Comparison between US GAAP and IFRS
With reference to US GAAP versus IFRS ‘ The basics issued by Ernst & Young in November 2012, both US GAAP and IFRS rely on verifying whether a reporting entity has control over another entity to decide whether consolidation is required. Moreover, if an investor gains significant influence over an investee, the adoptions of equity method of accounting under US GAAP and IFRS are consistent with one another.
However the two accounting standards have different definitions on control and power. Moreover, some exceptions offered by US GAAP for entities not to provide consolidated financial statements are not applicable under IFRS. The treatments for special purpose entities (SPEs), namely variable interest entities (VIEs) and voting interest entities, also differ.
Details of the differences between the two accounting standards are summarized below:
‘ Consolidation model
Under GAAP two models are present ‘ one for VIEs and one for voting interest entities. However, a single model applies to all entities under IFRS.
‘ Determination of consolidation
In particular, under US GAAP, all entities are first evaluated as if they are potential VIEs. If an entity is a VIE, the primary beneficiary of the entity needs to consolidate the VIE. If an entity is not a VIE, voting rights would be the yardstick to determine who needs to consolidate the entity. Noticeably, potential voting rights are not included in both cases.
Under IFRS, if an investor has
‘ the power over the investee,
‘ exposures or rights to variable returns from investor’s involvement with the investee, and
‘ the ability to use investor’s power over the investee to affect the amount of investor’s returns,
then the investor is said to control the investee. Moreover, an investor is presumed to control an investee if the former owns more than 50% of the voting-right shares of the latter, though potential voting rights must be considered.
Under US GAAP, primary beneficiary is determined based on the power and benefits that investors can enjoy from investing in an investee. In some cases, primary beneficiary can be determined based on a majority of the exposure to variability.
Under IFRS, whenever the substance of the relationship between entities indicates that an entity controls the SPE, consolidation is required.
Who needs to consolidate Britel under US GAAP?
Under US GAAP, we first need to verify whether Britel is a VIE.
Upon signing the agreement, TTL Group will no longer fund Britel’s operation and shortfall. This is clearly in violation against the characteristic of controlling financial interest holders in fulfilling investee’s contingent and operational financial needs. According to US GAAP, a VIE is an entity in which the equity investors do not have characteristics of controlling financial interest holders. As Britel is still wholly-owned by TTL Group and potential voting rights are not considered under US GAAP, Britel is considered a VIE.
Then we have to determine whether TTL Group or Centcom has control over Britel.
According to US GAAP, control of a VIE results from a reporting entity having both
‘ the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance, and
‘ the obligation to absorb losses of the VIE that potentially could be significant to the VIE or the right to receive benefits from the VIE that potentially could be significant to the VIE.
As Centcom gains absolute control over the administrative and operational procedures of Britel, whereas TTL Group only has the right to affect major expansion transactions in the board, Centcom has much greater power to direct the day-to-day activities of Britel that most significantly impact Britel’s economic performance.
Moreover, Centcom needs to absorb losses of Britel in contingent situations. Centcom is also entitled to receive 80% of EBITDA of Britel, which means Centcom can enjoy benefits from Britel that is significant to Britel. Being the primary beneficiary of Britel, Centcom has the control over Britel. In this case, only Centcom is required to consolidate Britel.
Who needs to consolidate Britel under IFRS?
In deciding on whether consolidated financial statements should be prepared, we have to verify whether Centcom and TTL Group control Britel.
According to IFRS 10:7, there are three criteria for verifying the power of control.
1) The power over the investee
According to IFRS 10:11, ‘power arises from rights, and such rights can be either straightforward or complex.’ In the case we studied, Centcom gains control over Britel as it is allowed by the agreement to manage Britel. In addition, Britel’s administrative and operational activities will be managed by Centcom. Centcom will have a significant influence over Britel’s daily operations.
Moreover, unanimous approval of the board is required for major expansion transactions of Britel. As Centcom would select one member of the six-member board of directors, Centcom can influence the decision-making processes involving Britel’s major expansion transactions.
It is noticeable that Britel is a wholly-owned subsidiary of TTL Group. TTL Group also has a dominant control over the election of members of the board of directors of Britel. Nevertheless, the issue of call option by TTL Group to Centcom grants the latter the right to fully acquire Britel if the call is exercised. This should be considered under IFRS and TTL Group’s 100% stakehold in Britel is not guaranteed and secure.
Considering the aforementioned factors, we believe that Centcom fulfills the first criterion, which is Centcom (investor) has the power over Britel (investee). However TTL Group has lost its direct influence over different aspects of Britel’s business after the agreement. TTL Group no longer has power over Britel.
2) Exposures or rights to variable returns from investor’s involvement with the investee
The return of Centcom on managing Britel is the variable management fee it is entitled to receive. The fee is calculated based on Britel’s EBITDA, which certainly has the potential to vary as Britel’s operating result varies. Also, management fee is paid only if Britel generates sufficient cash from its operations.
In addition, Centcom is required to fund any shortfall if Britel cannot meet with its debt obligations. Given that such shortfalls are not reimbursable, it should not be regarded as a loan to Britel. It should be a capital injection instead. Such contribution of fund will adversely affect Centcom’s return on managing Britel.
Summing up, the return of Centcom can be positive, negative, or both. This, being consistent with what is in IFRS 10:15, fulfills the second criterion.
Besides, the agreement still permits TTL Group to receive any residual claim on Britel’s profit, after deducting management fee paid to Centcom whenever applicable. Such claim can be positive if Britel is earning a profit, but it can be negative if Britel suffers a loss.
The return of TTL Group from Britel can be positive, negative, or both. This, being consistent with what is in IFRS 10:15, also fulfills the second criterion.
3) The ability to use investor’s power over the investee to affect the amount of investor’s returns
Apart from the two criteria mentioned above, ‘a parent must also have the ability to use its power over the investee to affect its returns from its involvement with the investee such that a parent has control over the investee.’ [IFRS 10:17].
It is known that Centcom is intended to integrate Britel’s activities into its own operations. Plans to terminate Britel’s employees, which is an ability of Centcom as an investor, are expected to affect Britel’s operating efficiency and productivity, thereby affecting Britel’s operating performance and thus the return of Centcom. Similarly, the consolidation of finance, accounting and customer service departments of Centcom and Britel would grant Centcom the dominance in governing Britel’s operating, investing and administrative policies, thereby affecting its return from Britel.
Moreover, Centcom would provide additional services to Britel’s customers upon managing Britel. Such services were not provided by Britel before. This further illustrates the ability of Centcom to influence investee’s operations through diversification of services and opt for a better operating performance of Britel.
The two aforementioned factors verified Centcom’s ability to use its power as an investor over Britel to affect the amount of Centcom’s returns from managing Britel.
Noticeably, Centcom has the final right on deciding and implementing the administrative and operating activities of Britel after the agreement is in force. TTL Group has lost its privilege to directly and exclusively influence the operations and thus the performance of Britel. Considering these, TTL Group has very limited ability to use its role as a parent to affect the return on Britel. Thus TTL Group fails to fulfill the third criterion.
Conclusively, only Centcom has control over Britel and needs to consolidate Britel under IFRS.
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