CONCEPT OF CONTROL – POWER & RIGHTS UNDER INDAS cope CONCEPT OF CONTROL – POWER & RIGHTS UNDER INDAS

Key Learning Points Definitions of Control Key Terms in Control Analysis of Control - Power Power & Rights Relevant activities Key Clauses in Shareholder agreements Relation between Power & Return Exposure to Variable Return Defacto Agent

Not Covered In Session Consolidation Methods Consolidation Procedures Joint Arrangement & Joint Control Consolidation procedures for Investment Entities Disclosures

DEFINITION OF CONTROL A. “Control” under Accounting Standards AS-21 Consolidated Financial Statements AS-23 Accounting for Investments in Associates in CFS Common Definition Control : 1. Ownership – Direct or Indirect through subsidiaries 2. More than 50% voting power OR 1. Control composition of BOD or governing body 2. To obtain economic benefits

Definition of “CONTROL” B. “Control” under Companies Act 2013 Section 2(27) defines it Definition Control : 1. Right to appoint majority of directors or 2. Control the management or policy decisions exercisable either individually or in concert with other, directly or indirectly, This control can be derived from shareholding rights or management rights or shareholder agreements or voting agreements or in any other manner

Definition of “CONTROL” C. “Control” under INDAS Regime Ind AS 24 Related Party Disclosures Ind AS 27 Consolidated & Separate Financial Statements Control : 1. Power to govern financial & operating policies of entity 2. To obtain benefits Control as per Ind AS 110 Consloidated Financial Statements 1. Investor controls an investee when it is exposed or 2. Has rights to variable returns from its involvement with investee and 3. Ability to affect those returns though its power over investee

KEY TERMS IN CONTROL Power Rights Policy decisions – Financial; Operating & Overall Management Variable Returns Ability to affect returns Exposure to risks

Analysis of term “ Power” & its related matters Power : Current ability to direct relevant activities Source : It arises from rights Type of Rights : 1) Substantive 2) Protective Relevant activities Activities that significantly affect investee’s returns

Indicator of Power - Rights Voting Rights ( equity instruments) Potential voting rights ( viz put & call option; convertible clauses) Right to appoint KMPs Decision making rights Removal rights Rights of Defacto agents & related parties

Source of Rights Contractual arrangements Shareholder agreements Legal requirements Nature of transaction

Type of Rights – Protective Rights Protective Rights : Rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate Power does not arise from protective rights Protective rights are typically held to prohibit fundamental changes in the activities of an investee that the holder does not agree with and usually apply only in exceptional circumstances ( i.e contingent event)

Illustrations of Protective Rights Approve an investee capital expenditure Seizure of assets in event of default in loan agreements Approve an investee’s issuance of equity or debt instruments Veto transactions between the investee and a related party Restrict an investee from undertaking activities that could significantly change the credit risk of investee to detriment of investor

Relevant Activity A. Relevant activities are the activities of the investee that significantly affect investee’s returns B. Examples of relevant activities include: a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding

Two or more Investors direct Relevant Activity Which Investor has Power ?? Identify which is very more significant effect on investees return OR On relevant activities

Two or more Investors direct Relevant Activity--Contd .... Two or more investors have the current ability to direct relevant activities and those, activities occur at different times The investors shall determine which investor is able to direct the activities That most significantly affect those returns consistently with the treatment of concurrent decision making rights . The investors shall reconsider this assessment over time if relevant facts or circumstances change

Challenge In Determining - Substantive / Protective Rights Fine line of demarcation Evaluation changes based on every facts & circumstances Ability to sell assets of the investee if an investee defaults on a loan, when default is considered an exceptional circumstance In case the investee defaults on a loan, the investor holding that right would need to re-assess whether that right has become a substantive right (rather than a protective right) When breach of a covenant in a borrowing arrangement causes the borrower to be in default. Veto right over annual budget – Protective or not ???

