Accounting for Investment by Paris Ltd
Hannah Cuskelly, 42625010
ACCT3103 Accounting for Corporate Structures
Introduction
The purpose of this report is to research and critically analyse information in order to identify the relationship between Paris Ltd’s and its investment in the six entities – London Ltd, Sydney Ltd, Beijing Ltd, Tokyo Ltd, Rome Ltd and Morocco Ltd. In order to determine the appropriate accounting treatment for each investor-investee relationship, the types of relationships must be defined and their criteria for application explained. The conclusions drawn from this information will determine the recommendations given regarding the accounting methods to be adopted for each type of investment, and which entities form part of the Paris Ltd Group.
Investor-Investee Relationships
Equity investments by an investor in an investee can confer control, significant influence, joint control or can be a passive investment. Control results in a parent and subsidiary relationship between investor and investee. Significant influence results in an investor and associate relationship and passive investment with no control or influence is simply an equity investment with an investor-investee relationship. Joint control results in a joint arrangement which can either be a joint operation or joint venture. Depending on the relationship applicable to each investment, the accounting treatment may be different.
Control
As defined in AASB 10:6-7, an investor has control over an investee when it has power over the investee, exposure to rights or variable returns from its involvement with the investee and the ability to use its power to affect the result of the investor's returns. All three criteria of this definition must be satisfied.
Power
“An investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities” (AASB 10:10). Key elements of this definition include “existing rights,” “current ability” and “relevant activities”. AASB 10 paragraphs 11-14 go on to clarify that owning a majority of the voting rights or other rights is not always required to have control. Voting rights may be restricted due to contractual arrangements. The investor’s rights are required to be sufficient for the investor to unilaterally direct the activities that most affect the investee’s returns. Relevant activities include the selling or purchasing of goods or services, researching and developing new products or obtaining funding, or making operating or capital decisions (AASB 10: B11-12).
Returns
“An investor is exposed, or has rights, to variable returns from its involvement with the investee when the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance” (AASB 10:15). Variable returns can be positive, negative or both with one of the most common forms of variable returns being dividends.
Ability to Use Power
“An investor controls an investee if the investor not only has power over the investee and exposure or rights to variable returns from its involvement with the investee, but also has the ability to use its power to affect the investor’s returns from its involvement with the investee” (AASB 10:17). This third criteria of control emphasises “ability” along with the importance of the link between power and returns. An investor can still have power but be a passive investor; so long as the investor has the capacity to exercise power should it want to do so. The ability to use its power also depends on whether the investor is acting as a principle (on behalf of itself) or as an agent (on behalf of others). If the investor is acting as an agent, control does not exist (AASB 10:18).
Assessing Control
When assessing control, it may not be as straightforward as a majority of voting rights granted by shares and in some cases, complicated assessment may be required. AASB 10 Appendix B provides guidance on all the limbs of control.
Paragraph B6 states that in the absence of any additional arrangements that may affect the investee’s decision making, ordinary shares resulting in voting rights are indicators of control, satisfying all three requirements of control. As all shares issued by each of the entities invested in by Paris Ltd, are ordinary shares with normal voting rights, and one vote is entitled per ordinary share, control can be assessed under this principle.
AASB 10: B25 states that, assuming that relevant activities of the investees are directed by a majority of votes, and that a majority of management that directs the relevant activities are appointed by the holder of the majority of voting rights, power can be evidenced by a majority of voting rights. Following AASB 10: B35, Paris Ltd has power over London Ltd and Tokyo Ltd by holding more than half of their voting rights at 80% and 55%, respectively.
Paris Ltd does not have power over an investee if the exceptions outlined in AASB 10: B36-37 apply. If another entity has existing substantive rights, to direct the relevant activities of the investee, and they are not an agent of Paris Ltd, Paris Ltd does not have power over the investee. Power over an investee does not exist, even if a majority of voting rights are held if the rights are not substantive. That is, that the rights have barriers that exist to prevent shareholders from exercising their rights.
The evidence is clear that London Ltd and Tokyo Ltd are controlled by Paris Ltd, with the majority of voting rights being held in both cases. It would be impossible for other shareholders to prevent Paris Ltd from directing these entities’ activities. Therefore, London Ltd and Tokyo Ltd are subsidiaries of Paris Ltd.
Entity Voting Rights (%) Control?
London 80% Control
Tokyo 55% Control
Beijing 55% (37%+18%)
Because Paris controls London, it controls their votes in Beijing Control
Sydney 50% No unilateral control
Morocco 50% No unilateral control
Rome 40% No unilateral control
Investment in Beijing Ltd requires further consideration, as Paris Ltd’s direct interest alone does not confer control. While Paris Ltd has only 37% direct interest in Beijing Ltd, its subsidiary London Ltd also has a direct interest, of 18%. Because Paris Ltd controls London Ltd through its majority of shares, it can control the activities of London Ltd and therefore, the votes that London Ltd has in other entities. As a result, Paris Ltd’s total voting rights in Beijing Ltd is 55% (37% + 18%). This is a majority and satisfies the criteria for control. Beijing Ltd is also a subsidiary of Paris Ltd.
When considering just the voting rights of Sydney Ltd, Morocco Ltd and Rome Ltd, power, and therefore control, is not so obviously determined. While Paris Ltd’s investment in Sydney Ltd totals 50%, this alone is not enough to satisfy the requirement of power. “An investor with less than a majority of the voting rights has rights that are sufficient to give it power when the investor has the practical ability to direct the relevant activities unilaterally” (AAB 10: B41). In order to determine if an investor has power, all other facts and circumstances are considered when a majority of voting rights does not exist, as per paragraph B42.
