by John Hughes
I was mulling over the role of potential voting rights in applying the consolidation rules under IFRS. The concept in IAS 27.14 is this:
- An entity may own share warrants, share call options, debt or equity instruments that are convertible into ordinary shares, or other similar instruments that have the potential, if exercised or converted, to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity (potential voting rights). The existence and effect of potential voting rights that are currently exercisable or convertible, including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be exercised or converted until a future date or until the occurrence of a future event.
That seems to make sense, and it’s broadly consistent with the content of CICA 1590. But I paused a bit more over the next paragraph, in IAS 27.15:
- In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect potential voting rights, except the intention of management and the financial ability to exercise or convert such rights.
It’s never clicked in my mind why that last bit, about disregarding the financial ability actually to use the potential voting rights, is appropriate. CICA 1590 approaches it this way:
- Exercises and conversions are only taken into account when the economic cost is not so high as to make them unlikely for the foreseeable future.
The term “economic cost” doesn’t focus on the potential parent’s financial ability in so many words, but it’s hard to see how it could meaningfully be applied any other way. If A has convertible instruments which could give it control of B, but it will never be able to finance the conversion, it’s irrelevant that a big Canadian bank could easily do so. So IFRS and Canadian GAAP directly differ in what weight they put on the economic plausibility of actually exercising those potential rights.
But does the IFRS approach make sense? In the example I just gave, what would be the logic of A consolidating B? As far as I can see, the implementation guidance attached to IAS 27 has only this to say:
- In addition, the entity examines all facts and circumstances that affect potential voting rights except the intention of management and the financial ability to exercise or convert such rights. The intention of management does not affect the existence of power and the financial ability of an entity to exercise or convert potential voting rights is difficult to assess.
Difficult to assess! Well, maybe so. But no more difficult than a whole lot else in IFRS. Mandating a black and white answer simply to ward off occasional complexity doesn’t exactly seem like a sophisticated approach, and certainly doesn’t appear in any way “principles-based.”
The 2008 Exposure Draft of the proposed replacement for IAS 27, as if acknowledging this, points to a different approach. The basis for conclusions document has this to say:
- The Board observed that options and convertible instruments can give the holder the power to direct the activities of an entity. Concluding that such instruments always or never give the holder control would be likely to cause inappropriate consolidation in some cases and failure to consolidate in others.
- …The Board also noted that, when considering options, what is important is the relationship between the option holder and the shareholder that is the counterparty to the option agreement. The option holder might not have a direct relationship with the entity to which the voting interests relate. Accordingly, whether an option holder controls an entity will often depend on whether the option holder is able to direct the shareholder that is the counterparty to the option agreement to act as instructed by the option holder. If this is the case, then the option holder controls the entity because of the relationship between the option holder, the shareholder with voting rights and the entity.
In emphasizing the nature of the relationship between the parties, this seems now to be running head-long towards the difficulty, stating in effect that the same fact pattern might generate a different control conclusion based on the human dynamics and other factors. It goes on like this:
- In the Board’s view, a reporting entity that is required to transfer little, or no, consideration to exercise an option over shares is likely to have control of those shares. In those circumstances, the option holder is likely to have acquired a controlling interest at the time it acquired the options and the reporting entity is in the same position as a passive majority voting shareholder. This view is consistent with the requirements in IAS 39 Financial Instruments: Recognition and Measurement and IAS 33 Earnings per Share.
- The Board observed that if an option to acquire shares in an entity is exercisable at a price that equals the fair value of those shares, the option holder does not obtain a return from those shares until that option is exercised. It is only once the option holder has obtained the shares that it has access to the returns. The Board concluded that in such circumstances the option fails the second part of the control definition.
And then, I guess, there’s a big grey zone in between. Clearly then, intention and financial ability come right into play here. Similarly, the proposed standards would require a sharper focus on situations when an entity doesn’t have a majority of the voting rights in another, but it’s the major shareholder and the other holdings are widely dispersed. And, by the way, it also specifies that “a reporting entity shall assess control continuously.”
Now I know this probably isn’t the most impactful area of the exposure draft (expected to be finalized before the end of the year) overall – many preparers will likely be more consumed by how it might change their assessments of special purpose entities. But it’s an interesting example for how it illustrates the continuing evolution of IFRS. IAS 27, with its notion of what’s too difficult and its resulting short-cut to an answer, only appeared in 2008. But just a few years later, here and elsewhere, the IASB now insists on following the logic of its principles all the way, however challenging the required judgments might be. The IASB Chair David Tweedie has recently been quoted as saying he’s “not terribly sympathetic” to concerns about standards overload based on the current work agenda. Fine with me, at least we know where we stand. But by the way, I think the ground is trembling…
The opinions expressed are solely those of the author (jhughes@mscm.ca)