Billy

Q1.18 HKFRS10


(a) The HKICPA issued HKFRS10 Consolidated Financial Statements, which is a replacement of
HKAS27 Consolidated and Separate Financial Statements and HK(SIC) INT 12 Consolidation
Special Purposes Entities..

Required:

(i) Discuss the existing guidance in defining control and why there is a need to replace
this guidance; and

(ii) Describe the main requirements that the HKICPA has outlined in the new HKFRS10.
Candidates are required to list any of these requirements are different from existing
HKAS27.


(b) Fragrance Taste Limited (FTL), a public limited company, is principally engaged in cafe
operations. FTL has owned and operated the well-known Fragrance coffee chain.

(i) FTL owned 52 percent of equity interests of AB Limited for several years. The rest of the
ordinary shares of AB were held by hundreds of investors, none individually holding more
than one percent of the ordinary shares. None of the investors has any arrangements to
consult each other or make collective decisions, and co-ordination between other investors
would not be easy. FTL managed the policies and appointed the majority of the directors of
AB.

FTL sold 3 percent of the ordinary shares of AB on 30 April 2012.

(ii) FTL also owns 35 percent of the ordinary shares of JK Limited for several years. Two other
investors, EF and GH, unrelated to FTL each hold 25 percent of the ordinary shares of JK.
The remaining ordinary shares of JK are dispersed.

FTL acquired an option to buy the 25 percent of voting shares in JK from EF on
30 April 2012. This call option is exercisable in 21 days time and that is in the money. JK
has annual shareholder meetings at which decisions to direct the relevant activities are
made. The next shareholder meeting is scheduled for 31 July 2012. However, shareholders
can call a special meeting to change the existing policies over relevant activities, but a
requirement to give notice to the other shareholders means that such a meeting cannot be
held for at least 30 days. The intent to exercise the call option by FTL is unknown.

(iii) FTL acquired 40 percent of the ordinary shares of XY Limited from its sole owner, RS, on
30 April 2012. XY will franchise and operate the Fragrance coffee. To protect the brand,
FTL has rights to determine the operational guidelines of the cafe operation which include
determining or changing of the operating policies, setting of the selling prices, selecting of
the suppliers, and selecting, acquiring or disposing of equipment

RS continues to appoint, remunerate or terminate the employment of key management
personnel and operational staff. The employees are expected to conduct the cafe operation
strictly in accordance with the operational guidelines.

It is agreed that FTL has 30 percent share of cafes profits as annual franchise fee.

Unless indicated otherwise, there are no other arrangements that affect decision making other
than voting rights.

Required:

Discuss how to account for the above investees in the consolidated financial statements
of FTL for the year ended 30 April 2012 under HKFRS10.






Billy
HONG KONG
MODULE A Financial Reporting
Workbook June 2013

BILLY ANG 2013 All rights reserved unless otherwise stated. 1

Q1.18 HKFRS10


(a) HKICPA previously had two different consolidation models: one for special purpose entities and
another for all other investees.

HKAS27 Consolidated and Separate Financial Statements requires the consolidation of entities that
are controlled by a reporting entity, and it defined control as the power to govern the financial and
operating policies of an entity so as to obtain benefits from its activities.

However, HK(SIC) INT12 Consolidation Special Purpose Entities which interpreted the
requirements of HKAS27 in the context of special purpose entities, placed greater emphasis on
risks and rewards.

This perceived conflict of emphasis had led to inconsistent application of the concept of control. This
was aggravated by a lack of clear guidance on which investees were within the scope of HKAS27
and which were within the scope of HK(SIC) INT12.

In the new consolidation standard, HKFRS10 Consolidated Financial Statements, the HKICPA has
stated that its objective is to develop a single consolidation model applicable to all investees.

The HKICPA hopes that a single model founded on a principles-based definition of control,
combined with the enhanced disclosures required under FRS12 Disclosure of Interests in Other
Entities, will reduce structuring incentives, promote consistency, and improve transparency.

Single control model

The new control model states that an investor controls an investee when the investor 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.

Compared with the requirements that were in HKAS27, the changes introduced by HKFRS10 will
require management to exercise significant judgement to determine which entities are controlled.

The new control definition reflects that an investor can achieve power over an investee in many
ways, not just through governing financial and operating policies by holding a majority of voting
rights. This revised definition focuses on the power over the investee, the variable returns and the
link between these two elements.

Power

Power is the current ability to direct the relevant activities of the investee that significantly influence
returns.