The size of the investor’s holdings of voting rights relative to the size and dispersion of that of the other vote holders can be an indicator of power (AASB 10: B42). Paris Ltd’s investment in Sydney Ltd is the largest percentage of shares held by a single entity, with all remaining shares held by geographically diverse groups of investors, who hold only small parcels of shares and are unlikely to attend meetings. It is very unlikely that the other investors would be able to stand together and outvote Paris Ltd in any decision-making activities, especially considering that the other shareholders are unlikely to attend meetings in the first place. These facts suggest that Paris Ltd has control over Sydney Ltd (AASB 10: B43).
In addition to normal voting rights, AASB 10: B19 states that special relationships between investor and investee can suggest that the investor has a more active interest in the investee’s activities which, may indicate power. An example given in the standard considers if the investee’s key management personnel are current or previous employees of the investor. If these persons have the ability to direct the relevant activities of the investee, this can indicate power and therefore, control. The fact that Sydney Ltd’s board of directors contains three of five members appointed by Paris Ltd also supports the conclusion that Paris Ltd has power over Sydney Ltd, and therefore control. Sydney Ltd is a subsidiary of Paris Ltd as will be consolidated s per AASB 10:4.
Entity Power? Returns? Ability? Control
Sydney Yes – the size of shareholding in comparison to other shareholders, passive nature of other shareholders, and the majority of board positions held
Yes – from shares Yes – from voting rights and held board positions Control
Joint Control
“A joint arrangement is an arrangement of which two or more parties have joint control” (AASB 11:4) and can be either a joint venture or a joint operation depending on the rights and obligations of each of the parties of the arrangement. As defined in AASB 11:7, joint control is the contractually agreed sharing of control of an arrangement, by two or more parties, which exists only when decisions about the relevant activities of the investee require the unanimous consent of the parties sharing control.
Paris Ltd holds 50% interest in Morocco Ltd, with the other 50% being held by Madrid Ltd. Both entities have rights to the net assets of the investee and there is a contractual agreement in place whereby both investors can only make operating, investing or financing decisions regarding Morocco Ltd, unanimously. It is clear that Paris Ltd does not have unilateral control over Morocco Ltd, but instead, joint control with Madrid Ltd. The facts clearly satisfy the requirements of a joint arrangement and more specifically, as the investors have rights to Morocco Ltd’s net assets only, a joint venture and not a joint operation (AASB 11:16). A joint operation would require the investor having rights to the assets as well as an obligation to the liabilities of the arrangement (AASB 11:15). As per AASB 128:6, a joint venture will be accounted for using the equity method.
Entity Power? Returns? Ability? Control
Morocco Joint – equal power held with Madrid Ltd Yes – from shares Yes – from voting rights and contractual agreement Joint Control
Significant Influence
If there is no control or joint control of an investee, significant influence may exist if the investor has the power to participate in the financial and operating policy decisions of the investee (AASB 128:3). Significant influence can be usually evidenced by representation on the board of directors or managing body of the investee; through participation in policy or decision-making activities; economic, organisational or technological dependency between entities (AASB 128:6). AASB 128:5 states that significant influence is assumed if an investor holds 20% or more of the voting power of the investee, regardless of whether it is held directly or indirectly unless it can be clearly established that this is not the case. If held interest is less than 20%, it is presumable that the investor has no significant influence, unless it can be clearly demonstrated otherwise.
Applying AASB 10.B42 principles to the case of Rome Ltd can assist in determining whether Paris Ltd has power over Rome Ltd. The relative size of Paris Ltd investment is 40%, which is not that much higher than that of the institutional investors at approximately 17% interest each. The remaining shareholdings are concentrated in the three institutional investors who could easily meet with each other and co-ordinate to exceed Paris Ltd’s voting power. Given that 10% of investors take no active role in the management of Rome Ltd, and the three institutional investors could easily coordinate, Paris Ltd does not control Rome Ltd. If AASB128:5 is assumed to hold, then Paris Ltd has significant influence over Rome Ltd with interest greater than 20% but less than 50%. Rome Ltd is considered an associate and will be accounted for using the equity method (AASB 128:16 & AASB 11:24).
Entity Power? Returns? Ability? Control
Rome No – due to the size of shareholding in comparison to other shareholders, active nature of institutional investors and potential cooperation between other shareholders to outvote investor
Yes – from shares Yes – from voting rights No – Significant Influence
Conclusion
Examining Paris Ltd’s investments draws the conclusions that the Paris Ltd Group consists of Paris Ltd as the parent entity and London Ltd, Beijing Ltd, Tokyo Ltd and Sydney Ltd as subsidiaries. Morocco Ltd is a joint venture with Madrid Ltd and Rome Ltd is an associate of Paris Ltd. As per AASB 10:4, all subsidiaries will be accounted for using through consolidation as described in AASB 3; Paris Ltd shall present consolidated financial statements for the Paris Ltd Group. Investments in associates or joint ventures shall be accounted for in separate financial statements in accordance with paragraph 10 AASB 127 (AASB 128:44).
References
AASB 3 – Business Combinations
AASB 10 – Consolidated Financial Statements
AASB 11 – Joint Arrangements
AASB 127 – Separate Financial Statements
AASB 128 – Investments in Associates and Joint Ventures
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