IFRS 10 and the curious case of understanding the defination of a subsidiary!

Where an investment is identified as a subsidiary then consolidated financial statements are prepared. This means acquistion is applied and goodwill calculated.

But what exactly is a subsidiary?

In the majority of cases, it is easy to identify a subsidiary because the investor holds a majority of the shares of the subsidiary.

However strictly we take a principles-based approach and in simple terms a subsidiary is an entity that is controlled. So it should be understood that the definition of a subsidiary is not a number rather it is based on the principle of control.

This principles-based approach is important as creative accountants adopting a legalistic approach may wish to try and argue that an investment is not a subsidiary, on the basis that the investor’s shareholding is less than 50% and so the entity should not be consolidated. These arguments are often used where the investment is highly geared. What the creative accountant is trying to do is take the investment’s liabilities off the group balance sheet as if the investment is defined as a subsidiary their liabilities are aggregated in full in the consolidated accounts.

In determining whether an investment is a subsidiary it is important to consider substance of the relationship and not just the size of the shareholding. If an investment is really controlled, then it is a subsidiary and its income expenses assets and liabilities should be consolidated in order that there is transparency and accountability.

Control is though normally, but not exclusively, evidenced by the investor holding a majority (50% +) of the voting rights.

Let’s consider a practical scenario.

Q Singapore & City

Singapore has recently acquired 40% of the equity capital and voting rights of City.  The other 60% of City’s shares are held by a wide variety of investors, none of whom owns more than 1% individually. None of the other shareholders has any arrangements to consult any of the others or make collective decisions. Since Singapore purchased the investment it has actively participated in establishing the operating and financial policies of City.

Required:

Discuss whether City should be accounted for as a subsidiary in the consolidated financial statements of Singapore.

A Singapore & City

On a first review, Singapore does not have the power to control City because it does not have a majority of the shares and voting rights and therefore on that basis City would not be regarded as a subsidiary.

However, the defination of control (and therefore whether it is a subsidiary) is not based on a number. It is a principle.

Singapore will control City if and only if Singapore has all of the following elements:

• power over the City i.e. Singapore has existing rights that give it the ability to direct the relevant activities
• exposure, or rights, to variable returns from its involvement with City
• the ability to use its power over City to affect the amount of its returns.

Singapore will also have to consider all relevant facts and circumstances when assessing whether it controls City.

The relatively small size of the other shareholdings alone is not conclusive in determining whether Singapore has rights sufficient to give it power.

But when we consider that Singapore has established the operating and financial policies of City, it is clear that Singapore does have the power to direct City.

A holding of 40% certainly gives Singapore an exposure to the variable returns. If City does well and pay dividends, then Singapore will benefit.

Further as there are no agreements between other shareholders to block Singapore then Singapore has the ability to use it powers.

In conclusion City is therefore a subsidiary of Singapore.