Analysis of Veto Rights - Substantive If the veto rights relate to changes to operating & financial policies that significantly affect investor returns, veto rights may not be merely protective. For Instance : Approving the annual operating budget of an investee is the relevant activity. Investor control the activity through veto right

Analysis of Veto Rights - Protective A. It rarely affect investee returns B. Veto rights over changes to Amendments to articles of incorporation Location of investee headquarters Name of investee Auditors Accounting principles for separate reporting of investee operations Co

Extracts from Shareholder agreements : Restrictions on the Powers of the Board and Company   Notwithstanding any other provision of this Agreement or any power conferred upon the Board by this Agreement, the Act or the Articles, the Parties shall ensure that the Company shall obtain the written consent of the Investors in any of the matters specified herein below till such time the Company successfully completes an IPO, unless such matters shall have been approved by an affirmative vote of a majority of the Board which shall include the affirmative vote of the Investors Directors. Modifications to the capital structure

Extracts from Shareholder agreements : Restrictions on the Powers of the Board and Company ... Contd  Any amendment to the privileges, powers or rights granted to the Investors;   The incurrence of any debt by the Company in excess of Rs. 5,00,000/-; Any Change in Control in the Company whether by the acquisition of shares or voting rights; The business plan and annual budget of the Company for any financial year and any amendment thereto; Any change in accounting/tax policies of the Company; Any changes to the rights of the Shareholders

Exposure to Variable Returns Returns that are not fixed and vary as per performance of investee Returns can be positive, negative or both   Exposures to variable returns is an indicator of Control Caution : Magnitude of Exposures to variable returns does not determine whether investor holds power Generally, the focus is on the returns that are generated by the investee. However, depending on the purpose and design of the arrangements and the investee, when the investor receives returns that are not generated by the investee, but stem from involvement with the investee, these returns are also considered.

Exposure to Variable Returns - Illustrations An investor can hold a bond with fixed interest payments. The fixed interest payments are variable returns for the purpose of this Ind AS because they are subject to default risk and They expose the investor to the credit risk of the issuer of the bond. The amount of variability (ie how variable those returns are) depends on the credit risk of the bond. Fees and exposure to loss from providing credit or liquidity support Dividend Remuneration for servicing an investee’s assets or liabilities

Relation between Power & Return  Decision making rights & its Delegation The terms and conditions of the arrangement are considered to assess whether an entity is an agent or a principal. The determination of whether a decision-maker is an agent or a principal is made based on the following: a) Scope of decision-making authority b) Rights held by other parties (e.g., existence of removal rights) c) Remuneration of the decision-maker d) Exposure to variability of returns through other interests

Defacto Agent Supplier-customer relationship Normally, a typical supplier-customer relationship is not expected to result in one party being a de facto agent of the other. This is because in a typical supplier-customer relationship, one party cannot direct the other party to act on its behalf, because the activities of each are directed by their respective shareholders, Board of Directors and management. However, a party with a close business relationship is an example of a de facto agent. Accordingly, where a close business relationship exists between a customer and a supplier, consideration needs to be given to whether the supplier is a de facto agent of the customer. The customer and supplier have common management or common shareholders The customer has the ability to direct product design, sales, etc. The supplier is a service provider (e.g., investment banker, attorney) that assists in structuring a transaction

Defacto Agent – Game Changer Example : A has a 40% interest in Z, whose relevant activities are directed by voting shares that entitle the holder to a pro rata share of returns of Z. Based on the facts and circumstances, A concludes that, by itself, its 40% interest does not give A control over Z. B holds a 15% interest in Z. A evaluates the facts and circumstances and concludes that B is a de facto agent of A.

Defacto Agent – Game Changer Example Contd..... Based on the combined interest, A concludes that it controls Z, because it can direct B how to vote by virtue of being a de facto agent. Accordingly, A consolidates Z in its CFS .

Assessments Control Assessment is a continuous Process...............

KaKa``