dividends, distributions of economic benefits, changes in the

value of an investment► Remuneration, fees, residual interests, tax benefits,

exposure from providing support► Synergies, cost savings, economies of scale, scarce

resources, proprietary knowledge

Returns can be only positive, only negative or positive and negative, but must have the potential to vary as a result of the investee’s performance


New definition of controlProtective rights

► Protective rights do not give power► When are rights merely protective rights?

► Fundamental changes in the activities of an investee► Only apply in exceptional circumstances

► Examples of protective rights include the right to:► Restrict an investee from undertaking activities that could

significantly change the credit risk of the investee► Approve an investee’s capital expenditures (greater than the

amount spent in the ordinary business)

► Protective rights do not prevent another investor from having control


New definition of controlSubstantive rights

► Does the investor have the current ability to exercise power?► Rights need to be substantive (i.e. the holder must have the

practical ability to exercise those rights)

► Factors to consider – whether?► Economic or other barriers exist (penalties, timing, etc.)► Multiple parties have to agree to exercise right► Holders would benefit from exercising the right► Right is currently exercisable


Consolidation for fund managers


Consolidation for fund managersWhat do they need to know?

► Whether the fund manager (FM) is acting as principal or as agent.

► If the FM is deemed to be acting as principal for a fund it manages the FM would consolidate the fund.

► Conversely, if the FM is acting as an agent, it would not consolidate the fund it manages.


Consolidation for fund managersA new concept of control

Power

Determine which party, if any, has power, that is, the current ability to direct the relevant activities. Power arises from rights, which may include:

- Voting rights- Potential voting rights- Rights to appoint key

personnel- Decision making rights

within a management contract

- Removal or kick-out rights

Power does not arise from protective rights

Iden

tify

ing

po

wer

Returns

Assess whether the investor is exposed, or has rights, to variable returns from its involvement with the investee. Returns can be positive, negative or both. Example of returns include:

- Dividends (from direct interest in the fund either directly or potentially through certain related parties)

- Remuneration (as result of earning management fees and performance fees)

Ass

essi

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Linkage

Evaluate whether the investor has the ability to use its power to affect the investor’s returns from its involvement with the investee. If applicable, determine whether the investor is a principal or an agent, considering:

- Scope of its authority- Rights held by other

parties- Remuneration- Exposure to variability

from other interests.

Eva

luat

e lin

kag

e

Understand the purpose and design of investee


Consolidation for fund managersLinkage between power and variable returns

► Typically, a fund manager is likely to satisfy the first two criteria of the control model, as follows:

► Power — likely to have power, as the fund manager would normally have decision-making rights over the relevant activities.

► Variable returns — exposed to variable returns, as a result of earning management fees and performance fees and direct interest, if any.

► The key determinant in deciding whether a fund manager has control over a fund is the link between power and variable returns.


Principal?


► Delegated power – principal or agent?► An agent is a party engaged to act on behalf of

another party or parties (the principal(s))► An agent does not control an investee► Question – whether the FM is acting as a principal or

as an agent that is acting primarily on behalf of other investors?

Agent?



► De facto Agents► - nature of relationships with other parties (such as

related parties) needs to be considered ► - fund manager’s decision-making rights and

exposure to variable returns via the de facto agent, together with its own, will need to be considered in totality when assessing control.


Consolidation for fund managers Factors to consider

IFRS 10 paragraph B60 requires that the following factors are evaluated to determine whether the fund manager is acting as principal or agent:

1. Scope of the fund manager’s decision-making authority over the fund.

2. Rights held by third parties (including removal rights)

3. Remuneration to which the fund manager is entitled in accordance with the remuneration agreement(s)

4. Fund manager’s exposure to variability of returns from other interests that it holds in the fund.


Consolidation for fund managers1. Scope of decision-making

► Range of activities that are permitted by the decision-making agreement or by law► Whether relevant activities have been delegated

► Discretion that the decision-maker has when making decisions about those activities