The determination of power is based on current facts and circumstances and is continuously
assessed. The fact that control is intended to be temporary does not obviate the requirement to
consolidate any investee under the control of the investor.

An investor can have power over an investee even if other entities have existing rights that give
them the current ability to participate in the direction of the relevant activities, but do not give them
control.

For a right to give power, it must give the current ability to direct the relevant activities. Rights are
only considered if they are substantive (i.e., the holder must have the practical ability to exercise the
right). Whether rights are substantive depends on facts and circumstances.

The purpose and design of an investee is also critical when assessing whether a right is substantive.

Power does not have to be exercised. To be substantive and give power, a right must give the
investor the current ability to direct the investees relevant activities. However, current ability does
not always mean able to be exercised this instant. It can be the ability to exercise when decisions
need to be made.

Billy
HONG KONG
MODULE A Financial Reporting
Workbook June 2013

BILLY ANG 2013 All rights reserved unless otherwise stated. 2
In evaluating whether rights are substantive, the investor has to assess whether its rights and rights
held by others, are protective rights.
Protective rights (often known as veto rights) are 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.

Protective rights do not give the investor control over the investee since it only allows the investor to
block certain decisions outside the ordinary course of business (i.e. usually apply only in exceptional
circumstances) and cannot prevent another investor from having power over an investee.

The fact that the right to make decisions is contingent upon an event occurring does not mean that
the right is always a protective right.

However, assuming that the right is substantive, the likelihood that the holder will exercise a right is
not a factor in determining whether it is merely a protective right, or is potentially a right that gives
power.

An investor with more than half the voting rights would meet the power criteria in the absence of
restrictions or other circumstances.

However, in some cases, holding majority of the voting rights do not give the holder the power to
direct the relevant activities. This might be the case, when:

- relevant activities are directed by contract .
- relevant activities are directed by government, judiciary, administrator, receiver, liquidator, or
regulator.
- voting rights are not substantive
- voting rights have been delegated to a decision-maker, which then holds the voting rights as an
agent.
- voting rights are held as a de facto agent of another investor.

When an investor holding less than half of the voting rights, the investor should consider potential
voting rights, economic dependency and the size of its shareholding in comparison to other holdings,
together with voting patterns at shareholder meetings. This last consideration will bring the notion of
de facto firmly within the consolidation standard.

When assessing whether it has power over an investee, an investor also considers the potential
voting rights that it holds, as well as potential voting rights held by others. Common examples of
potential voting rights include options, forward contracts, and conversion features of a convertible
instrument.

If an investor has less than a majority of voting rights, but holds a substantive option that, if
exercised, would give the investor a majority of voting rights, that investor would likely have power.

HKFRS10 is silent on whether the intention of the holder (i.e., whether it intends to exercise the
option or not) is considered. In contrast, HKAS27 was explicit that managements intention was not
considered.

However, HKFRS10 is clear that an option is only considered in the assessment of power if it is
substantive (i.e., the holder has the practical ability to exercise. Common factors to consider when
evaluating whether an option is substantive include:

- exercise price or conversion price, relative to market terms
- ability to obtain financing i.e. economic barrier
- timing and length of exercise period

To give power, an option must give an investor the current ability to direct the relevant activities
when the decisions need to be made. Thus, for example, if an option was deeply-out-of-the-money
at the reporting date, but expected to become in-the-money before the relevant activities of the
investee need to be directed, then the option may be substantive.

The financial ability of an investor to pay the exercise price should be considered when evaluating
whether an option is substantive, because this could be an economic barrier, as contemplated by
HKFRS10. This was previously prohibited from being considered under HKAS27.
Billy
HONG KONG
MODULE A Financial Reporting
Workbook June 2013

BILLY ANG 2013 All rights reserved unless otherwise stated. 3
Under HKAS27, an option needs to be currently exercisable to give control. However, under
HKFRS10, an option can give an investor the current ability to direct an investees relevant activities
even when it is not currently exercisable. This is because the term current is used more broadly in
HKFRS10 than in HKAS27. Although current often means as of today or this instant in practice,
the HKICPAs use of the term in HKFRS10 broadly refers to the ability to make decisions about an
investees relevant activities when they need to be made.

When the relevant activities are not directed through voting rights, but rather, are directed by other
means, such as through a contract, analysis of power should include the original formation
documents and governance documents of the investee, as well as the marketing materials provided
to investors and other contractual arrangements entered into by the investee.