► Level of involvement that the decision-maker had in determining the scope of its authority► Opportunity and incentive to gain power

► Purpose and design► Risks to which the investee was designed to be exposed► Risks investee was designed to pass on to investors


Consolidation for fund managers2. Rights held by other parties

► Held by a single investor decision-maker is an agent

► More parties that have to agree on removal more likely that decision-maker is a principal

► Removal rights held by an independent board who can remove decision-maker for any reasons more likely decision-maker is an agent

Fund manager

Fund

Kick-out rights

Voting rights

Investors


Consolidation for fund managers2. Rights held by other parties (cont’d.)

Many parties required toact together

Single party/few parties required to act together

Exercisable only for cause Exercisable without cause

Significant financial penalty to exercise Insignificant financial penalty to exercise

Skills held by decision-makerare unique

Several other parties could fulfil role of decision-maker

Not currently exercisable Currently exercisable

Principal Agent

Decision-maker

Evaluating whether removal rights are substantive


Consolidation for fund managers3. Remuneration

► To be an agent, remuneration must :► Be commensurate with services provided AND► Includes only terms, conditions, or amounts that are

customarily present in arrangements for similar services negotiated on an arm’s length basis

Commensurate “Market” terms Conclusion

Greater magnitude and variability of remuneration compared to expected

returns – more likely principal

× Not an agent

× Not an agent

× × Not an agent


Consolidation for fund managers4. Exposure to variability through other interests

► Are any interests held by related parties?

► Greater the magnitude of, and variability associated with, its economic interests, more likely it is a principal

► Does exposure differ from other investors?

Delegated 80%

Fund manager

Fund

Delegated 80%

Parent

Investors

Direct 20%


Consolidation for fund managersAnalysis of the examples in IFRS 10

The overall evaluation of whether a decision maker is acting in the capacity of principal or an agent is primarily a qualitative evaluation requiring the use of judgement.

ExampleScope of decision

making rightsRemoval rights Remuneration Other interests Conclusion

13Narrowly defined parameters

None 1% of net asset value10% direct interest

Agent

14AWide ranging discretion

Removal for cause1% of net asset value and 20% of profits after a hurdle is reached

2% direct interest

Agent

14BWide ranging discretion

Removal for cause1% of net asset value and 20% of profits after a hurdle is reached

20% direct interest

Principal

14CWide ranging discretion

Removal without cause by independent board

1% of net asset value and 20% of profits after a hurdle is reached

20% direct interest

Agent

15 Narrow discretionRemoval without cause by widely dispersed investors

1% of net asset value and 10% of profits after a hurdle is reached

35% direct interest

Principal


Application under the local laws


Application under the local lawsA typical fund structure

Foreign promoters

Fund Manager

Mutual Fund /

Investment Entity

SECP / Registrar

Regulator

Other Investors

Trustee

Custodian

Shariah Advisor Auditor Distributor Unit Holders

No Cross Holding or Common Directorship


Application under the local laws (cont’d.)Roles and responsibilities A FM shall:► manage the assets of the fund► maintain proper accounts and records► obtain a rating of the fund► process payments immediately► manage the fund according to its

constitutive documents, etc.► establish & maintain sufficient risk

management systems and controls

A trustee shall:► control/hold the property of the fund► approve the sale, purchase, issue & transfer

of units by the fund► ensure that the investment and borrowing

limits are complied with► ensure that the FM has been diligent in

appointing brokers► call a meeting of the unit holders► not invest in the fund for which it acts as

trustee

A unit holder shall:► be bound by the terms of the trust deed► not be liable to make any further contributions to the fund► have a beneficial interest in the trust proportionate to the units held by him► receive reports from the trustee in accordance with the regulations


Application under the local laws (cont’d.)

Criteria under IFRS 10

Explanation As per local laws and practices

Conclusion

1. Scope of decision-making authority.

(Wide / narrow ranging discretion)

Range of activities that the FM is permitted to direct (by agreement or law)

Discretion that FM has when making decisions

Level of involvement the FM had in determining the scope of authority

Regulation 55 of the NBFC Regulations, 2008 and SECP circular no.7 of 2009 specifies the limits on how much to invest (quantitative thresholds) and where to invest (rated debt securities, etc.)

The nature of investments is also defined in the offering document / trust deed.

Normally a FM sets up a fund and his powers are defined in the offering document / trust deed.

Investment parameters are defined by law and are also set out in the offering document and the trust deed.

Depending on the facts and circumstances of the case the FM may have wide or narrow ranging discretion, hence it could be either an agent or a principal.




Explanation As per local laws and practices Conclusion

2. Rights held by third parties.

(Are they substantive or protective?)

Factors to determine whether rights are substantive include:

Financial or other barriers

Removal rights held by a single party (without cause)

Removal rights held by many parties (with cause)

A typical trust deed provides a right to remove the FM if any of the following happens:

Wilful contravention of the trust deed

Liquidation of FM

Receiver being appointed at FM

Becoming ineligible to act as a FM

The suspension of redemption of units of the fund for more than fifteen working days and the unit holders representing at least three-fourth in value of total outstanding units pass a resolution to remove the FM.

Rights that provide for the removal of the FM for committing fraud or wilful contravention are protective rights.

Typically, the rights are not substantive because they normally require numerous parties to exercise them.

Power does not arise from protective rights and they are not relevant when assessing whether a FM is acting as principal or agent.




Explanation As per local laws and practices

Conclusion

2. Rights held by third parties (cont’d).

(Are they substantive or protective?)

In some cases, rights held by other parties (such as liquidation rights and redemption rights) may be considered in the same way as removal rights if, in substance, they have the same effect as a removal right when assessing whether a FM is an agent or a principal.

1. Liquidation rights2. Redemption rights

As per NBFC Regulations 2008, regulation 54, sub-regulation 3(a) the net assets of an Open End Scheme shall be one hundred million rupees at all times during the life of the scheme and all existing Open End Schemes shall ensure compliance with this minimum scheme size by the first day of July 2012.

If a small number of unit holders hold substantial percentage of units in a fund, this might indicate that they hold substantive rights to remove the FM.



Criteria under IFRS 10 Explanation As per local laws and practices

Conclusion

3. Remuneration.

(Commensurate and market based).

The greater the magnitude and variability of remuneration - more likely the FM is deemed to be a principal.

A FM may charge performance based or fixed fee or a combination of both which shall not exceed the limit prescribed in Regulation 61 of the NBFC Regulations, 2008 and such fee structure shall be disclosed in the Offering Document.

Both the criteria are generally met and, hence, it indicates that the FM is an agent.



Criteria under IFRS 10 Explanation As per local laws and practices

Conclusion

4. Exposure to variability of returns from other interests held.

(Percentage of holding)

Interest does not mean just an equity or debt investment.

Examples of other interests: guarantees / indemnity, liquidity facilities, subordinated loans, etc.

Also need to consider not only the interests held by the decision-maker directly, but also the interests held by related parties.

As per the Companies Ordinance, 1984:

20% interest –associate

50% interest –subsidiary

Section 237 of Companies Ordinance, 1984 requires every holding company to present consolidated accounts including the financial statements of the holding company and its subsidiaries.

Indemnity provided by FM to the fund to cover exposure such as WWF.

Management will have to determine at what point the investment becomes large enough such that it is influencing the behaviour of the FM, or the group as a whole, and that actually, the fund is controlled by the group. The examples in the standard suggest that this might be at about 20%.