In some circumstances, it may be difficult to determine whether an investors rights give it power
over an investee. In such cases, the investor considers other evidence that it has the current ability
to direct an investees relevant activities. For example, the investor may have evidence that it has
the practical ability to:

- Appoint, approve or nominate the investees key management personnel (or Board of Directors)
- Direct the investee to enter into, or veto any changes to, significant transactions that affect the
investors exposure to variable returns
- Dominate either the nominations process for electing members of the investees governing
body, or obtaining proxies from other holders of voting rights

Returns

The second element of control is that an investor must have exposure, or rights, to variable returns
from its involvement with the investee to control it. HKFRS10 uses the term returns rather than
benefits under HKAS27 to avoid giving the impression that only positive returns are relevant. In
fact, variable returns can be positive, negative, or both.

Exposure to variable returns is an indicator of control. This is because the greater an investors
exposure to the variability of returns from its involvement with an investee, the greater the incentive
for the investor to obtain rights that give the investor power.

Link between power and returns

The last element of control is the investors ability to use its power over the investee to affect the
amount of its returns. HKFRS10 stresses that, for an investor to control an investee, it must not only
meet the first two conditions - that is, have power over the investee and exposure or rights to
variable returns from the investee - but must also have the ability to use its power to affect the
returns from its involvement with that investee.

This means that an investor with decision-making rights must determine whether it is acting as a
principal or as an agent to the investee.

An investor (the agent) does not control an investee when the investor exercises decision-making
rights delegated to it, and therefore does not consolidate the investee.

Under HKFRS10, an investor should also determine whether another entity is acting as an agent for
the investor, in which case, the decision-making rights delegated to its agent are treated as if they
were held by the investor directly.

Determining whether a decision maker is acting as a principal or as an agent requires judgment to
evaluate all of these factors. However, a decision maker is an agent if a single party holds
substantive rights to remove the decision maker without cause. If two or more parties must act
together to exercise substantive removal rights, then such rights are not, in isolation, sufficient to
identity the decision maker as an agent.

The principal-agent guidance included in HKFRS10 is new and is intended to differentiate between
powers that an entity exercises for its own benefit and those it exercises on behalf of others. This
issue is particularly relevant to businesses such as venture capital firms and fund managers. These
entities often hold direct interests in an investee, along with additional holdings in funds managed on
behalf of others, and the lack of guidance in HKAS27 on this issue has led to mixed practice in the
past.
Billy
HONG KONG
MODULE A Financial Reporting
Workbook June 2013

BILLY ANG 2013 All rights reserved unless otherwise stated. 4
(b) AB Limited

Despite the fact that FTL only owes 48% of equity interest of AB after the disposal of 3% on
30 April 2012, FTL continues to control AB since:

- the other shareholdings of AB are widely dispersed with other investors individually owing less
than 5%.
- there is no history of shareholder activism and the other shareholders have not been well-
represented in the past meetings.
- FTL continues to nominate the nomination process for ABs governing body.

FTL should continue to consolidate AB with the de facto control over it.

Tutorial note: guidance to determine de facto control in HKAS27 is less explicit.

JK Limited

In the absence of the call option, FTL does not have power over JK since only two other investors
(i.e. relatively a small number) could easily cooperate to outvote FTL.

The call option (i.e. potential voting rights) held by FTL is considered as substantive since the call
option is in the money, the call option is exercisable before operating decisions on JK need to be
made and there are no other countervailing factors.

Managements intent to exercise does not affect the assessment of whether the call option is
substantive unless this intention is caused by barriers or other practical difficulties.

Hence, FTL should consolidate JK with the de facto control over it.

Tutorial note: the call option should not be considered for control assessment under HKAS27 since
it is not currently exercisable at 30 April 2012. The moneyness of the option is irrelevant for control
assessment under HKAS27. Moreover, the managements intent is not taken into account for
control assessment. Hence, with merely 35% equity interest in JK, FTL does have control over JK
under HKAS27.

XY Limited

The assessment of whether FTL has power over XY hinges on the determination of the relevant
activities, and whether FTL has the current ability to direct that activity through its rights.

The rights held by FTL must be evaluated to determine if they are substantive, or whether they are
merely protective rights.

Despite the fact that FTL only owns 40% of equity interest of XY, it appears that FTL has power
over XY since:

- the operational guidelines appears to govern the relevant activities that most significantly affects
XYs returns,
- FTL has the rights to determine the operational guidelines, and
- the rights are considered as substantive rights and not protective rights especially after
considering the substantial level (i.e. 40% equity interest and 30% profit sharing) of exposure to
variability of returns from XY.

Hence, FTL should consolidate XY with the de facto control over it.

Tutorial note: no guidance on franchise agreements exists in HKAS27.