The Decision Tree

1. Scope of decision-making authority

Wide ranging discretion Principal

Narrow ranging discretion Agent

2. Rights held by third partiesSubstantive Agent

Protective Not relevant

3. RemunerationCommensurate and market based Agent

Not commensurate and market based Principal

4. Exposure to variability of returns from other interests held

20% or more Principal

< 20% Agent


Investment entities


Investment entitiesOverview

► ‘Investment entity’ is now defined in IFRS 10► An investment entity does not consolidate subsidiaries

unless they provide investment-related services (see later)► An investment entity measures its subsidiaries at fair value

through profit or loss in accordance with IFRS 9 Financial Instruments (IAS 39 in Pakistan)

► An entity must consider all facts and circumstances, including purpose and design, to make the assessment

► The amendment is effective for annual periods beginning on or after 1 January 2014, but may be applied earlier


Investment entitiesDefinition

► An investment entity is an entity that:► Obtains funds from one or more investors for the

purpose of providing those investors with professional investment management services

► Commits to its investors that its business purpose is to invest funds solely for returns from capital appreciation, investment income or both

And► Measures and evaluates the performance of substantially

all of its investments on a fair value basis


Investment entitiesTypical characteristics

Factors to consider alongside the definition:► The entity has more than one investment – to diversify the

risk portfolio and maximise returns► The entity has more than one investor – to pool funds to

maximise investment opportunities► Investors in the entity are not related parties of the entity► Ownership interests in the entity are in the form of equity or

similar interests


Investment entitiesReassessment of status

► If there are changes to:► One or more of the three elements of the definition of an

investment entity

Or► The typical characteristics of an investment entity

Then the entity must reassess whether it is an investment entity

► Any change in investment entity status must be accounted for prospectively from the date of change


Investment entitiesParent of an investment entity

Non-investment entity parent of an investment entity

► The exception to consolidation is not retained by the parent entity if it is not an investment entity itself

► Instead, the parent must consolidate all its subsidiaries

► This is a difference from US GAAP – all parent entities can retain (or ‘roll-up’) the exception to consolidation of its investment entity subsidiary


Investment entitiesConclusion

(Non-Investment Entity Parent)

Ultimate Parent (Listed)

(Non-Investment Entity Parent)

Fund Manager

Investment Entity

(Mutual Fund)

50% Investee 40% Investee

Consolidation (IFRS 10, Para. 4)

> Consolidation, if listed

> No consolidation, if unlisted

(IFRS 10, Para. 4)

No consolidation (IFRS 10, Para. 31)

At fair value through profit or loss (IAS 39 /

IFRS 9)


Continuous assessment


Continuous assessment

► Reassess if facts and circumstances suggest change to one of the criteria of control

► Examples:► Changes to dispersion of other shareholdings► Acquisition of new rights or existing rights becoming

substantive


Transition


Transition

► Effective for annual periods beginning on or after 1 January 2013 (in Pakistan, 1 January 2015)

► Retrospective application► As if it was always consolidated (since the date of gaining

control)► If under IFRS 10, there is a change in the consolidation

conclusion at the date of initial application, the requirement to adjust comparative information is limited to the period immediately preceding the date of initial application. Adjustment to earlier periods is permitted but not required.


Current issues / challenges


Current issues / challenges

1. Clarification required with regard to ICAP Circular 2008/01 ‘Consolidation of Mutual Funds by Fund Managers’.

2. Section 3 of CO84 - a subsidiary if another company holds more than fifty percent of its voting power or directors.

Section 237 – holding company to present consolidated financial statements of the group as those of a single enterprise.

A clarification may prove useful to indicate that the requirement in the Companies Ordinance presents the bare minimum criteria for consolidation.


Current issues / challenges (cont’d.)

3. A survey conducted in EU markets revealed that application of IFRS 10 would lead to consolidation of more entities/funds because of the new definition of control.

4. A challenge will be to continue to reassess the status each year due to a change in percentage of holding as a result of open-end nature of the fund and adjust the accounting treatment accordingly.

ifrs 10 consolidated financial statements consolidation for fund managers

Documents

investee slide

returns slide

power returns

activities power

fund managers background

fund managers application

variable returns

investee exposure